3 45pm capital markets - part 2

Bank Tax Institute Capital Markets: Recent Tax Developments

November 14, 2013 Keith Anzel – Citigroup David Shapiro – PwC Jack Burns – EY

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Introduction TOPICS: ► Application of the Economic Substance Doctrine in Recent Court Decisions Involving Tax Beneficial Financial

Products & Related Developments ► (Bank of NY Mellon Corp., BB&T Bank, Sovereign Bank (Santander), IRS “Stock Loan” GLAM, and IRS responses to Section

7701(o))

► Application of Debt v. Equity Analysis and Related Applications of the Substance Over Form Doctrine in Recent Court Decisions

► (Barnes Group, and Tyco)

► The Other Tax Aspect of Tyco: Re-domiciling, and, More Recent M&A Transactions with Tax Re-domiciling Aspects

► Loan Syndications and Non-US Hedge Fund Investors ► Transfer Pricing Initiatives in the Post-Financial Crisis Era ► Developments Pertaining to Low Income Housing Tax Credits ► Potential Tax Benefits under Section 199, for Production Activities: Bank-Developed Software Provided to

Bank Customers ► Contractual Arrangements Treated as Partnerships for US Federal Income Tax Purposes, and, Check-the-Box

“Virtual” Corporations

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Application of the Economic Substance Doctrine in Recent Court Decisions & Related Developments

Bank of NY Mellon Corp. v. Comm’r, 140 T.C. 15 (Feb. 11, 2013), as modified by T.C. Memo. 2013-225 (Sep. 23, 2013)

Facts ► BNY transferred income-producing US assets to Trust Arrangement, referred to as

“STARS.” ► Trust became subject to UK taxes on its income, which were claimed as foreign tax

credits (“FTCs”) for US federal income tax purposes. ► BNY obtained $1.5 billion of below market cost financing from a UK bank. The

financing was approximately 300 bps below market because the UK bank also obtained UK tax benefits from the UK Trust Arrangement and provided rebate payments to BNY equal to a portion of the UK Bank’s UK tax benefits.

Tax Court Holdings ► The Trust lacked economic substance. ► In the initial Feb. 11, 2013, decision:

► BNY was not entitled to the claimed FTCs or expense deductions relating to the STARS transaction;

► BNY was required to recognize the rebate payments received from UK Bank as taxable income; and

► The income attributed to the Trust with a UK trustee was not entitled to foreign-source income treatment.

► On reconsideration (on Sep. 23, 2013), the Tax Court allowed interest expense deductions and permitted exemption of the income from the rebate payments.

Initiation:

US Bank

Non-US Bank (UK)

Non-US SPE

(UK Trust)

US Assets

Equity (for UK tax purposes)

$ “Repo Loan”

(for US tax purposes)

Ongoing:

US Bank

Non-US Bank (UK)

Non-US SPE

(UK Trust)

$ Rebate

UK Tax on

Income

Income from

Assets

$

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Bank of NY Mellon Corp. v. Comm’r [Cont’d]

Other Considerations ► After the Sep. 23, 2013 modifications, the result of the Tax Court’s determination that

the transaction lacked economic substance was as follows: ► FTCs disallowed ► Deduction for foreign taxes not allowed ► Interest expense deductions allowed ► Income from rebate payments exempted from tax ► No penalties (not assessed)

Initiation:

US Bank

Non-US Bank (UK)

Non-US SPE

(UK Trust)

US Assets


$ “Repo Loan”


Ongoing:

US Bank

Non-US Bank (UK)

Non-US SPE

(UK Trust)

$ Rebate

UK Tax on

Income

Income from

Assets

$

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BB&T Bank (Salem Fin., Inc. v. U.S., 2013 U.S. Claims LEXIS 1372 (Sep. 20, 2013))*

Facts ► Similar facts to the Bank of NY Mellon Corp. case. ► “STARS” transaction, involving FTCs. ► Court of Federal Claims held that BB&T Bank’s transaction lacked economic

substance.

Compare results of Bank of NY Mellon Corp. vs. BB&T Bank:

* Salem Fin., Inc. is a subsidiary of BB&T Corporation, a bank for US federal income tax

purposes.

Initiation:

US Bank

Non-US Bank (UK)

Non-US SPE

(UK Trust)

US Assets


$ “Repo Loan”


Ongoing:

US Bank

Non-US Bank (UK)

Non-US SPE

(UK Trust)

$ Rebate

UK Tax on

Income

Income from

Assets

$

Tax Items Considered Bank of NY Mellon Corp. BB&T Bank

FTCs Disallowed Disallowed

Deduction for foreign taxes Disallowed Disallowed

Deduction for interest expense Allowed Not allowed

Income from rebate payments Excluded Included

Penalties No penalties (not assessed) Penalties upheld

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BB&T Bank [Cont’d]

Other Considerations ► Analysis of rebate payment, as a “tax effect,” within the Economic Profit Test. ► Bifurcating the transaction between the Trust and the loan, and, treating the loan as

an “above” market interest rate loan. ► If Bank can borrow at a lower interest rate, does this mean the loan is lacking in

economic substance? ► What are the collateral consequences of a determination that a transaction lacks

economic substance? See ACM Partnership, 157 F.3d 231 (3d Cir. 1998), and the tax treatment of economic losses and costs.

Initiation:

US Bank

Non-US Bank (UK)

Non-US SPE

(UK Trust)

US Assets


$ “Repo Loan”


Ongoing:

US Bank

Non-US Bank (UK)

Non-US SPE

(UK Trust)

$ Rebate

UK Tax on

Income

Income from

Assets

$

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Santander Holdings USA, Inc. v. U.S. (also referred to as Sovereign Bank, U.S. District Court, MA)

Facts ► Similar facts to the Bank of NY Mellon Corp. and BB&T Bank cases. ► “STARS” transaction, involving FTCs.

Based on Ruling on Partial Summary Judgment Motion, announced Sep. 25, 2013: ► Rebate income is not a “tax effect” and, therefore, is recognized as part of the Bank’s

economic profit from the transaction. ► If the Court also concludes that foreign tax expense is not an expense in determining

economic profit, the transaction would be deemed to have substantial economic profit and could, therefore, be considered to have economic substance.

► Awaiting decision.

Compare: ► In BNY Melon and BB&T, the Trust Arrangement was ruled to be non-economic

because the Rebate was removed from pre-tax economic income, as a so-called “tax effect.”

► The opposite is apparently ruled to be the case in Santander. ► Query: What is the US Government’s analysis re: Compaq and IES, in

Santander?

Initiation:

US Bank

Non-US Bank (UK)

Non-US SPE

(UK Trust)

US Assets


$ “Repo Loan”


Ongoing:

US Bank

Non-US Bank (UK)

Non-US SPE

(UK Trust)

$ Rebate

UK Tax on

Income

Income from

Assets

$

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GLAM 2012-009 (Nov. 5, 2012) (dealing with prior law, i.e., Notice 97-66, as applicable prior to the effective date of Section 871(m), but with a new twist on the application of the economic substance doctrine).

Facts ► “The GLAM described a stock loan transaction in which a Lender resident in a 30%

withholding tax jurisdiction lent US stock to the Foreign Affiliate of a US Financial Institution, which was also resident in a 30% jurisdiction.

► The Foreign Affiliate then sold short the stock and entered into a total return swap to hedge its short position.

► When the US issuer of the subject stock paid a dividend, the Foreign Affiliate received 100% of the dividend under the total return swap. The Foreign Affiliate then paid the Lender a 70% substitute dividend payment and an “Enhancement Fee” equal to 20% of the gross dividend.

► Relying on prior law (Notice 97-66, 1997-2 C.B. 328), which provided that no US tax was required to be withheld on substitute payments made by a borrower in a 30% jurisdiction to a lender who was also in a 30% jurisdiction, the Foreign Affiliate did not withhold any tax on the substitute dividend payment to the Lender.

► See Notice 2010-46, which withdrew Notice 97-66, effective in 2010. ► The current system for “non-cascading” of withholding taxes relies on proof of

withholding previously in the chain of payments.

Initiation (Prior to the Payment of $100 Dividend):

Non-US Stock

Borrower

Dividend Cash Flows, Under Prior US Tax Laws:

Counter Parties of

Stock Borrower

US Stock

Borrowed US Stock

Non-US Owner of US

Equities (Stock Lender)

30% US WHT rate jurisdiction


NPC (Total Rate of Return on US Stock)

Non-US Stock

Borrower

Counter Parties of

Stock Borrower

$90 (cash) from

Dividend, instead of

$70

$10 Profit from

Trade

Non-US Owner of US


$0 WHT (Notice 97-66)

US Stock

$0 WHT (NPC Regs.)

$70 Substitute Dividend

$20 Enhancement Fee

$100 TRS Dividend

Payment

$100 Dividend ($0 WHT)

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GLAM 2012-009 (Nov. 5, 2012) [Cont’d]

GLAM Conclusions ► The GLAM concluded that because the “enhancement fee” of 20% of the gross

dividend was much higher than the typical 10 to 20 basis points for a stock loan, these transactions were not bona fide stock loan transactions and lacked economic substance.

► In the example in the GLAM, the Foreign Affiliate paid the Lender an “Enhancement Fee” of 20% of the gross dividend and retained 10% of the gross dividend as its spread. The GLAM characterized this 10% spread as “an implicit fee” paid by the Lender to the Foreign Affiliate for its help in facilitating the Lender’s tax avoidance and re-characterized the enhancement payments as “tax effects.”

► In its strained analysis of the economic profit test, the GLAM concluded that the enhancement fee received by the Lender was a “tax effect” that was not part of the Lender’s pre-tax economic profit. Thus, the GLAM concluded that the Lender incurred a “pre-tax loss” and entered the transaction solely for tax avoidance.

Observation ► The more appropriate US tax analysis for this fact patterns is a substance-over-form

analysis, as to whether (a) the Lender is really the beneficial owner, or (b) the Lender is deemed to be the Lender to a US borrower; either of which would trigger the US withholding tax.

► Conclusion: Economic Substance is a difficult fit in these facts. ► Query: Whether Notice 97-66 was even applicable to these facts. ► Related Comment: Discuss Equity Swap Guidance, if released before 11/14/2013.

Initiation (Prior to the Payment of $100 Dividend):

Non-US Stock

Borrower

Dividend Cash Flows, Under Prior US Tax Laws:

Counter Parties of

Stock Borrower

US Stock

Borrowed US Stock

Non-US Owner of US




NPC (Total Rate of Return on US Stock)

Non-US Stock

Borrower

Counter Parties of

Stock Borrower

$90 (cash) from

Dividend, instead of

$70

$10 Profit from

Trade

Non-US Owner of US


$0 WHT (Notice 97-66)

US Stock

$0 WHT (NPC Regs.)

$70 Substitute Dividend

$20 Enhancement Fee

$100 TRS Dividend

Payment

$100 Dividend ($0 WHT)

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I.R.C. Section 7701(o) – Codification of Economic Substance

Section 7701(o)(1) ► A transaction is treated as having economic substance only if:

► “(A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and ► (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.”

Section 7701(o)(2)(B) ► “The Secretary shall issue regulations requiring foreign taxes to be treated as expenses in determining pre-tax profit in appropriate cases.” Other Considerations ► Note that the Economic Profit Test, where applicable, requires a comparison of the profits relative to the tax benefits:

► Profit potential is only taken into account “if the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected”

► It is unclear what a “substantial” ratio would be. (Similarly see Notice 98-5, since withdrawn), and, the practical difficulty of comparing expected profits with expected tax benefits.

► The issues raised in recent cases, such as BB&T Bank, as to what is a “tax effect” would presumably be equally applicable under the statute. ► See Section 6664 for the “per se” penalty rule for non-economic transactions entered into after Mar. 30, 2010, and the corresponding increase in penalty rate

from 20% to 40% for undisclosed non-economic transactions in Section 6662(i).

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Managing Assertions by Field Examiners and Counsel Coordination Regarding the Economic Substance Doctrine

Chief Counsel Notice CC-2012-008 (Apr. 3, 2012)

Chief Counsel Notice CC-2012-008 ► Background:

► This Notice provides: ► (1) Instructions regarding Counsel’s role during an examination that involves the application of the economic substance doctrine under the common

law or Section 7701(o) (the “codified economic substance doctrine”), including penalties related to the codified economic substance doctrine under Sections 6662, 6662A, or 6676;

► (2) Instructions for reviewing a statutory notice of deficiency or a notice of final partnership administrative adjustment if a Business Operating Division concludes that a transaction lacks economic substance; and

► (3) Coordination procedures for litigating the common law economic substance doctrine or the codified economic substance and a related penalty. ► Counsel Coordination Procedures

► Specifically, the Notice provides that “[b]efore applying the common law economic substance doctrine or the codified economic substance doctrine to a transaction, the Service should consider all of the substantive arguments and technical analysis that are reasonably relevant to the proper tax treatment of the transaction.”

Note: ► For DFO approval requirement, see: LMSB-20-0910-024 (Sep. 14, 2010). ► For a list of the inquiries that Examiners must answer and analyze before asserting disallowance under the economic substance doctrine (including the

corresponding penalties), and, before seeking DFO approval, see: LB&I-4-0711-015 (Jul. 15, 2011).

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Application of Debt v. Equity Analysis and Related Applications of the Substance Over Form Doctrine in Recent Court Decisions

Barnes Group, Inc. v. Comm'r, T.C. Memo 2013-109 (Apr. 16, 2013) – Application of the substance-over-form doctrine to determine that a controlled foreign corporation (“CFC”) had paid a taxable dividend to its US Parent company.

Facts ►As part of a reinvestment plan, the Taxpayer formed domestic and foreign entities wholly owned by the Taxpayer. ►One of the Taxpayer’s foreign subsidiaries transferred foreign currency in exchange for the newly formed foreign entity's stock, the foreign

entity transferred foreign currency in exchange for the newly formed domestic entity's stock, and the newly formed domestic entity converted the foreign currency into U.S. currency which was loaned to the Taxpayer.

Tax Court Holdings ►The Tax Court held that the transfers of the foreign subsidiary's excess cash (which was eventually used to pay down the Taxpayer's debt) was

in substance a dividend. ►Further, the Tax Court held that the foreign subsidiary was not prevented from investing directly in the newly formed domestic entity, and thus

the newly formed foreign entity had no business purpose. ►The stated business purpose of the newly formed domestic entity was belied by the taxpayer's failure to respect the form of the reinvestment

plan by paying interest to the domestic entity on the putative loan, and the domestic entity's failure to pay preferred dividends to the foreign entity.

►Accordingly, the Tax Court disregarded the form of the transaction steps, including: (i) the foreign subsidiary’s transfer of cash to the new formed foreign entity; (ii) the newly formed foreign entity’s transfer of cash to the newly formed domestic entity; and (iii) the newly formed domestic entity’s transfer of cash to Taxpayer.

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Application of Debt v. Equity Analysis and Related Applications of the Substance Over Form Doctrine in Recent Court Decisions

Tyco – (Tax Court petitions filed in July, 2013) – Debt owed by US Subsidiaries to a Luxembourg finance vehicle under an ultimate non-US Parent Company being challenged by IRS as equity; with corresponding disallowance of interest expense deductions by the subsidiaries.

►Through a merger, Tyco re-domiciled its US Parent to Bermuda in the late 1990’s and also levered-up certain US operating subsidiaries. The IRS challenged the interest deductions with respect to inter-company debt owed by Tyco’s US subsidiaries to the Luxembourg Co., on debt-equity grounds. (Note: some of the US subsidiaries were subsequently disposed of).

►Tyco maintains that the debt instruments had all the formal indicia of debt: fixed maturities, stated interest (all of which was paid), formal debt instruments, and, a capacity to service the debt payments, with supportive analysis. Its "intercompany loans were bona fide indebtedness for federal income tax purposes," the company said in court documents.

►The IRS disagrees and has determined that Tyco and its related companies owe $883.3 million in taxes and $154 million in penalties for tax years from 1997 to 2000.

►Tyco is challenging this $1 billion tax bill assessed by the IRS. Tyco disagrees with the IRS assertion that the inter-company payments were non-deductible dividends rather than deductible interest expense.

Considerations ►The Tyco decision could have a broad impact on other companies facing similar challenges from the IRS over debt-vs-equity questions in

intercompany transfers. ►An IRS court win would be in stark contrast to the debt-vs-equity loss the agency had suffered in Scottish Power, where the IRS lost in an

attempt to recharacterize inter-company debt as equity. ►Question: Whether IRS wins, on debt-equity grounds, in cases involving perceived tax shelters (e.g., Pritired and HP, discussed in prior

year BTI session) are relevant to the debt-equity analysis for inter-company debt, or even inter-company hybrid instruments (e.g., PepsiCo, also discussed in prior year BTI session).

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The Other Tax Aspect of Tyco: Re-domiciling, and More Recent M&A Transactions with Tax Re-domiciling Aspects

The backdrop to the Tyco-IRS litigation was the re-domiciling of Tyco from the US to a non-US jurisdiction (i.e., Bermuda) and the result from levering-up US subsidiary operations. Tyco’s inversion transaction occurred in the late 1990’s (i.e., prior to the 2004 enactment of Section 7874, the US anti-inversion provision).

►Consider recent M&A transactions, involving US Acquiring Co. and non-US Target, which have permitted US companies to re-domicile, from the US, to a low-taxed jurisdiction:

►Acquisitions in the: ►Pharmaceutical Industry ►Media Industry ►Advertising Industry ►Consulting Industry

►See Section 7874, regarding the treatment of Expatriating Entities. ► In general, expatriating entities are treated as US entities after re-domiciling, or, their shareholders are subject to taxable gain in the US,

unless the re-domiciling involves a substantial change in stock ownership (e.g., in a stock-for-stock acquisition of a foreign target) and substantial non-US operations.

►Relevance to US Banks: ►Although banks have over-arching regulatory constraints, preventing the re-domiciling of their Parent Co. or major banking subsidiaries, the

Investment Banking / Advisory Groups of US Banks are advising their US non-banking clients on the impact of re-domiciling. (This raises potential franchise-related issues for the re-domiciling company and its investment banking advisors, since re-domiciling is often a politically-charged issue in Washington, D.C.).

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Loan Syndications and Non-US Hedge Fund Investors Background ►US Banks that originate commercial loans to corporate customers, from time to time, sell the loans to non-US hedge funds, via syndication

transactions. IRS Scrutiny ►For several years, the IRS has been inquiring (typically through examination IDRs issued to the non-US hedge fund) whether the non-US

hedge fund actively participated in either the loan origination process or any subsequent substantial modification of the loan. Such inquiry is directed at whether the non-US hedge fund was engaged in a US lending trade or business and, hence, had effectively connected income (“ECI”).

Bank Procedures ►The banks involved in such syndications should have procedures preventing their non-US hedge fund clients from risks of having ECI. Such

procedures should include prohibitions of non-US hedge fund investors from being involved in the negotiation of the terms of the commercial loan and adequate aging of the loan prior to syndication. Consider procedures for substantial loan modifications.

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Transfer Pricing ► In the post-financial crisis period, a number of business changes have prompted re-consideration of the transfer pricing policies for many

banks. ►For example, to the extent that the post-crisis environment requires US based banks to hold significant amounts of excess liquidity in extremely

low-interest bearing investments (such as deposits with the Federal Reserve Bank), the excess liquidity generates a negative spread for the Bank and, to the extent that non-US subsidiaries of the US Bank are not also generating excess liquidity, the cost of this negative spread could be shared with the non-US subsidiaries.

►Query: Whether non-US based banks generating a similar negative spread from excess liquidity in their home country could charge a portion of

the negative spread to their US branch or US subsidiary. ►Also, in the post-financial crisis era (partly due to changes prompted by the Dodd-Frank Act), there are increased circumstances where there is

a separation of the legal entity that has legal title to the trading positions (i.e., the “booking” vehicle) and the legal entity that employs the traders and trade management personnel (i.e., the trade management vehicle). This phenomenon heightens the importance of appropriate recognition of the intermediation service provided by the booking vehicle and, where applicable, other profit sharing arrangements.

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Low-Income Housing Tax Credits (LIHTCs) Historic Boardwalk Hall LLC v. Comm’r, 694 F.3d 425 (3d Cir. 2012) (hereinafter “Historic Boardwalk”) – The Historic Boardwalk decision (discussed during the prior year BTI conference) disallowed Historic Rehabilitation Tax Credits (“HRTCs”) to an investor that was determined by the Court not to be an equity partner in the venture because, other than the tax credits, the investor had insufficient upside or downside in the venture to be considered an equity partner. Background: ►The Historic Boardwalk decision has had detrimental consequences for secondary market investments in projects generating HRTCs, as well

as other targeted tax credits (such as LIHTCs), due to uncertainty about how much upside or downside is needed to acquire targeted credits (i.e., credits supposedly immune from scrutiny under the economic substance doctrine).

Possible Safe Harbor Rules ►Per Treasury’s Office of Tax Legislative Counsel, as of Sep. 24, 2013, Treasury expects to issue safe harbor guidance relating to Historic

Boardwalk, potentially describing permissible guarantees, puts and calls, which could be used in secondary investments without risk of IRS disallowance of credits.

►Question: Whether the Rev. Proc. (or other guidance from Treasury), with respect to HRTCs, can be useful in structuring secondary market transactions involving LIHTCs.

Proposed GAAP Changes ►GAAP proposals include accounting for LIHTC investment losses within the tax provision, a simplified cost basis recovery method, and

potential reclassification of the balance sheet investment, to a deferred tax asset. ►Note: Adoption would be optional.

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Deductions under I.R.C. Section 199 Background ► Section 199 provides a tax benefit, in the form of an additional tax deduction for certain qualified domestic production activities. In general, the additional

deduction is equal to 9% of the qualified production activities income (“QPAI”) for the year. For Banks, the issue is whether a portion of their income is attributable to software developed by the Bank, or, whether or not there is an explicit fee received by the Bank from the Customer, for software license or usage.

► Section 199 tax benefits may be available if the Company develops software that end users have access to either via: ► Their own computer via a download from the internet or from a tangible medium (a disk) (also know as “fat client architecture”), or ► Online (also know as “thin client architecture”) and they meet one of the following:

► The Company also provide substantially similar software to other clients via a download from the internet or on a tangible medium, or ► A Competitor provides substantially similar software to the Company’s software that is either provided as a download or on a tangible medium.

Examples: ► Business Intelligence Tools (“BIT”). BIT is an application software designed to retrieve, analyze and report data. The tools generally read data that have been

previously stored, often, though not necessarily, in a data warehouse. The business intelligence is used by the end user to make business decisions. ► Merchant Services. Software to manage credit and debit card processing and analysis ► Investment Services. Software to perform investment related research ► Loan Processing Tools. Software to expedite, facilitate and perform analysis ► Loan Management Tools. Software to manage loan participation arrangements ► Lending Services Tools. Software for end users to consider borrowing requirements, mortgage calculators, amortization schedule, buy vs. lease, etc. ► Fx trading software provided to Fx customers of the Bank

Note: Treas. Reg. Section 1.199-3(i)(6)(ii) provides, in relevant part, “Gross receipts derived from . . . online banking services . . . and other similar services do not constitute gross receipts derived from a lease, rental, license, sale, exchange, or other disposition of computer software.”

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Deductions under I.R.C. Section 199 - “Is Software Qualified Production Property?”

Is software developed by the taxpayer wholly in United

States?

Are at least 20% of software development costs incurred in

United States?

Is the software development activity in US “substantial in

nature”?

Does a competitor provide similar software* to its

customers through download or on physical medium?

Does the Company provide similar software* to customers

through download or on physical medium?

Do customers receive software on physical medium (CD, DVD)

or by download?

Can customers directly access the software online?

Software is qualified production property (QPP), at least in part

Software is not QPP.

No No No

No No

No No

Yes Yes Yes

Yes Yes

Yes Yes

* Similar software has only minor or immaterial differences, provides the same functional results, and has a

significant overlap in features.

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Deductions under I.R.C. Section 199 - “Domestic Production Deduction Computation”

Identify QPP. (see other slide)

Allocate receipts using a reasonable method (FMV) between QPP (DPGR) and embedded services and/or non-QPP (non-DPGR)

Compute domestic production gross receipts (DPGR)

Determine QPP costs.

Determine cost of goods sold for QPP, under sec. 174 or Rev. Proc. 2000-50 rules. Allocate CGS across total expected unit to be licensed.

Allocate and apportion other deductions to QPP using principles of section 861, including same methods used for foreign tax credit or other operative sections.

Subtract QPP costs from DPGR. Compute Qualified Production Activity

Income (QPAI).

Calculate sec. 199 deduction.

Deduction is 9% of QPAI.

Cannot exceed: • 9% of taxable income. • 50% of employer’s W-2 wages that are

allocable to DPGR

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Virtual Entities ►A contractual arrangement between two related entities within a bank group could be viewed as a partnership for US federal income tax

purposes, if the impact of the arrangement is that the two contracting parties are entering a joint business venture with a view to the sharing of profits and losses therefrom. See Luna v. Comm’r, 42 T.C. 1067 (Sep. 18, 1964);

►A contractual arrangement can therefore permit, for US federal income tax purposes, the deemed transfer of a bank’s business operations (or portion thereof) to a deemed, separate business entity. Although such entity would generally be considered a partnership for US federal income tax purposes, it may also be “checked” into corporate form.

►For an example of a contractual arrangement being treated as a deemed business entity, which was also “checked” as a corporate entity, see PLR 201305006.

►The tax planning opportunities from the use of such virtual entities may include the deemed transfer of assets (e.g., foreign assets) to the virtual entity; particularly where the legal title to such assets cannot be transferred, due to regulatory or business considerations.

►The treatment of contractual arrangements as business entities, for US federal income tax purposes, is not necessarily a recent development (consider the US federal income tax treatment of German Silent Partnerships and Japanese “TK” Arrangements). However, the possibility of also making “check-the-box” elections to treat these deemed business entities as corporations for US federal income tax purposes, is a relatively recent tax planning strategy.

Example ► A US Bank conducts a swap dealer business in the Country X branch of the US bank. The swap book has large offsetting assets and liabilities, due to

offsetting MTM movements of matched Notional Principal Contracts. The Section 861 interest expense allocations of US Bank are detrimentally impacted by the asset-side of this matched book. However, this detrimental impact may be eliminated if the matched positions are subject to a contractual arrangement that is treated as a business entity, for US federal income tax purposes only, and are therefore deemed to be transferred from the Country X branch of the US Bank to a “virtual” entity that has elected to be treated as a corporation for US federal income tax purposes.

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Nonreliance Notice and U.S. Treasury Circular 230 Disclosure Due to the preliminary nature of this document, it does not constitute tax advice or opinion and hence cannot be relied upon for any purpose, including penalty protection. In order for Ernst & Young to render tax advice or issue an opinion, additional steps may be required including (but not limited to), research, obtaining written representations from management, and/or verifying the facts upon which the opinion would be based. Any U.S. federal income tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.

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3 45pm capital markets - part 2

Technology

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