Firm Cites Need for Rules on Branch Interest Expense in FTC Regs

April 1, 2019

David. J. Kautter
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Ave, NW
Washington, DC 20220

Michael J. Desmond
Chief Counsel
Internal Revenue Service
1111 Constitution Ave, NW
Washington, DC 20224

Charles P. Rettig
Commissioner
Internal Revenue Service
1111 Constitution Ave, NW
Washington, DC 20224

Lafayette (Chip) G. Harter III
Deputy Assistant Secretary
(International Tax Affairs)
Department of the Treasury
1500 Pennsylvania Ave, NW
Washington, DC 20220

RE: Branch Basket Interest Allocation

Dear Messrs. Kautter, Rettig, Desmond, and Harter:

We respectfully submit this letter on behalf of State Street Corporation in response to the request for comments in the Notice of Proposed Rulemaking (REG-105600-18) addressing foreign tax credits and related issues published by the Department of the Treasury (“Treasury”) and the Internal Revenue Service (the “IRS”) in the Federal Register on December 7, 2018 (the “Proposed Regulations”).¹ Specifically, this letter responds to the request for comments set forth in the preamble to the Proposed Regulations with respect the allocation of interest expense for purposes of calculating the new separate limitation category of section 904(d)(1)(B).²

I. Overview

The Tax Cuts and Jobs Act (“TCJA”) amended section 904(d) to add two new “baskets” for purposes of determining a taxpayer's foreign tax credit limitation — a “Section 951A Basket” in section 904(d)(1)(A), and a “Branch Basket” in section 904(d)(1)(B). The TCJA retained the general basket and passive basket, which were the only two limitation categories following changes to section 904 in 2004.³

In light of the changes to section 904 by the TCJA and the pending worldwide apportionment election under section 864(f) (applicable for taxable years beginning after December 31, 2020), the proposed regulations stated that "the Treasury Department and the IRS expect to reexamine the existing approaches for allocating and apportioning expenses, including in particular the apportionment of interest, research and experimentation (“R&E”), stewardship, and general & administrative expenses, as well as to reexamine the CFC netting rule' in §1.861-10(e). The Treasury Department and the IRS request comments with respect to specific revisions to the regulations that should be made in connection with this review.”

Specifically regarding the new Branch Basket, the preamble to the proposed regulations states:

The proposed regulations do not propose any special rules for determining the amount of deductions allocated and apportioned to foreign branch category income, including deductions reflected on the books and records of foreign branches. Therefore, the proposed regulations provide that the rules for allocating and apportioning deductions in §§1.861-8 through 1.861-17 that apply with respect to the other separate categories also apply to the foreign branch category. The Treasury Department and the IRS request comments on whether any special rules should be issued for determining the allocation and apportionment of deductions between the foreign branch category and the general category. In addition, the Treasury Department and the IRS request comments on whether special rules should be provided for financial institutions with branches subject to regulatory capital requirements, including for example, rules similar to those in § 1.882-5.

As the preamble contemplates, special rules are appropriate for allocating and apportioning expense to the Branch Basket in order to avoid allocations that are inconsistent with the underlying economics. As described herein, this is particularly true with respect to the allocation of interest expense to a foreign branch⁴ of a financial institution with a functional currency other than the U.S. dollar (in all likelihood, a vast majority of financial institution foreign branches). Accordingly, we recommend adapting the existing framework for an allocation of interest to a branch under the § 1.882-5 regulations (with appropriate modifications), as described in detail below. Appendix A illustrates several examples applying this approach.

II. Foreign Branch Interest Allocation

Absent special rules for allocating interest expense to the Branch Basket, the existing rules of §§ 1.861-8 through 1.861-13 will apply and generally allocate interest expense according the relative value of the branch assets.⁵ Specifically, § 1.861-9T(f)(2) requires a domestic corporation to take into account branch assets and combine branch interest expense with the domestic corporation's interest expense for purposes of applying the asset method. With respect to a branch that is a QBU within the meaning of section 989(a) and that uses a functional currency other than the U.S. dollar, § 1.891-9T(g)(2)(ii)(A)(1) generally provides that the branch's assets are measured using an average of the beginning and end-of-year functional currency amount of assets.

In the absence of a Branch Basket, this aggregate approach was workable because most interest expense of a financial institution was allocated to the general basket, regardless of whether the expense was incurred by a branch. Post-TCJA, however, it is critical to accurately determine net income (taking into account expense allocation and apportionment) attributable to a foreign branch. The existing approach fails to take into account the fact that foreign branches of financial institutions with foreign functional currencies have assets and liabilities that reflect functional currency interest rates, rather than U.S. interest rates, potentially resulting in the over- or under-allocation of interest expense to the Branch Basket.

For example, consider a foreign branch with liabilities of 90x and assets of l00x, and thus a 9:10 leverage ratio. The domestic owner of the branch has 900x of liabilities and l000x of assets (excluding branch assets), and thus also has a 9:10 leverage ratio. The domestic corporation borrows at a U.S. interest rate of 2% and lends at 2.2% (a 20 basis point spread), and the interest rate in the foreign branch functional currency is 1% and 1.1%, respectively (a 10 basis point spread). Total interest expense is 18.9x: 18x with respect to 900x of US liabilities, and .9x with respect to 90x of branch liabilities. Allocating interest expense based on assets results in 1.72x (18.9 * [100 / 1100]) allocable to the Branch Basket, resulting in a Branch Basket loss of (.62x) (1.1x interest income, less 1.72x allocable interest expense).

This result does not comport with economic reality: The branch is borrowing and lending profitably in a foreign jurisdiction at prevailing market interest rates, is taxed in the foreign location based on those profits, yet is denied any foreign tax credit because it is considered to operate at a loss for foreign tax credit limitation purposes.⁶ The result is particularly difficult to justify in situations similar to this example, where the foreign branch and domestic corporation have comparable leverage ratios.

The distortion is exacerbated as the branch grows. Consider a similar domestic corporation with 900x of liabilities and 1000x of assets that lends at 2.2% and borrows at 2%. The domestic corporation operates a Country X branch with assets attributable entirely to customer deposits borrowed at a 1% rate that are deposited with the central bank at a 1.1% rate. The Branch Basket limitation becomes increasingly negative as the amount of deposits increases:

Deposits	Interest Income	Interest Allocation	Branch Basket Income
100	1.1	1.73	(.63)
200	2.2	3.33	(1.13)
300	3.3	4.85	(1.55)
400	4.4	6.29	(1.89)

Thus, a branch that operates profitably in a low-interest rate jurisdiction will generate more Branch Basket losses the more actual profits that the branch generates. This concern is not hypothetical — many financial institutions maintain significant branches in jurisdictions with interest rates below the prevailing U.S. rates (for example, Japan). The opposite result follows if the branch operates in a high interest rate environment. In such a case, the interest expense for foreign tax credit limitation purposes of the branch would be understated applying the current asset method approach.

To avoid these distortions, regulations should deviate from § 1.861-9T(f)(2) and instead recognize that for financial institutions⁷ the amount of branch local currency liabilities incurred — principally deposits⁸ — determines the amount of total branch assets, whereas for a non-financial company, branch assets are typically the given and determine the amount of debt, if any, the branch incurs. For a financial institution, deposits are determined by customer needs and market factors. Once a bank receives deposits in a specific currency, it will seek their most profitable deployment, typically through financial assets denominated in that currency. The return available to it will correlate strongly with the interest rate it pays for the deposits. Thus, for these institutions, liabilities in different currencies are not truly fungible, for both liability interest rates and financial asset returns will align by currency, and there will be significant differences between currencies. Moreover, given the short-term nature of the assets and liabilities involved (typically demand deposits), the risks of unhedged currency exposure are too great to treat all borrowing as equivalent across jurisdictions and branches.

III. Utilizing the Existing Inbound Framework for Interest Allocation to a Branch

Unlike the outbound context where there was little reason to carefully determine interest expense allocable to a foreign branch before the TCJA, properly determining the interest expense of a branch has long been significant in the inbound context. Treas. Reg. § 1.882-5 provides guidance for determining the amount of a foreign corporation's allowed interest expense with regard to its U.S. activities. These regulations provide a sound theoretical framework for allocating interest expense of a regarded owner to a branch without regard to whether the regarded owner is domestic or foreign. Accordingly, we suggest adopting the approach of § 1.882-5 with two modifications: First, a Fixed Ratio Election is not necessary for taxpayers that already keep books and records in accordance with U.S. tax principles. Second, the regulations should regard otherwise disregarded liabilities between a branch and the regarded owner.

The § 1.882-5 regulations follow a three-step process. Under step one, the foreign corporation determines the total value of its U.S. assets, as defined by reference to Treas. Reg. § 1.884-1(d).

Under step two, the taxpayer's U.S.-connected liabilities (“USCL”) are determined by multiplying the value of those U.S. assets by either the “actual ratio” or “fixed ratio."⁹ The actual ratio is determined by dividing the total amount of worldwide liabilities for the taxable year by the total value of worldwide assets for the taxable year.¹⁰ Stated differently, the taxpayer must calculate its worldwide leverage ratio, then apply that ratio to U.S. assets to determine USCL. The taxpayer may elect, however, to apply a fixed ratio rather than compute the actual ratio (“Fixed Ratio Election”).

The fixed ratio was originally proposed in 1980, but was only permitted if the actual ratio could not be determined.¹¹ In response to comments, the final regulations issued in 1981 allowed all taxpayers to make a Fixed Ratio Election, and eliminated the requirement that USCL determined under the fixed ratio could not exceed the actual ratio. The Fixed Ratio Election has been subsequently modified to account for changes in bank regulatory rules, but has always permitted a taxpayer to perform the calculation under step two without examining its books and records and adjusting them to conform to U.S. tax principles.¹² This concern does not exist in the context of a U.S.-based financial institution, which already tracks its debt liabilities (branch and otherwise) in accordance with U.S. tax principles. Thus, a Fixed Ratio Election is unnecessary for properly allocating interest expense to the Branch Basket.

Finally, under step three, interest expense is adjusted by comparing the amount of USCL for the taxable year (determined using the fixed or actual ratio) with the average total amount of U.S. booked liabilities (USBL) of the taxpayer.¹³ If the USCL exceed the USBL of the taxpayer, interest expense is increased by the amount of the excess USCL multiplied by the average interest rate with respect to U.S.-dollar denominated liabilities that are not U.S.-booked liabilities and are reflected on the books of offices or branches of the foreign corporation outside the United States for the taxable year (i.e., excess interest expense).¹⁴ If the USBL exceed the USCL, then the branch's interest expense is reduced pro rata according to a scaling ratio (USCL divided by the average total amount of USBL).¹⁵

Under this framework, the interest expense attributable to the branch is only adjusted to account for a discrepancy in the leverage ratio of the branch vis-a-vis the foreign corporation (or deemed leverage ratio of the foreign corporation if the taxpayer makes a Fixed Ratio Election). This approach avoids distortions caused by variations in functional currency interest rates, and accordingly provides an appropriate model for allocating interest expense to the Branch Basket.

For purposes of applying this framework in the outbound context, we recommend an aggregate calculation that combines all branch assets and liabilities. Such an approach is consistent with the foreign tax credit regime, which applies the limitation of section 904 to each category on an aggregate basis. That is, the limitation is applied based on Branch Basket income in total, not to each individual branch.¹⁶ The same is true for the other limitation categories as well (i.e., the section 951A limitation is not applied to each CFC). Such an approach is also less burdensome for practitioners and the Service, and takes into account interbranch liabilities and assets without complex adjustments that would be necessary for a branch-by-branch approach.

The proposed regulations should provide rules, however, specifically regarding assets and liabilities between a branch and the domestic corporation, which are not given effect pursuant to §§ 1.882-5(c)(2)(viii) and (d)(2)(viii).¹⁷ The Proposed Regulations generally take into account otherwise disregarded transactions for purposes of accurately determining Branch Basket income.¹⁸ However, certain disregarded transactions are not taken into account, including payments of interest.¹⁹ The preamble to the proposed regulations explains that generally “interest payments to or from a foreign branch reflect a shift of, or return on, capital rather than a payment for goods and services.” While interest expense could be used to inappropriately manipulate Branch Basket income in certain circumstances, head office-branch liabilities result from ordinary course transactions in the context of a financial institution. Typically, a financial institution that receives a foreign currency deposit will create a branch asset and liability by transferring the deposit to a branch that operates in that currency and thus may, for example, have deposit access to the currency's central bank. The liability is entirely a function of ordinary course commercial operations that sensibly seek to move the foreign currency exposure to the branch most able to manage it. These branch deposits are recognized for local branch regulatory and tax purposes.

Consequently, we recommend regarding assets and liabilities (and payments thereon) between a regulated financial institution and its branches for interest allocation purposes as well as for purposes of basketing the interest income from resulting branch assets. Doing so more accurately reflects the true economic income attributable to the branches and presents little opportunity for inappropriate tax planning.

IV. Application of Principles to Foreign Branch Basket

Under an approach similar to principles of § 1.882-5, we propose that interest expense could be allocated to the Branch Basket through a series of steps:

This approach prevents distortions resulting from variations in functional currency interest rates and more accurately tracks the actual economic profits derived by the branch (whether by increasing or decreasing Branch Basket income, as appropriate). Moreover, this approach generally follows that of § 1.882-5, and thus offers a familiar framework for both practitioners and the Service while more accurately aligning the foreign tax credit limitation with economic profits.

Interest expense allocated in this manner should then be taken out of allocable interest under § 1.861-9T, the branch assets excluded from the allocation fraction, and no further interest would be apportioned to the Branch Basket. Thus, under this approach a domestic taxpayer's interest expense would be allocated and apportioned first by applying the direct allocation rules of § 1.861-10T. Second, interest expense would be allocated and apportioned to the Branch Basket using the approach described herein. Finally, any remaining interest expense would be allocated to the general basket, passive basket, and Section 951A basket as generally described in the Proposed Regulations (excluding all branch assets and liabilities) pursuant to §§ 1.861-9T through -13T.

* * * * *

We appreciate the request for comments regarding interest allocation, and would welcome the opportunity to discuss any comments or questions about the proposed approach at your convenience. You may reach Paul Oosterhuis by phone at 202-371-7130 and through email at paul.oosterhuis@skadden.com, and Christopher Bowers by phone at 202-371-7060 and through email at chris.bowers@skadden.com.

Sincerely,

Paul Oosterhuis

Christopher Bowers
Skadden, Arps, Slate, Meagher & Flom LLP
Washington, DC

cc:
Douglas Poms
International Tax Counsel
Office of Tax Policy
U.S. Department of the Treasury

Harvey Mogenson
Senior Counsel
Office of Tax Policy
U.S. Department of the Treasury

Daniel McCall
Deputy Associate Chief Counsel (International)
Office of Chief Counsel
Internal Revenue Service

Barbara Felker
Branch Chief, ACCI Branch 3
Office of Chief Counsel
Internal Revenue Service

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Appendix A: Examples

Example 1 — Underleveraged Foreign Branch: Foreign Branch (FB) has liabilities of 80 and assets of 100. U.S. Bank (USP) has total liabilities of 900 and assets of 1000. The functional currency borrow rate is 1% with a spread of 10 basis points (that is, FB can borrow at 1% and lend at 1.1% in the foreign jurisdiction). The USP borrow rate is 2% with a spread of 20 basis points.

Accordingly, USP's Branch Basket income is .1, determined by reducing FB's interest income of 1.1 (100 assets *1.1% lending rate) by its interest expense of .8 (80 liabilities * 1% borrow rate) and .2 of allocated interest expense.

Example 2 — Underleveraged Foreign Branch, Partially Funded by Home Office-Branch Deposit: The facts are the same as Example 1, except that a customer deposit of 50 in FB currency held by USP is deposited by USP with FB (at FB's borrowing rate of 1%). FB deposits the 50 with the central bank (at its 1.1% lending rate).

Accordingly, USP's Branch Basket income is .25, determined by reducing FB's interest income of 1.65 (150 assets * 1.1% lending rate) by its interest expense of 1.30 (130 liabilities * 1% borrow rate) and .1 of allocated interest expense.

Example 3 — Overleveraged Foreign Branch: Foreign Branch (FB) has liabilities of 90 and assets of 100. USP has total liabilities of 800 and assets of 1000. The functional currency borrow rate is 1% with a spread of 10 basis points (that is, FB can borrow at 1% and lend at 1.1% in the foreign jurisdiction). The U.S. borrow rate is 2% with a spread of 20 basis points.

Accordingly, USP's Branch Basket income is.3, determined by reducing FB's interest income of 1.1 (100 assets * 1.1% lending rate) by its interest expense of .9 (90 liabilities * 1% borrow rate) reduced by .1 of excess branch interest expense, for net interest expense of .8.