Bank Tax Update

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Bank Tax Update
2008 Banking Conference FAE Conference
Center September 25, 2008 405pm 455pm
Mark H. Leeds Greenberg Traurig (212)
801-6947 leedsm_at_gtlaw.com
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Mark Leeds

• Mark H Leeds is a shareholder with the law firm
  of Greenberg Traurig. At Greenberg, Mark is a
  member of the Tax and Capital Markets practice
  groups. Marks professional practice focuses on
  the tax consequences of a variety of capital
  markets products and strategies, including
  over-the-counter derivative transactions, swaps,
  tax-exempt derivatives and strategies for
  efficient utilization of tax attributes, such as
  net operating losses. Mark is also the
  editor-in-chief of Derivatives Financial
  Products Report, a Thomson/RIA monthly
  publication. Prior to joining Greenberg, Mark
  served as a Managing Director at Deutsche Bank,
  general counsel of a credit derivative company
  and, prior to that, Mark was a partner at
  Deloitte Touche where he led the Capital
  Markets Tax Practice.

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TAM 200811019 An Opportunity to Convert 100 ECI
Securities to 10 Rule ECI Securities
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Background on Bucketing Securities Held by a US
Branch

• 6 Categories of Securities in the hands of a US
  Branch of a foreign bank
• Debt instruments acquired in the course of making
  loans to the public
• Debt instruments acquired in the course of
  distributing stocks or securities
• Debt instrument held to satisfy reserve
  requirements
• Debt instruments payable on demand or in less
  than one year from acquisition
• Debt instruments issued by the US government
• Debt instruments not falling into any of the
  above categories

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The 10 Rule Applies to Debt Instruments Held in
Residual Category

• The 10 Rule treats income earned on debt
  instruments held in the residual category as ECI
  only to the extent of such income, multiplied by
  a fraction
• 10/(Total Ave. book value of residual
  securities/book value of total assets of the US
  branch)
• For many US branches of foreign banks, the 10
  rule results in less than all of the interest on
  residual income securities from being treated as
  ECI
• Note If income is limited by 10 Rule, Treas.
  Reg. 1.861-8 will limit amount of losses that
  are ECI

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The 10 Rule is Overridden if Bonds are not held
in the Banking Business

• Treasury Regulation 1.864-4(c)(5)(vi)(a)
  provides that special banking rules do not apply
  to stocks and securities held in connection with
  the trading of stocks or securities for their
  own account.
• If the stock or securities trading occurs in the
  U.S., then the default rule is that income is
  wholly ECI.
• Keep in mind that Code 864(b)(2) exempts stock
  or securities trading from ECI status if that is
  the sole US contact.

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Facts of the TAM the Opportunity It Presents to
US Branches

• Branch held securities in a trading book all
  income was ECI.
• Branch contributed cash to a partnership in
  exchange for common and preferred pship
  interests
• Partnership used the cash to purchase the trading
  securities
• Branch entered into an agreement to continue to
  manage the assets now held in the partnership
• Branch sold preferred partnership interests to a
  third party
• Partnership common units constituted Tier One
  Capital

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IRS Rulings on Partnership Transactions

• Initial issue was whether the 10 Rule could
  apply. (Was the asset a pship interest or
  securities?) Here, the IRS looked through the
  pship
• US Branch formed the partnership
• US Branch continued to manage the debt
  instruments after acquisition by the pship
• Securities would have been attributable to branch
  if acquired directly by pship
• Second issue was whether purpose of holding is
  determined at pship or partner level. Here, the
  IRS looked at the pship level. Pship was an
  investor not a trader.

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IRS Withdraws Adverse Regulations on Character of
Loan Losses Held by Banking Affiliates
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Rules Prior to August 2006 Supported Treatment of
Losses as Ordinary

• Code 1221(a)(4) treats notes accounts
  receivable as ordinary assets if they are
  acquired in connection with the performance of
  services
• Burbank Liquidating Corp., 39 TC 999, held that
  providing credit to borrowers can be a service
• FNMA, 100 TC 541, held that providing liquidity
  to the secondary market can be a service
• Code 581(c) mandates ordinary treatment for
  loans held by banks

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IRS Reacts Badly to the Expansion of Code
1221(a)(4)

• In August 2006, the IRS mounted a 2-front attack
  on the treatment of loan losses by non-banks
  non-bank subsidiaries of banks as ordinary losses
• TAM 200651003 IRS challenges that loans acquired
  for cash can ever fall within the Code
  1221(a)(4) exception
• IRS proposes regulation that would preclude
  ordinary treatment for loans acquired from an
  extension of credit

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In April 2008, the IRS Has a Change in Heart

• In REG-109367-06, the IRS withdrew the proposed
  regulation before it became effective.
• In the release, the IRS stated that it will not
  challenge return reporting positions of taxpayers
  under section 1221(a)(4) that apply existing
  law.
• It is much easier for a non-bank subsidiary to
  qualify as being in the business of extending
  credit to customers than to qualify as being in
  the business of providing liquidity to the
  secondary market.

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Using REMIC Residual Interests to Avoid a Loss of
a NYS and NYC Net Operating Loss Carryover
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New York State and City Income Tax Rules
Background

• The New York State Financial Corporation Tax
  (Article 32) requires that tax be paid on the
  greater of net income or a percentage of assets
  held within New York
• The New York State and City General Corporate Tax
  (Article 9-A) likewise imposes a tax on the
  greater of two measures, an income test or an
  asset test.
• If NYS and NYC taxable income are reduced by net
  operating loss carryovers, then the asset base
  will apply. Nonetheless, the NOL carryover will
  be reduced.
• Example NOL carryover is 150 and taxable income
  before NOL carryover is 100. 20 of tax would
  be imposed on asset based tax. Asset-based tax
  is imposed and NOL carryover is still reduced to
  50.

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Background on Taxation of Income from REMIC
Residual Interests

• REMIC Residual Interests generate a type of
  income known as excess inclusion income.
• NOL carryovers may not be offset against excess
  inclusion income. As a result, excess inclusion
  income creates a floor on taxable income.
• There is no New York adjustment for excess
  inclusion income.
• REMIC residuals can be held by a US branch of a
  foreign bank, but should be held in a trading
  account. If this is the case, then all excess
  inclusion income should be ECI

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Interaction of the Excess Inclusion Rules with
the NYS NYC Tax Rules

• Same facts as before, but now the affected
  company replaces existing income-generating
  assets with REMIC residual interests that
  generate 21 of NY tax on excess inclusion
  income. As a result, income, not asset-based,
  tax applies.
• Although the NOL is not currently utilized, it
  can now be carried forward and used in future
  years.
• There are variations on this strategy using other
  transactions that generate a floor on taxable
  income for federal income tax purposes.