The 10% Rule: TAM 201325012

By Edward Tanenbaum, Esq.  

Alston & Bird LLP, New York, NY

In a carefully reasoned analysis, the IRS National Office
determined in TAM 201325012 that interest earned by a foreign bank
on notes pledged as collateral for access to the Federal Reserve
must be allocated between effectively connected income (ECI) and
non-ECI under the "10% Rule" established in Regs.
§1.864-4(c)(5)(ii)(b)(3).

The taxpayer was a foreign bank with a U.S. branch, which
actively and materially participated in soliciting and negotiating
liquidity and credit-support commitments, including letters of
credit, standby bond purchase agreements, and standby asset
purchase agreements (the Commitments). The Commitments obligated
the taxpayer to maintain access to the Federal Reserve Discount
Window to secure funding for the U.S. banking business, which
requires the posting of collateral. The taxpayer acquired from
broker-dealers, with the material participation of the U.S. branch,
medium-term notes issued by commercial banks on the interbank
market (the Notes) to pledge as collateral to the Federal Reserve.
The taxpayer treated the Notes as securities under Regs.
§1.864-4(c)(5)(v).

The general ECI rules of §864(c) provide that U.S.-source fixed
or determinable annual or periodical income, which includes
U.S.-source interest, is ECI if it is derived from assets used in
or held for use in the conduct of a U.S. trade or business (the
asset-use test) or if the activities of a U.S. trade or business
were a material factor in realizing the income (the
business-activities test). But special rules apply to determine the
ECI of a U.S. banking, financing, or similar business under Regs.
§1.864-4(c)(5), rules that apply notwithstanding the asset-use test
or business-activities test. If a foreign corporation conducts a
U.S. banking, financing, or similar business (as defined in the
regulations), then U.S.-source interest on securities is ECI only
if the securities are attributable to a U.S. office1
through which such business is conducted and the securities were
acquired: (1) as a result of, or in the course of, making loans to
the public; (2) in the course of distributing such securities to
the public; or (3) for the purpose of being used to satisfy the
reserve or similar requirements established by a U.S. banking
authority.  A security is attributable to a U.S. office if the
office materially participates in soliciting the security,
negotiating the terms of the security, or performing other
activities necessary to acquire the security.

When a security is so attributable to a U.S. office but does not
otherwise meet one of the above three criteria to be ECI, it falls
into a residual category in Regs.
§1.864-4(c)(5)(ii)(b)(3)
((b)(3) securities).  The income from a
(b)(3) security is subject to the 10% Rule, which
limits the amount of income that constitutes ECI. To determine the
ECI from (b)(3) securities, the income amount is
multiplied by a fraction (not to exceed 1), the numerator of which
is 10%, and the denominator of which is the ratio of the monthly
average book value of the (b)(3) securities to
the monthly average book value of the total assets of the U.S.
banking, financing, or similar business.

The origin of the 10% Rule is set forth in Technical Memorandum
1970TM LEXIS 39 (12/23/70)), which accompanied a Notice of Proposed
Rulemaking with respect to an amendment to regulations conforming
them to §864(c). One of the purposes of the 10% Rule was to make a
distinction between banking activities and income from non-banking
investment activities and to strike a balance between income that
could be taxed on a net progressive basis (receiving the benefit of
offsetting expenses) and income that would be required to be taxed
on a flat gross withholding tax basis.

The TAM finds that the taxpayer was engaged in a U.S. banking
business through a U.S. office and, further, that the Notes were
securities attributable to the U.S. office because the office
materially participated in the Notes' acquisition. Nevertheless,
the IRS concluded that, because the Notes were not acquired in the
course of making loans to the public, distributing the securities
to the public, or satisfying reserve or similar requirements
established by a U.S. banking authority, the Notes were
(b)(3) securities, and the interest thereon could
not be entirely ECI as it was subject to the 10% Rule.

First, the TAM determined that the Notes were not acquired in
the course of making loans to the public. The TAM acknowledged, on
the one hand, that the Commitments solicited and negotiated by the
taxpayer's U.S. office constituted securities acquired in the
course of making loans to the public. In contrast, under the
regulations, because the taxpayer purchased the Notes through
broker-dealers on an interbank market, the Notes were not
considered acquired in the course of making loans to the public.
The IRS concedes that the acquisition "arguably" related directly
to the taxpayer's U.S. banking business because the Notes were
acquired to post as collateral to ensure liquidity to fund the
Commitments. Still, the IRS contends that the Notes do not fit into
this category because they were not acquired from customers or
incident to customer loans (e.g., through foreclosure on default of
customer loans, as illustrated in the regulations).  Moreover,
the term of the Notes, which exceeds one year, disqualified them
from an exception to the special ECI rules for short-term
securities.

Second, the taxpayer did not acquire the Notes in the course of
distributing them to the public. The TAM observes that the taxpayer
was not an underwriter or market maker for the Notes, nor did the
taxpayer distribute the Notes to the public upon acquisition. 
Rather, the taxpayer acquired the Notes for its own account to
pledge as collateral with the Federal Reserve.

Finally, the IRS concluded that the Notes were not acquired to
satisfy reserve or similar requirements of a U.S. banking
authority. First, the TAM observes that the Notes are not a
permissible form of reserves under the rules of the Federal Reserve
Board, which requires that reserves be vault cash or reserve
deposits with Federal Reserve Banks. Next, the IRS considers
whether the collateral requirement for accessing the Federal
Reserve Discount Window, the reason the taxpayer acquired the
Notes, may be considered "similar to reserve requirements." The TAM
determines that the collateral requirement is not similar to a
reserve requirement because there is a "clear functional
distinction." The Federal Reserve's reserve requirements facilitate
monetary policy while the collateral requirement, which is not
uniformly imposed, secures borrowings voluntarily incurred by banks
from the Discount Window.

TAM 201325012 is one of the first in-depth interpretations of
whether income from securities is subject to the 10% Rule, i.e.,
whether securities are acquired: (1) in the course of making loans
to the public; (2) in the course of distributing the securities; or
(3) to satisfy reserve or similar requirements. As to the first
category, the Notes were ultimately doomed because they were
purchased on an over-the-counter market, and the second category
was clearly inapplicable.  But the TAM's dismissal of the
Federal Reserve Board's collateral requirement as insufficiently
"similar" to a "reserves requirement" seems questionable,
particularly in today's banking regulation climate. In any event,
foreign banks seeking to derive ECI via U.S. offices should be
aware that the IRS may closely scrutinize so-called investment
income - even though the underlying investment is "arguably…
directly related" to U.S. banking activity.

This commentary also will appear in the October 2013 issue
of the
 Tax Management International Journal.
 For more information, in the Tax Management Portfolios,
see Katz, Plambeck, and Ring, 908 T.M.
, U.S. Income Taxation
of Foreign Corporations, and in Tax Practice Series, see ¶7130,
Foreign Persons - Effectively Connected Income.

 


 

  1 See AM 2009-010 (10/2/09) for Chief
Counsel's opinion as to the effect of a U.S. office of an agent,
even one with no authority to conclude contracts in the name of the
foreign entity, in creating ECI.