Law Firm Seeks Changes to Correct Disparity Under BEAT Regs

February 15, 2019

Internal Revenue Service
CC: PA: LPD: PR (REG-104259-18)
Courier's Desk
1111 Constitution Avenue NW
Washington, DC 20224

RE: Correcting the Disparate Treatment of United States Branch Interest Expense Between the Adjusted US Booked Liabilities and Separate Currency Pools Methods For Base Erosion and Anti-Abuse Tax Purposes

Dear Sir/Madam:

Mayer Brown LLP respectfully submits this letter in response.to the request for comments included in the Notice of Proposed Rulemaking, "Base Erosion and Anti-Abuse Tax," published by the Department of the Treasury ("Treasury") and the Internal Revenue Service (the "IRS" or the "Service") in the Federal Register on December 21, 2018 (the "Proposed Regulations"). Mayer Brown represents many clients affected by the Proposed Regulations.

We appreciate very much the hard work of Treasury and the IRS in addressing the complexities and challenges of the Base Erosion and Anti-Abuse Tax ("BEAT") under Section 59A.¹ Our comments are focused only on one aspect of the Proposed Regulations, specifically the determination of related party interest expense incurred by a United States branch of a non-US bank that uses the Separate Currency Pool ("SCP") method to determine its branch interest expense.

In many cases, a branch that uses the Adjusted US-Booked Liability ("AUSBL") method for determining its branch interest expense will experience a much lower amount of "base erosion payments" within the meaning of Section 59A(d)(l) than does a branch that uses the SCP method. This disadvantage does not appear to be supported by tax policy, nor is a reason clearly articulated in the Notice of Proposed Rulemaking. Further, given that banks are highly regulated entities in the United States and abroad, they have limited or no ability to manipulate the location of their debt in order to secure a more favorable treatment under the BEAT, regardless of whether they use the AUSBL or the SCP method. Thus, this disparity should be addressed in the final regulations to be issued under Section 59.

I. Branch Interest Deductions

The calculation of the interest expense allowable as a deduction for a US branch of a non-US bank in determining its effectively connected income ("ECI"), that is, income that is taxable in the United States, is governed by Treasury Regulation§ 1.882-5. In general, if the US branch is part of a bank that is a resident of a country with an income tax treaty with the United States, Treasury Regulation § 1.882-5 will apply to determine the Business Profits of the US branch (referred to as a "permanent establishment" or "PE" under a treaty).²

Treasury Regulation § 1.882-5 provides two methods for the calculation: the AUSBL method and the SCP method. The election to use the AUSBL or the SCP method is binding for the year in which made and the succeeding four years. Treas. Reg. § 1.882-5(a)(7). The two methods overlap to a certain extent although, as indicated by its name, the SCP is undertaken for each separate currency in which the non-US bank does business. Since the SCP incorporates elements of the AUSBL method, it makes sense to start with a description of the latter.

A. The AUSBL Method

The calculation of the interest expense allowable as a deduction in determining a US branch's net ECI under the AUSBL method involves a three-step process:³

Step 1: The bank must calculate the average value of its US assets.⁴

Step 2: The average US assets are multiplied by a ratio in order to determine the "US connected liabilities" ("USCL"). For this step, a taxpayer may elect to use (i) an actual ratio resulting from dividing the taxpayer's average worldwide liabilities over its worldwide assets or (ii) a fixed 95% ratio.⁵

Step 3: The USCL determined in Step 2 are then multiplied by a rate of interest. To determine this rate of interest, the taxpayer uses the following method.⁶ If the foreign corporation's USCL are greater than its "average US-booked liabilities" (i.e., the average liabilities properly reflected on the books of the US trade or business under Treasury Regulation § 1.882-5(d)(2)), its interest expense deduction is the total amount of interest paid or accrued on its average US-booked liabilities, plus the interest expense allowed on the amount of its USCLs that exceeds its average US-booked liabilities (the "excess USCL"). The interest expense on the taxpayer's excess USCLs (the "excess interest") may be calculated by reference to (i) a safe-harbor rate consisting of a published average 30-day London Interbank Offering Rate for the year or (ii) a rate determined by dividing the total interest expense on US-dollar liabilities that are not US-booked liabilities and that are shown on the books of the foreign corporation outside the United States by the average amount of those US-dollar liabilities.

If, instead, the foreign corporation's US-booked liabilities equal or exceed the USCL, the amount of interest expense allocable to ECI is the total amount of interest paid or accrued on the US-booked liabilities, appropriately reduced to correspond to the amount of USCL pursuant to the so-called "scaling ratio."

B. The SCP Method 

The calculation of the interest expense allowable as a deduction in determining a US branch's net ECI under the SCP method also involves a three-step process, this one laid out in Treas. Reg. § 1.882-5(e):

Step 1: US assets in each currency are identified and valued.⁷

Step 2: The USCL in each currency pool are determined by multiplying the value of US assets in that currency pool by (i) the actual ratio of worldwide liabilities to worldwide assets or, at the taxpayer's election, (ii) a fixed 95% ratio.⁸

Step 3: The interest deduction for a particular currency pool consists of the USCL in that currency multiplied by the weighted average interest rate of the bank's worldwide liabilities in that currency (i.e., the bank's worldwide interest expense for the year in that currency divided by its average worldwide liabilities in the currency).⁹

In contrast to the AUSBL method, the SCP method does not look to US-booked liabilities and to whether USCL exceed or are less than US-booked liabilities. As a result, under the SCP, a US branch does not separately deduct "excess interest" and does not apply the "scaling ratio" to reduce its interest deduction. Indeed, the concepts of "excess interest" and "scaling ratio" are foreign to the SCP method.

II. Application of the BEAT to US Branch Interest Deductions under the AUSBL and SCP Methods

The BEAT imposed by Section 59A functions as a minimum tax on "applicable taxpayers" within the meaning of Section 59A(e).¹⁰ More specifically, if a taxpayer's "base erosion payments" exceed a minimum threshold percentage, the taxpayer must add back such base erosion payments to its taxable income to arrive at its "modified taxable income." Section 59A(c)(1). Base erosion payments are generally payments or accruals made by a US taxpayer (or the US taxable operations of a non-US taxpayer) (i) to a foreign related party on which no US tax is paid by the foreign related party or on which less than the full amount of US withholding tax is imposed and (ii) which are deductible for US tax purposes. Section 59A(d). The BEAT is then imposed on the modified taxable income. Section 59A(a). If the BEAT exceeds the taxpayer's regular tax liability, the taxpayer must pay the higher BEAT liability. Id.

Neither the statutory BEAT rules nor the legislative history accompanying the enactment of the BEAT rules contain any rules addressing the application of the BEAT to interest deductions incurred by a US branch of a non-US taxpayer. The IRS has issued Proposed Regulations that address the application of the BEAT to branch interest deductions.¹¹ The Proposed Regulations provide different rules for US branches using the AUSBL method and those using the SCP method.

Proposed Treasury Regulation § 1.59A-3(b)(4)(i)(A) provides that the base erosion payments of taxpayers using the AUSBL method shall equal the sum of three items. First, the US branch determines its interest on qualified nonrecourse indebtedness and integrated financial products that is attributable to US assets (directly allocable liabilities) to the extent owed to foreign related parties.¹² Second, interest paid or accrued on US-booked liabilities that are owed to foreign related parties is determined. Prop. Treas. Reg. § 1.59A-3(b)(4)(i)(A)(1). Third, excess interest is considered to be paid to foreign related parties in the same ratio that worldwide liabilities of the whole bank are due to foreign related parties. Prop. Treas. Reg. § 1.59A-3(b)(4)(i)(A)(2).

In the case of a taxpayer using the SCP method, Prop. Treas. Reg. § 1.59A-3(b)(4)(i)(B) provides that the base erosion payments shall equal the sum of two items. First, like in the AUSBL method, the US branch determines its interest on qualified nonrecourse indebtedness and integrated financial products that is attributable to US assets (directly allocable liabilities) to the extent owed to foreign related parties. Second, the interest expense attributable to the USCL in each currency pool is considered to be paid to foreign related parties in the same ratio that worldwide liabilities of the whole bank in that same currency are due to foreign related parties

An example can illustrate the difference between the determination of the amount of base erosion payments under the AUSBL method and under the SCP method. Assume the following facts about a foreign bank and its US branch:

• The US branch does not have any directly allocable liabilities outstanding (i.e., qualified nonrecourse indebtedness or integrated financial products). Thus, the first part of the equation under either the AUSBL or the SCP method is zero.

• The US branch has $1,000x of US-booked liabilities outstanding, of which $200x are due to foreign related parties. The US branch incurred $50x of interest expense on its US-booked liabilities with each US-booked liability bearing a 5% interest rate.

• The US branch has $1,053x of US assets. This would result in USCLs of $1,000x ($1.053x*95%), assuming that the US branch elected to use the fixed ratio of 95%. In other words, the USCL of the foreign branch would equal the US-booked liabilities.

• The weighted average interest rate on all of the bank's borrowings in each different currency is always 5%.

• 30% of the worldwide liabilities of the bank in each currency are held by foreign related parties.

Under the A USBL method, $10x of the US-booked interest expense would be considered base erosion payments within the meaning of Section 59A because they are paid to foreign related parties ($200x*5%). The bank would not have any additional base erosion payments resulting from its interest expense because it does not have any "excess interest" (the USCL equal the US-booked liabilities).

Under the SCP method, however, the bank would have $15x of base erosion payments resulting from multiplying the $50x of interest attributable to its USCL by the 30% ratio of worldwide liabilities owed to foreign related parties. There is no rational reason as to why the disparate results should occur.

III. Solutions to the Disparity Between AUSBL and SCP Under the BEAT

It appears that the disparate treatment between the AUSBL and SCP methods may have been an inadvertent consequence resulting from the differing technical framework of each method.

More specifically, the AUSBL method determines the interest expense attributable to the US branch in two stages: first, as it relates to interest on the US-booked liabilities and, second, to the extent such amount needs to be adjusted upwards or downwards to account for any differences between the US-booked liabilities and the USCL. In the first stage, the taxpayer is only deemed to have base erosion payments to the extent of its actual interest paid on US-booked liabilities to foreign related persons, regardless of whether its ratio of worldwide liabilities owed to foreign related persons is greater than the same ratio at the level of its US-booked liabilities.

In the SCP method, however, the determination of interest expense attributable to the US branch does not have two stages. Instead, for each currency pool, it is a direct result of the interest expense attributable to the taxpayer's USCL because, as explained above, the SCP does not look first to the US-booked liabilities. As such, unless the Proposed Regulations are amended, there is no opportunity for an SCP method taxpayer to reduce its amount of base erosion payments based on the extent of its US-booked liabilities owed to parties other than foreign related persons (even if the ratio of liabilities owed to foreign related parties is less for its US-booked liabilities than for its worldwide liabilities).

A. Permit Subtraction of Qualified US-Booked Interest to Determine Base Erosion Payments ("Stacking Approach")

To ensure that a US branch of a non-US bank is not overstating its US base erosion payments, Treasury could provide in the final regulations that taxpayers using the SCP method will determine their amount of base erosion payments as follows. First, the taxpayer would calculate its amount of "related USCL interest" in each currency pool by multiplying the interest expense attributable to USCL in such currency pool by the ratio of worldwide liabilities owed to related parties-to-total worldwide liabilities in such currency pool. Then, for each currency pool, the taxpayer would determine its base erosion payment amount by subtracting from the amount of "related USCL interest" the amount of interest expense on US-booked liabilities that was paid to parties other than foreign related persons.

In other words, this proposal would involve adding an additional step to the existing rule for the determination of BEAT payments under the SCP method pursuant to Prop. Treas. Reg. § 1.59A-3(b)(4)(i)(B)(2). By doing so, the taxpayer is put on equal footing with a similarly situated taxpayer using the AUSBL method given that it will not be deemed to have base erosion payments to the extent that its interest on US-booked liabilities was paid to parties other than foreign related persons.

B. Election to Use Ratio of US-Booked Liabilities Held by Foreign Affiliates

As an alternative to the solution described in III.A, Treasury could also allow a taxpayer using the SCP method to determine the amount of base erosion payments of its US branch by multiplying the interest attributable to its USCLs by the percentage derived by dividing its US-booked liabilities due to foreign related persons by the amount of its total US-booked liabilities.

Regardless of whether the US branch is using its worldwide leverage ratio or the fixed 95% assumed leverage ratio in Step 2, in both cases, it is the amount of US assets that determines the amount of leverage that is assumed to be properly allocable to the US branch. Since US assets are the determinant of the amount of leverage, it follows that the amount of US branch debt held by foreign related parties should be the determinant of the amount of interest that is treated as base erosion payments. The percentage of related party debt issued by non-US branches does not create base erosion payments and should not be the determinant of the amount of interest that is considered to have been paid by the US branch.

* * *

We would be pleased to discuss with appropriate personnel the issues addressed in this letter if that would be helpful. Please feel free to contact Mark H. Leeds at (212) 506-2499 or Lucas Giardelli at (212) 506-2238.

Sincerely,

MAYER BROWN LLP
New York, NY

Cc:
David J. Kautter
Assistant Secretary, Office of Tax Policy
Department of the Treasury

Lafayette "Chip" G. Harter III
Deputy Assistant Secretary (International Tax Affairs)
Department of the Treasury

Douglas L. Poms
International Tax Counsel
Department of the Treasury

Brian Jenn
Deputy International Tax Counsel
Department of the Treasury

Charles P. Rettig
Commissioner
Internal Revenue Service

William M. Paul
Chief Counsel (Acting)
Internal Revenue Service

Sheila Ramaswamy
Office of Associate Chief Counsel, International
Internal Revenue Service

Karen Walny
Office of Associate Chief Counsel, International
Internal Revenue Service

L. Ulysses Chatman
Office of Associate Chief Counsel, International
Internal Revenue Service

Brad McCormack
Office of Associate Chief Counsel, International
Internal Revenue Service

Anand Desai
Office of Associate Chief Counsel, International
Internal Revenue Service

Julie Wang
Office of Associate Chief Counsel, Corporate
Internal Revenue Service

John P. Stemwedel
Office of Associate Chief Counsel, Corporate
Internal Revenue Service