Institute of International BankersSeminar on U.S. Taxation of International Banks

June 18-19, 2007

Panel on Global Dealing and Attribution of ProfitsChair

Todd TucknerManaging Director, Head of Tax (Americas)

UBSStamford, CT

Government Speakers

Steven A. MusherAssociate Chief Counsel (Int’l)

Internal Revenue Service

Paul EpsteinSenior Technical Reviewer, Branch 5

Office of the IRS Associate Chief Counsel (Int’l)

Private Sector Speakers

Bill Chip

Covington & Burling

Washington, D.C.

Hal Hicks

Skadden

Washington, D.C.

Phil West

Steptoe & Johnson

Washington, D.C.

2

Overview

• Introductions• General Comments from IRS

– Final OECD PE Reports– Reg Status– Other

• Examples– Inbound dealing with split hedging

• Source, ECI, Profit Attribution, 482, and related issues• Treatment of foreign branch liabilities funding ECI and non-ECI

activities

– Hedge fund management in US– Globally traded non-dealer assets booked in US branch

• Q&A

3

Inbound Dealing With Split Hedging

FB

US BD

US Branch

BD logistics and control

functions

All front office BD personnel

Customer trading as agent for FB?

Risk manages derivatives and hedges?

Provision of capital, credit rating

BD logistics and control functions

All BD client-facing derivatives booked here

Most BD hedges booked here

4

Inbound Dealing With Split Hedging

• Foreign Bank Parent - books customer derivatives– Serves as counterparty– Bears capital risk– Provides certain back-office functions in home office

and U.S. banking branch• U.S. Regulated Broker Dealer – books hedges

– Provides all customer trading services as agent for foreign parent

– Bears no risk of loss– Assume alternative dependent and independent

agent status of U.S. broker-dealer

5

Inbound Dealing With Split Hedging

• Net profits are determined on combined derivatives and hedging books

• Residual profit split TPM?

• Cash/book transfer mechanism:– FB compensates US BD using TPM based on

fixed percentage of net profits– Losses not cash transferred into US BD.

6

Alternative Transfer Pricing Analysis

• Profit Split Method– Routine returns

• Return to capital (Prop. Reg. §1.482-8(e))• Back office functions (Reg. §1.482-9T)

– Comparability on return to capital• Percentage of Profits (hedge fund model)

– See “Role of Capital” discussion in OECD Attribution Report, Part III, Para. 149-160

• Ex ante projection of returns on comparable expected risks

7

Example: Hypothetical Profit Calculation

Foreign Bank US BD Total

Derivatives - MTM gains $1,500 -0- 1,500Derivatives - Periodic Inc 500 -0- 500Cost of Carry (400) (400)

Hedges - MTM losses -0- (800) (800)Hedges - FDAP income -0- 200 200Cost of Carry -0- (400) (400)

Total 1,600 (1,000) 600

8

Example Assumptions• Routine return to capital: 30% of profits• Routine back office amount:

– $100 (cost plus 10%) total– $50 each to home office and U.S. PE based on

actual cost and value in each location

• US BD earns all of the residual profit– Assumption based on the fact that all front office,

non-routine marketing and sales, trading, risk management functions are performed by US BD

9

ExampleSec. 482, Treaty Analysis

Foreign Bank US  BDTotal

Routine functions:

Return to Capital $180 (30% x  $600) -0- 180Operations functions 100 (Cost  plus 10%) -0- 100

Residual functions: 0 320 320

Total 280 320 600

Booked Amounts 1,600 (1,000) 600

Compensating Adjustments (1,320) 1,320 -0-

10

ECI Analysis

• Profits of foreign bank must be allocated between the bank's home office and its US branch– Use source and allocation rules of sections 861-865

• Allocate and source derivative income, gain, loss under Prop. Reg. §1.863-3

• If allocated and sourced US:– ECI under 864(c)(3)?

• FB has US banking branch

– Prop. Reg. §§ 1.864-4(c)(2), (c)(3) and (c)(5)(vi) refine "all or nothing" treatment under current 864(c) regulations.

• Under proposed regulations, cost of carry ignored and interest expense substituted under sec. 1.882-5

11

Issues

• Contrast treaty and Code results• Treatment of losses

– When not passed down– When shared

• Regulatory issues associated with compensating adjustments– From FB to US BD?– From US BD to FB?

• Could occur if book amounts reversed (e.g., b/c derivatives in BD and hedges in FB)

• Availability of alternative methods

12

Issues

• Cost of carry– Reg sec. 1.882-5(a)(1)(ii): Not available to allocate directly– OECD Report: may be allocated if arm’s length compensation of

treasury function• Even if interdesk/interbranch amount• Subject to equity allocation

• Equity allocation– Prop global dealing regs: reg. sec. 1.882-5 applies– Cost of carry under AOA qualified treaty (e.g., UK, Japan)

• See OECD Report Part II (para. 120, Annex para. 4-5) for US approach

– US Model TE (Art. 7(3)):• Permits sec. 1.882-5 step 2 principles, in lieu of risk weighting (i.e.,

5% fixed ratio imputation on cost of carry may be elected)

13

Inbound Dealing With Split HedgingTreatment of foreign branch liabilities funding ECI and non-ECI activities

FB

US BD

US Branch

BD logistics and control

functions

All front office BD personnel

Customer trading as agent for FB?

Risk manages derivatives and hedges?

BD logistics and control functions

All BD client-facing derivatives booked here

BD hedges booked here

Liabilities fund both ECI

and non-ECI activities

14

Treatment of Foreign Branch Liabilities Funding ECI and non-ECI Activities

• If non-global dealing book, issue is whether book as a whole gives rise to U.S. booked liabilities within the meaning of 1.882-5(d)(2)(iii) (applicable to banks) or (ii) (applicable to non-banks). 

• If so, all liabilities are U.S. booked liabilities, giving rise to U.S. source interest

– If U.S. booked interest is less than 882-5 interest, excess interest can result– If U.S. booked interest is more than 882-5 interest, 1.884-4(b)(6) may treat it as

not paid by the branch; TP may specifically identify it in its books and records up to the due date of the return under 1.884-4(b)(6)(iii)

• Whether book is ECI generator is a matter of "facts and circumstances“• Rule not intended to require tracing of liabilities to specific assets  • U.S. trade or business need not acquire the liabilities. 

– Branch participation rule for liabilities temporarily adopted in Notice 89-80 and the 1992 final regulations, but removed in 1996. 

• Anti-abuse rule could throw a liability out if acquired to raise the overall average borrowing rate of the U.S. trade or business. 

• Global dealing book?

15

Hedge Fund Management in US

FB

US Sub

Hedge Fund

Management

Contract

Investors

US Branch

16

Hedge Fund Management in US

• Availability of 864(b) safe harbor– What if hedge fund deals in loans?

• Trading vs. originating

– What if hedge fund is a fund of funds?– Impact on safe harbor of agent activity– If ETB through a PE, application of:

• Global dealing regs• Treaties• Material participation regs (if debt securities)

17

Hedge Fund Management in US

• Effect on analysis of partner being ETB through U.S. branch?

• Can fund take position it is an investor, not a trader, and not in a trade or business?– Impact of favorable result here on pass through of

expenses as 162 item?• Impact of 1446 hit to partnership results• What if hedge fund invests in derivatives?

– Prop. Reg. 1.864(b)-1 extends safe harbor to derivatives if hedge fund is not a dealer.

• Legislative activity

18

Globally Traded Non-Dealer Assets Booked In US Branch

FB

US BranchNon-Dealer

Book

US branch book traded by US and foreign branch

traders; P/L split among US and foreign branches

based on relative trader compensation.

19

Globally Traded Non-Dealer Assets Booked In US Branch

• Proposed regs n/a to non-dealer assets?• Treaty vs. regs:

– Treaty (UK and Japan)• Under UK and Japanese treaty, then the Authorized OECD Approach is

available, but must be used consistently for the entire branch, not just the trading operation. 

• Base differences result between Code and treaty?– Regs (other countries)

• If assets are debt securities, material participation test applies? See reg. sec. 1.864-4(c)(5)(iii).

• If branch materially participates in acquisition, 100% ECI instead of profit split?

• If home office acquires securities, 100% non-ECI even if booked and/or disposed of through the branch?

• Inapplicability of the 10% rule? See reg. sec. 1.864-4(c)(5)(vi)• Authorization for equitable split income/split asset approach in a

trading (non-banking trade or business) context