- 18 -

from depositors who now pay explicit fees for banking services.
Nevertheless, the 1977 choice of the fungibility approach was an important
accommodation of the subsequent surge in withholding tax lending by US
banks.

This conclusion is clearly confirmed by a comparison of 1976 and
1978 (most recent published by the Internal Revenue Service in the

Statistics of Income) data on US banks' worldwide income:

US_banks' reported taxable incomes
(billions of dollars)

1976 1978 Change
(1978 - 1976)
Foreign 3.2 6.7 3.5
Domestic -1.1 73.2 72.1
Worldwide 2.1 3.5 1.4
c. Separate Limitation for Interest Income

Under US tax rules, most US taxpayers compute two foreign tax
credit limits: one for interest income and the other for all other sources
of foreign income. However, banks are allowed to compute one limit, and
this special treatment is of considerable value to them.

Major US banks earn large amounts of foreign fee incomes from the
banking services of their domestic offices; for example, commissions from
the issuance of letters of credit. Because this type of income is generally
exempt from taxation by source countries, it provides large net additions
to banks' overall capacities to claim US tax credits for foreign tax
payments. Thus, under the standard computation rule, the net capacity of

banks to absorb foreign withholding taxes would be significantly reduced.

6. Concluding Remarks
This paper has explored the possible réle of US foreign tax
credit rules on the loan selection and pricing decisions of US banks. A

conclusion of the exploration is that favourable US tax treatment was a


- 12 -

contrast to the first comparison, the borrower, and not the bank, is the

beneficiary of the tax-based subsidy of foreign lending by US banks.

"Co-operating" Foreign Governments

Under US foreign tax credit regulations, a foreign withholding
tax is creditable only if it is designed to reach the realised net income
of the US taxpayer. Furthermore, a creditable tax must be compulsory and
must not represent compensation for a specific benefit. In particular, a
tax levied by a foreign government will not be creditable to a US taxpayer
if the tax's imposition is dependent on the availability to the taxpayer of
US tax credits - that is foreign "soak-up" taxes are not creditable for a
US taxpayer.

Governments of major developing countries are aware of the home
country tax environments faced by their bank creditors.’ Thus, it seems
reasonable, to postulate that these governments structure their withholding
tax arrangements for US bank creditors to avoid having it appear that their
taxes constitute a rebate of interest charges to borrowers. That is, the
sensitivity of developing countries to the home-country tax environments
of their bank creditors may explain the choices of these countries to
borrow heavily through government-owned and quasi-government entities,
credit conditions permitting, rather than in the name of the government
itself. The choice by a government of using separate borrowing entities is
only definitely welfare enhancing for. the country if full tax rebates are
paid to borrowers and if there are positive withholding tax receipts net of

such payments. 8

Ty > Ty

Consider a bank with an initial asset-mix such that, at given
interest rates, Ty > T,*. Under such circumstances, the bank can profit by
reducing the portfolio share of high return foreign taxable assets. The
bank will profit from the rearrangement as long as it did bear some portion
of the total incidence of the larger withholding tax payments. Overall,
there is no arbitrage opportunity which can be exploited to benefit both

the bank and foreign tax authorities.


13.

14.

15.

16.

- 22 -

Because Brazil directly rebates a portion of the withholding tax
payments to the borrowers, US banks are now only allowed to claim
credits for a 15 per cent. tax rate directly against US taxes. See
Revenue Ruling 78-258, Internal Revenue Bulletin, 1978.

Sensitivity to tax revenue losses and distortions of lending terms led
the United Kingdom to cap the creditable rate of foreign withholding
taxes in the Finance Act of 1982. The Act provides that UK banking
offices cannot claim a tax credit for more than the amount. of taxes
which would have been paid at a 15 per cent. tax rate.

Under a tax-sparing agreement, a developing country would give up the
tax on income earned by foreign investors and the investor's home
country would treat the income as if a tax had been paid. For a
general discussion of US tax policy and developing countries see
United States Taxation and Developing Countries, edited by Robert
Hellawell, Columbia University Press, 1980.

The tracing approach continues to be the basis of public financial
reporting by US banks.

"Revised Foreign Tax Credit Regulations Liberalise Treatment of Banks
and Oil Companies", Tax Notes, 17th November 1980, p. 998.

See "New Proposed Regulations for Determining the Creditability of
Foreign Taxes" (an article furnished by Price Waterhouse and
Company), International Tax Journal, Vol. 9 (September 1983),
pp. 387-397.



-3-

There are three basic principles of US taxation of a
US taxpayer's foreign source income.” First, to avoid double taxation of
US taxpayers' foreign income, the United States defers to foreign host
governments with respect to the taxation of foreign income by allowing
US tax credits for foreign taxes. Second, US tax credits for foreign tax
payments are not allowed to reduce US taxes against US domestic taxable
income. Third, a premise underlying US tax regulations for the
deductibility of interest is that all sources of borrowed funds to a bank
are interchangeable or fungible. That is, the tax-assignment of a bank's
interest expense to foreign income is simply based on the ratio of its
foreign to its total assets. Thus, all interest expense associated with a
bank's. financing of its US tax-exempt investments is assigned as a tax-
deduction against domestic taxable income.?

The above three principles are reflected in the derivation of a
US bank's worldwide net after-tax income (WWNI, ) from its worldwide net
before-tax income (WNT, ) - To simplify the derivation, only interest-

related earnings and expenses are considered.

WN, = WGI - E (2)
E,= te (3)
A
Ey =E- Ey (4)
where
E= aUS bank's total interest expense

Ey = a US bank's interest expense apportioned as a deduction against

its foreign source taxable income
Ey = a US bank's interest expense apportioned as a deduction against
its domestic taxable income

It is assumed that the modelled US bank is subject to foreign

governments’ taxation of its gross foreign source earnings and to only


- 19 -

recognised, and anticipated, inducement for the reliance of developing

countries on bank debt financing in the late 1970s. A possible change in

this policy was indicated by the 1978 Treasury decision to limit the US tax
creditability of the 25 per cent. Brazilian withholding tax.

US banks interpreted the Treasury's Brazilian tax decision as
presaging a general review and tightening of US tax policy with respect to
the foreign lending activities of US banks. In 1980, the Treasury responded
to these expressions of concern through the issuance of proposed foreign
tax credit regulations through which it sought to"... relieve some of the
anxiety that bankers have felt about changes in the foreign tax credit
area". 9 This policy was reaffirmed in 1983 with the Treasury's issuance of
revised proposed regulations which would incorporate into US tax rules a
strong presumption of the creditability against a bank's US tax liability
of foreign withholding taxes. 16 Thus, the ongoing refinement of US tax
policy in this area continues to be towards more favourable treatment of
bank lending to the developing countries even in the face of a debt crisis
which was clearly deepened, if not caused, by an over-reliance by

developing countries on variable rate bank financing.


10.

11.

12.

-21-

shore lending is concentrated in Mexico and Brazil, you may be
contacted. by their Treasury officials as to the financial impact
on..their economies." Letter of 27th March 1979 from Walter B.
Wriston (Chairman of Citibank) to W. Michael Blumenthal
(Secretary of the Treasury), Treasury Freedom of Information
Document 79-2038.

The former condition may be satisfied by an incremental budgetary
allocation to a government-sector borrower. In other cases, it may be
satisfied by the granting of licences to borrowers for the purchase of
foreign exchange at preferential exchange rates.

Historically, the foreign tax credit limitation has been either based
on total foreign income or per country income, or both. For a thorough
discussion of the history of US foreign tax credit regulations see
Elizabeth Owens, The Foreign Tax Credit, Harvard Law School, 1961.
The most recent change was made in the Tax Reform Act of 1976, which
eliminated the option of the per country computation. However, the
elimination of the option had little significance for banks because of
the advantage to them of the overall method.

A creditor bank, subject to a per country limitation, would need to
receiye a gross spread on a withholding tax loan greater than GS* for
it to realise a larger net spread on such a loan than from a domestic
loan with an equal adjusted gross spread. The formula for establishing
this threshold value of the gross spread on a withholding tax loan is:
Gs =C +t, GS
d “a
1- te
C = a bank's cost of funds
Gs = adjusted gross spread

Thus, for the withholding tax loan example developed in Table 2, GS*
equals 467 basis points.

Only if US and non-US banks agree on the valuation of withholding tax
loans would the adjustment to a change in US tax rules mainly be
accounted for by changes in the composition of US banks' loan
portfolios. For a general discussion of taxes as an important
imperfection in securities markets see S.M. Shaefer, "Taxes and
Securities Market Equilibrium" in W.F. Sharpe and C.M. Cootner,
editors, Financial Economics: Essays in Honor of Paul Cootner,
Prentice-Hall, 1982.

The following withholding tax rates generally apply to cross-border
interest remittances to US banks: Argentina - 11.25 per cent.,
Brazil - 25 per cent., Mexico - 15 per cent. and Venezuela - 15 per
cent.

These four countries accounted for 70 per cent. of the $164 million
foreign withholding taxes paid by US banks in 1976, the last year for
which such data are available (Statistics of Income, Internal Revenue
Service).


- 16 -

b. Fungibility

The tax rules for the apportionment of deductions between US and
foreign source gross income are very important in the setting of a
taxpayer's foreign tax credit limitation. For a US bank, the rules
governing the apportionment of interest expenses are of particular
importance because the average interest cost of funds to a US bank's
domestic offices is typically much lower than that of its foreign offices.
The lower interest cost of funds is mainly accounted for by the higher
implicit returns (in the forms of various banking services) paid to
depositors at the domestic offices and the fact that Federal Reserve
reserve requirements apply only to funds raised by the US offices of banks.

The US Treasury's 1977 revision of its interest apportionment
regulations significantly increase banks' foreign tax credit limits. The
pre-1977 regulations were based on the so-called "tracing" approach which
required a bank to consider its head offices and each of its foreign
branches as separate entities. Thus, for a bank the tracing approach meant
a recognition of the lower average cost of funds of its domestic operations
in the computation of its foreign tax credit Limit.14

The post-1977 regulations are based on the "fungibility"
approach, which requires a taxpayer's entire interest expense to be
attributed to all its activities. The application of the fungibility,
rather than the tracing, approach can produce a higher computed value for a
bank's foreign tax credit limit. This is illustrated in Figure 2, where
reduction in the bank's reported domestic taxable income produced by the
switch in ‘tax rules is represented by 0-0'. The addition to the bank's
foreign tax credit limit (T,*" - T°) at each level of net before~tax
income is shown as the shaded area in the figure. For example, a bank with
net’ before-tax income OD would report a foreign tax credit limit of OB
under a fungibility rule, as compared with a value of OA under a tracing
“rule.

The significance of a choice between the two interest deduction
methodologies for the size of foreign tax credit limitations is being
reduced by changes in banks' funding behaviour. In particular, larger
proportions of the funding needs of the domestic operations of US banks are

now being met by the purchase of funds at market-related interest rates


-8-

net of the two effects when a bank has excess foreign tax credits and
positive domestic taxable income.

The above discussion points to a relationship between the level
of interest rates and the portfolio composition choices of banks, namely, a
bank's net after-tax income would rise in response to the following changes
in asset mix:

+,
Dy = F(r)
A >T*
when T, >T, (1)
A = F(r)
A
and
+. >
Da = F(r) when Te*¥ = Ty
A

That is, a bank with excess foreign tax credits increases its net after-tax
income by reducing the proportion of its portfolio devoted to foreign
taxable assets in response to an increase in the level of interest rates.
The carryover rule of US foreign tax credit regulations lessens
the sensitivity of bank portfolio choices to interest rate cycles. The
carryover rule allows a US taxpayer to carryback over two years, and then
carryforward over five years, excess foreign tax credits from its current
tax years. The rule thus accommodates the investment by a bank, over an
interest rate cycle, of a larger proportion of its portfolio in foreign
taxable assets with relatively high acquisition and/or liquidation costs -
characteristic of loans to developing countries. That is, the carryover
rule loosens the constraint imposed on banks' portfolio selection by the

foreign tax credit limitation.

After-Tax Equivalent Rates of Return

Market rates of return relationships are derived from equations
8a, 8b.1 and 8b.2 such that a bank (under assumed conditions) would not be
able to alter its net after-tax income by rearranging its portfolio. The

purpose of this exercise is to demonstrate that information about the tax


when

where

when

where

WWNI| = WWNT, - (Ty - T,) -T

= WWNI, - Ty

a
Ty - Te

Ty - Ty = net US tax Payment
‘= - -T.*) -
WWNI WHNT (Ty Ty ) Tr

Ty > TA

‘Ty - T,* = net US tax payment

f£

(8a)

(8b)

In turn, equation (8b) may be rewritten to reflect the two computations of

T,* when a US bank's domestic taxable operations are profitable (8b.1) and

wher. they are not profitable (8b.2).

when.

when

f£
WWNT = WHT, - Ty - [T, - tyr, FL-E,)]

= - - *
WWNT,, Ty Tr + T,

cl E,> 0
ae

- [T

d

WWNT | = WNT, -T f

d
- t (WWI, - rp)!

= WWNI, -

Ts

(8b.1)

(8b.2)


-4-

US taxation of its net income.* Such taxes against the gross interest
earnings of creditors are referred to as withholding taxes because of the
method by which they are collected. The US bank's foreign and gross (before
credit) US tax liabilities may-be computed as follows:

f

et Fe (5)
_ f d

Tg = ty (r, FL tr, Dy - BD (6)

where

=)
"

f total foreign-withholding taxes paid against gross interest

earnings of a US bank

ct
"

f foreign rate of withholding taxation

8
"

'q = gress (before foreign tax credit) US tax liability of a US bank

o
"

d US rate of taxation

Under US tax rules, a bank's limit on the amount of its foreign

tax payments creditable against its US tax liability (T,*) is equal to:

£ d f
k= - - = - -
Ty (epFL-B,) [ty (WNT, - cD )] = ty (EL FL- EB, - E,) (7a)
(WWNT, -r‘p)
‘b non
hi a D-£E,? 0
when re Oe dz
. w= - rf =
and equal to Ty ty (WWNI,, nD) = Ty (7b)
d .
when Y Dd, - Ey < 0 (a domestic taxable loss)

Based on the above, expressions for a US bank's worldwide net

after-tax income (WWNT) may be derived - see Figure 1.


-17-

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ana Butse22 ay3
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QtwT] atpaa> xea UsTa2I103
atna AqT{IqrBunyz ay 0) uoTaT

aapun yueq sn & JO JWI] JTper> xeq ustTe103 pagndwod = wd

yueq sn & jo
AQT TqeTT XeI SN (ITPead xe7 UZTII0j 210Jaq) sso13 =

yueq sn & jo awoouT xej-220j3aq aU = ITNMM

Satna xe} OMJ ABpuN JWT] IJTpezs xeq usta10j pagndwos s,yueEq sn V

Z ean8rg

V*

az = PL


-7-

Based on the above, the relationship between the bank's net
after-tax income (WWNI.) and the level of interest rates may be derived.
Consider a bank with a given asset-mix , + D + D, = A). An across-the-

board change in the interest rate level (r) is represented as:
f d n
dr = dr, = dr, = dr, =d ® (9)

Given these assumptions, the partial derivatives OWWNT , / 6x may
be signed for the three cases represented by (8a), (8b.1) and (8b.2)

respectively.
OWWNI Sty Dd,” 1) (10a)
or
when Ty *> Te
FLe0 (10b.1)
when T T* and 1D, - E, 20
£7 “f tot od
SWWNI =- te F< 0 (10b.2)
or
. d
when Te > T,* and Tr De Eas 0

The signs of OWWNT ,/ Sr in the three cases reflect two endowment
effects that link a bank's net after-tax income to the interest rate level.
Firstly, the deduction in the computation of a bank's domestic taxable
income of the interest costs for its investment in tax-exempt assets.
Secondly, foreign withholding taxes are assessed against .gross interest
receipts. Only the first, and not the second, endowment effect enters into
the computation of the net after-tax income of a bank with an excess
foreign tax credit limitation (10a). On the other hand, only the second
effect matters for a bank with a domestic taxable loss and excess foreign

tax credits (10b.2). Finally, the sign of OWWNT / Sr is determined by the


International Finance Discussion Papers
Number 243

April 1984

FEDERAL TAXATION AND THE DOMESTIC-FOREIGN
ASSET CHOICE OF A U.S. BANK

by

Allen B. Frankel

NOTE: International Finance Discussion Papers are preliminary materials
circulated to stimulate discussion and critical comment. References in
publications to International Finance Discussion Papers (other than an
acknowledgment by a writer that he has had access to unpublished materials)
should be cleared with the author or authors.


-10-
T, < T,*

Consider a bank with an. initial asset-mix such that, at given
interest rates, T, < Ty.” Under such circumstances, the bank can profit by
increasing the portfolio share of high return foreign taxable assets. The
bank will profit from the rearrangement as long as it does not bear the.
total incidence of its larger withholding tax payments. Overall, the
indicated revision of portfolio shares can increase the bank's net after-
tax income, increase its payment of foreign taxes and reduce its net
payment of US taxes.

A numerical example may be useful to illustrate the creation of
the above arbitrage opportunity under US tax rules. It is assumed that the
bank's US tax rate is 50 per cent. and that it has a 10 per cent. cost of
funds. The bank is assumed to be faced with the choice of adding to its
holdings either a domestic loan (no withholding tax) or a foreign taxable
loan with a 25 per cent. withholding tax.

Comparisons of the after-tax profitability of the loan options
are shown in Table 1. Columns 2 and 3 are, respectively, based on
assumptions that the borrower bears the full initial incidence of the
25 per cent. withholding tax and the bank bears the full initial
incidence .®

Overall, Table 1 reveals that under US tax rules a foreign
taxable loan can be more profitable (line 8) than a domestic loan with an
equal, or even smaller, adjusted gross spread (line 5). The domestic and
foreign loans reflected in columns 1 and 2, respectively, would provide
the bank with equal 200 basis points adjusted gross spreads (line 5). The
200 basis points larger net spread (line 8) for the foreign loan, as
compared with the domestic loan, is accounted for by: the availability of
the 400 basis points US foreign tax credit (line 8) that more than offsets
the larger pre-credit US tax liability on the foreign loan (line 6).

By contrast, the domestic and foreign loans reflected in
columns 1 and 3, respectively, would‘ provide the bank with equal 100 basis
points net spreads (line 8). A comparison of the adjusted gross spreads
(line 5) indicates that the bank absorbs the full initial incidence of. the
300 basis points withholding tax. The equality for the bank of the net
profitability (columns 1 and 3 line 8) of the two loan options is accounted
for by the receipt by the bank of a 300 basis points foreign tax credit. By


-9-

status of a bank, as well as market rate relationships, is required for the
identification of profitable rearrangements of banks' asset holdings.
Below, the market rates of return relationships are for three cases that
are described by two conditions: a bank's foreign tax credit position
(whether it is above or below its foreign tax credit limit) and the
profitability of its domestic taxable operations.

d
: * -E2
Case 1: TT, <T*, ro Eye 0
fod. yf 4
Tee tee Tn 7
1-ty (12)
Case 2: T,>T.* rop, - E,>0
. f Ff? tit d=
. fy d_ d > d
Teete = Tn 7 Tn (13)
1-ty
Case 3: Eq <0
d
=r
n
(14)

3. US Tax Creditability of Foreign Withholding Taxes

Let us reconsider the asset choice problem of a US bank when it
is assumed that market rates of return on foreign taxable assets are non-
negatively related to the rates of tax withholding imposed by various
countries on gross interest payments by home-country borrowers to foreign
bank creditors. In effect, it is assumed that only when the rate of tax
withholding is above a threshold rate does the market require borrowers to
compensate bank creditors for foreign tax payments. This section examines
when a bank is able to increase its net after-tax income as a result of its

payment of foreign withholding taxes.


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(Pa—7q3a)

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YN “NI ~ xT
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qwoeked xe2 uB1 2205 3 = P39? 3 guewked x23 uBye203
wl 0 < r Gp? veya 1b os Pa-?a3a vaya
ot (a-74}3)Pa = FZ —_ Phe gL
L

@1-P2y

hp yuemfed xe2 sn 29K

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(PINMA)
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a Ad

awoouT xe3-1933e JOU S,AUeG SN E 30 UOTIeATIAg

1 aan8ry


- 20 -

Footnotes

*

International Finance Division, Federal Reserve Board. This paper
represents the views of the author and should not be interpreted as
reflecting the views of the Board of Governors of the Federal Reserve
System or members of its staff. This paper benefited from the comments
and criticism of Julian Alworth, Richard Freeman, Richard Herring,
Johnathan Hoffman, Peter Isard, Jeffrey Marquardt and Howard Sherman.

"Creditability of Foreign Taxes", American Bankers Association,
October 19, 1979 (Memorandum submitted to Jerome Kurtz, Commissioner
of the Internal Revenue Service).

A general US tax rule is that income is classified as foreign source
if its payee is not US domiciled. For example, interest payments

received from a foreign branch of a US bank are a source of foreign
income to a US taxpayer.

Under the Tax Equity and Fiscal Responsibility Act of 1982, US banks
must reduce their tax deductions for interest expense by an amount
equal to 15 per cent. of the interest expense associated with their
investment in tax-exempt securities. The model in the paper abstracts
from this change in the tax environment of US banks.

Recognising that foreign and US state governments may tax some, or
all, of the net income of a US bank would have somewhat complicated
the derivation of the model. However, the insights provided by the
model about the influence of taxation on US banks' asset choices are
thought not to be affected by the omissions. This is because these net
taxes tend to influence only the location of asset bookings rather
than the actual asset-mix choice of a bank.

In order to simplify the presentation, the derivation omits the
endowment effect of equity financing. Through the endowment effect
generated by the partial equity financing of a bank's asset portfolio,
the bank's net before-tax income is positively related to the level of
interest rates.

The determination of the sharing of the initial incidence of the
withholding tax is a separate matter from the assignment of tax-
related interest rate risk. Bank loan agreements specify whether the
creditor bank ("gross" loan) or the foreign debtor ("net" loan)
absorbs the interest rate-related risk generated by the taxation of
borrowers’ gross interest payments. Under either type of loan
agreement, the full amount of foreign tax payments is creditable
against a US bank's US tax liability.

Such sensitivity is strongly suggested by the following excerpt froma
1979 comment on proposed US foreign tax credit regulations:

"Where the developing countries are interested in maintaining
relationships with US banks, their government may have an
interest in this issue. Because a large percentage of US off-


This paper develops a simple model of US bank taxation which
emphasises the influence of tax rules on banks' portfolio choices among
domestic and foreign assets. It is a thesis of this paper that US tax
policy for banks provides part of the explanation of the "why" of the large
credit exposures of US banks in the developing countries. This
contribution encompasses not only the response of banks to the tax-based
financial incentives but also to the perception of banks that the tax rules
were meant to be interpreted as signals of a general US public policy
stance favouring bank financing of the developing countries' external
borrowing requirements.

The paper is organised as follows: Section 2 develops a simple
model of the taxation of US banks. Section 3 discusses the implications of
the creditability of foreign taxes paid on gross interest receipts by a
US bank against the bank's US tax liability. Section 4 discusses the
relationship between the foreign tax credit and bank portfolio management.
Section 5 examines particular US tax rules that affect the creditability

of foreign taxes for US banks. Section 6 presents the concluding remarks.

2. A Simple Model of US Bank Taxation

Consider the three classes of assets a US bank may invest in,
classified according to the tax status of related income: foreign taxable
(FL), domestic taxable (D,) and domestic non-taxable (D,)- The last
grouping includes investments in the federally tax-exempt securities of Us
state and local governments. The assumed certain market rates of return on
each of these three homogeneous classes of bank assets are re rt, and rf,
respectively. Later in the paper, the consequences of a relaxation of the
homogeneity assumption will be examined. The total assets (A) of the bank
are equal to the sum of its holdings of the three types of assets
(A = FR + Dd, + DD):

It follows that the bank's worldwide gross income (WWGI) may be

expressed as:

wel =F. +r¢p, +r¢p 1)
nis al a et


-13-

4. Foreign Tax Credits and Bank Portfolio Management

To co-ordinate loan creations in a multi-branch US bank,
management guidelines are issued. Such guidelines indicate a minimum
expected "hurdle" rate of return required for the loan if it is to be
submitted for credit approval. This screening mechanism reflects the cost
and time-dependent nature of the bank's asset-mix decisions. That is, the
bank's management operates as if there are costly re-contracting penalties
for "wrong" loan approval decisions.

Let us now consider the implications for a bank's foreign taxable
loan portfolio of two alternative hurdle rates for loan creation

guidelines:

1. a minimum adjusted gross spread (Table 1 line 5) and

2. a minimum net spread (Table 1 line 8).

By choosing the minimum adjusted gross spread alternative, a
bank's management encourages the avoidance of withholding tax loans where
the bank shares in the initial incidence of the tax. A bank management's
use of an adjusted gross spread guideline could reflect its assessment that
market spreads for withholding tax borrowers were too narrow in light of
its own credit judgements and interest rate expectations.

On the other hand, by selecting a net spread guideline, the
bank's management encourages the presentation of loan proposals with
ex ante justifications dependent on the presumed availability of foreign

tax credit limit capacity (T,* > T,)-

5. Specific Tax Rules

The section outlines and evaluates three current US tax rules
that individually, and jointly, favour banks making loans subject to
foreign withholding taxes.

a. Computation of Foreign Tax Credit Limit

Under current US tax rules, a taxpayer's overall limitation on
foreign tax credits is based on its total foreign source income.
Alternatively, the foreign tax credit limitation could be based on a

taxpayer's foreign income from each separate country. Under such a per


-15-
Table 2

After-Tax Profitability of Loan Alternatives

(Per country! vs. Overall Foreign Tax Credit Limit)

Foreign Loan
25 per cent. withholding tax
Domestic
Loan
paid by paid by
borrower bank
(1) (2) (3)
(in basis points)
1. Adjusted Gross Spread
(same as Table 1 line 5) 200 200 -100
2. less Pre-Credit US Tax
(same as Table 1 line 6) 100 300 100
3. plus US Foreign Tax Credit
(a) Overall i) 400 300
(same as Table 1 line 7) 2 2
(b) Per Country oO 300 100
4. equals Net Spread
(a) Overall 100 300 100
(same as Table 1 line 8)
(b) Per Country 100 200 -100
Memorandum
5. US Tax Receipts
(line 2 less line 3)
(a) Overall 100 -100 -200
(b) Per Country 100 0 0

1 It is assumed that the creditor bank has no other source of income within the
foreign borrower's country.

2 Equal to per country foreign tax limitations and less than foreign tax payments
(Table 1 line 4).


April 1984

Federal Taxation and the Domestic-Foreign
Asset Choice of a US Bank
by Allen B. Frankel*

1. Introduction

Several explanations have been offered for the prominence of
commercial banks among the creditors of the developing countries. One
explanation, which has gathered acceptance, focuses on the government-
insured status (deposit insurance and equity-preserving access to official
credit facilities) of banks' creditors. This status isolates banks'
compensation of their creditors from the performance results for their loan
portfolio choices.

The government-insurance explanation of the importance of
commercial banks among the creditors of the developing countries is not a
fully-developed view of government involvement in banks' credit decisions.
In particular, it does not account for either banks' preferences for
foreign assets or bank supervisors' acceptance of such choices. The
insurance explanation does not recognise the general réle assumed by public
policy with respect to the inclusion of credits to developing countries in
banks' portfolios and, in particular, does not take into account the tax
rules chosen to guide the operations of the credit allocation mechanism.

The US banking community has indicated its awareness of the
guidance function of tax policy. In a 1979 memorandum the American Bankers

Association argued:

"In some countries, the United States must, for political and
strategic reasons, maintain its financial position, including
the availability of both private and governmental credits and
loan guaranties. To the extent that changes in tax regulations
cause US banks to withdraw from foreign markets, this goal of the
United States would be undermined. The American Bankers

Association certainly claims no expertise in US foreign policy,
but we do wonder what the reaction would be in the countries of
the developing world if the loan windows of this nation's

commercial banks are closed to them."


Title: Federal Taxation and the Domestic-Foreign Asset Choice of a U.S. Bank
Author: Allen B. Frankel

Address: Board of Governors of the Federal Reserve System
Washington, D. C. 20551

Date: June 1984

Series and Number: International Finance Discussion Papers, No. 243
Pages: 22

Price: No charge

JEL Subject Classification: 441, 312

Keywords: Bank lending to LDCs, U.S. taxation of foreign-source income.

This paper develops a simple model of US bank taxation which emphasises
the influence of tax rules on banks' portfolio choices among domestic and foreign
assets. It is a thesis of this paper that US tax policy for banks provides part
of the explanation of the "why" of the large credit exposures of US banks in the
developing countries. This contribution encompasses not only the response of
banks to the tax-based financial incentives but also the perception of banks that
the tax rules were meant to be interpreted as signals of a general US public
policy stance favouring bank financing of the developing countries' external

borrowing requirements.


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Table 1

After-Tax Profitability of Loan Alternatives

(Overall foreign tax credit limit)

Gross Foreign Interest
Income

less Cost of Funds
equals Gross Spread
less Foreign Tax

equals Adjusted Gross Spread
(excludes foreign tax)

*
less Pre-Credit US Tax
plus US Foreign Tax Credit

equals Net Spread

Foreign Loan
25 per cent. withholding tax

Domestic
Loan

paid by paid by

borrower bank

q) (2) (3)

(in basis points)

1200 1600 1200

1000 1000 1000

200 600 200

o 400 300

200 200 -100

100 300 100

o 400 300

100 300 100

* Equals 50 per cent. of line 3.



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country limitation, taxes paid to any country could be used against only
the pre-credit US tax on income from sources within that country.”

Table 2 compares the net spreads which would be realised by a US
bank creditor if it made the loans examined in Table 1 under an overall and
a per country computation of its US foreign tax credit limitation. Table 2
line 4 indicates that the net spreads on foreign loans would be reduced, by
100 and 200 basis points, respectively, if the per country method was used
to compute the US foreign tax credit limitation. Table 2 line 5 indicates
that this reduction would be accounted for by the smaller US tax subsidies
(Table 2 columns 2 and 3 line 5b less line 5a) available to creditor
banks. !

Let us now consider the implications for US bank creditors of a
changeover of US tax rules from an overall foreign tax credit limitation to
a per country limitation. Such a changeover would prompt US banks to raise
their lending spreads on, or reduce the portfolio shares of, loans to high
withholding tax borrowers. }! This might have particularly affected the
willingness of US banks to extend credits to borrowers in a number of
developing countries in the 1970s (such as Argentina, Brazil, Mexico and
Venezuela) which levy high withholding tax rates on interest payments by
resident borrowers to foreign creditors. !*

The sensitivity of US lending to borrowers in developing
countries, as opposed to those in industrialised countries, to possible
changes in US foreign tax credit rules is. largely accounted for by the
structure of the US tax treaty network. The United States has bilateral tax
treaties with most of the major industrialised countries but none with a
major international borrower among the developing countries. The lack of
such treaties reflects the absence of interest by developing countries'
governments in securing tax concessions for the external investment
activities of home-country investors and the US policy of not entering into

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tax-sparing agreements.