Foreign bank could apply interest and liability-ratio rules after closing U.S. branch

Plain-English summary

A foreign bank planned to close its U.S. branch and transfer most branch assets to its home office. It represented that interest earned after the closure would continue to be treated as effectively connected income when IRC § 864(c)(6) applied. The IRS ruled that the regulatory 10 percent rule would determine the effectively connected portion of interest from qualifying securities acquired through the U.S. banking business and held after the branch closed. The bank also could elect the actual liability-to-asset ratio method for later years with effectively connected income under IRC § 864(c)(6) or (7). That election was available because the bank had used the fixed-ratio method for more than the required five years.

Ruling snapshot

• Question: How would the bank calculate effectively connected interest income and related interest expense after closing its U.S. banking business?
• Outcome: Approved. The bank could apply the 10 percent interest rule and elect the actual liability-to-asset ratio method for the relevant post-closure years.
• Key authorities: IRC §§ 864 and 882; Treas. Reg. §§ 1.864-4(c)(5) and 1.882-5

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201908016 Third Party Communication: None
Release Date: 2/22/2019 Date of Communication: Not Applicable
Index Number: 864.02-00, 864.02-06,
882.04-00, 882.07-02 Person To Contact:
--------------------------
Telephone Number:
---------------------- ----------------------
--------------------------------------------------- Refer Reply To:
------------------------- CC:INTL:B05
---------------------------------- PLR-121637-18
Date:
November 26, 2018

Legend

Bank = --------------------------
State Branch = --------------------------------------------------
Parent = ---------------
Country A = ------------
Country B = ----------
State = ----------------------
Date A = -----------------
Date B = -------------------
Year X = -------

Dear ---------------:

We respond to your letter dated Date A, requesting rulings on behalf of Bank
pursuant to section 864(c)(6) and section 1.864-4(c)(5) and 1.882-5(a)(7)
regarding the proper U.S. federal income tax treatment of interest income and
interest expense related to its U.S. banking business but which arises after Bank
ceases to conduct a U.S. banking business.

The rulings contained in this letter are based upon information and
representations submitted by the taxpayer and accompanied by a penalty of
perjury statement executed by an appropriate party. While this office has not
verified any of the material submitted in support of the request for rulings, it is
subject to verification on examination.
PLR-121637-18 2

                                   Facts

Bank is wholly owned by Parent, a financial holding company organized under
the laws of Country A. Bank is organized under the laws of, and regulated as a
bank in, Country B. Bank operates in the United States through the activities of a
branch licensed in State. The activities of State Branch include making loans to
U.S. and foreign borrowers, acquiring bonds, and entering into swaps.

Bank has represented that State Branch and its predecessors have been
engaged in the conduct of a banking, financing, or similar business in the United
States, within the meaning of section 1.864-4(c)(5), for many years. It further
represented that, with the exception of some loans and bonds acquired by non-
U.S. operations of Bank and later transferred to State Branch, all of the loans and
bonds held by State Branch were acquired with the material participation of
employees of State Branch or its predecessors. All of the loans held by State
Branch were acquired in the course of making loans to the public as described in
section 1.864-4(c)(5)(ii)(a)(1). All of the bonds held by State Branch are
securities described in section 1.864-4(c)(5)(ii)(b)(3), other than those acquired
by non-U.S. operations of Bank and later transferred to State Branch.

State Branch uses an annual U.S. tax accounting period ending Date B. Bank
currently uses the adjusted U.S. booked liabilities method to determine the
amount of interest expense it can deduct under section 1.882-5 and has
represented that it made an election to use the fixed ratio more than five years
ago.

Bank has decided to wind down the U.S. banking business of State Branch and
transfer most of the State Branch assets (the “Transferred Assets”) to Bank’s
home office in Country B before the end of Year X. Bank has represented that
after the close of Year X, Bank will not be engaged in the conduct of a trade or
business in the United States. However, to the extent that interest earned on the
Transferred Assets would have been effectively connected income if such
interest had been earned in a year in which Bank was engaged in a trade or
business within the United States, Bank will continue to treat such interest as
effectively connected income after the closing of its State Branch pursuant to
section 864(c)(6).

                            Law and Analysis

Ruling Request 1

Bank has requested a ruling that provides that the flush language of section
1.864-4(c)(5)(ii) describing the amount of interest from securities described in
section 1.864-4(c)(5)(ii)(b)(3) that is effectively connected income (the “10%
rule”) applies to determine the amount of interest on securities described in
PLR-121637-18 3

section 1.864-4(c)(5)(ii)(b)(3) acquired by Bank in connection with its U.S.
banking business and held by Bank after it ceases to be engaged in the active
conduct of a trade or business in the United States that is treated as effectively
connected income, so long as such interest is subject to section 864(c)(6).

Section 882(a)(1) provides-

   A foreign corporation engaged in trade or business within the
   United States during the taxable year shall be taxable as provided
   in section 11, or 59A, on its taxable income which is effectively
   connected with the conduct of a trade or business within the United
   States.

In determining the income effectively connected with the conduct of a trade or
business within the United States, section 882(a)(2) provides-

   In determining taxable income for purposes of paragraph (1), gross
   income includes only gross income which is effectively connected
   with the conduct of a trade or business within the United States.

Section 864(c)(1)(A) provides-

   In the case of a nonresident alien individual or a foreign corporation
   engaged in trade or business within the United States during the
   taxable year, the rules set forth in paragraphs (2), (3), (4), (6), (7),
   and (8) shall apply in determining the income, gain, or loss which
   shall be treated as effectively connected with the conduct of a trade
   or business within the United States.

Section 864(c)(2) provides that the determination of whether fixed, determinable,
annual or other periodic U.S. source income described in section 881(a) is
treated as effectively connected with the conduct of a trade or business within the
United States generally is made pursuant to an asset use or business activities
test. However, section 1.864-4(c)(5)(ii) provides in relevant part that interest from
securities or any gain or loss from the sale or exchange of securities which are
capital assets, which is from sources within the United States and derived by a
foreign corporation in the active conduct of a banking, financing or similar
business in the United States shall be treated as effectively connected for such
year with the conduct of that business only if the securities giving rise to such
income, gain, or loss are attributable to the U.S. office through which such
business is carried on and the securities were acquired in the manner provided in
section 1.864-4(c)(5)(ii)(a) or the securities have the characteristics described in
section 1.864-4(c)(5)(ii)(b).
PLR-121637-18 4

Section 864(c)(4)(B)(ii) provides for the effectively connected treatment of foreign
source interest income if it is derived in the active conduct of a banking,
financing, or similar business within the United States. Section 1.864-6(b)(2)(ii)(b)
applies the principles of section 1.864-4(c)(5)(ii) in determining whether foreign
source interest income is attributable to a U.S. office of a banking, financing or
similar business.

For purposes of determining effectively connected income with respect to U.S.
source income relating to a banking, financing or similar business, section 1.864-
4(c)(5)(v) defines a security as “any bill, note, bond, debenture, or other evidence
of indebtedness, or any evidence of an interest in, or right to subscribe to or
purchase, any of the foregoing items.” Section 1.864-6(b)(2)(ii)(c) provides the
same definition for securities that give rise to foreign source income.

In determining whether a security is attributable to a U.S. office or fixed place of
business, section 1.864-4(c)(5)(iii)(a) provides in relevant part that a security
“shall be deemed to be attributable to a U.S. office only if such office actively and
materially participated in soliciting, negotiating, or performing other activities
required to arrange the acquisition of the stock or security.” The U.S. office does
not have to be the only participant involved in the acquisition of the stock or
security.

Section 1.864-4(c)(5)(i) provides that the U.S. trade or business of a foreign
corporation is considered a banking, financing, or similar business if the activities
of the foreign corporation’s business consist of (a) receiving deposits of funds
from the public, (b) making personal, mortgage, industrial, or other loans to the
public, (c) purchasing, selling, discounting, or negotiating for the public on a
regular basis, notes, drafts, checks, bills of exchange, acceptances, or other
evidences of indebtedness, (d) issuing letters of credit to the public and
negotiating drafts drawn thereunder, (e) providing trust services to the public, or
(f) financing foreign exchange transactions for the public.

For the effectively connected income rules of section 1.864-4(c)(5)(ii) to apply to
securities, the securities must either be acquired in the manner provided in
section 1.864-4(c)(5)(ii)(a) or have the characteristics described in section 1.864-
4(c)(5)(ii)(b). Section 1.864-4(c)(5)(ii)(a) applies to securities that were acquired
(1) as a result of, or in the course of making loans to the public, (2) in the course
of distributing such stocks or securities to the public, or (3) for the purpose of
being used to satisfy the reserve requirements, or other requirements similar to
reserve requirements, established by a duly constituted banking authority in the
United States. Section 1.864-4(c)(5)(ii)(b) applies to securities that are (1)
payable on demand or at a fixed maturity date not exceeding one year from the
date of acquisition, (2) issued by the United States, or any agency or
instrumentality thereof, or (3) not otherwise described in section 1.864-
PLR-121637-18 5

4(c)(5)(ii)(a) or (b)(1) or (b)(2). Securities in this residual category are commonly
referred to as “(b)(3) securities.”

Pursuant to the 10% rule, the amount of interest from (b)(3) securities that is
treated as effectively connected for the taxable year with the active conduct of a
banking, financing, or similar business in the United States is determined by
multiplying the entire amount of such interest for the taxable year from sources
within the United States by a fraction. The numerator of this fraction is ten
percent. The denominator is equal to the ratio of (1) the monthly average book
value of the (b)(3) securities held by the U.S. office through which the banking,
financing, or similar business is carried on over (2) the monthly average book
value of the total assets of such U.S. office.

Section 864(c)(6) provides-

   For purposes of this title, in the case of any income or gain of a
   nonresident alien individual or a foreign corporation which—

   (A) is taken into account for any taxable year, but

   (B) is attributable to a sale or exchange of property or the
   performance of services (or any other transaction) in any other
   taxable year,

   the determination of whether such income or gain is taxable under
   section 871(b) or 882 (as the case may be) shall be made as if
   such income or gain were taken into account in such other taxable
   year and without regard to the requirement that the taxpayer be
   engaged in a trade or business within the United States during the
   taxable year referred to in subparagraph (A).

Section 864(c)(7) provides-

   For purposes of this title, if—

   (A) any property ceases to be used or held for use in connection
   with the conduct of a trade or business within the United States,
   and

   (B) such property is disposed of within 10 years after such
   cessation,

   the determination of whether any income or gain attributable to
   such disposition is taxable under section 871(b) or 882 (as the case

PLR-121637-18 6

  may be) shall be made as if such sale or exchange occurred
  immediately before such cessation and without regard to the
  requirement that the taxpayer be engaged in a trade or business
  within the United States during the taxable year for which such
  income or gain is taken into account.

Bank represents that State Branch and its predecessors have been engaged in
the conduct of a banking, financing, or similar business in the United States,
within the meaning of section 1.864-4(c)(5), for many years. Bank further
represents all of the loans and bonds held by State Branch were acquired with
the material participation of employees of State Branch or its predecessors, with
the exception of some loans and bonds acquired by non-U.S. operations of Bank
and later transferred to State Branch.

Bank represents that after the close of Year X, Bank will not be engaged in the
conduct of a trade or business in the United States. However, to the extent that
interest earned on the Transferred Assets would have been effectively connected
income if such interest had been earned in a year in which Bank was engaged in
a trade or business within the United States, Bank will continue to treat such
interest as effectively connected income after the closing of its State Branch
pursuant to section 864(c)(6).

Pursuant to section 864(c)(6), when income is taken into account in one taxable
year but is attributable to a transaction that occurred in any other taxable year,
the determination of whether income is taxable under section 882 is made as if
the income were taken into account in the other taxable year.

Based solely on the submitted facts and representations, the 10% rule of section
1.864-4(c)(5)(ii) applies to determine the amount of interest on (b)(3) securities
acquired by Bank in connection with its U.S. banking business and held by Bank
after it ceases to be engaged in the conduct of a trade or business within the
United States that is treated as effectively connected income, so long as such
interest is subject to section 864(c)(6).

Ruling Request 2

Bank has requested that it be permitted to elect to apply the actual ratio method
prescribed in section 1.882-5(c)(2) in the manner provided by section 1.882-
5(a)(7) for taxable years in which it is no longer engaged in a trade or business
within the United States but continues to have effectively connected income
related to its U.S. banking business under section 864(c)(6) or 864(c)(7).

For purposes of determining the effectively connected income of a foreign
corporation under section 882(a)(1), section 882(c)(1)(A) provides that in the
PLR-121637-18 7

case of a foreign corporation, the deductions shall be allowed only for purposes
of section 882(a) and (except for limited deductions for charitable contributions
and gifts) only if and to the extent that they are connected with income which is
effectively connected with the conduct of a trade or business within the United
States. Section 882(c)(1)(A) further provides that the proper apportionment and
allocation of the deductions for this purpose shall be determined in regulations
prescribed by the Secretary.

Section 1.882-5 provides a three-step process for determining the amount of
interest expense of a foreign corporation that is allocable under section 882(c) to
income that is (or is treated as) effectively connected with the conduct of a trade
or business within the United States. Under these rules, U.S.-connected liabilities
must be determined by multiplying the U.S. assets determined under section
1.882-5(b) by the taxpayer's actual worldwide liability-to-asset ratio. Section
1.882-5(c)(4) provides that a taxpayer that is a bank as defined in section
585(a)(2)(B) (without regard to the second sentence thereof) may elect to use a
fixed ratio of 95 percent in lieu of its actual ratio.

Section 1.882-5(a)(7) provides rules for making elections under section 1.882-5,
such as the election to use the fixed ratio or actual ratio under section 1.882-5(c).
It provides in relevant part that:

   An elected method . . . must be used for a minimum period of five years
   before the taxpayer may elect a different method. To change an election
   before the end of the requisite five-year period, a taxpayer must obtain the
   consent of the Commissioner . . . . The Commissioner . . . will generally
   consent to a taxpayer's request to change its election only in rare and
   unusual circumstances. After the five-year minimum period, an elected
   method may be changed for any subsequent year on the foreign
   corporation’s original timely filed tax return for the first year to which the
   changed election applies.

Bank represents that it made an election to use the fixed ratio for purposes of
section 1.882-5 more than five years ago. Based solely on the submitted facts
and representations, Bank is permitted to elect to use the actual ratio for
purposes of section 1.882-5 in the manner provided by section 1.882-5(a)(7) for
taxable years in which it is no longer engaged in a trade or business within the
United States but continues to have effectively connected income related to its
U.S. banking business under section 864(c)(6) or 864(c)(7).

                                  Rulings

Based on the information submitted and the representations made, we rule as
follows:
PLR-121637-18 8

(1) The 10% rule of section 1.864-4(c)(5)(ii) applies to determine the amount
of interest on (b)(3) securities acquired by Bank in connection with its U.S.
banking business and held by Bank after it ceases to be engaged in the
conduct of a trade or business within the United States that is treated as
effectively connected income, so long as such interest is subject to section
864(c)(6).

(2) Bank may elect to apply the actual ratio method prescribed in section
1.882-5(c)(2) in the manner provided by section 1.882-5(a)(7) for taxable
years in which it is no longer engaged in a trade or business within the
United States but continues to have effectively connected income related
to its U.S. banking business under section 864(c)(6) or 864(c)(7).

                                   Caveats

Except as expressly provided herein, no opinion is expressed or implied
concerning the tax consequences of any aspect of any transaction or item
discussed or referenced in this letter.

                          Procedural Statements

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of
the Code provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this
letter is being sent to your authorized representative.

A copy of this letter must be attached to any income tax return to which it is
relevant. Alternatively, taxpayers filing their returns electronically may satisfy this
requirement by attaching a statement to their return that provides the date and
control number of the letter ruling.

                                    Sincerely,


                                    _________________________
                                    Anthony J. Marra
                                    Senior Counsel, Branch 5
                                    Office of Associate Chief Counsel
                                    (International)