In a recently released Technical Advice Memorandum (TAM) 201325012, the IRS said that interest earned by a foreign bank on notes pledged as collateral for access to the Federal Reserve must be allocated between effectively connected income (ECI) and non-ECI under the “Ten Percent Rule” in Regulations Section 1.864-4(c)(5)(ii)(b)(3).
The taxpayer was a foreign bank with a U.S. branch, which actively and materially participated in soliciting and negotiating liquidity and credit-support commitments, including letters of credit, standby bond purchase agreements and standby asset purchase agreements (the “Commitments”). The Commitments obligated the taxpayer to maintain access to the Federal Reserve Discount Window to secure funding for the U.S. banking business, which requires the posting of collateral. The taxpayer acquired from broker-dealers, with the material participation of the U.S. branch, medium-term notes issued by commercial banks on the interbank market (the “Notes”) to pledge as collateral to the Federal Reserve. The taxpayer treated the Notes as securities under Regulations Section 1.864-4(c)(5)(v).
The general ECI rules of Code Section 864(c) provide that U.S. source fixed or determinable annual or periodic (FDAP) income—i.e., interest—is ECI if it is derived from assets used in or held for use in the conduct of a U.S. trade or business (the “asset-use test”) or the activities of a U.S. trade or business were a material factor in realizing the income (the “business-activities test”). However, special rules apply to determine the ECI of a U.S. banking, financing or similar business under Section 1.864-4(c)(5), rules that apply notwithstanding the asset-use test or business-activities test. If a foreign corporation conducts a U.S. banking, financing or similar business (as defined in the regulations), then U.S. source interest on securities is ECI only if the securities are attributable to a U.S. office through which such business is conducted and were acquired (1) as a result of, or in the course of, making loans to the public; (2) in the course of distributing such securities to the public; or (3) for the purpose of being used to satisfy the reserve or similar requirements established by a U.S. banking authority. A security is attributable to a U.S. office if the office materially participates in soliciting, negotiating or performing other activities necessary to acquiring the security.
When a security is so attributable to a U.S. office but does not otherwise meet one of the above criteria to be ECI, it falls into a residual category in Regulations Section 1.864-4(c)(5)(ii)(b)(3) (“(b)(3) securities”). The income from a (b)(3) security is subject to the “Ten Percent Rule,” which limits the amount of income that constitutes ECI. To determine the ECI from (b)(3) securities, the income amount is multiplied by a fraction. The numerator is ten percent. The denominator is the ratio of the monthly average book value of the (b)(3) securities to the monthly average book value of the total assets of the U.S. banking, financing or similar business.
The TAM finds that the taxpayer was engaged in a U.S. banking business through its U.S. branch and, further, that the Notes were securities attributable to the U.S. branch because the branch materially participated in the Notes’ acquisition. Nevertheless, the IRS concluded that, because the Notes were not acquired in the course of making loans to the public, distributing the securities to the public or satisfying reserve or similar requirements established by a U.S. banking authority, the Notes were (b)(3) securities, and the interest thereon could not be entirely ECI, as it was subject to the Ten Percent Rule.
The IRS notes that an objective of the special rules of Regulations Section 1.864-4(c)(5) was to distinguish between banks’ banking income and nonbanking investment income. As such, the rules provide the three bright-line categories for classifying securities to determine whether income thereon is entirely ECI (i.e., banking income) or partly ECI and partly non-ECI (i.e., banking and nonbanking income). The IRS concludes that the Notes did not fit into one of the three categories of the regulations, so interest on the Notes was subject to allocation under the Ten Percent Rule.
First, the TAM determines that the Notes were not acquired in the course of making loans to the public. The TAM acknowledges, on the one hand, that the Commitments solicited and negotiated by the taxpayer’s U.S. branch constitute securities acquired in the course of making loans to the public. In contrast, under the regulations, because the taxpayer purchased the Notes through broker-dealers on an interbank market, the Notes are not considered acquired in the course of making loans to the public. The IRS concedes that the acquisition “arguably” related directly to the taxpayer’s U.S. banking business because the Notes were acquired to post as collateral to ensure liquidity to fund the Commitments. Still, the IRS contends that the Notes do not fit into this category because they were not acquired from customers or incident to customer loans (e.g., through foreclosure on default of customer loans, as illustrated in the regulations). Moreover, the term of the Notes, which exceeds one year, disqualifies them from an exception to the special ECI rules for short-term securities.
Second, the taxpayer did not acquire the Notes in the course of distributing them to the public. The TAM observes that the taxpayer was not an underwriter or market maker for the Notes, nor did the taxpayer distribute the Notes to the public upon acquisition. Rather, the taxpayer acquired the Notes for its own account to pledge as collateral with the Federal Reserve.
Finally, the IRS concludes that the Notes were not acquired to satisfy reserve or similar requirements of a U.S. banking authority. First, the TAM observes that the Notes are not a permissible form of reserves under the rules of the Federal Reserve Board, which requires that reserves be vault cash or reserve deposits with Federal Reserve Banks. Next, the IRS considers whether the collateral requirement for accessing the Federal Reserve Discount Window, the reason the taxpayer acquired the Notes, may be considered “similar to reserve requirements.” The TAM determines that the collateral requirement is not similar to a reserve requirement because there is a “clear functional distinction.” The Federal Reserve’s reserve requirements facilitate monetary policy, while the collateral requirement, which is not uniformly imposed, secures borrowings voluntarily incurred by banks from the Discount Window.
TAM 201325012 is one of the first in-depth interpretations of whether income from securities is subject to the Ten Percent Rule—i.e., whether securities are acquired (1) in the course of making loans to the public, (2) in the course of distributing the securities or (3) to satisfy reserve or similar requirements. As to the first category, the Notes were ultimately doomed because they were purchased on an OTC market, and the second category was clearly inapplicable. However, the TAM’s dismissal of the Federal Reserve Board’s collateral requirement as insufficiently “similar” to a “reserves requirement” seems questionable, particularly in today’s banking regulation climate. In any event, foreign banks seeking to derive ECI via U.S. branches should be aware that the IRS may closely scrutinize so-called investment income—even though the underlying investment is “arguably… directly related” to U.S. banking activity.