Seminar on US Taxation of International Banks Sponsored by: The Institute of International Banks

Treasury Regulations Section Advanced Applications and Issues Panel: Anthony Porcaro Paul Epstein William Chip Don Favre Stuart Zwerling Credit Suisse Internal Revenue Service Covington and Burling LLP PricewaterhouseCoopers LLP Deloitte Tax LLP

Practical Considerations – Treas. Reg Section T - Elections Elections Related to Interest Expense Deduction For most elections related to calculation of interest expense deduction, requirements are generally satisfied by completing Schedule I. AUSBL vs. Separate Currency Pools Valuations of Assets – Adjusted Basis vs. Fair Market Value Actual Ratio vs. Fixed Ratio - Restricted to actual ratio if using FMV to value assets. However, to properly elect to apply the LIBOR published rate to excess liabilities, additional information is required to be attached to the tax return. Must provide source of LIBOR (annual election).

Practical Considerations – Treas. Reg Section T - Elections Protective Filers A taxpayer filing a protective tax return on Form 1120F may voluntarily file Schedule I with the tax return to preserve timely elections. To be complete, the taxpayer is only required to check the appropriate boxes for each election. Must be timely, including extension period. The protective elections are not considered timely filed if filed during the additional extended period described under Treas. Reg. Sections (a)(3).

Practical Considerations – Treas. Reg Section T - Elections Treaty Based Positions Protective interest expense allocation elections may be made for a year in which a treaty method is used by completing and filing schedule I on a timely filed tax return. If Schedule I is not filed, the taxpayer forfeits the right to make such elections for the applicable year.

Practical Considerations – Treas. Reg Section T - Elections If taxpayer fails to make any of the interest expense deduction or branch profits tax related elections in time and manner prescribed in regulations, Director of Field Operations may make binding elections on behalf of taxpayer.

Practical Considerations – Treas. Reg Section T BPT Election to Reduce Liabilities Annual Statement Requires: - Disclosure of Reduction in Liabilities - Amount of Reduction

Foreign Bank US Branch BorrowerDepositor 1. Borrow2. Lend Assumptions ¥ borrow/lend rate = 2.0%/2.1% $ borrow/lend rate = 4.0%/4.1% FX rates = $.1000 (Day 1), $.1010 (Average), $.1020 (Day 360) Buy/Sell FX 3. Repay4. Repay FX Dealer Assumptions

BorrowerDepositor 1. Borrow 2.0%2. Lend 2.1% Financial profit (loss) = (¥ ¥1020) * ($.1020) = $.102 Taxable income (loss) Interest income = (¥1000 * 2.1% = ¥ 21) * $.1010 = $2.121 Interest expense = ¥1000 * 2.0% = (¥ 20) * $.101 = ($2.020) FX gain (loan) = [(¥ ¥21) * $.1020] - [¥1000 * $.1000] - interest income = $2.021 FX loss (borrowing) = [¥1000 * $.1000] - [(¥ ¥20) * $.1020] - interest expense = ($2.020) $ ($2.202) + $ ($2.02) = $ Repay ¥ Repay ¥ Sell $.1020 = $.102 Case 1: Matched loan book (third-parties) Spot FX Dealer Foreign Bank US Branch

Financial profit (loss) = (¥ ¥1020) * ($.1020) = $.102 Taxable income (loss) Interest income = (¥1000 * 2.1% = ¥ 21) * ($.1010) = $2.121 Interest expense ( ) = $100 * 4.0% = ($4.00) FX gain (loan) = [(¥ ¥21) * $.1020] - [¥1000 * $.1000] - interest income = $2.021 FX loss (disregarded borrowing) = 0 Taxable income = $ ($4.00) + $2.021 = $.142 Borrower 1. Borrow 2.0% 2. Lend 2.1% 3. Repay ¥ Repay ¥ Sell $.102 = $.102 Case 2: Matched loan book (interbranch) Spot FX Dealer Foreign Bank US Branch

BorrowerDepositor 1. Borrow 4.0%3. Lend 2.1% Financial gain = $ $ = $.10 Taxable Income Interest income = (¥1000 * 2.1%) * ($.1010) = $2.121 FX gain (loan) = (¥1021 * $.1020) – (¥1000 * $.1000) - interest income = $2.021 FX loss (fwd) = $ – (¥1021 * $.1020) = ($.042), of which FX gain if no rate change = $ – (¥1021 * $.1000) = $2.00* FX loss due to rate change = ($.042) - $2.00 = ($2.042) Interest expense = $4.00 Taxable income = $ $ ($.042) - $4.00 = $.10 * Equates to excess of $$ and ¥¥ lending rates. 2. Buy $ Sell 104.1/1021 = $ Repay ¥ Repay $104 Case 3: Unmatched loan book (third parties) Fwd FX Dealer Spot FX Dealer Foreign Bank US Branch

Depositor 1. Borrow 4.0% 3. Lend 2.1% Spot FX Dealer Fwd FX Dealer 2. Buy $.1000 Case 4: Unmatched loan book (interbranch) 4. Repay ¥ Sell 104.1/1021 = $ Repay $104 Financial gain = $ $ = $.10 Taxable Income Interest income (disregarded) = 0 FX gain (disregarded loan) = 0 FX loss (fwd) = $ – (¥1021 * $.1020) = ($.042), of which FX gain if no rate change = $ – (¥1021 * $.1000) = $2.00 FX loss due to rate change = ($.042) - $2.00 = ($2.042) Interest expense ( ) = 0 Taxable income = ($.042) Foreign Bank US Branch

Authorities (§ ) 1992 proposed regulations: NFC gain or loss attributable to a “U.S. booked liability” must be “scaled back” to the same extent as interest deductions final regulations (preamble): “The final regulations also delete the provision in the proposed regulations that applied the scaling ratio to section 988 exchange gain or loss from an unhedged liability. The amount and source of exchange gain or loss from a section 988 transaction will therefore continue to be determined under section 988, without any reduction as a result of the scaling ratio in § ” 2006 amendments (preamble): “A foreign bank’s U.S. branch commonly books third-party liabilities denominated in non-dollar currencies and uses the proceeds to make interbranch loans. Because interbranch transactions generally are not recognized for U.S. tax purposes, the third-party liability is treated as unhedged. As noted in the preamble to the 1996 final regulations, foreign currency gain or loss from an unhedged liability remains subject to the rules of section 988. As a result, the U.S. branch may have currency gain or loss with respect to the third-party borrowing but may not be entitled to recognize currency gain or loss with respect to the offsetting interbranch transaction.”

Remedies? 1.“Don’t ask, don’t tell”? 2.“RTA” (global dealing regs)? 3.Corporate intermediary? 4.“Authorized OECD Approach”? 5.Bilateral APA? 6.Unilateral APA (Rev. Proc )? 7.NatWest?!

Overview: The Material Participation Test  If a taxpayer is engaged in a banking, financing or similar business, dividends, interest, gain or loss from stock or securities that are capital assets are treated as ECI if a US office “materially participated” in soliciting, negotiating or performing other activities required to arrange the acquisition of the stock/securities. This rule contrasts to the “asset use” or “business activities” tests that generally apply to determine effectively connected of income.

The Material Participation Test – Cont. This rule applies to stock / securities that Were acquired  In the course of making loans to the public  Distributing stock/securities to the public  To satisfy regulatory reserve requirements, or Which are securities  That are payable on demand or at a fixed maturity date not exceeding 1 year from acquisition  Issued by the US government or an agency Any other securities not described above (“(b)(3) securities”) are subject to the “10% rule”.

The 10% Rule Treas. Reg (c)(5)(ii) limits ECI treatment of the last category of securities to a fraction:  10 percent, divided by  The ratio of “(b)(3) securities” (determined by book value) over The average book value of all assets of the US office

The 10% Rule – Example  US branch originates loans and buys debt securities that are (b)(3) securities. (b)(3) securities generate interest income of $7.5 million. The (b)(3) securities represent 15% of the average book value of assets of the US office  ECI = 10% / (15% x $7.5 million)  ECI Amount is = $5 million  Non-ECI Amount is $2.5 million

TAM Facts  Taxpayer was a foreign bank.  Taxpayer was a dealer in securities and engaged in a banking, financing or similar business in the US through a branch.  Taxpayer separately ran a securities arbitrage activity.  The securities were predominantly debt securities.

TAM Conclusions  MTM treatment under Section 475 is not determinative in investment/trading analysis under Section 864 – Book treatment is a relevant fact to be considered.  Per (c)(5)(vi), the “10%” rule override applies to income from securities that are traded for Bank’s own account through U.S. trade or business.  Notwithstanding that a security generates income that is wholly ECI as a result of the 10% rule override, such security is included in the numerator of the denominator of the 10% rule formula.

TAM Example $1 billion in average book value of assets of the US office. $50 million in (b)(3) securities – held for investment – Such securities generate $2.5 million in interest income. $150 million in (b)(3) securities – held for trading – such securities generate $8 million in interest income.

TAM – Example Cont. 10% rule formula is: 10% divided by $50 million + $150 million ($200 million) divided by $1 billion 10% / ($200 million/$1 billion) = 50% 50% of $2.5 million and 50% of $8 million is ECI However as a result of the 10% rule override 100% of the $8 million is ECI.

TAM Facts  Taxpayer was a foreign bank with a US branch.  Taxpayer ran a securities arbitrage activity.  To help increase regulatory capital, Taxpayer set up a partnership, sold interests to third parties and caused the partnership to acquire some debt securities previously held in the arbitrage activity.  Partnership was engaged in an investment management activity and at no time was the partnership engaged in a US trade or business.

TAM Facts Preferred Interest Bank (Common Interest) LLC - (b)(3) Securities Cash (b)(3) Sec.

TAM Conclusions Taxpayer’s interest in P-ship is not tested as a separate entity- level asset under the asset use, business activities or material participation tests. An aggregate approach should be used. Since Taxpayer was engaged in a banking finance or similar business within the U.S. the Taxpayer’s interest in the Partnership using the aggregate approach is evaluated using the material participation test and not the asset use or business activities tests. Securities can be converted from trading securities to investment securities when sold to the partnership. Taxpayer’s distributive share of partnership income was divided by total partnership income to determine the partnership’s total assets and (b)(3) securities to be used in the 10% rule formula.