Tax Update: Current and Proposed Changes to the Calculation of Tax Interest Expense of Foreign Banks



FFIEC Releases Bank Secrecy Act / Anti-Money Laundering Examination Manual



Current and Proposed Changes to the Calculation of Tax Interest Expense of Foreign Banks



Up Close: Emilio Escandon, Partner

The Internal Revenue Service and Treasury Department recently issued Notice 2005-53 describing current and proposed changes to the tax rules for determining the interest expense of a foreign bank that is engaged in a U.S. trade or business. The notice attempts to reduce the scope of challenges under audits by minimizing the need to analyze operations and data located outside the United States.

Current Tax Interest Expense Calculation

Currently, the interest expense deduction is calculated based on a three-step process:

1. The value of average U.S. assets is calculated based on their adjusted basis or an election may be made to value them based on their fair market value. Generally, an asset is a U.S. asset if it generates income effectively connected with a U.S. trade or business (“EC”) or if upon its disposition, any realized gain would be EC.
2. Average U.S.-connected liabilities are calculated by multiplying the U.S. assets obtained in step 1 above by either an actual ratio (average worldwide liabilities divided by average worldwide assets, calculated under U.S. tax rules) or a fixed ratio of 93% for foreign banks.
3. The amount of deductible interest expense is determined by comparing the amount of U.S.-connected liabilities for the taxable year, as determined above, with the average total amount of U.S. booked liabilities. If the average total amount of U.S. booked liabilities exceeds the average total amount of U.S.-connected liabilities, the deductible interest expense is the product of the total amount of interest paid or accrued within the taxable year by the U.S. trade or business on U.S. booked liabilities and a fraction (average U.S.- connected liabilities over average U.S. booked liabilities). If the average U.S.-connected liabilities exceed the average U.S. booked liabilities, the deductible interest expense is the total amount of interest paid or accrued plus the excess of the average U.S.-connected liabilities over the average U.S. booked liabilities multiplied by the ratio of interest expense paid or accrued for the taxable year shown on the books of the offices or branches of the foreign corporation outside the United States by the average U.S.-dollar denominated liabilities shown on the books of the offices or branches of the foreign corporation outside the United States for the taxable year.

   Transactions of any type between separate offices or branches of the same taxpayer do not create assets or liabilities for the purposes of this calculation.

   An election can be made to calculate deductible interest expense based on the sum of the separate interest deductions for each of the currencies in which the foreign corporation has U.S. assets. Average U.S. assets and average U.S. connected liabilities are calculated as stated above. For each currency pool, the prescribed interest rate is determined by dividing the total interest expense that is paid or accrued for the taxable year with respect to the foreign corporation's worldwide liabilities denominated in that currency, by the foreign corporation's average worldwide liabilities denominated in that currency.

Changes to Tax Interest Expense Calculation Under New Notice

In the notice, the IRS states that it is considering increasing the current fixed ratio from 93% to 94-96%. In order to avoid questions under audit with respect to the computation of the actual ratio, banks have been electing to use the low fixed ratio and are being penalized by paying more taxes. The notice appears to address this issue. Taxpayers should not use a fixed ratio greater than 93% until a definitive proposal is issued.

The notice states that the regulation will be revised to allow foreign banks to elect on an annual basis to use the 30-day LIBOR rate as a safe harbor for purposes of determining the interest on U.S.-connected liabilities in excess of U.S. booked liabilities in order to determine the actual dollar borrowing rate of their non-U.S. branches and offices. This rate will allow banks to avoid computing average U.S. dollar interest expense on non-U.S. liabilities denominated in U.S. dollars and proving such computation under audit. This safe harbor existed prior to 1996. This safe harbor is effective for tax years ending after July 14, 2005.

The notice also states that the IRS is considering not allowing banks that elect the fixed ratio to also use the fair market value method to determine U.S. assets.

If you have any questions on this or other tax related matters, please contact Raul Incera at rincera@mbafcpa.com or at (305) 373-5500.

On June 30, 2005, the Federal Financial Institution Examination Council (FFIEC) released the Bank Secrecy Act (BSA) / Anti-Money Laundering (AML) Examination Manual. The manual was developed jointly by federal banking agencies and the Financial Crimes Enforcement Network (FinCEN), a bureau of the U.S. Department of the Treasury, with input from the Office of Foreign Assets (OFAC), which assisted in the development of the sections of the manual that relate to OFAC reviews. Designed to ensure consistency in the application of the BSA/AML requirements, the manual provides guidance to examiners for carrying out BSA/AML and controls OFAC examinations.

It is important to note that the manual does not set new standards; instead it represents a compilation of existing regulatory requirements, supervisory expectations, and sound practices for BSA/AML compliance. The manual contains an overview of BSA/AML compliance program requirements, BSA/AML risks and risk management expectations, industry sound practices, and examination procedures.

Among the key topics addressed by the manual, the use of Suspicious Activity Reports (SAR’s) is perhaps the most notable. SAR’s forms represent the foundation of the BSA reporting system, and they include critical financial information that is used to fight terrorism, money laundering and other financial crimes. To detect suspicious activities, a financial institution must have the appropriate policies, procedures, and processes in place to monitor and identify unusual activity such as lack of legitimate business activities, unusual transactions and transaction volume, and frequent fund transfer transactions.

In order for the information in the SAR’s to be utilized by the government, the forms must be properly completed. The forms must have information such as: who is conducting the transaction, what instrument or mechanism is being used, when did it occur, where did the activity take place, and why did it take place.

To properly monitor customer accounts, financial institutions must have good Customer Due Diligence and Customer Identification programs in place. If both programs are well-developed, an institution can predict with relative certainty the types of transactions that customer accounts should display, as well as the true identity of the customers associated with each account. These programs provide vital structure to banks as they work to adhere to safe and sound banking practices, allowing them to avoid criminal exposure from customers who attempt to use bank products to perform fraud.

The BSA/AML manual reinforces the agencies’ and FinCEN’s position that sound BSA/AML risk management enables a banking organization to identify BSA/AML risks and better direct its resources. The BSA/AML Examination Manual is available at:

http://www.ffiec.gov/bsa_aml_infobase/documents/
BSA_AML_Man.pdf

If you have questions about the BSA/AML manual, please contact Frank Gonzalez at fgonzalez@mbafcpa.com or at (305) 373-5500.

The FDIC's annual audit and reporting requirements, including audit committee requirements, apply to insured institutions with $500 million or more in total assets ("covered institutions").

For covered institutions with total assets of less than $1 billion, the proposal would lift the current requirement that management assess and report on the effectiveness of internal control over financial reporting. The proposal would also remove the requirement directing external auditors to examine and attest to management's internal control assertions. Finally, outside directors on the audit committee would no longer be required to be independent of management.

The proposal would relieve covered institutions in this size range from these requirements only for purposes of Part 363. These covered institutions must continue to comply with the remaining provisions of Part 363, including the annual financial statement audit requirement.

The FDIC's proposal would not relieve covered institutions that are public companies from their obligations to comply with the provisions of the Sarbanes-Oxley Act and the Securities and Exchange Commission's implementing rules on internal control assessments by management and attestations by external auditors and, if applicable, audit committee independence.

For further information on the proposed FDIC changes, please contact Frank Gonzalez at fgonzalez@mbafcpa.com or at (305) 373-5500.

Emilio Escandon
PARTNER

Emilio Escandon is a Partner in the Tax department of Morrison, Brown, Argiz & Farra, LLP, where he directs the firm's tax practice in the Broward Office. He brings more than fourteen years of public accounting experience managing various tax client engagements, as well as nine years of corporate tax experience as Senior Vice President-Corporate Tax at Intercontinental Bank, a publicly-traded $2.5 Billion Super-Community Bank in South Florida.

Previously with a Big Four accounting firm, Emilio has proactively managed a diversified portfolio of clients and has broad industry experience including: Manufacturing (Aviation Parts; Apparel; Household Appliances); Consumer Business (Fragrance Retail; Furniture Retail; Fragrance Distribution; Travel Related); Financial Institutions (Depository Institutions; Mortgage Companies); Food & Beverage (Coffee Roasting/Wholesaler; Food Wholesaler); Pharmaceuticals; Telecommunications (Telecom Provider; Telecom Infrastructure); and Advertising. Emilio also has experience in servicing multinational corporations (Spanish and UK).

As a partner at MBAF, Emilio has focused particular attention on key tax issues relating to Mergers & Acquisitions, S Corporations, Executive Compensation and FAS 109.

Emilio is a graduate of the University of Florida and is a member of the AICPA and the FICPA. He has served as former Chair of the Federal Taxation Committee of the FICPA and is a current a member of the Editorial Committee of CPA Today. He is also a current board member and former Chair of Junior Achievement of Greater Miami.

If you would like to discuss your company’s tax consulting needs with Emilio, please call him at (305) 373-5500 or email him at: eescandon@mbafcpa.com