Are convertible bonds and credit linked notes held by an international banking facility treated as loans for Article 32 IBF purposes?

Plain-English summary

Commonwealth Bank of Australia operated an international banking facility (IBF) that invested in convertible bonds (bonds with an embedded equity call option) and credit linked notes (CLNs) issued by special-purpose vehicles in synthetic securitizations. It asked whether those instruments are "loans" of an IBF under Tax Law section 1453(f)(2)(A).

The Department held:

• A convertible bond held by the IBF is treated as a loan under section 1453(f)(2)(A) and 20 NYCRR section 18-3.2(k) for the period the bond is held and the related asset is recorded in the IBF's financial accounts.
• After analyzing the purpose and use of CLNs (including federal banking-regulator guidance on synthetic CLOs), the Department held that a CLN invested in by the IBF is likewise treated as a loan for that section while the IBF holds it and records the asset.
• Important caveat: the opinion makes no determination on whether the income attributable to those convertible bonds and CLNs is eligible gross income of the IBF -- that must be decided under section 1453(f)(2) and 20 NYCRR section 18-3.4.

What this means for you

Some structured instruments count as IBF "loans"

For Article 32 purposes, an IBF that invests in convertible bonds or credit linked notes is treated as holding loans under section 1453(f)(2)(A) while it holds the instrument and books the related asset -- the Department looked at economic substance, not just the label.

"Treated as a loan" is not the same as "income is eligible"

The opinion stops at characterizing the asset. Whether the income from those instruments is eligible gross income of the IBF (the part that drives the IBF tax benefit) is a separate question under section 1453(f)(2) and was left open.

Holding period and books matter

The loan treatment applies only while the IBF holds the instrument and records the related asset in its accounts.

Common questions

Q: Are convertible bonds held by an IBF treated as loans?
A: Yes, under section 1453(f)(2)(A) and 20 NYCRR section 18-3.2(k), while the IBF holds the bond and records the asset.

Q: What about credit linked notes (CLNs)?
A: Same result -- a CLN invested in by the IBF is treated as a loan for that section while held and booked.

Q: Does that mean the income is automatically eligible IBF income?
A: No. The opinion did not decide income eligibility; that is tested separately under section 1453(f)(2).

Citations and references

Statutes, regulations, and authorities:
- Tax Law section 1453(f)(2)(A) (international banking facility; loans)
- Tax Law section 1453(f)(2) (eligible gross income of an IBF)
- 20 NYCRR section 18-3.2(k) (IBF loans)
- Commonwealth Bank of Australia, TSB-A-03(1)C (Apr. 4, 2003)

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/corporation_ao_2003.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/corporation/a03_1c.pdf

Original ruling text

New York State Department of Taxation and Finance

Office of Tax Policy Analysis
Technical Services Division

TSB-A-03(1)C
Corporation Tax
April 4, 2003

STATE OF NEW YORK
COMMISSIONER OF TAXATION AND FINANCE
ADVISORY OPINION

PETITION NO. C010605A

On June 5, 2001, a Petition for Advisory Opinion was received from Commonwealth Bank
of Australia, 599 Lexington Avenue, 17th Floor, New York, New York 10022.
The issue raised by Petitioner, Commonwealth Bank of Australia, is whether convertible
bonds and credit linked notes are loans of an international banking facility (“IBF”) for purposes of
section 1453(f)(2)(A) of Article 32 of the Tax Law.
Petitioner submits the following facts as the basis for this Advisory Opinion.
An IBF invests in convertible bonds. It also invests in credit linked notes (CLNs) that are
issued by a special-purpose vehicle (SPV).
Petitioner states that a convertible bond gives its owner the option to exchange the bond for
a predetermined number of common shares. The convertible bondholder hopes that the issuing
company’s share price will go up so that the bond can be converted for a profit. But if the shares
go down, there is no obligation to convert; the bondholder remains just that. A convertible bond is
a bond with an equity call option embedded in it and is therefore like a package of a corporate bond
and a warrant. Because of the embedded call option, the coupon rate is below market. When the
owner of a convertible bond wishes to exercise its option to buy shares, the owner does not pay cash,
it just gives up the bond.
Petitioner describes a CLN as follows. The credit risk of loans on the originating bank’s
balance sheet is transferred to the securitization SPV via the sale of individual single name CLNs
rather than the assignment or participation of the loans themselves. The SPV purchases the CLNs
from the originating bank, and the credit premium from this portfolio of notes is used to pay the
required risk premium to investors on the risk tranches of the synthetic securitization. The investor
receives the coupon and par redemption provided there has been no credit event. The value of a
CLN as opposed to a traditional sale or participation of assets is that: (a) the structure is confidential
with respect to the bank’s customers; (b) the CLN or credit swaps terms generally allow the bank
the flexibility to use the contract as a hedge for any senior obligation of the reference obligors
(including loans, bonds, derivatives, receivables and so on), and (c) specific asset due diligence
regarding transfer to the SPV can be avoided.
For example, a foreign bank buys European corporate bonds. The bank sets up a SPV and
transfers the credit risk with respect to the bonds to such SPV. The SPV then issues the CLNs which
the IBF invests in.

-2­
TSB-A-03(1)C
Corporation Tax
April 4, 2003

Applicable Law and Regulations
Section 1453(f) of the Tax Law provides for a deduction in determining entire net income
for the adjusted eligible net income of an IBF. Section 1453(f)(1) of the Tax Law provides that the
eligible net income of an IBF “shall be the amount remaining after subtracting from the eligible
gross income the applicable expenses.”
Section 1453(f)(2) of the Tax Law provides:
Eligible gross income shall be the gross income derived by an international
banking facility from:
(A) making, arranging for, placing or servicing loans to foreign persons,
provided, however, that in the case of a foreign person which is an individual, or
which is a foreign branch of a domestic corporation (other than a bank), or which is
a foreign corporation or foreign partnership which is eighty per centum or more
owned or controlled, either directly or indirectly, by one or more domestic
corporations (other than banks), domestic partnerships or resident individuals,
substantially all the proceeds of the loan are for use outside of the United States;
(B) making or placing deposits with foreign persons which are banks or
foreign branches of banks (including foreign subsidiaries or foreign branches of the
taxpayer) or with other international banking facilities; or
(C) entering into foreign exchange trading or hedging transactions related to
any of the transactions described in this paragraph.
Section 18-3.2 of the Franchise Tax on Banking Corporations Regulations (Regulations)
provides the meaning of certain terms for purposes of Subpart 18-3 of the Regulations dealing with
IBFs. Section 18-3.2(k) of the Regulations provides that “The term loan means any loan, whether
the transaction is represented by a promissory note, security, acknowledgment of advance, due bill,
repurchase agreement or any other form of credit transaction, if the related asset is recorded in the
financial accounts of the IBF.”
Opinion
Where an IBF invests in a convertible bond, as described above, such convertible bond
would be treated as a loan under section 1453(f)(2)(A) of the Tax Law and section 18.3-2(k) of the
Regulations for the period of time that the bond is held by the IBF and the related asset is recorded
in the financial accounts of the IBF.
Before a determination can be made regarding the CLNs, a discussion about their purpose
and use is necessary. Joint Office of the Comptroller of the Currency (OCC) and Federal Reserve

-3­
TSB-A-03(1)C
Corporation Tax
April 4, 2003
Board Issuance on Credit Derivatives, “Capital Interpretations – Synthetic Collateralized Loan
Obligations,” dated November 15, 1999 (OCC Banking Bulletin 99-43, December 1999) describes
synthetic securitizations including CLNs that are issued as part of such securitizations. This
document notes that credit derivatives are being used to synthetically replicate collateralized loan
obligations (CLOs), and that credit derivatives are on- and off-balance sheet financial instruments
that permit banking organizations to assume or transfer credit risk on a specified or “referenced”
asset or pool of assets. The document provides, in part:
In some recent synthetic CLOs, the sponsoring banking organization uses a
combination of credit default swaps1 and CLNs2 to essentially transfer to the capital
markets the credit risk of a designated portfolio of the organization’s credit
exposures. Such a transaction allows the sponsoring institution to allocate economic
capital more efficiently and to significantly reduce its regulatory capital
requirements.
In this structure, the sponsoring banking organization purchases default
protection from an SPV for a specifically identified portfolio of banking book credit
exposures, which may include letters of credit and loan commitments. The credit
risk on the identified reference portfolio (which continues to remain in the sponsor’s
banking book) is transferred to the SPV through the use of credit default swaps. In
exchange for the credit protection, the sponsoring institution pays the SPV an annual
fee. The default swaps on each of the obligors in the reference portfolio are
structured to pay the average default losses on all senior unsecured obligations of
defaulted borrowers.
In order to support its guarantee, the SPV sells CLNs to investors and uses
the cash proceeds to purchase U.S. Government Treasury notes. The SPV then
pledges the Treasuries to the sponsoring banking organization to cover any default
losses.3 The CLNs are often issued in multiple tranches of differing seniority and in
an aggregate amount that is significantly less than the notional amount of the
reference portfolio. The amount of notes issued typically is set at a level sufficient

1

A credit default swap is similar to a financial standby letter of credit in that the
institution writing the swap provides, for a fee, credit protection against credit losses associated
with a default on a specified reference asset or pool of assets.
2

CLNs are obligations whose principal repayment is conditioned upon the performance
of a referenced asset or portfolio. The assets’ performance may be based on a variety of
measures, such as movements in price or credit spread, or the occurrence of default.
3

The names of corporate obligors included in the reference portfolio may be disclosed to
investors in the CLNs.

-4­
TSB-A-03(1)C
Corporation Tax
April 4, 2003
to cover some multiple of expected losses, but well below the notional amount of the
reference portfolio being hedged.
There may be several levels of loss in this type of synthetic securitization.
The first-loss position may be a small cash reserve, sufficient to cover expected
losses, that accumulates over a period of years and is funded from the excess of the
SPV’s income (i.e., the yield on the Treasury securities plus the credit default swap
fee) over the interest paid to investors on the notes. The investors in the SPV assume
a second-loss position through their investment in the SPV’s senior and junior notes,
which tend to be rated AAA and BB, respectively. Finally, the sponsoring banking
organization retains a high quality senior risk position that would absorb any credit
losses in the reference portfolio that exceed the first- and second-loss positions.
Typically, no default payments are made until the overall transaction’s
maturity, regardless of when a reference obligor defaults. While operationally
important to the sponsoring banking organization, this feature has the effect of
ignoring the time value of money.
*

*

*

For risk-based capital purposes, banking organizations investing in the notes
must assign them to the risk weight appropriate to the underlying reference assets.4
*

*

*

The sponsoring institution must be able to demonstrate that virtually all of
the credit risk of the reference portfolio has been transferred from the banking book
to the capital markets.
*

*

*

A failure on the part of the sponsoring banking organization to require the
investors in the CLNs to absorb the credit losses that they contractually agreed to
assume may be considered an unsafe and unsound banking practice....
Financial Accounting Standards Board Statement of Financial Accounting Standards
No. 125 Accounting for Transfers and Servicing of Financial Assets and Extinguishments of
4

Under this type of transaction, if a structure exposes investing banking organizations to
the creditworthiness of a substantive issuer, e.g., the sponsoring institution, then the investing
institutions should assign the notes to the higher of the risk categories appropriate to the
underlying reference assets of the sponsoring institution.

-5­
TSB-A-03(1)C
Corporation Tax
April 4, 2003
Liabilities paragraph 26, (FAS125, par.26) describes a qualifying special-purpose entity for purposes
of paragraph 9 of FAS125, which addresses the accounting treatment for transfers and servicing of
financial assets. Such FAS125, paragraph 26 provides that:
A qualifying special-purpose entity5 must meet both of the following
conditions:
a. It is a trust, corporation, or other legal vehicle whose activities are
permanently limited by the legal documents establishing the special-purpose entity
to:
(1)
(2)

(3)

(4)

Holding title to transferred financial assets
Issuing beneficial interests (If some of the beneficial interests are in
the form of debt securities or equity securities, the transfer of assets
is a securitization.)
Collecting cash proceeds from assets held, reinvesting proceeds in
financial instruments pending distribution to holders of beneficial
interests, and otherwise servicing the assets held
Distributing proceeds to the holders of its beneficial interests.

b. It has standing at law distinct from the transferor. Having standing at law
depends in part on the nature of the special-purpose entity. For example, generally,
under U.S. law, if a transferor of assets to a special-purpose trust holds all of the
beneficial interests, it can unilaterally dissolve the trust and thereby reassume control
over the individual assets held in the trust, and the transferor “can effectively assign
his interest and his creditors can reach it.”6 In that circumstance, the trust has no
standing at law, is not distinct, and thus is not a qualifying special-purpose entity.
Based on the Petitioner’s description of CLNs and the discussion of their purpose and usage
above, where an IBF invests in a CLN, such CLN would be treated as a loan for purposes of section
1453(f)(2)(A) of the Tax Law and section 18-3.2(k) of the Regulations for the period of time that
the IBF holds the CLN and the related asset is recorded in the financial accounts of the IBF.
No determination is made in this advisory opinion as to whether the income that an IBF
receives that is attributable to its investments in convertible bonds and CLNs, as described above,

5

The description of a special-purpose entity is restrictive. The accounting for transfers
of financial assets to special-purpose entities should not be extended to any entity that
does not satisfy all of the conditions articulated in this paragraph.

6

Scott’s Abridgement of the Law on Trusts, 156 (Little, Brown and Company, 1960),
296.

-6­
TSB-A-03(1)C
Corporation Tax
April 4, 2003
will constitute eligible gross income of the IBF. Such determination must be made pursuant to the
requirements of section 1453(f)(2) of the Tax Law and section 18-3.4 of the Regulations.

DATED: April 4, 2003

NOTE:

/s/
Jonathan Pessen
Tax Regulations Specialist IV
Technical Services Division

The opinions expressed in Advisory Opinions are
limited to the facts set forth therein.