Risk-weighted assets usually cannot apportion a foreign bank's support expenses

Plain-English summary

Chief Counsel considered whether foreign banks may use the relative value of risk-weighted assets to divide supportive expenses between effectively connected U.S. income and other income. The memorandum concluded that this method is generally unreasonable for costs such as human resources, information technology, risk control, credit management, tax, audit, and treasury because asset risk weights do not show the resources spent on those functions. Some assets may even receive a zero or near-zero risk weight despite still requiring management effort. A bank could use the method for a specific expense category only if it supplies evidence of a clear proportional relationship between that cost and the risk weighting of each asset class. Records showing employee time by asset category could help establish that relationship.

Ruling snapshot

• Question: Are relative risk-weighted asset values a reasonable key for apportioning supportive expenses to effectively connected income?
• Outcome: Advice given: generally no, unless a taxpayer proves a clear factual relationship for a specific expense category.
• Key authorities: IRC §§ 61, 861, and 882(c); Treas. Reg. §§ 1.861-8 and 1.861-8T(c)(1)

Full text (IRS public release)

           Office of Chief Counsel
           Internal Revenue Service
           Memorandum
           Number: 201614031
           Release Date: 4/1/2016
           CC:INTL:B03:JPCowan
           POSTU-132168-14

 UILC:     861.08-02

  date:    February 11, 2016

     to:   Vincent J. Guiliano, Senior Counsel
           (Large & Mid-Size Business)

  from:    Richard L. Chewning, Senior Counsel
           (International)


subject:   Use of Relative Risk Weighted Asset Value as Apportionment Key



           You have requested that the National Office issue Chief Counsel Advice addressing
           whether the relative value of risk weighted assets is a reasonable key for apportioning
           deductions for supportive expenses under Treas. Reg. § 1.861-8. This memorandum
           should not be used or cited as precedent.

           FACTS

           Numerous foreign persons are engaged in a banking, financing, or similar business in
           the United States through a branch which earns effectively connected income (ECI).
           The local banking regulator in many of those foreign persons’ home countries require
           the foreign person to hold capital equal to a certain percentage of its risk-weighted
           assets (“RWAs”), as determined under local banking regulations that implement
           regulations issued by the Basel Committee on Banking Supervision (Basel Accord).
           Several of those foreign persons are asserting that they are permitted to use the relative
           value of risk weighted assets as a reasonable key for apportioning deductions for
           supportive expenses under Treas. Reg. § 1.861-8. This advice is not specific to any
           one of those foreign persons.

           LAW AND ANALYSIS

           For purposes of determining ECI under section 882(c) and Treas. Reg. § 1.861-
           8(f)(1)(iv), a taxpayer takes into account its deductions for overhead, general, and
POSTU-132168-14                               2

administrative expenses (hereafter “supportive expenses”) by first allocating such
deductions to all gross income, then apportioning to its statutory grouping (or groupings)
of effectively connected gross income based upon the relative value of the RWAs used
in its U.S. trade or business to the value of the RWAs used in its worldwide trade or
business. You have asked whether the relative value of RWAs is a reasonable key for
apportioning the taxpayer’s deductions for supportive expenses under Treas. Reg. §
1.861-8.

A foreign person with a U.S. trade or business is generally required under Treas. Reg. §
1.861-8 to perform a two-step analysis whereby deductions are first allocated based on
the factual relationship of the deduction to a class of gross income which ordinarily
consists of items (or subdivisions of such items) of income enumerated under section

61. See Treas. Reg. § 1.861-8(a)(2) and (3). Next, the deductions within the class of
gross income must be apportioned, again based on factual relationships, between the
statutory grouping (or groupings) and the residual grouping. Id. Special rules exist for
certain expenses such as interest and research and experimental expenditures.

With respect to the allocation step, a deduction is considered definitely related to a class
of gross income and therefore allocable to that class if it is incurred as a result of, or
incident to, an activity, or in connection with property, from which that class of gross
income is derived. Treas. Reg. § 1.861-8(b)(2). In many cases, supportive expenses
are factually related to all the taxpayer’s gross income and therefore, are allocated to all
such gross income. Because the issue you present is not related to the proper
allocation of supportive expenses we are assuming that the supportive expenses are
allocated to all of the gross income of the foreign persons.

Step two of the rules require that the supportive expenses be apportioned between the
statutory grouping of ECI and the residual grouping of non-ECI within the class of
income to which the expenses have been allocated (in this case all gross income). See
Temp. Treas. Reg. 1.861-8T(c)(1). The apportionment must reflect to a reasonably
close extent the factual relationship between the deduction and the grouping of gross
income. Id. Because apportionment is made on the basis of the factual relationship
between a deduction and the statutory grouping of gross income, a taxpayer is required
to furnish information which will establish that factual relationship. Treas. Reg. § 1.861-
8(f)(5). As an example of the type of information required to be furnished, the
regulations provide that in reviewing a taxpayer’s overall foreign tax credit limitation, the
District Director should consider, and request if need be, “information which would
enable him to determine the extent to which deductions attributable to functions
performed in the United States are related to earning foreign source income, United
States source income, or income from both sources. “ Id.

Typically, supportive expense deductions include costs associated with numerous
disparate activities. Representative activities in a banking, financing, or similar business
include risk control, credit management, audit/tax, treasury, group strategy, IT, and
human resources. It will be difficult for a foreign person engaged in a banking,
POSTU-132168-14                             3

financing, or similar business to establish that the costs associated with most of those
activities may be reasonably apportioned to the statutory grouping of ECI based upon
relative RWA values. For example, the costs associated with activities such as human
resources and IT expense have no clear relationship to the relative values of RWAs and
therefore using RWAs for those costs would be unreasonable. Other back office
support functions, such as risk control, credit management, tax/audit, and treasury,
relate more generally to the banking operation as a whole, or a particular business line,
rather than to a particular asset class, making the use of RWAs as an apportionment
key for such expenses unreasonable. RWA-based apportionment likely will result in
relative values being attributed to assets that bear no factual relationship to the amount
of time or other resources expended in issuing, acquiring, or managing those assets
and performing the supportive activities. The most drastic illustration of this is that
under the Basel II regulations, certain assets may be determined under an RWA
approach to have a value of zero (or close to zero) and thus not support the
apportionment of any supportive expense. This result is unreasonable because all
assets inherently entail some cost to manage.

Nonetheless, it is theoretically possible that it could be established that using RWA
relative values is a reasonable method for apportioning the costs of certain specific
activities to the statutory grouping of ECI. This would only be the case, however, where
a clear factual relationship is established between the specific category of expense and
the relative risk weighting of assets as determined under local banking regulations. To
do so, a taxpayer would need to provide information demonstrating that the cost of
engaging in the particular activity or incurring the particular expense bore a clear
proportionate relationship to the risk weighting with respect to each particular asset
class. That information might include, for example, time records indicating that
employees engaged in an activity that was supportive of ownership and management of
assets used in the business and that the time devoted to each asset category—both in
the U.S. and in the home office—was proportionate to the asset category’s risk
weighting. If so, then apportionment of those costs based on RWAs might be deemed
reasonable. You must consider whether adequate information has been supplied to
enable you to make that determination.


Please call Jeffrey Cowan at (202) 317-4924 if you have any further questions.