Institute of International Bankers Seminar on U.S. Taxation of International Banks June 18-19, 2007 Panel on Global Dealing and Attribution of Profits Chair Todd Tuckner Managing Director, Head of Tax (Americas) UBS Stamford, CT Government Speakers Steven A. Musher Associate Chief Counsel (Int’l) Internal Revenue Service Paul Epstein Senior Technical Reviewer, Branch 5 Office of the IRS Associate Chief Counsel (Int’l) Private Sector Speakers Bill Chip Covington & Burling Washington, D.C. Hal Hicks Skadden Washington, D.C. Phil West Steptoe & Johnson Washington, D.C.

2 Overview Introductions General Comments from IRS –Final OECD PE Reports –Reg Status –Other Examples –Inbound dealing with split hedging Source, ECI, Profit Attribution, 482, and related issues Treatment of foreign branch liabilities funding ECI and non-ECI activities –Hedge fund management in US –Globally traded non-dealer assets booked in US branch Q&A

3 Inbound Dealing With Split Hedging

4 Foreign Bank Parent - books customer derivatives –Serves as counterparty –Bears capital risk –Provides certain back-office functions in home office and U.S. banking branch U.S. Regulated Broker Dealer – books hedges –Provides all customer trading services as agent for foreign parent –Bears no risk of loss –Assume alternative dependent and independent agent status of U.S. broker-dealer

5 Inbound Dealing With Split Hedging Net profits are determined on combined derivatives and hedging books Residual profit split TPM? Cash/book transfer mechanism: –FB compensates US BD using TPM based on fixed percentage of net profits –Losses not cash transferred into US BD.

6 Alternative Transfer Pricing Analysis Profit Split Method –Routine returns Return to capital (Prop. Reg. § (e)) Back office functions (Reg. § T) –Comparability on return to capital Percentage of Profits (hedge fund model) –See “Role of Capital” discussion in OECD Attribution Report, Part III, Para Ex ante projection of returns on comparable expected risks

7 Example: Hypothetical Profit Calculation Foreign BankUS BDTotal Derivatives - MTM gains $1, ,500 Derivatives - Periodic Inc Cost of Carry (400) (400) Hedges - MTM losses -0- (800) (800) Hedges - FDAP income Cost of Carry -0- (400) (400) Total 1,600(1,000) 600

8 Example Assumptions Routine return to capital: 30% of profits Routine back office amount: –$100 (cost plus 10%) total –$50 each to home office and U.S. PE based on actual cost and value in each location US BD earns all of the residual profit –Assumption based on the fact that all front office, non-routine marketing and sales, trading, risk management functions are performed by US BD

9 Example Sec. 482, Treaty Analysis Foreign BankUS BDTotal Routine functions: Return to Capital $180 (30% x $600) Operations functions 100 (Cost plus 10%) Residual functions: Total Booked Amounts 1,600(1,000)600 Compensating Adjustments (1,320)1,320-0-

10 ECI Analysis Profits of foreign bank must be allocated between the bank's home office and its US branch –Use source and allocation rules of sections Allocate and source derivative income, gain, loss under Prop. Reg. § If allocated and sourced US: –ECI under 864(c)(3)? FB has US banking branch –Prop. Reg. §§ (c)(2), (c)(3) and (c)(5)(vi) refine "all or nothing" treatment under current 864(c) regulations. Under proposed regulations, cost of carry ignored and interest expense substituted under sec

11 Issues Contrast treaty and Code results Treatment of losses –When not passed down –When shared Regulatory issues associated with compensating adjustments –From FB to US BD? –From US BD to FB? Could occur if book amounts reversed (e.g., b/c derivatives in BD and hedges in FB) Availability of alternative methods

12 Issues Cost of carry –Reg sec (a)(1)(ii): Not available to allocate directly –OECD Report: may be allocated if arm’s length compensation of treasury function Even if interdesk/interbranch amount Subject to equity allocation Equity allocation –Prop global dealing regs: reg. sec applies –Cost of carry under AOA qualified treaty (e.g., UK, Japan) See OECD Report Part II (para. 120, Annex para. 4-5) for US approach –US Model TE (Art. 7(3)): Permits sec step 2 principles, in lieu of risk weighting (i.e., 5% fixed ratio imputation on cost of carry may be elected)

13 Inbound Dealing With Split Hedging Treatment of foreign branch liabilities funding ECI and non-ECI activities

14 Treatment of Foreign Branch Liabilities Funding ECI and non-ECI Activities If non-global dealing book, issue is whether book as a whole gives rise to U.S. booked liabilities within the meaning of (d)(2)(iii) (applicable to banks) or (ii) (applicable to non-banks). If so, all liabilities are U.S. booked liabilities, giving rise to U.S. source interest –If U.S. booked interest is less than interest, excess interest can result –If U.S. booked interest is more than interest, (b)(6) may treat it as not paid by the branch; TP may specifically identify it in its books and records up to the due date of the return under (b)(6)(iii) Whether book is ECI generator is a matter of "facts and circumstances“ Rule not intended to require tracing of liabilities to specific assets U.S. trade or business need not acquire the liabilities. –Branch participation rule for liabilities temporarily adopted in Notice and the 1992 final regulations, but removed in Anti-abuse rule could throw a liability out if acquired to raise the overall average borrowing rate of the U.S. trade or business. Global dealing book?

15 Hedge Fund Management in US

16 Hedge Fund Management in US Availability of 864(b) safe harbor –What if hedge fund deals in loans? Trading vs. originating –What if hedge fund is a fund of funds? –Impact on safe harbor of agent activity –If ETB through a PE, application of: Global dealing regs Treaties Material participation regs (if debt securities)

17 Hedge Fund Management in US Effect on analysis of partner being ETB through U.S. branch? Can fund take position it is an investor, not a trader, and not in a trade or business? –Impact of favorable result here on pass through of expenses as 162 item? Impact of 1446 hit to partnership results What if hedge fund invests in derivatives? –Prop. Reg (b)-1 extends safe harbor to derivatives if hedge fund is not a dealer. Legislative activity

18 Globally Traded Non-Dealer Assets Booked In US Branch

19 Globally Traded Non-Dealer Assets Booked In US Branch Proposed regs n/a to non-dealer assets? Treaty vs. regs: –Treaty (UK and Japan) Under UK and Japanese treaty, then the Authorized OECD Approach is available, but must be used consistently for the entire branch, not just the trading operation. Base differences result between Code and treaty? –Regs (other countries) If assets are debt securities, material participation test applies? See reg. sec (c)(5)(iii). If branch materially participates in acquisition, 100% ECI instead of profit split? If home office acquires securities, 100% non-ECI even if booked and/or disposed of through the branch? Inapplicability of the 10% rule? See reg. sec (c)(5)(vi) Authorization for equitable split income/split asset approach in a trading (non-banking trade or business) context