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Treasury Releases Documents on Banks, Information Reporting

SEP. 14, 2017

Treasury Releases Documents on Banks, Information Reporting

DATED SEP. 14, 2017
DOCUMENT ATTRIBUTES

The Treatment of Branches under a Territorial System

September 14, 2017

Q1: What distinguishes branches from subsidiaries?

The advantage of a subsidiary is that it is separate from its owner. The advantage of a branch is that it is not separate.

The vast majority of U.S. companies conduct foreign activities through subsidiaries. Doing business in a foreign country through a foreign subsidiary can insulate the U.S. parent from liability, facilitate compliance with obligations under an unfamiliar legal system, and reduce the potential for conflicts between U.S. and foreign law.

The banking industry is an exception to this general rule. Banks often find it more efficient to conduct their core lending and deposit-taking businesses through branches. A foreign branch of a U.S. bank is treated as part of the bank for legal, regulatory and tax purposes both in the United States and the country where the branch is located.1

Q2: How are foreign branches taxed today?

All of a foreign branch’s income is taxed currently. Unlike foreign subsidiaries, there are no opportunities for deferral, and no pools of retained earnings that have not been subject to U.S. taxation.

Q3: Why do banks care about branches?

For reasons unrelated to taxes, many banks conduct a significant proportion of their foreign activities through branches. A failure to provide parity of treatment between branches and subsidiaries would have unpredictable, and potentially very unfavorable, consequences for our industry.

Q4: Should activities conducted through branches qualify for territorial treatment?

Yes. A territorial system represents a policy decision not to tax income derived from the conduct of an active business in a foreign country. There is no reason to treat the same activities, in the same country, less favorably because they are conducted by a branch rather than a subsidiary. Active businesses conducted through branches should qualify for the same benefits as active businesses conducted through subsidiaries. Many OECD countries — including the countries in which our principal foreign competitors are based — make a territorial exemption available to branches on the same terms as subsidiaries.

Q5: In extending the territorial system to branches, should branches be treated as if they had become corporations?

No. It would be unnecessary and counterproductive to treat foreign branches as if they had suddenly morphed into corporations upon the entry into force of the new system. There are real and meaningful differences between branches and subsidiaries. Tax reform won’t affect those differences. Branches will still be branches: the benefits of the territorial system can be extended to them without deeming them to have become subsidiaries.

The objective should be to ensure parity of treatment between branches and subsidiaries. Parity does not require that branches be treated, contrary to reality, as if they had become corporations.

a. Companies should not be required to recognize gain or loss in respect of their foreign branches.

In transitioning to a territorial system, there presumably will not be any taxation of a foreign subsidiary’s built-in gain.2 Taxing gain in branches but not in subsidiaries would create inappropriate disparities between the treatment of banks (and other companies that conduct foreign activities through branches) and companies that conduct foreign activities through subsidiaries.

The U.S. tax system currently taxes gains realized upon the outbound transfer of property to a foreign corporation. No such transfer will be deemed to occur, and therefore no tax will be imposed, when a foreign subsidiary becomes eligible for territorial treatment: the subsidiary’s assets are already outside the United States. For the same reason, no transfer should be deemed to occur when a U.S. company’s interest in a foreign branch becomes eligible for territorial treatment. The day after the territorial system enters into force, the branch will own the same assets that it did the day before. Built-in gain in respect of the assets of a foreign branch should be treated no better, and no worse, than built-in gain in respect of the assets of a foreign subsidiary.

b. Current-law rules for reconciling branch accounts maintained in a foreign currency should remain in place.

Special tax accounting rules apply to U.S. companies whose branches keep their books in currencies other than the U.S. dollar. Under IRC § 987, such companies are required to keep track of the difference between the amount of income that has been taken into account for U.S. tax purposes (translated into dollars at historic exchange rates) and the corresponding foreign currency amounts reflected on the branch’s books. The cumulative amount of these differences can build up over time, and can be very substantial. Taxpayers are required to make true-up adjustments when a branch is terminated, sold, or returns assets to the United States.

These rules were enacted in an effort to create greater parity between the treatment of foreign business activities conducted through branches and subsidiaries. They will be needed for the same purpose under a territorial system, and should remain in place in their current form. For this purpose, IRC § 987 adjustments in respect of pre-enactment income should be includible in income or deductible at the generally applicable corporate rate in the year of a remittance or other triggering event. The tax treatment of other IRC § 987 adjustments should be determined by reference to the treatment of gain or loss on the sale of a subsidiary.

c. Future outbound transfers to branches and subsidiaries should be subject to uniform rules.

In connection with the adoption of a territorial system, Congress should consider whether the current-law safeguards will afford sufficient protection against base erosion under the new system. The rules governing outbound transfers of property under IRC § 367 may need to be modified or reinforced to preserve their intended effect following the effective date of tax reform. The rules as so modified should apply to branches as well as to subsidiaries. If post-effective date transfers of property to a foreign subsidiary would trigger gain recognition, loss recapture, or imputed royalties, then post-effective date transfers to a foreign branch should have the same consequences.

Q6: Why is the allocation of capital an issue for branches and not for subsidiaries?

Branches don’t have separate capital; subsidiaries do. A subsidiary is a stand-alone legal entity: its paid-in capital and retained earnings can be determined by looking at its financial statements. A branch is not a stand-alone entity. This is one of the chief benefits of doing business through branches. All of the domestic and foreign branches of a U.S. bank share in a single pool of capital. The creditors of a branch generally have recourse to all of the bank’s assets, without regard to where those assets are located.

Q7: How should capital be allocated?

Congress should adopt an authorized OECD approach (“AOA”) under which capital is allocated among a bank’s global businesses in the same proportions as the bank’s risk-weighted assets (“RWA”). The United States has agreed to apply this evolving international standard in several recent bilateral tax treaties. The methodology essentially corresponds to the longstanding U.S. tax rules governing U.S. branches of foreign banks.

Under this approach, the amount of a bank’s worldwide capital that is allocable to a particular branch would be determined using the following formula:

Branch capital = worldwide capital x branch RWA ÷ worldwide RWA.

For example, if a bank has $100 billion of worldwide RWA supported by $12 billion of capital, then a branch with $10 billion of RWA would be allocated $1.2 billion of capital [$12 billion worldwide capital x $10 billion branch RWA/$100 billion worldwide RWA].

The use of an AOA should reduce the potential for inconsistencies between U.S. and foreign computations of branch capital.

Q8: What other questions will arise?

The adjustments required in order to extend territorial treatment to branches should be manageable. We have set out some recommendations in the attached appendix.

Moreover, the practical and technical issues associated with bringing branches into a territorial system would appear to be much more straightforward — and less likely to present problems for taxpayers and tax authorities — than the issues that would need to be dealt with in order to leave them out.

A territorial system that excludes branches — a system in which branches are taxable and subsidiaries are exempt — almost inevitably will be more difficult to administer, more vulnerable to manipulation, and less fair than a system in which all active foreign business income is subject to a single set of rules.

The drafters of the Camp tax reform bill may have come to realize this in the course of their efforts to develop a territorial system that did not include branches. Contrary to some accounts, the Camp proposal did not preserve the status quo for banks. Instead, the proposal provided for complex and far-reaching changes in the treatment of branches.

As indicated above, a number of OECD countries — including most of the countries in which our principal foreign competitors are based — have made territorial treatment available to branches on the same terms as subsidiaries.


Appendix: Determining Branch Net Income under a Territorial System

September 7, 2017

1. Overview.

As indicated above, one of the advantages of doing business through a branch network is flexibility: resources can be moved from place to place to support business needs; assets held in one location can support business operations conducted in multiple locations. The fact that branches are part of a single legal entity means that transfers between them do not need to take a particular legal form. However, many interbranch transactions are denominated as loans, swaps or service agreements, and rise to payments that are deductible or includible in income for foreign tax purposes.

Notwithstanding the truism that interbranch transactions are disregarded for U.S. tax purposes,3 the U.S. tax authorities recognize that such transactions can represent a useful tool in a variety of cases. Such transactions may be taken into account in determining the allocation of revenues and expenses among the participants in a global trading business. Moreover, courts have determined that interbranch transactions must be taken into account for tax treaty purposes.4

The U.S. tax authorities should take account of interbranch transactions in determining branch net income eligible for territorial treatment. This will have the ancillary benefit of reducing the disparity between the methodologies used for U.S. and foreign tax purposes.

2. Recommended approach.

Congress, and the U.S. tax authorities, should have a strong bias in favor of simplicity. The following principles should produce workable and fair results, and avoid unnecessary complexity:

a. Capital allocation comes first.

As indicated above, the amount of capital allocable to a foreign branch should be determined by reference to the ratio that the branch’s RWA bears to the bank’s total RWA. A branch’s indebtedness necessarily will be equal to the difference between its capital, determined as described above, and its gross assets. The debt attributed to the branch may be more or less than the amount of third-party or interbranch debt shown on the branch’s financial statements. The current rules applicable to U.S. branches of foreign banks provide a mechanism for making upward and downward adjustments when necessary. A similar mechanism will need to be adopted for foreign branches of U.S. banks.

b. Pre-effective date transactions.

Income and expense on transactions that were entered into prior to the effective date of tax reform generally should be determined based on the original terms of the transactions. Interbranch positions should be marked to market for tax purposes if they relate to third-party positions that are marked to market.

c. Future transactions.

Income and expenses in respect of post-effective date transactions should be determined in accordance with their terms, so long as the terms are consistent with arm’s length standards.

d. Interbranch transactions should be regarded only for purposes of allocating items of income and expense.

Taking interbranch transactions into account for purposes of determining a branch’s net income eligible for territorial treatment does not require that the transactions be subject to all of the rules that would apply to transactions between related corporations. For example, payments to the foreign branch of a U.S. bank should not be subject to the withholding tax rules that would apply to payments to an actual foreign corporation.


Explanation of Proposed Clarification to Section 6050W

September 14, 2017

Internal Revenue Code section 6050W1, enacted by the Housing Assistance Tax Act of 2008, became effective on January 1, 2011, and requires entities that settle or reimburse merchants for credit card and other electronic payments (known as the “payment settlement entity” for the purpose of this statute) to report to the Internal Revenue Service (“IRS”) the total amount of payments relating to these transactions as well as the name, address and taxpayer identification number (TIN) of each merchant or a “payee” to whom they make payments in settlement of reportable transactions. In addition, payments made in settlement of payment card transactions have been subject to potential US federal backup withholding — 28% on the gross payment to the merchant — since January 1, 2013, if the merchant fails to provide its TIN to the payment settlement entities that are required to do the reporting. Furthermore, in the event there is a failure to properly report to either the payee or the IRS, penalties under sections 6721 and 6722 apply.

Generally, merchants with foreign addresses are not subject to section 6050W reporting. The statutory language specifically reads:

Except as provided by the Secretary in regulations or other guidance, such term [payee] shall not include any person with a foreign address.2

Accordingly, under the statute, a payment settlement entity (a “PSE”) should be relieved from the requirements of section 6050W when it makes a payment to a payee with a foreign address (the “foreign address exclusion”).

However, the IRS over the last several years has issued several pieces of guidance in order to clarify when such reporting regarding merchants with foreign addresses is and is not required. This guidance originally eliminated the foreign address exclusion in virtually all cases, and while the IRS has issued notices that would allow the use of the foreign address exclusion in certain cases, otherwise unnecessary tax documentation will still need to be collected from merchants in certain markets. The collection of this documentation from merchants generally not subject to US tax creates an overly burdensome, anti-competitive, and costly penalty for US PSEs, particularly since foreign-based PSE are not required to obtain this documentation. Moreover, the prospect of 28% withholding on merchant reimbursements has driven many foreign merchants to utilize foreign-based PSEs that are not subject to the 6050W requirements.

The proposed technical correction makes clear a payee with a foreign address should only be included in the definition of a “payee” for purposes of section 6050W when there is actual knowledge the payee is a US person.

IRS guidance

The IRS has issued regulations under section 6050W, including specific guidance on the foreign address exception, as well as Notices that explain its intent to amend those regulations to include “risk factors” that act as a trip wire to trigger reporting and potential backup withholding.3 Two of those factors effectively override the foreign address exclusion for entire regions of the world.

Together, the regulations and the notices outline when a PSE must report (and potentially backup withhold) or document payees with foreign addresses. The proper application of the foreign address exclusion is vital to the operations of a PSE. These documentation and reporting requirements present significant challenges, burdens and risk to a PSE that fails to properly report or withhold.

Beyond certain transition relief, Treas. Reg. § 1.6050W-1(a)(4) generally requires a US PSE to obtain tax documentation, i.e., a withholding certificate, generally furnished on a Form W-8BEN-E, Certificate of Foreign Status of Beneficial Owner (Entities) from a payee with a foreign address before it can treat that payee as foreign and not subject to section 6050W reporting. However, under Treas. Reg. § 1.6050W-1(a)(5)(ii)(B), a non-US PSE is not required to report payments to a payee that does not have a US address as long as the PSE neither knows nor has reason to know that the payee is a US person.

In Notice 2011-714, the IRS provided further guidance on the foreign address rule. It stated that in the case of US PSEs making payments outside the US, no reporting is required unless one of four risk factors is present. Those four “risk factors” are (i) a US address associated with the merchant, (ii) the payor has standing instructions to direct the payment to a bank account maintained in the US, (iii) the merchant submits for payment in US dollars, or (iv) the payor knows or has reason to know the merchant is US. In the case where a risk factor is present, no reporting is required only if the payor obtains a valid Form W-8 or documentary evidence establishing the merchant’s non-US status.

The second and third factors in the Notice — the US PSE has standing instructions to direct the payment to a bank account maintained in the US and the payee submits for payment in US dollars — create significant challenges for US PSEs because these factors apply to the majority of merchants in the Caribbean and Central and Latin America.

In response to comments from US PSEs on Notice 2011-71, Notice 2012-25 essentially applies the same four risk factors in Notice 2011-71 to a US PSE making payments from inside the United States if payment is made to an account outside the United States and the payor has reasonably determined based on all information available that the merchant is doing business outside the United States. As with Notice 2011-71, if a risk factor is present, a payor must obtain a valid Form W-8 or documentary evidence establishing the merchant’s non-US status in order to apply the foreign address exclusion.

Reasons for clarification

In general, the primary purposes for information reporting is for the IRS to receive information about income received by a US taxpayer from a third party. Section 6050W accomplishes this goal by requiring PSEs to report payments made to merchants. On its face, section 6050W also balances the goal of collecting such third party tax information with the compliance and economic burden it imposes on PSEs through the foreign address exclusion. The foreign address exclusion acknowledges that there is no need for US information reporting or documentation where a PSE makes payments to a person with a foreign address. The Congressional Record shows the Senate version of the exclusion excepted payees that were "foreign persons" but this language was amended, as reflected in the current statute, to except payees with a foreign address.

In Notices 2011-71 and 2012-2, the IRS imposes two factors — payment is requested to be made to a bank account maintained in the United States and a request for payment in US dollars — that override the foreign address exclusion where there is no clear indication that the merchant is a US person. Under the Notices, the existence of either of these factors requires the US PSE to obtain US tax documentation from the payee.

While under current law the existence of these factors can be overcome by the US PSE obtaining a Form W-8, in reality, when a US PSE tries to obtain such documentation from a foreign payee, the foreign payee often has no experience with US tax law and is more likely to refuse to do business with the US PSE rather than sign a US tax form that they do not fully understand. Furthermore, if the US PSE does not obtain the Form W-8, the US PSE must withhold 28% of the gross amount due to the payee. Either of these results imposes significant economic burden to the US PSE.

Any guidance issued by the IRS should balance the importance of tax information with the burden it imposes. A payee with a foreign address should only be included in the definition of a “payee” for purposes of section 6050W when there is actual knowledge the payee is a US person. Accordingly, revising the foreign address exclusion to rely on actual knowledge properly clarifies the purpose of the exclusion.

Proposed legislative fix

To clarify the foreign address exclusion and move back to the intent of the statute, the exclusion articulated in section 6050W(d)(1)(B) should be revised to provide:

Exclusion of foreign persons — Such term shall not include any person with only a foreign address absent actual knowledge by the payment settlement entity that the participating payee is a US person.

Explanation of the legislative proposal

The IRS’s current authority under the foreign address exclusion is replaced with an actual knowledge standard imposed on US PSEs. This technical correction more accurately reflects Congressional intent to focus the foreign address exclusion on the payee’s address.

The actual knowledge standard works to appropriately limit the application of section 6050W’s documentation and information reporting to payees that are relevant to the IRS. The factors issued in the Notices — specifically, payment is requested to be made to a bank account maintained in the US and a request for payment in US dollars — would no longer impose documentation requirements on US PSEs without actual knowledge that the payee is otherwise a US person.

FOOTNOTES

1This paper focuses on such “true” (as opposed to hybrid) branches, because this is the fact pattern that is of primary importance to banks. Hybrid branches are disregarded for U.S. tax purposes, but are respected as separate entities for most other purposes.

2The one-time transition tax will be imposed on foreign subsidiaries’ retained earnings, and not on unrealized gains in respect of their shares or assets. As indicated in the text, branches don’t have retained earnings: all of their income is subject to current U.S. tax.

3Transactions effected between integral parts of a single company (i.e., between a foreign branch and its U.S. home office, or between two foreign branches of the same company) normally don’t have significant non-tax economic consequences. A company can’t borrow money from itself, or sell property to itself, or enforce remedies against itself. Creditors and counterparties may be indifferent to the place where a company holds its assets, so long as the assets are held by the company directly, and not through a separate legal entity.

4See National Westminster Bank v. U.S., 512 F3d 1347 (CA Fed Cir 2008) (affirming three lower court determinations that the IRS had wrongfully failed to take account of interbranch transactions in determining the income of NatWest’s U.S. branch): 44 Fed Cl 120 (Ct Fed Cl 1999) (“NatWest I”, dealing with interbranch loans), 58 Fed Cl 491 (Ct Fed Cl 2003) (“NatWest II”, dealing with capital allocation) and 69 Fed Cl 128 (Ct Fed Cl 2005) (“NatWest III”).

1Except as otherwise indicated, all “section” and “Treas. Reg. § ” references contained herein refer, respectively, to sections of the Internal Revenue Code of 1986, as amended, and to the Treasury Regulations promulgated thereunder.

2Section 6050W(d)(1)(B). The reference to Secretary refers to the Secretary of the US Treasury, which includes the Internal Revenue Service. For convenience, the Secretary and the IRS will be referred to only as the “IRS”.

3Notice 2011-71, 2011-2 C.B. 233 (August 19, 2011); and Notice 2012-2, 2012-2 C.B. 538 (October 18, 2012) (each discussed below).

42011-2 C.B. 233 (August 19, 2011).

52012-2 C.B. 538 (October 18, 2012).

END FOOTNOTES

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