TAX AND DEBT MANAGEMENT ASPECTS OF H.R. 1505 (THE FINANCIAL INSTITUTIONS SAFETY AND CONSUMER CHOICE ACT OF 1991) Scheduled for a Hearing before the COMMITTEE ON WAYS AND MEANS on May 29, 1991 Prepared by the Staff of the JOINT COMMITTEE ON TAXATION May 24, 1991 JCX-7-91 . CONTENTS Page INTRODUCTION 1 I. OVERVIEW OF H.R. 1505 2 A. Modification of Regulation of Financial Institutions 2 B. Reform of the Deposit Insurance Program ... 3 C. Infusion of Funds into the Bank Insurance Fund of the Federal Deposit Insurance Program 4 D. Expanded Bank Powers 5 II. PRESENT-LAW RULES RELATING TO BANKS AND OTHER FINANCIAL INSTITUTIONS 7 A. Use of Social Security Numbers to Enforce Deposit Insurance Limitations 7 B. Tax Treatment of Commercial Banks 7 1. Bad debt reserves 8 2. Interest on debt used to purchase or carry tax-exempt bonds 10 3. Foreign activities of U.S. banks and U.S. activities of foreign banks 11 a. Foreign income of U.S. financial institutions 11 b. U.S. income of foreign financial institutions 16 4. Character of certain indebtedness .... 18 5. Net operating loss carryovers 20 6. Common trust funds 20 C. Tax Treatment of Thrift Institutions 22 1 Bad debt reserves 23 2. Deductibility of dividends by thrift institutions 25 3. Foreclosure of property securing loans 26 D. Tax Treatment of Life Insurance Companies and Beneficiaries 27 1. Taxation of life insurance companies.. 27 2. Taxation of owners and beneficiaries of life insurance contracts and annuity contracts 30 E, Tax Treatment of Other Entities Engaged in Financial Activities 32 1. Credit unions 32 2. Regulated investment companies 32 3. Real estate investment trusts 33 4. Real estate mortgage investment conduits 34 5. Small business investment companies... 34 6. Other sources of consumer credit 35 III. PRINCIPAL ISSUES TO THE WAYS AND MEANS COMMITTEE RAISED BY H.R. 1505 36 INTRODDCTION The House Committee on Ways and Means has scheduled a public hearing on May 29, 1991, to review the tax and debt management aspects of the Administration proposal to recapitalize the bank insurance system, modify the regulation of banks and other depository institutions, and expand allowable activities of banking corporations. The hearing will focus on H.R. 1505, the Financial Institutions Safety and Consumer Choice Act of 1991, introduced by Messrs. Gonzalez and Wylie on March 20, 1991. H.R. 1505 was jointly referred to the Committee on Banking, Finance, and Urban Affairs, the Committee on Energy and Commerce, and the Committee on Ways and Means. This document,^ prepared by the staff of the Joint Committee on Taxation, provides a brief description of H.R. 1505 (Part I), the present tax rules applicable to banks and other financial institutions (Part II), and the principal tax and debt management issues within the jurisdiction of the Committee on Wa.ys and Means that are raised by H.R. 1505 (Part III). ^ On May 23, 1991, the Subcommittee on Financial Institutions, Regulation and Insurance forwarded H.R. 1505, as amended, to the full Committee on Banking, Finance and Urban Affairs. ^ This document may be cited as follows: Joint Committee on Taxation, Tax and Debt Management Aspects of H.R. 1505 the ( Financial Institutions Safety and Consumer Choice Act of 1991) (JCX-7-91), May 24, 1991. -2- I. OVERVIEW OF H.R. 1505 On March 20, 1991, the Administration's proposal for recapitalizing and modifying the Federal Deposit Insurance System was introduced in H.R. 1505 (the Financial Institutions Safety and Consumer Choice Act of 1991), and was referred jointly to the Committee on Banking, Finance, and Urban Affairs, the Committee on Energy and Commerce, and the Committee on Ways and Means. In general, the proposed legislation would (1) significantly modify the regulation of financial institutions, (2) reform the deposit insurance system, (3) provide for the infusion of funds into the bank insurance system, and (4) expand the powers of banks. A. Modification of Regulation of Financial Institutions The proposed legislation would create a new agency within the Treasury Department, to be known as the Office of Depository Institutions Supervision, which would oversee the operations of Federally chartered banks, savings and loan associations, their holding companies and their subsidiaries. This new agency would perform the regulatory functions now performed by the Office of the Comptroller of the Currency and the Office of Thrift Supervision. The bill would amend the Internal Revenue Code to reflect the change in names to be made by the bill. State-chartered banks, their holding companies and subsidiaries would be supervised by the Federal Reserve. Except for exemptions granted by the Federal Deposit Insurance Corporation (FDIC) to well-capitalized banks, all State-chartered banks and their subsidiaries would be prohibited from engaging in activities in which Federally-chartered banks could not engage. The proposed legislation would impose new criteria for examining banks based on the capital level and size of the bank. The FDIC would retain its authority to examine insured banks. In general, the FDIC would be required to make an on-site examination at least once each year (once each 18-months in the case of small well-capitalized banks). The FDIC would be granted the power promptly to take over any bank that is poorly capitalized. Corrective action could include cuts in dividend rates. Under the bill, credit unions would remain separately regulated and insured by the National Credit Union Administration (NCUA). However, the bill would provide that the Director of the Office of Depository Institutions Supervision would be one of members of the Board of Directors of the NCUA. . -3- B. Reform of the Deposit Insurance Program Insurance limits Under the bill, individual depositors would be covered by Federal deposit insurance to a maximum of $100,000 per individual per institution, plus an additional coverage of $100,000 per individual per institution for retirement savings e.g IRAs). The bill would enforce this limitation ( , by requiring that all bank accounts (including non-interest bearing accounts) insured by the FDIC be identified by account owner's taxpayer identification number i.e. the ( , individual's social security number) or employer identification number. In addition, the FDIC would be required to conduct a study on the feasibility of implementing a system of deposit insurance based on a nationwide limitation in deposit insurance for each depositor, utilizing the taxpayer identification number to identify each depositor in the deposit insurance system. Under the bill, assets held in a revocable trust and certain escrow accounts would be aggregated with other deposits of the grantor of the trust. Irrevocable trusts would be treated under the bill as separate benefi-ciaries with each trust eligible for $100,000 of insurance. The bill generally would deny so-called "pass-through coverage" so that entities with multiple beneficiaries e.g. ( , pension trusts) would be insured only to a maximum of $100,000, instead of $100,000 per beneficiary that is provided under present law. The bill would deny pass-through coverage to bank investment contracts (BICs). Under a special rule, an exception would be provided for self-directed defined contribution pension plans e.g. ( , Keogh plans), but these amounts would be combined with other retirement amounts of that insured individual as part of that individual's $100,000 insurance limitation for retirement benefits. The bill would retain pass-through coverage to State and local government pension plans (under Code sec. 457) . The bill would provide that insurance would not be provided to brokered deposits unless extending coverage to brokered deposits would lower the costs to the FDIC of providing insurance coverage to depc itors of a problem bank. In order to minimize insurance risks, undercapitalized banks would not be permitted under the bill to solicit deposits by offering interest rates significantly higher than other insured institutions in the normal market area. The bill would deny insurance to foreign deposits. Uninsured deposits of large banks ("Too big to fail") The FDIC would be explicitly prohibited by the bill from -4- providing insurance to uninsured deposits unless (1) the FDIC finds that coverage of all accounts would be less costly than paying off only insured accounts or (2) the Federal Reserve Board and the Treasury Department find that failure to protect all depositors would pose a "systemic risk." C. Infusion of Funds into the Bank Insurance Fund of the Federal Deposit Insurance Program FDIC borrowing authority The bill would grant the FDIC the authority to borrow up to $25 billion from the Federal Reserve System. The stated purpose of such loans would be to fund existing losses of insured institutions. Such loans are to bear interest equal to rates on Treasury securities with comparable maturities and must be secured by dedicated increases in bank insurance premiums in amounts sufficient to service and retire the debt in accordance with its terms. This borrowing authority would be in addition to existing authority of the FDIC to borrow from the Treasury and the Federal Financing Bank. These loans would have the full faith and credit of the Federal Government but probably would not be subject to the Federal debt limit. The bill also would provide that any borrowings by the FDIC from the Treasury under the $5 billion of borrowing authority of present law would be treated as an increase in the net worth of the FDIC. Consequently, any such borrowings could permit additional FDIC borrowings of $45 billion under the present law provision that permits FDIC borrowings of up to 9 times the FDIC's net worth. The stated purpose of these borrowings would be to provide the FDIC with adequate working capital. These loans also would be backed by the full faith and credit of the Federal Government. Both of these borrowings would be exempt from the "pay-as-you-go" restrictions of the Omnibus Budget Reconciliation Act of 1990. ^ On May 7, 1991, the Subcommittee on Financial Institutions, Supervision, Regulation and Insurance of the Committee on Banking, Finance, and Urban Affairs forwarded H.R. 2094, as amended, to the full Committee on Banking, Finance and Urban Affairs. H.R. 2094 would provide for $25 billion of increased borrowing by the FDIC directly from the Treasury (for a total borrowing authority of $30 billion) and limits the amount of other direct borrowing that the FDIC would be able to do. -5- Insurance premiums The bill would permit the FDIC to assess insurance premiums based on a bank's relative risk position. The risk position of a bank would be measured primarily by the ratio of the bank's capital to the bank's risk-weighed assets. Banks' insurance premiums (including any risk-based insurance premium) would be capped under the bill at $.30 per $100 of deposits. D. Expanded Bank Powers Types of permitted holding companies The bill would grant additional powers to banks depending upon how the bank is owned. The bill would permit banks to be held in two different types of holding companies. In a "financial services holding company", a holding company (which is not itself a bank) could own banks, insurance companies, and brokerage houses. In a "diversified holding company", a bank could be held indirectly through a financial services holding company which, in turn, could be held by the diversified holding company so long as "the bank is well-capitalized. The bill would amend the Internal Revenue Code to reflect the change in names of holding companies to be made by the bill. Banks would be allowed to own subsidiaries that engage in certain activities, such as sales of insurance, subject to regulation of those activities in the subsidiaries. Rules applicable to transactions between members of the same holding company ("firewalls") The bill would put limits on loans by a bank to other members of that bank's financial services holding company group and would prohibit all loans to other members of that bank's diversified holding company group. Where a bank does not have adequate capital, the bill would require the financial services holding company either build up the bank's capital, sell the bank, divest themselves of the non-bank financial activities, or subject the holding company itself to the capital requirements and regulation applicable to banks. The bill would grant regulatory authority to prevent use of insured deposits to gain a competitive advantage in other financial services activities over competing firms. The bill also would require strict disclosure to insure that customers of non-banking service companies are not misled due to the presence of an insured institution within the affiliated group that the non-banking services also are insured. -6- Interstate banking The bill would permit a financial services holding company to purchase a bank in any State. The bill also would permit both Federal and State chartered banks to open initial branches in any State. New types of permitted businesses Under the bill. Federally-chartered banks would be permitted to sell directly insurance in any state where State-chartered banks in that State also are permitted to sell insurance. In other States, the bill would allow the sale of insurance through bank subsidiaries. As indicated above, the bill would permit insurance companies to be owned by a financial service holding company. The bill would require that sales of securities be done through an affiliate of a financial service holding company. The bill would restrict participants of bank common trust funds to trusts and other assets held in a fiduciary capacity. Section 245(d) of the bill would amend the Internal Revenue Code to provide that transfer of all or substantially all of the assets of a common trust fund to a mutual fund by merger, conversion, reorganization, or similar transaction would be tax-free. The bill generally would require that all real estate development and brokerage be done by an affiliate of a diversified holding company. Nonetheless, the bill would permit State-chartered banks to continue existing real estate brokerage activities. -7- II. PRESENT-LAW ROLES RELATING TO BANKS AND OTHER FINANCIAL INSTITUTIONS A. Dse of Social Security Numbers to Enforce Deposit Insurance Limitation Under regulations issued by the Federal Deposit Insurance Corporation (FDIC), deposits maintained in a bank insured by the FDIC are identified by the name of the individual account holder and are insured according to the "rights and capacities" in which they are held. There rights and capacities are set out in FDIC regulations. The FDIC currently relies upon the insured depository institution's records when determining the amount of insurance available to a depositor. The FDIC presumes that funds are owned as shown on the "deposit account records" of the insured depository institution. If the FDIC determines that the deposit account records are unambiguous, those records are binding on the depositor. No other records are considered in determining legal ownership. "Deposit account records" are account ledgers, signature cards, CDs, passbooks, and certain computer records. The Interest and Dividend Compliance Act enacted in 1983 requires that each interest bearing account include the owners taxpayer identification number. Institutions are required to report annually to the Internal Revenue Service the amount of interest earned by each depositor along with the depositor's taxpayer identification number. The FDIC does not rely on taxpayer identification numbers in determining deposit insurance coverage. Insurance is based upon actual ownership of the deposited funds and tax identification numbers are not necessarily conclusive as to ownership. B. Tax Treatment of Commercial Banks The Federal income tax rules that apply to most corporations under present law also generally apply to corporations that operate as commercial banks. In addition, however, certain special rules apply to banks. The most important of these special rules are: (1) the treatment of bad debt reserves of "small banks"; (2) the treatment of interest expense on debt used to purchase or carry tax-exempt bonds; (3) the taxation of foreign activities of U.S. banks and U.S. activities of foreign banks; (4) the treatment of gain or loss on securities as ordinary gain or loss; (5) the carryover period for net operating losses; and (6) the treatment of common trust funds of banks. For purposes of some of the special rules, a "bank" generally is defined as a bank or trust company incorporated