Keywords: IRS, Inland Revenue Service, 10% securities rule, fractional taxation, foreign bank branches, Technical Advice Memorandum 201325012,
Detailed special rules apply to determine whether, and the extent to which, income from a security is considered attributable to the conduct of a banking, financing, or similar business in the United States by a non-US bank. Unfortunately, until June 2013, the Internal Revenue Service (the "IRS") had proffered very little guidance on the application of these rules. On June 24, 2013, the IRS released Technical Advice Memorandum 201325012 addressing whether income from certain securities is eligible for the advantages of the rule for "10% securities."1 The rule for 10% securities is beneficial to most US bank branches because it limits the amount of interest and gain on the security that is taxable in the United States to a fraction, as more fully described below.
The reason why the IRS auditing agent and the taxpayer sought Technical Advice appeared to be that the taxpayer did not take advantage of the rule for 10% securities. It is reasonable to assume that the taxpayer in ruling had losses and wanted the full income from the securities to absorb such losses. While the IRS stuck to its position that the rule for 10% securities limited the taxpayer's ability to include income from the medium term notes ("MTNs") in its US taxable income, the T.A.M. provides planning opportunities for US branches of non-US banks that are not in loss carryforward positions.
All interest from loans and all gain or loss from the sale of loans is treated as effectively connected to the conduct of a trade or business in the United States if:
- the loans are treated as securities,2
- the securities are capital assets, that is, they are held for investment and not as inventory,
- the income from the securities is United States source income;
- the income is derived in connection with a banking, financing or similar business in the United States,
- the stocks and securities are attributable to a US office where the banking, financing or similar such business is carried on, and
- the securities are described in one of five detailed categories.
The five categories that describe securities all of the income from which is subject to US federal income tax are as follows:
- the securities were acquired as a result of, or in the course of making loans to the public;3
- the securities were acquired in the course of distributing such securities to the public;4
- the securities were acquired for the purpose of satisfying reserve requirements of a duly constituted banking authority;5
- the securities are payable on demand or at a fixed maturity date not exceeding one year;6 or
- the securities are issued by the United States or any agency or instrumentality thereof.7
If securities meet the five-part test described above, but do not fall into one of these five categories, the securities fall into the catch-all or residual category of Treasury Regulation § 1.864-4(c)(5)(ii)(b)(3). Interest income on loans described in Treasury Regulation § 1.864- 4(c)(5)(ii)(b)(3) and held by a US branch of a non-US entity engaged in a banking, financing or similar business is not fully taxable in the United States. Instead, applicable Treasury regulations determine the amount of interest income earned on securities described in Treasury Regulation § 1.864-4(c)(5)(ii)(b)(3) that is taxable in the United States by multiplying such interest income by a fraction. The numerator of such fraction is 10%.8 The denominator of such fraction is the percentage derived by dividing the book value of such securities held by the US office by the total book value of the total assets held by the US banking office of the taxpayer.9 The fraction is capped at 1. The fraction is also used to determine the amount of gain or loss from dispositions of securities described in Treasury Regulation § 1.864-4(c)(5)(ii)(b)(3) that is considered to be attributable to the US banking, financing or similar business conducted by the taxpayer in the US Securities described in Treasury Regulation § 1.864-4(c)(5)(ii)(b)(3) are sometimes referred to as "10% securities" in reference to the numerator of this fraction.
The use of the fraction described in the flush language of Treasury Regulation § 1.864- 4(c)(5)(ii)(b)(3) can result in a significant portion of the interest income and gain or loss attributable to 10% securities not being subject to US federal income tax income. For example, if the book value of 10% securities held by a taxpayer engaged in a banking, financing, or similar business constituted 50% of the total assets held by the US banking office of the taxpayer, the denominator of the applicable fraction would be 50%. Thus, the fraction would be 10%/50% or 20%. On these facts, only 20% of the interest income and gain or loss from dispositions of 10% securities would be subject to US federal income tax. Accordingly, the determination as to whether securities are described in Treasury Regulation § 1.864- 4(c)(5)(ii)(a)(1) or Treasury Regulation § 1.864- 4(c)(5)(b)(3) can have significant federal income tax consequences.
In T.A.M. 201325012, a US bank branch of a non-US bank ("Branch") was regularly engaged in making loans to the public and other activities described in Treasury Regulation § 1.864- 4(c)(5)(i). As part of its US banking business, Branch wrote liquidity and credit-support commitments, including the issuance of letters of credit and standby bond and asset purchase agreements. The income from these activities was treated as effectively connected to the conduct of a US trade or business and included in the US taxable income of Branch.
Branch's credit-support commitments exposed the bank to significant liquidity risk. A US Federal Reserve Board regulation (Reg D) required Branch to post collateral equal to 100% of its liquidity exposure. This rule required Branch to pledge securities with the Federal Reserve Bank's Discount Window. Branch acquired outstanding MTNs on the interbank market through broker/dealers to satisfy this collateral requirement. Branch also subscribed for MTNs on and "prior to their issue date." All MTNs acquired for collateral purposes were held for seven days or less prior to being pledged to the Discount Window. It appears that Branch did not have any input into the terms of the MTNs that it acquired on or before their issue date. The issue before the IRS was whether these MTNs were 10% securities.
The MTNs were not payable on demand or at a fixed maturity date not exceeding one year from the date of acquisition. The MTNs were not issued by the United States or any of its agencies or instrumentalities. As a result, the MTNs would be considered to be 10% securities if they did not fall into categories (A), (B) or (C) listed above. As analyzed below, the IRS found that the MTNs did not fit into any of these categories and, as a result, should be treated as 10% securities in Branch's hands.
A) Making Loans to the Public
The IRS held that the MTNs were not securities described in Treasury Regulation § 1.864- 4(c)(5)(ii)(a)(1). The IRS explicitly held that "when the US banking business acquires a security on an exchange or an OTC market, the security is not considered to have been acquired as a result of, or in the course of, making loans to the public." The IRS found that the interbank market is an "organized OTC market through which banks loan funds to one another."10 Furthermore, the IRS held that "acquisitions on the exchange or organized OTC markets are not acquisitions from customers and are not acquired through the origination of a customer loan or incident to the terms of such original customer loan." Accordingly, the IRS held that the acquisition of the MTNs in secondary market transactions was not undertaken in the course of making loans to the public, apparently even when the Branch was providing original funds to the borrowers.
The IRS's analysis is noteworthy because there is a certain amount of overlap between the standard employed by the IRS to determine whether the MTNs were loans made to the public and the standard employed to determine whether a non-US person is engaged in a lending business in the United States. (This issue frequently comes up in connection with offshore hedge fund activities.) The federal income tax rules provide different taxation schemes for non- US persons who invest or trade in US securities and US persons who hold and acquire US securities as a result of originating loans in a lending business. In the former cases, non-US persons are subject only to certain withholding taxes that may be imposed on income from the US securities. In general, the interest from such loans would be exempt from US withholding tax pursuant to the "portfolio interest" exception.11
In contrast, if income from securities is derived in connection with the conduct of a US lending business, such income is subject to the same federal income tax regime that applies to US persons, that is, the non-US person is subject to graduated tax on taxable income.12
At the margins, it can be difficult to differentiate between non-US persons who are trading in securities and non-US persons who are engaged in a lending business. The holding of T.A.M. 201325012 clarifies that a loan acquired in the interbank market, even if acquired pursuant to a commitment prior to the origination of the loan, should not be considered to have been acquired in a lending business. T.A.M. 201325012 also explicitly recognizes that loans purchased in OTC (that is, bilateral) markets should not be considered to constitute lending transactions.
The facts and conclusion of T.A.M. 201325012, however, must be considered in light of the IRS's audit guidance in AM2009-010 (PRENO- 119800-09) (September 22, 2009). In AM2009- 010, the IRS considered whether a non-US corporation that acquired loans made to US persons within the United States was engaged in a banking, financing or similar business in the United States within the meaning of Treasury Regulation § 1.864-4(c)(5)(i). The non-US corporation had no office or employees located in the US It retained an origination company, pursuant to a service agreement, to originate loans to US borrowers. The origination company solicited US borrowers, then negotiated the terms of the loans, performed credit analyses with respect to US borrowers , and all other activities relating to loan origination other than the final approval and signing of the loan documents. The funding of the loans and final approval were undertaken by the non-US corporation from outside of the US
Although the conclusion of AM2009-010 has detractors, the view of the IRS was that the conduct of these activities in the US by the agent was attributable to the non-US corporation. As a result, the non-US corporation was considered to be engaged in a banking or financing business in the United States. AM2009-010 does not address whether the loans should be considered to be described in Treasury Regulation § 1.864- 4(c)(5)(ii)(a)(1). Based upon the IRS's discussion of the issues, however, it seems clear that the IRS found that the loans originated by the origination company should be considered to have been acquired as a result of making loans to the public. Thus, the critical distinction (a thin line indeed) between the two conclusions appears to rest on the fact that in AM2009-010, the non-US person was attributed with the loan origination while in T.A.M. 201325012 the non-US person was not attributed with the origination activity.
B) Distributing Securities to the Public
Since the taxpayer in T.A.M. 201325012 did not act as an underwriter or market maker with respect to the MTNs, the IRS held that the Branch did not acquire the loans in connection with the distribution of securities. Accordingly, the MTNs were not treated as described in Treasury Regulation § 1.864-4(c)(5)(ii)(a)(2).
C) Securities Held as Reserve Assets
The last issue considered by the IRS was whether the MTNs were held as reserve assets. The IRS began by noting that prior to 1980, states could impose requirements on non-US banks to hold various assets as reserve assets. (After the passage of the International Banking Act of 1978, only the Federal government could impose reserve requirements on non-US banks.) The IRS noted that the broad language of Treasury Regulation § 1.864-4(c)(5)(ii)(a)(3) was intended to reach assets held in reserve pursuant to these rules.
In contrast, the IRS noted that Discount Window transactions serve two functions. First, it helps stabilize demand for Federal Reserve balances. Second, it provides liquidity for depository institutions. These functions differed considerably from regulator-imposed reserve requirements. First, Discount Window borrowings are initiated by the banking institutions. In contrast, reserve requirements are imposed on the bank by a regulator and apply continuously. The Reg D requirements are transaction-specific and collateralize the full borrowing. Reg D does not function as a reserve that protects creditors and depositors based upon a percentage of the liabilities. Accordingly, the IRS held that Reg D collateral requirements should not be treated as a reserve requirement.
Since the MTNs did not fit into any of the categories that would have subjected the interest earned thereon to full inclusion in the US taxable income of the Branch, the MTNs were respected as 10% securities in the hands of the Branch. T.A.M. 201325012 is an important piece of guidance for several reasons. First, it offers parameters that distinguish between lending and investment and trading activities. Second, it adopts a relatively narrow view of when an asset will be considered a reserve asset. Third, it provides a framework for evaluating when securities will generally be treated as 10% securities.
Originally published June 27, 2013
1 The 10% rule is contained in Treasury Regulation § 1.864- 4(c)(5)(ii)(b)(3).
2 Treasury Regulation § 1.864-4(c)(5)(v) defines a security as "any bill, note, bond, debenture or other evidence of indebtedness, or any evidence of an interest in . . . any of the foregoing items."
3 Treas. Reg. § 1.864-4(c)(5)(ii)(a)(1).
4 Treas. Reg. § 1.864-4(c)(5)(ii)(a)(2).
5 Treas. Reg. § 1.864-4(c)(5)(ii)(a)(3).
6 Treas. Reg. § 1.864-4(c)(5)(ii)(b)(1).
7 Treas. Reg. § 1.865-4(c)(5)(ii)(b)(2).
8 Treas. Reg. § 1.864-4(c)(5)(ii)(flush lang.).
9 In fact, the fraction is determined monthly, the monthly fractions are then aggregated and divided by 12.
10 See Treas. Reg. § 1.864-4(c)(5)(iv)(c).
11 See Code § 864(b)(2), Code § 871(a)(1)(A) and Code § 881(a)(1).
12 See Code § 871(b) and Code § 882(a).
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