U.S. Federal Income Taxation of U.S. Branches of Foreign Banks: Selected Issues and Perspectives

Abstract

An earlier version of this article was presented to the Tax Club in New York in December 1993.The title of this article notwithstanding, the United States does not in fact tax the U.S. branches of foreign banks; branches are not regarded as distinct entities for most federal income tax purposes. Rather, the United States taxes foreign corporations (including banks) that are engaged in a trade or business within the United States on taxable income that is effectively connected with the conduct of that U.S. trade or business.But the story is not so simple. Various provisions of the Code and Regulations-including especially Regulations section 1.882-5, providing for the determination of the deductible interest expense of a foreign bank attributable to its U.S. trade or business, the branch profits tax, and the branch level interest tax-treat U.S. branches of foreign banks as separate entities, to one degree or another. Also, most income tax treaties provide that there should be attributed to a U.S. branch (a permanent establishment) the business profits that it might be expected to earn if it were a distinct and separate entity.Moreover, in recent years, the nature of international banking has evolved considerably. Many banks now actively trade and deal in foreign currencies; in interest rate and foreign currency forward and futures contracts, options, and swaps; and in various equity- and commodity-derivative products, as well as in securities. These activities have resulted in a tremendous expansion of the volume and type of transactions involving multiple branches of these banks, both in providing financial products to customers and in hedging the risks assumed by the banks. The involvement of multiple branches in these transactions takes a variety of forms, including transactions between branches (such as swaps, sales of property, loans, and forward contracts) and joint efforts to provide products to customers. These developments have placed considerable pressure on the concepts that traditionally have been applied in determining the amount of a foreign bank's taxable income for U.S. federal income tax purposes, including the extent to which a branch should be disregarded as a separate entity.