Does income from interest rate swaps and financial futures contracts that a bank's New York International Banking Facility (IBF) uses to hedge against interest rate risk count as tax-exempt IBF income, and can the related expenses still be deducted?

Subject

Whether income from interest rate exchange agreements and financial futures contracts, used to hedge a New York International Banking Facility (IBF) against interest rate fluctuations, constitutes eligible gross income of the IBF, and whether the related expenses can be deducted.

Plain-English summary

A foreign bank ("Bank X") operating both a regular New York branch and a New York International Banking Facility (IBF) had interest rate exposure — short-term variable-rate liabilities against longer-term fixed-rate assets. To manage that risk, Bank X entered into interest rate exchange agreements (swaps) with other parties, converting fixed-rate exposure into floating-rate exposure without exchanging any actual principal, and separately traded Eurodollar financial futures contracts to further hedge both its New York branch and its IBF. The bank asked whether the income and gains from these hedging transactions counted as tax-exempt "eligible gross income" of the IBF (the special New York deduction for qualifying international banking income), and if not, whether the associated expenses could still be deducted as direct or indirect IBF expenses.

The Department ruled no on both counts. The IBF regulations define eligible gross income narrowly — for hedging-type transactions, only "foreign exchange trading or hedging transactions" qualify, meaning the purchase/sale/exchange of foreign currency, or forward contracts to exchange foreign currency at a future date to hedge a foreign-currency-denominated loan or deposit. Interest rate swaps and Eurodollar financial futures are fundamentally different: they hedge against interest rate risk, not foreign currency risk, and don't involve exchanging foreign currency or any actual loan/deposit principal at all — each party just continues owing on its own separate liability. Since the swap and futures income falls entirely outside the "eligible gross income" definition, it follows automatically (under the IBF regulations' expense-matching rule) that the expenses tied to that non-eligible income — direct or indirect — cannot be subtracted when computing the IBF's eligible net income either. The Department separately confirmed there are no additional Article 32 franchise tax implications from the fact that Bank X recognizes futures gains/losses at different times for book purposes (spread over the contract's original term) versus tax purposes (recognized when the futures position is sold).

What this means for you

Banks operating a New York IBF that hedge with interest rate derivatives

Interest rate swaps and financial futures used purely for interest-rate risk management do not qualify as tax-favored IBF "eligible gross income," even when they're used in conjunction with genuine foreign-exchange hedges to manage the same asset/liability book. Keep these transaction types on separate books/analysis from true currency-hedging transactions, since only the latter can generate eligible IBF income.

Banks with mismatched book vs. tax timing on futures gains/losses

If your futures gains/losses are amortized over the contract term for GAAP purposes but recognized immediately upon sale for tax purposes, this ruling confirms that timing mismatch by itself creates no separate New York Article 32 tax consequence for the IBF.

Accountants preparing Article 32 returns for banks with IBFs and derivatives books

The controlling distinction is in 20 NYCRR § 18-3.4(d): eligible gross income from hedging is limited to currency purchase/sale/exchange and currency forward contracts tied to a foreign-currency loan or deposit — interest rate derivatives simply aren't in that category, regardless of hedging purpose or economic function. Because eligible income and eligible expenses are matched (§ 18-3.3(c), § 18-3.5, § 18-3.8), excluding the income automatically excludes the matching expenses too.

Common questions

Q: Do interest rate swaps used to hedge an IBF's loans and deposits qualify for the IBF tax exemption?
A: No. Only foreign-currency-related hedging transactions qualify as eligible gross income — interest rate swaps hedge a different risk (interest rate, not currency) and don't involve currency exchange or actual loan/deposit principal.

Q: If the swap/futures income isn't eligible, can the related expenses still be deducted from the IBF's eligible net income?
A: No. Because eligible net income only allows deducting expenses attributable to eligible gross income, and this income isn't eligible, the matching expenses (direct or indirect) can't be subtracted either.

Q: Does a book-vs-tax timing difference on futures gains/losses create extra New York tax exposure?
A: No. The Department found no additional Article 32 franchise tax implications from that timing difference alone.

Q: Can another bank rely on this ruling?
A: No. This advisory opinion binds the Department only for the taxpayer and facts presented, and cannot be relied on by anyone else.

Citations and references

Statutes and regulations:

• Tax Law § 1453(f)(2) (definition of eligible gross income of an IBF)
• 20 NYCRR § 18-3.4(d) (foreign exchange trading/hedging transactions as eligible gross income)
• 20 NYCRR § 18-3.3(c) (expenses applicable to eligible gross income)
• 20 NYCRR § 18-3.5 (direct expenses of an IBF)
• 20 NYCRR § 18-3.8 (indirect expenses of an IBF)

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/corporation_ao_1988.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/corporation/a88_25c.pdf

Original ruling text

New York State Department of Taxation and Finance

Taxpayer Services Division
Technical Services Bureau

TSB-A-88 (25)C
Corporation Tax
November 10, 1988

STATE OF NEW YORK
COMMISSIONER OF TAXATION AND FINANCE
ADVISORY OPINION

PETITION NO. C880622B

On June 22, 1988, a Petition for Advisor Opinion was received from Peat Marwick Main &
Co., 345 Park Avenue, New York, New York 10154.
Issues:
The issues raised pertain to section 1453(f) of Article 32 of the Tax Law and Subpart 18-3
of the Franchise Tax on Banking Corporations Regulations (hereinafter "Regulations") promulgated
thereunder, which contain the provisions for an international banking facility ("IBF"). Specifically,
the issues are:
1.

2.

3.

(a)

Under section 18-3.4(d) of the Regulations, does eligible gross income of an IBF
include income derived from interest rate exchange agreements entered into with
foreign persons, which are recorded on the financial accounts of the IBF, and entered
into for the purpose of hedging IBF eligible loans and deposits against interest rate
fluctuations; or alternatively,

(b)

Under section 18-3.5 of the Regulations, can the expenses (or negative expenses,
when there is a net receipt to Bank X) generated by interest rate exchange agreements
that are recorded on the financial accounts of the IBF be treated as direct expenses of
the IBF?

(a)

Under section 18-3.4(d) of the Regulations, does eligible gross income of an IBF
include income derived from financial futures contracts which are entered into for the
purpose of hedging loans and deposits against interest rate fluctuations; or
alternatively,

(b)

Under section 18-3.5 of the Regulations, can the expenses (or negative expenses,
when such hedging activities generate a gain to Bank X) generated by financial
futures transactions be treated as direct expenses of the IBF; or alternatively,

(c)

Under section 18-3.8 of the Regulations, can the expenses (or negative expenses,
when such hedging activities generate a gain to Bank X) generated by financial
futures transactions be treated as allocable indirect expenses of the IBF?

Would the difference between when a gain or loss on financial futures transactions is
recognized under book versus tax reporting rules create any New York State tax implications
with regard to the IBF?

TP-9 (9/88)

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Corporation Tax
November 10, 1988
Facts:
Assume Bank X is incorporated in a foreign country, but maintains and operates a New York
and an International Banking Facility (IBF) branch within the United States.1 Furthermore, assume
that Bank X is a bank as defined under section 1452 of Article 32 of the Tax Law. In computing
Bank X's entire net income, a deduction is made for the adjusted eligible net income of its IBF
branch. (No election has been made under section 1454(b)(2) to use the IBF formula allocation
method.)
Bank X has interest rate exposures because it has short-term variable rate liabilities and
longer-term fixed rate financial assets. If interest rates were to rise, Bank X's liabilities would be
more costly and the value of its assets would decline. In order to effect asset/liability management
with respect to its banking business in both its New York and IBF branches, Bank X enters into
interest rate exchange agreements. Under these agreements, Bank X enters into a contract with
another party (generally a foreign person), whereby the other party agrees to pay Bank X a variable­
rate amount and Bank X agrees to pay the other party a fixed rate amount, each amount determined
by reference to a percentage of a notional principal amount specified in the agreement. By these
transactions, Bank X is able to, in effect, convert a liability that is held at a fixed rate of interest into
a floating rate obligation. In this way, Bank X is able to hedge its assets and liabilities against interest
rate fluctuations.
The interest rate exchange agreements that are used to hedge New York branch assets and
liabilities are booked in the financial accounts of the New York branch, whereas interest rate
exchange agreements that are used to hedge IBF assets and liabilities are booked in the financial
accounts of the IBF. Any gains or losses generated by these interest rate exchange agreements are
booked in the branch where the agreement generating the gain or loss is booked.
Since these interest rate exchange agreements do not effect a perfect hedge, Bank X also
purchases and sells financial futures contracts. These financial futures contracts are matched and
intended to work in conjunction with the interest rate exchange agreements to more fully hedge the
New York and IBF branches' assets and liabilities against interest rate fluctuations. These

1

Petitioner errs in its statement that an IBP is a branch. In section 204.8(a)(1) of the Board of
Governors of the Federal Reserve System Regulations, an IBF is defined as "a set of asset and
liability accounts segregated on the books and records of a depository institution, United States
branch or agency of a foreign bank, or an Edge or Agreement Corporation that includes only
international banking facility time deposits and international banking facility extensions of credit."

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TSB-A-88 (25)C
Corporation Tax
November 10, 1988
contracts are agreements to make or take delivery of a specified amount of three month Eurodollar
obligations at a specified date or during a specified period under conditions established by the
International Monetary Market. They are initially booked on the financial accounts of the New York
branch.
Under generally accepted accounting principles, any gains or losses recognized by Bank X
upon the sale of the financial futures contracts are deferred and accrued as income or expense over
the original term of the futures contracts. For example, if the bank purchases a December 1988
contract in June of 1987 and sells this contract in September 1987, the gain or loss is realized in
September 1987. Under generally accepted accounting principles, this gain or loss is amortized over
the original term of the contract (i.e., from December 1988 through March 1989). However, for tax
purposes Bank X would recognize the gain or loss upon the sale of the financial futures contract (i.e.,
September 1987 in the above example). This can result in the creation of a timing difference between
book and tax income.
After the total net gain or loss on the financial futures hedging activities is determined for
the year, Bank X allocates this gain or loss to the New York branch and the IBF. The net hedging
gain or loss is then allocated to the IBF under an asset allocation formulas as follows:
Bank X calculates the total dollar volume of the underlying financial transactions
booked in the IBF being hedged by the financial futures contracts for the year. This
amount is then divided by the total dollar volume of the financial transactions of the
New York branch and IBF being hedged by the financial futures contracts for the
year. This ratio is multiplied by the financial futures hedging gains or losses for the
year, to arrive at the amount to be allocated to the IBF.
Any such gains or losses allocated to the IBF under this formula are recorded on the books and
records of the IBP at year end.
Discussion:
Adjusted eligible net income of an IBF is determined by subtracting from the eligible net
income of the IBF the ineligible funding amount and the floor amount. Eligible net income is the
amount remaining after subtracting from eligible gross income the expenses applicable to such
gross income.
Issue l(a) and 2(a)
Section 1453(f)(2) defines eligible gross income as the gross income derived by an
international banking facility from:
(A)

making, arranging for, placing or servicing loans to foreign persons, provided,
however, that in the case of a foreign person which is an individual, or which is a
foreign branch of a domestic corporation (other than a bank), or which is a foreign

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Corporation Tax
November 10, 1988

corporation or foreign partnership which is eighty per centum or more owned or
controlled, either directly or indirectly, by one or more domestic corporations (other
than banks), domestic partnerships or resident individuals, substantially all the
proceeds of the loan are for use outside of the United States;
(B)

making or placing deposits with foreign persons which are banks or foreign branches
of banks (including foreign subsidiaries or foreign branches of the taxpayer) or with
other international banking facilities; or

(C)

entering into foreign exchange trading or hedging transactions related to any of the
transactions described in this paragraph.

Section 18-3.4(d) of the Regulations states:
[e]ligible gross income includes gross income derived from foreign exchange trading
or hedging transactions that are solely entered into for or directly traceable to any of
the transactions described in subdivisions (a), (b) or (c) of this section. [Such
transactions are the making, arranging for, placing or servicing loans to foreign
persons and the making or placing of deposits with certain foreign persons]. Gross
income from foreign exchange trading or hedging transactions related to a deposit (as
defined in subdivision (c) of section 18-3.2 of this Subpart) from a foreign person,
is eligible gross income when such deposit can be traced directly to a transaction
described in subdivision (a), (b) or (c) of this section. A foreign exchange trading or
hedging transaction is not solely entered into for or directly traceable to any of the
transactions described in subdivision (a), (b) or (c) of this section unless the foreign
exchange trading or hedging transaction is recorded in the financial accounts of the
IBF. The term "foreign exchange trading or hedging transaction" as used in this
subdivision means:
(1)

the purchase, sale or exchange of foreign currency; or

(2)

the acquisition, disposition or performance of any contract to purchase, sell
or exchange foreign currency at a future date under terms fixed in the contract
if the contract hedges a foreign currency denominated loan or deposit.

A forward contract hedges such foreign currency denominated loan or deposit if the
effect of a change in the value of the foreign currency on the United States dollar
value of the forward contract, either alone or in combination with other such
contracts, offsets the effect of the change on the United States dollar value of such
foreign currency denominated loan or deposit. A hedging relationship may be

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Corporation Tax
November 10, 1988

established by reference to particular facts and circumstances (for example, the
amount of the forward contract, particular currency, initial date and maturity)
indicating a hedging purpose, or by designating a contract as being intended for the
purpose of hedging a loan or deposit.
Herein, interest rate exchange agreements and financial futures contracts are entered into to
effect asset/liability management by hedging against interest rate fluctuations. In an interest rate
exchange agreement, two parties agree to exchange amounts calculated as though there were interest
on specified amounts of liabilities. However, such amounts are not interest because there is no loan
or deposit involved in the agreement. No principal is actually exchanged and each party continues
to be liable on its own offsetting liability.
The financial futures contracts are matched and work in conjunction with the interest rate
exchange agreements. A financial future contract is an agreement to make or take delivery of a
specified amount of three month Eurodollar obligations at a specified date or during a specified
period under conditions established by the International Monetary Market.
The Regulations specifically state that eligible gross income from foreign exchange trading
or hedging transactions is limited to such income derived from "(1) the purchase, sale or exchange
of foreign currency or; (2) the acquisition, disposition or performance of any contract to purchase,
sell or exchange foreign currency at a future date..." (emphasis added) to the extent that the
transaction is solely entered into for or directly traceable to the making, arranging for, placing or
servicing loans to foreign persons and the making or placing of deposits with certain foreign persons.
Clearly, the income derived from the interest rate exchange agreements and the financial
futures contracts described herein do not constitute foreign exchange trading or hedging transactions.
Therefore, the income derived from such interest rate exchange agreements and such financial
futures contracts does not constitute eligible gross income for purposes of section 1453(f)(2) of the
Tax Law.
Issue l(b) and 2(b) and (C)
Section 18-3.3(c) of the Regulations states:
[e]xpenses applicable to the eligible gross income of the IBF are those expenses or
other deductions (including expenses or other deductions from interoffice
transactions) described in sections 18-3.5 through 183.8 of this Subpart that are
directly or indirectly attributable to the eligible gross income of the IBF.
Section 18-3.5 of the Regulations describes the direct expenses of the IBF and section 18-3.8
of the Regulations describes the indirect expenses of the IBF.

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November 10, 1988

As stated in the Regulations, only expenses that are directly or indirectly attributable to
eligible gross income of the IBF may be subtracted in determining eligible net income. Since the
income derived from interest rate exchange agreements and financial futures contracts does not
constitute eligible gross income, the expenses attributable to such income, whether direct or indirect,
may not be subtracted from eligible gross income when computing eligible net income.
Issue 3
There are no franchise tax implications under Article 32 of the Tax Lay with regard to an IBF
as a result of the difference between when a gain or loss, on the financial futures transactions
described herein, is recognized under book versus tax reporting rules.

DATED: November 10, 1988

s/FRANK J. PUCCIA
Director
Technical Services Bureau

NOTE: The opinions expressed in Advisory Opinions
are limited to the facts set forth therein.