-8-
bank lending to Brazil and Mexico provide a strong basis for an a priori
judgment of much larger effects (at any interest rate level) on
post-1930 earnings of a switch to a per country tax credit computation.
4, Interaction

Consider a "what-if" situation, namely that the President's
Proposal removing the interest deduction for banks carrying tax-exempt
securities is enacted, but the proposed change in the foreign tax credit
limitation computation is not. This change in tax structure would tend
to reduce the ‘overall availability of tax-based subsidies, although
banks' limits on tax eredits for their foreign tax Payments would be
raised. Therefore it follows from the above analysis that, in response
to such a reorientation of tax incentives, banks would more actively
solicit foreign loans where a foreign tax credit could be made available.
Under present circumstances, such solicitations might be focused on
reconfiguring exposures to developing countries rather than enlarging
them.

Changes in U.S. tax credit rules affect lending to borrowers in
developing countries, more than to those in industrialized countries,
largely because of the structure of the U.S. tax treaty network. The
United States has bilateral tax treaties with most of the major
industrialized countries but none with a major developing country debtor.
The lack of such treaties reflects the long-standing absence of interest

on the part of the governments of developing countries in securing tax


2. Bad Debt Loss Reserve

Historically, banks have been allowed under RS rulings to build
reserves for bad debts through deductions from before-tax incomes. The
Tax Reform Act of 1969 provides statutory guidance concerning the
maximum additions to bad debt reserve accounts that banks can use a3 a
basis for tax deductions. In particular, the 1969 Act provides that
banks can use either the "experience" method or the "percentage" method
in determining the maximum permissible additions to their IRS bad debt
reserves. The Act schedules step reductions of the maximum percentage
and, starting in 1988, the Act requires all banks using reserve
accounting to adopt the experience method.

The President's tax plan has two proposals, which are unchanged from
those in the November 1984 Treasury plan, related to the tax
deductibility of loan losses. First, starting with the effective date of
the new tax law, banks and other financial institutions could no longer
claim tax deductions for unrealized loan losses on the basis of any
reserve technique; instead, loan loss deductions would be limited to
actual charge-offs as they occurred. It has been pointed out that this
proposal would bring the tax treatment of financial institutions into
line with that of other taxpayers who are not allowed to set up
tax-deductible reserves against anticipated losses. However, because of
higher, and rising, levels of actual loss, few large banking
organizations have been recently able to take advantage of the reserve
deduction. Thus, the proposal, if it had been in effect, would not have

had a significant effect on banks' recent earnings.


Table 1

After-Tax Profitability of $100 Loan Alternatives

(Overall Foreign Tax Credit Limitation)

Foreign Loan with 25

Domestic percent withholding tax:
Loan Fully Paid Fully paid
by_ borrower by bank
Q) (2) (3)
(in dollars)
1. Gross Interest Income 12 16* 12
2. Cost of Funds 10 10 10
3. Gross Spread 2 6 2
(= L.1 - L.2)
4, Foreign Tax oO 4 Be
(= .25 x L.1)
5. Adjusted Gross (Quoted) Spread
Over Cost of Funds 2 2 -1
(= L.3 - L.A)
6. Pre-Credit U.S. Tax 1 3 1
(= .50 x L.3)
7. Tax Credit for Foreign Tax oO 4 3
Payments
(= L.A)
8. Net After-Tax Spread 1 3 1
(= L.5 - L.6 + L.7)
¥ “Includes a foreign tax of $4 (.25 x $16) which is fully paid by borrower.
ee

Foreign tax of $3 equals 25 percent of the $12 gross interest income of the bank.



-4-
bonds and the foreign tax credit computation have an important
interactive influence on banks' portfolio decisions. Furthermore, as
the following framework sets out, this interaction is also influenced by
other parts of the tax code, such as the proposed recapture of IRS
loan-loss reserves.

A Framework of U.S. Bank Taxation

Three basic principles underlie U.S. taxation of a U.S. bank's
foreign source income. First, to avoid double taxation of the U.S.
bank's foreign income, the United States defers to foreign host
governments with respect to the taxation of foreign income by allowing
U.S. tax credits for foreign taxes paid. Second, the United States
limits these tax credits to whichever amount is the smaller: the bank's
U.S. tax liability against its foreign source income or against its
worldwide income. Third, all sources of borrowed funds to a bank are
viewed as interchangeable or fungible, and, in U.S. tax regulations for
the deductibility of interest, the assignment of a bank's interest
expense to foreign income is simply based on the ratio of its foreign to
its total assets. Thus, regardless of how a bank finances its U.S.
tax-exempt investments, the deductible part of the interest
expense associated with the financing is assigned against the bank's
domestic taxable income. It follows that under current U.S. tax rules,
the limit on foreign taxes that a bank may credit against its U.S. tax
liability is equal to its U.S. tax rate applied to: (1) its foreign
taxable income when the bank has a U.S. domestic taxable profit and (2)
its worldwide taxable income when the bank has a U.S. domestic taxable

loss.


+3-

The second proposal would require a financial institution to
recapture in its taxable income, over a 10-year period, the net
accumulation of tax-deferred income reflected in its loan-loss reserves,
which amounts to its IRS reserve. The Proposal is designed to prevent a
double deduction for claims that become Partially or wholly worthless
after the effective date. That is, the proposal is designed to avoid
providing financial institutions with a windfall gain, namely, the
forgiveness of deferred tax liabilities. However, because it would not
impose a lump sum tax, the proposal might prompt banks to alter lending
and investment activities in favor of certain assets that continue to
earry tax benefits.2/ Banks might invest in tax-preferred assets which,
through mechanisms such as excess deductions, provide a tax shelter for
income from non-tax-preferred assets. One such mechanism, under current
law, involves the deduction by banks (but not other investors) of
interest incurred to carry tax-exempt bonds.

3. Tax-Exempt Related Interest Deductions/Foreign Tax Credit Limitation

The President's plan would end the deduction by banks of interest
incurred to carry tax-exempt bonds acquired after January 1, 1986, and
would also change the foreign tax credit limitation for all taxpayers
from an overall to a per country computation. 3/ Under current tax

provisions the 80 percent interest deduction for earrying tax-exempt

2/ A lump sum tax has only income effects.

3/ Historically, the base for the foreign tax credit limitation has
varied between total foreign income, per country income, or both. The
most recent change was made in the Tax Reform Act of 1976, which
eliminated the option of the per country computation; however, this
change had little significance for banks because of their strong

preference for the overall method.


-~6-
with the choice of adding to its holdings either a $100 domestic loan
(no withholding tax) or a $100 foreign taxable loan with a 25 percent
foreign (withholding) tax against gross interest, each with a "quoted" 2
Percent before-tax spread to the bank. Both loans would have a one-year
term.

Comparisons of the after-tax profitability of the loan options are
shown in Table 1. Columns 2 and 3 are, respectively, based on the two
extreme assumptions that the borrower fully pays the 25 percent
withholding tax or, alternatively, the bank fully pays the tax.9/
Overall, Table 1 reveals that a foreign taxable loan will be more
profitable (line 8) than a domestic loan with an equal, adjusted gross
spread (line 5) if the borrower bears some portion of the tax. This
larger net (after-tax) spread for foreign loans, as compared with
domestic loans, arises because the U.S. tax credit for foreign taxes
(line 7) more than offsets the larger pre-credit U.S. tax liabilities on
the foreign loan (line 6).

Foreign Tax Credit: Treasury Proposal

The President's plan proposes that the foreign tax credit limitation
be based on a taxpayer's foreign income from each separate country.
Under a per country limitation, taxes paid to any country could be used
against only the pre-credit U.S. tax on income from sources within that

country.

5/ 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 the borrower's
gross interest payments. Under either type of loan agreement, the full

amount of foreign tax payments is now creditable against a U.S. kt
U.S. tax 1iabiltey. Pay 8 3 bank's


International Finance Discussion Papers

Number 263

September 10, 1985

SOME IMPLICATIONS OF THE PRESIDENT'S TAX PROPOSALS FOR
U.S. BANKS WITH CLAIMS ON DEVELOPING COUNTRIES

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.


Table 2

After-Tax Profitability of $100 Loan Alternatives
(Per Country vs. Overall Foreign Tax Credit Limitation)

Adjusted Gross Spread Over Cost
of Funds
(= Table 1 L.5)

Pre-Credit U.S. Tax
(= Table 1 L.6)

Tax Credit for Foreign Tax
Payments
(a) Overall Limitation
(= Table 1 L.7)

(b) Per Country Limitation
(= L.2 for foreign loans)

Net After-Tax Spread
(a) Overall Limitation
(= L.1 - L.2 + L.3(a) =
Table 1 L.8)

(b) Per Country Limitation
(L.1 - L.2 + L.3(b))

Memorandum
Incremental Impact on U.S. Tax
Receipts
(a) Overall Limitation
(L.2 - L.3(a))

(b) Per Country Limitation
(L.2 - L.3(b))

Foreign Loan with

Domestic 25 percent withholding tax:
Loan Fully paid Fully paid
by borrower by bank
a) (2) (3)
(in dollars)
2 2 -1
1 3 1
0 4 3
£ 3 1
1 3 1
1 2 71
1 -1* -2*
1 0 (0)

* - indicates a tax-subsidy shared by the borrower and the bank.



-7-

Table 2 compares the net spreads which would be realized by a U.S.
bank creditor if it made the loans examined in Table 1 under an overall
and a per country computation of its U.S. foreign tax credit
Limitation. 6/ A comparison of lines 4(a) and 4(b) indicates that. the net
spreads on foreign loans would be smaller if the per country, rather
than the overall, method were used to compute the U.S. tax credit
limitation for foreign tax payments. In fact, line 4(b) reveals that if
the borrower is not willing to pay enough of the tax, then the bank
should choose to make the domestic loan. Finally, a comparison of lines
5(a) and 5(b) indicates that the lower relative profitability of the
foreign loan under a per country computation of the U.S. tax credit is
accounted for by the absence of a (cross-national) tax subsidy.

Table 3 has been prepared to provide a rough indication of the
possible impact of the proposed change. It reveals that if the per
country limitation had applied in 1980, rather than the overall
limitation, the after-tax earnings of the largest U.S. banks would have
been as much as $208 million smaller, or about 10 percent of the 1980
retained earnings of U.S. money center banks. The $208 million figure is
an estimate of what excess U.S. tax credits would have been, under a per
country limitation, on tax payments by U.S. banks to the governments of
Brazil and Mexico--25 and 15 percent tax rates, respectively.
Unfortunately, post-1980 estimates cannot be made because of the absence
of comparable data. Nevertheless, large 1981 and 1982 increases in U.S.
—$7~The comparison is somewhat overdrawn because of the assumption

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


-5-

Elimination of the current deduction of interest incurred to carry
tax-exempt securities would raise domestic taxable income and,
correspondingly, raise the ceiling on a bank's creditable foreign taxes
if otherwise the bank would have reported a domestic taxable loss.
Similarly, the enactment of the proposed recapture of loan-loss reserves
would raise a bank's limitation on creditable foreign tax payments.
Under either circumstance, the bank might find it profitable to react by
raising the share of its holdings devoted to foreign taxable assets. For
a bank with excess foreign tax credit capacity, a sufficient condition
for this to be advantageous is that the bank not bear the full cost of
higher foreign tax payments, or, in other words, that foreign borrowers
bear part of the burden of a U.S. bank's creditable foreign tax payments.

Governments of developing countries have revealed their awareness
of the tax environments of their bank creditors by imposing and/or
altering withholding tax statutes. Such taxes against interest Payments
by eligible domestic borrowers to foreign creditors are widely
recognized to be a means by which borrowing countries have extracted
interest subsidies from creditor banks' "home" governments. 4/

A numerical example may be useful to illustrate this tax-arbitrage
Possibility. Assume that a bank's U.S. tax rate is 50 percent and that
it has a 10 percent cost of funds. Then assume that the bank is faced

4/ Yo minimize the actual tax burden on borrowers, developing country
governments have provided tax rebates. In some countries, such as
Brazil, the rebates have been overtly paid. In turn, this led U.S. tax
authorities to challenge the full U.S. creditability of the Brazilian
withholding tax. In other countries, "hidden" rebates have been paid
through incremental budget allocations to state-owned enterprises or
through. the issuance of licenses to purchase foreign exchange at
preferential rates.


1. Introduction

This paper provides an assessment of the proposed treatment of
banks under the President's 1985 tax reform plan.1/ The plan would
modify, or eliminate, a variety of mechanisms by which a bank's income
from a given asset is not fully taxed, that is, by which such income is
sheltered. The major conclusion of the assessment is that the
President's program would, if enacted as proposed, result ina
relatively less favorable tax environment for the current asset
portfolios of major U.S. banking organizations. The conclusion is based
on: (1) the impact on banks’ earnings and capital of a proposed shift
in the basis for taking tax deductions on bad debts; (2) the proposed
elimination of the current deduction of interest expenses incurred by
banks to carry tax-exempt bonds; and (3) the proposed limitation on the
ability to credit against U.S. tax liabilities any taxes paid to foreign
countries.

“Section 2 focuses on the proposal to make current reserves for bad
debts subject to tax. Section 3 analyzes the interaction of the second
and third proposals listed above. The second proposal would completely
disallow the tax-deductibility of interest expense incurred by banks to
carry tax-exempt securities. The third proposal, discussed in section
3, would change the computation of the limitation on U.S. tax credits
for taxes paid to foreign countries to a per country basis from the
present total, or overall, basis. Section 4 turns to the interaction of
various parts of the tax proposal on banks' credit decisions. Section 5

presents the concluding remarks.

17 The President's Tax Proposals to the Congress for Fairness, Growth

and Simplicity, May 1985.


-9-
concessions for the external investment activities of home-country
investors and the U.S. policy against entering into tax-sparing
agreements. 7/

All other things being equal, a per country (relative to an
overall) foreign tax credit limitation, on the one hand, might penalize
banks for excessive country concentrations of withholding tax loans. On
the other hand, Brazil and Mexico, major beneficiaries of the current
U.S. tax code, might find their borrowing terms adversely affected by
the proposed change in the computation of the foreign tax credit
limitation. However, if accompanied by the disallowance of interest to
finance tax-exempt securities, the diversification incentive provided by
the changeover to per country computation would be weakened.

5. Concluding Remarks

In the past, banks negotiated loans to foreign borrowers on the
basis of "net" interest rates.8/ It was the general presumption that
withholding taxes should be disregarded, by treating such taxes as a
deduction in computing taxable net incomes, or by a bank's restricting
its reported income to the interest received net of withholding taxes.

In the 1970s, U.S. banks successfully sought a change in the U.S.
tax treatment of foreign withholding taxes. Starting in the mid-to-late
1970s, these taxes were regarded as the equivalent of creditable income
taxes even if, as in most cases, the borrower and not the bank retained
“77 Under tax-sparing agreements, one country agrees not to tax the
income received by investors from a second country. In turn, the second
government agrees to allow its investors to claim tax credits as if the
tax had been paid.

8/ For a thorough international comparative study, see Foreign Tax_
Credit for Banks, Peat Marwick, Mitchell and Company, June 19


“11-
jurisdictions; that is, they might take advantage of favorable
treatments of withholding tax loans available under the tax codes of
other countries in which they have banking offices.11/ The objective of
such shifting would be to minimize the overall tax burden through both
net reductions and restructurings (in terms of countries to which taxes
are paid) of foreign tax payments. In effect, such activity would
amount to a bank-managed redistribution of the fiscal burden among
governments of the favorable tax treatment of international bank lending

to developing country borrowers.

11/ The U.K. Finance Act of 1982 introduced an upper limit of 15
percent on the amount of credit for foreign withholding tax on loan
interest. Reportedly, this legislation was, at least in part, in
response to U.S. banks' efforts to minimize their net U.K. taxes through
the booking of withholding tax loans (to Brazil) at their London
branches.


ABSTRACT

This paper examines some implications of the President's 1985 tax
reform plan for U.S. banks with claims on developing countries. An
assessment is presented of how the plan would modify, or eliminate, a
variety of mechanisms by which banks shelter income from taxation. A
particular focus of the paper is an analysis of the consequences for
large U.S. banks of the proposed change in the computation of the U.S.

tax credit for taxes paid to foreign countries.


SOME IMPLICATIONS OF THE PRESIDENT'S TAX PROPOSALS FOR

U.S. BANKS WITH CLAIMS ON DEVELOPING COUNTRIES

by
Allen B. Frankel*

September, 1985

*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.


Table 3
U.S. Banks' Excess Foreign Tax Credits Under _a Per Country
Foreign Tax Credit Limitation*
(millions of dollars)

Excess Foreign Tax

Credits at
14 percent 1980
Creditable Foreign Effective Tax Rate

Borrowing Taxable Incomes Taxes Against Interest on 6 Large U.S.
Country of U.S. Banks** Reported by U.S. Banks Banks' Foreign Incomes

(1) (2) (3)
Brazil 257 137 101
Mexico 467 172 107

* Based on published and unpublished data from the Internal Revenue Service. The
published source is "Corporate Foreign Tax Credit, 1980: An Industry Focus", by
William States (Statistics of Income Bulletin, Summer 1984).

** Other than branch income.



~10-
responsibility for payment of the tax (through withholding at source).
Recognition of this change by borrowers was incorporated in their
demands for improved "net" credit terms. Finally, non-U.S. banks'
increasing participation, over the period from the late 1970s through
the early 1980s, in international bank credit markets appears to have
been accommodated by favorable rulings of their home-country tax
authorities.

At a Congressional hearing on the President's tax program, a
representative of the American Bankers Association reported on the
significance of the availability of the foreign tax credit .9/ In
particular it was asserted that "...if the foreign tax credit were not
available, U.S. banks would have to increase interest charges in order
to maintain an adequate return. Competition from other banks will not
permit such pricing. The increased tax cost would put U.S. banks at a
competitive disadvantage with foreign banks, whose costs would not be
similarly increased, and might well force U.S. banks out of important
overseas markets."

The more limited burden associated with the proposed change in the
foreign tax credit (as compared with the elimination of the foreign tax
credit) might have to be absorbed by banks with (ex post) excess country
concentrations of withholding tax loans. 10/ However, some of these banks
might be able to dissipate the cost by shifting loans to other tax

wT “Statement of John R. Petty on behalf of the American Bankers
Association before the Committee on Ways and Means", U.S. House of
Representatives, July 26, 1985.

10/ The development of a swap market in loans to developing country

debtors has been inhibited by bank concerns about required writedowns in
loan values that might be triggered by swap transactions.