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Bank Tax Update

Bank Tax Update. Mark H. Leeds Greenberg Traurig (212) 801-6947 leedsm@gtlaw.com. 2008 Banking Conference FAE Conference Center September 25, 2008 4:05pm – 4:55pm. Mark Leeds.

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Bank Tax Update

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  1. Bank Tax Update Mark H. Leeds Greenberg Traurig (212) 801-6947 leedsm@gtlaw.com 2008 Banking Conference FAE Conference Center September 25, 2008 4:05pm – 4:55pm

  2. 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. Mark’s 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.

  3. TAM 200811019: An Opportunity to Convert 100% ECI Securities to 10% Rule ECI Securities

  4. 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

  5. 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

  6. 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.

  7. 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 p’ship 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

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

  9. IRS Withdraws Adverse Regulations on Character of Loan Losses Held by Banking Affiliates

  10. 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

  11. 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

  12. 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.

  13. Using REMIC Residual Interests to Avoid a Loss of a NYS and NYC Net Operating Loss Carryover

  14. 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.

  15. 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

  16. 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.

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