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By Edward Tanenbaum, Esq. Alston & Bird LLP New York, New York
The precise definition of a “bank” under our tax laws is relevant not only for purposes of applying domestic bank tax rules but also in the international context. For example, special rules exist for determining when a foreign entity engaged in a banking business is considered to be engaged in a U.S. trade or business and in determining whether its income is “effectively connected” with such trade or business. In addition, the definition is relevant for purposes of determining whether a foreign entity receiving U.S.-source interest is a bank which, to the extent it receives interest on an extension of credit pursuant to a loan agreement entered into the ordinary course of its trade or business, would foreclose its opportunity to treat the interest as tax-free portfolio interest.
There's not much out there in the form of guidance except for the definition of a “bank” contained in Internal Revenue Code (“Code”) §581, and that definition is technically limited in its application to Code §582 and §584. In MoneyGram International, Inc. v. Commissioner of Internal Revenue, the U.S. Court of Appeals for the Fifth Circuit (“Appeals Court”) dissected the language of §581 and confirmed that the word “bank” as used therein is to be narrowly construed.
The case involved the extent to which the taxpayer would be entitled to deduct capital losses against ordinary income, a benefit that is limited to “banks” within the meaning of §581 (as opposed to the rule permitting the deduction of capital losses only against capital gains). The Internal Revenue Service, as well as the Tax Court, determined that the taxpayer did not meet the definition of “bank” as contained in §581 and disallowed the offset. The Appeals Court, however, determined that the Tax Court applied incorrect definitions of the terms “deposits” and “loans” as used in §581, vacated the Tax Court's order and remanded the case for reconsideration in accordance with the Appeal Court's determination.
Section 581 provides in relevant part that
the term “bank” means “a bank or trust company incorporated and doing business under the laws of the United States…. or of any state, a substantial part of the business of which consists of receiving deposits and making loans and discounts … and which is subject by law to supervision and examination by State or Federal authority having supervision over banking institutions….
The Tax Court correctly cited to a Fourth Circuit case, Staunton Industrial Loan Corp. v. Commissioner, to the effect that the plain meaning of the word “bank” includes an entity that (1) receives deposits from the general public, repayable to the depositors on demand or at a fixed time; (2) uses deposited funds for secured loans; and (3) establishes the relationship of debtor and creditor with the depositor.
All well and good — but where the Tax Court erred, according to the Appeals Court, was in fashioning its own definitions for the terms “deposits” and “loans.” For example, in the case of “deposits,” the Tax Court said that “deposits” means funds given to a bank for safekeeping, that are repayable by the bank and which are held “for extended periods of time” (and that the taxpayer had not held the funds for safekeeping or for extended periods of time). With regard to “loans,” the Tax Court held that the term requires an agreement memorialized by a loan instrument that is repayable with interest and that generally has a fixed and often lengthy repayment period (facts also not met in the instant case).
The Appeals Court disagreed with the definitions given by the Tax Court for “deposits” and “loans.” It rejected the idea that the definition of “deposits” includes the requirement that funds be placed for an extended period of time. Duration, it held, is not an essential element of a deposit. In addition, the Appeals Court disagreed with the Tax Court's definition of “loan,” i.e., that a loan requires a memorialized instrument that is repayable with interest and that generally has a fixed (and often lengthy) repayment period. The Appeals Court noted that charging interest on funds advanced is not normally a requirement for the advance to be considered a loan.
The dissenting judge in the case noted that the Tax Court's errors were not that significant because in his view, the taxpayer came nowhere near the definition of a bank. He characterized the taxpayer's customers as purchasing products, i.e., money orders, and not as depositing funds for safekeeping, and observed further that the taxpayer did not make loans in a conventional sense.
There are, indeed, instances in which the Code consciously treats all entities that primarily provide banking and financing services alike. In these cases, the taxpayers covered include any entity which is engaged in a lending business even if it is not necessarily regulated as a bank.
As previously mentioned, one classic example of a broader intention is found in §864(c)(4)(B)(ii), which classifies certain foreign-source interest income as effectively connected with a U.S. trade or business to the extent derived from the active conduct of a banking, financing or similar business. Taxpayers eligible for this treatment include any entity (not just a “bank”) making loans in the ordinary course of a trade or business. So, too, §954(h)(2)(B), which exempts from subpart F income banking and financing income earned by eligible CFCs, includes as an eligible CFC any entity that is predominantly engaged in a lending or finance business. Thus, these two examples demonstrate that the references in each statute are intended to include any entity engaged in a lending business. This can be contrasted with statutes that explicitly use the term “bank,” which are intended to capture entities that accept deposits and make loans and that are regulated as such.
These examples are to be contrasted to the scope of the portfolio interest exclusion in §881(c)(3)(A), pursuant to which a foreign corporation which is a “bank” is not entitled to the portfolio interest exclusion under certain circumstances with respect to its receipt of U.S.-source interest income. The term “bank” is not defined for these purposes, although the IRS has looked to the narrow definition of banks contained in Code §581 for purposes of the exception to the portfolio interest exclusion, emphasizing the factor of receiving deposits as critical.
Although it potentially broadened the definition of “bank” at least for §581 purposes, the Appeals Court opinion in MoneyGram Int’l confirms that a narrow reading of the §581 “bank” is required when interpreting statutes which specifically apply only to “banks,” such as §881(c)(3)(A); and not to all banking, lending or finance businesses, such as §864(c)(4)(B)(ii) and §954(h).
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