Foreign Bankers Seek Guidance on BEAT

September 13, 2018

Mr. Chip Harter
Deputy Assistant Secretary (International Tax Affairs)
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20224

Re: Section 59A (BEAT) As Applied to Foreign Banks

Dear Mr. Harter:

The Institute of International Bankers (the “IIB”) would like to thank you and your colleagues again, for taking the time to discuss with us on August 8 the unique concerns section 59A (the “BEAT”) raises for IIB's members.

As we discussed on August 8, the BEAT contains a number of ambiguities that, if not addressed through interpretive regulatory guidance, risk singling out foreign banking organizations (“FBOs”) and other similar foreign financial institutions operating in the United States for harsh treatment in a manner that is inconsistent with the legislative intent set forth in the official legislative history and disproportionate to other industries, including domestic competitors. These ambiguities also could impose tax penalties on foreign financial institutions for complying with obligations that are either mandated by law or by regulators, and that are intended to promote the stability of the global financial system. These concerns, and our recommendations for how to address them, are set out in more detail in our letter dated July 24, 2018.

In our call on August 8, we explained in more detail a number of matters relating to our request for guidance on three issues that are critical to IIB's members. Those matters are repeated below.

1. Interest on debt issued to comply with regulatory rules.

As we noted in our comment letter, the overall regulatory scheme applicable to many foreign financial institutions and their U.S. subsidiaries compels them to lend debt to U.S. subsidiaries with prescribed terms, in some cases, and more generally imposes significant legal constraints on how U.S. subsidiaries are funded. Those constraints may, to take one example, govern the extent to which U.S. subsidiaries must be funded through intercompany loans rather than third party sources.

In addition, in respect of U.S. branches of FBOs, because a branch does not need to have its own separately stated equity capital, the U.S. branches of FBOs are also typically funded (to the extent they do not issue debt to other parties) through interbranch loans from the bank's head office (or other branches).

We recommend that interest paid on debt issued by members of a foreign financial institution's U.S. group or U.S. branch not be treated as a base erosion payment if the debt was issued in order to bring the institution into compliance with U.S. or non-U.S. regulatory requirements, since debt of this kind does not erode the U.S. tax base.

We believe this guidance should not be limited to “total loss absorbing capacity” instruments, but should also capture any debt that was issued in order to bring the foreign financial institution into compliance with home country or U.S. rules implementing the Basel Committee on Banking Supervision and/or Financial Stability Board standards or similar rules applicable to other regulated financial institutions like U.S. broker-dealers, since those rules are legally binding on those financial institutions.

We envision that a foreign financial institution would be required to demonstrate that debt of a U.S. subsidiary or branch in fact was issued to satisfy a particular regulatory rule, and would be pleased to work with you on an appropriate mechanism for doing so.

We encourage Treasury to adopt a rule that does not depend on there being a match between the terms of a foreign financial institution's external debt and the corresponding intragroup funding. As we noted in our prior letter, there is ordinarily not a match between an institution's intragroup funding and its external debt, and a rule that required that type of matching would fail to reflect the realities of how foreign financial institutions operate in practice.

We are happy to discuss with you further on how Treasury might design a rule that addresses these concerns, and that is still narrow enough to carry out the policy underlying the BEAT.

2. Excess interest.

The term “excess interest” refers to a deduction that a U.S. branch of an FBO may be entitled to take, based on formulas set forth in Treasury regulations that refer to certain assumptions and elections relating to the leverage of the branch and the foreign bank.¹ This deduction may be more than, or less than, the interest actually paid by the U.S. branch as a legal matter. As discussed in our July comment letter, current law does not treat the deduction for excess interest as giving rise to a payment absent specific statutory direction to do so. We believe that regulations under the BEAT similarly should not treat excess interest as a “payment” and therefore should not treat the deduction for excess interest as giving rise to a base erosion payment.

We are aware that some other commentators have recommended an allocation methodology for “excess interest” that would treat a portion of excess interest as paid to related parties in proportion to the amount of interest paid by the foreign bank to related parties. We request the opportunity to discuss further with you both the policy considerations as to how excess interest should be treated, and a number of very significant implementation issues with an allocation approach, which should be resolved before an approach of that kind is adopted. We briefly summarize below the principal concerns that we have identified to date relating to the implementation of an allocation approach.

Our concerns are:

First, a rule that is based on determining the amount of interest, as defined for U.S. federal income tax purposes, that is paid by a foreign bank will be extremely difficult to administer. Instruments treated as debt for home country tax purposes may not qualify as debt for U.S. tax purposes, for example “Additional Tier 1” securities typically issued by foreign banks. Conversely, instruments not treated as debt for home country tax purposes may qualify as debt for U.S. tax purposes, for example sale-and-repurchase agreements (“repos”). Hedging costs also may be treated differently for U.S. and non-U.S. purposes. It is not practical for either FBOs or IRS examiners to review every financing-related transaction carried out outside the United States by a foreign bank in order to determine the U.S. tax characterization of the transaction. Current law recognizes this impracticality, in Treasury regulation sections 1.882-5 and 1.884-4.²

Second, if not properly structured, a rule of this kind could apply very differently depending on the legal structure of an FBO. An FBO whose top-tier legal entity is the bank will typically raise all of its funding from third parties, in which case none of its U.S. branch's excess interest would be treated as a base erosion payment. Other FBOs have more complicated structures, for example a structure where the top-tier legal entity is a bank holding company that raises debt from third parties, typically because it is required to do so for regulatory reasons, and lends the money to its bank subsidiary. A bank of this kind literally does borrow from a related party, namely the holding company. If the determination of whether the bank borrows from related parties for purposes of an excess interest allocation rule is made without taking into account the fact that the funding for this bank is derived by the holding company from third parties, a significant amount of the excess interest of this bank's U.S. branch may be treated as a base erosion payment. That is, the rule would apply in dramatically different ways to banks that in fact derive all of their funding from third parties but happen to have different legal structures.

Third, for regulatory and other reasons, it is common for members of a bank group to lend to each other, including situations where member A lends to member B at the same time that member B is lending to member A, on terms that may differ or that may be the same. If the determination of whether member A (the bank) is borrowing from member B (an affiliate) is made on a gross basis, it will be highly distortive and the result will bear no resemblance to the bank's actual funding cost.

A further consideration is that taxpayers and auditors may in practice look to the proposed regulations in order to determine their year-end tax reserves. In order to avoid distortion in year-end financial statements, it is important that any proposed rules be crafted in a manner that is administrable and that bear a rational relationship to the policy goals of the BEAT. We do not believe that an allocation approach to excess interest would satisfy those goals unless the concerns we refer to above are dealt with.

3. ECI.

We believe that Treasury should treat the BEAT as inapplicable to income that is effectively connected with the conduct of a trade or business in the United States (“ECI”) and that Treasury has regulatory authority to write regulations providing that treatment, as described in more detail in our letter to you on July 24. We encourage Treasury to exercise that authority. A payment already subject to U.S. federal income tax in the hands of the payee as ECI should not be treated as gross receipts or as a base erosion payment.

Sincerely,

Briget Polichene
Chief Executive Officer
Institute of International Bankers
New York, NY

cc:
Doug Poms
Harvey Mogenson
Kevin Nichols
Daniel Winnick