The Global Shadow Bank – Systemic Risk and Tax Policy Objectives: The Uncertain Case of Foreign Hedge Fund Lending to U.S. Borrowers and Transacting in U.S. Debt Securities

With the recent financial crisis in the U.S. starting in 2007, much attention has been drawn to the issue of whether and to what extent financial regulation should keep pace with financial innovation and the shadow banking system. However, often ignored is the Internal Revenue Code’s failure to adequately keep pace with financial innovation. One example of how the tax laws lag behind financial innovation can be found in foreign persons lending to U.S. borrowers and transactions in U.S. debt securities. Most of the U.S. federal income tax law governing this area was written before complex shadow banking transactions and sophisticated debt products were even contemplated. This leaves a great deal of uncertainty about how the tax laws should be interpreted and applied. In order to analyze these uncertainties and their potential affects in more detail, I will concentrate on financial innovation in the hedge fund industry – focusing on foreign hedge fund lending to U.S. borrowers or transacting in U.S. debt securities.First, Part II will identify how certain tax laws lag behind shadow bank transactions that are becoming more and more commonplace. I will explore typical foreign hedge fund lending and U.S. debt securities transactions and demonstrate how the current law provides inadequate guidance as to how these transactions will be taxed. Part III will discuss why it may be absolutely vital to fix this problem – suggesting that we should consider the possibility that this kind of uncertainty in the taxation of certain shadow bank transactions may increase systemic risk making the U.S. financial system more fragile. Whether hedge funds are systemically important because of their interconnectedness to the financial system and credit channels is currently being discussed at the highest levels of our government. I posit that we should at the very least also consider whether tax uncertainty in the transactions that create the interconnectedness and credit channels increases systemic risk. Part IV will look at the tax policy reasons for the current law‘s enactment and posits that the existing uncertainty frustrates these very tax policy goals.Finally, Part V will contend that no matter what rules or standards policymakers adopt to fix the problem in this area, the rules or standards should get to the substance of the transactions and not merely the form. In order to adopta substantive approach, the IRS needs more information about foreign funds and their transactions. It seems to me that we should at least consider the use of two disclosure regimes being fashioned as this is being written that will potentially already be applied to certain foreign persons for other purposes – (i) the FATCA provisions of the Hiring Incentives to Restore Employment Act of 2010 to capture U.S. persons attempting to evade U.S. tax via foreign vehicles and (ii) the disclosure and reporting provisions applied to certain nonbank financial institutions and investment advisors under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 in the regulatory arena. In fact, these new tools, if applied in this area, may be instrumental not only to the implementation of rules or standards in this area but also to the issue of what the rules or standards should be based on what has the potential to be effectively implemented. It’s time to face the global shadow banking system – both with respect to how we want to regulate it and with respect to how we want to tax it.