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LEGAL RULING 96-6

September 12, 1996

SUBJECT: FOREIGN BANKS WITH UNITED STATES (CALIFORNIA) OPERATIONS WATER'S-EDGE ELECTION--BAD DEBT RESERVE CALCULATION

ISSUES

1. When a foreign bank with United States (U.S.) (California) branch operations makes a water's-edge election, what is the correct method of calculating the beginning bad debt reserve balance for U.S. branch operations?

2. When a foreign bank with U.S. (California) branch operations terminates a water's-edge election, what is the correct method of calculating the foreign bank's beginning bad debt reserve balance for the income years following the termination of the U.S. branch's water's-edge election?

FACTS

1. Corporation A, a foreign bank with U.S. (California) branch operations, makes a water's-edge election. Corporation A has requested an opinion as to the correct beginning bad debt reserve for the U.S. branch operations for the first year of the water's-edge election and has proposed three alternative methods to compute the beginning bad debt reserve: first, use zero as the beginning bad debt reserve; second, use the ending bad debt reserve for the worldwide entity; or third, recompute the beginning bad debt reserve based solely on the experience of the U.S. branch operations.

2. Corporation B, a foreign bank with U.S. (California) branch operations, terminates its water's-edge election. Corporation B has requested an opinion as to the correct beginning bad debt reserve for the worldwide entity and has proposed three alternative methods to compute the beginning bad debt reserve: first, use zero as the beginning bad debt reserve; second, use the ending bad debt reserve for the U.S. branch operations alone; or third, recompute the bad debt reserve based on the experience of the worldwide entity.

LAW

Every bank doing business within this state shall annually pay to the state a tax according to or measured by its net income. (See California Revenue and Taxation Code (Rev. & Tax.) §§ 23151, 23181, and 23183.)

Under the unitary method of taxation as applied by California, the business income of each entity included in the combined report is combined, and an apportionment formula is applied to the unitary business income to derive the group's income from California sources. In a procedure commonly described as "intrastate apportionment," each taxpayer member of the group determines its apportioned share of the California business income in accordance with FTB Legal Ruling 234, October 27, 1959, as modified by FTB Notice 90-3, June 8, 1990 (see, also, Appeal of Kaiser-Frazer Sales Corporation, Cal. St. Bd. of Equal., Nov. 7, 1958). Each taxpayer then adjusts its apportioned share of the business income by any California nonbusiness income or loss and any adjusted net operating loss carryovers in order to determine its net income subject to California taxation. Unlike the Federal consolidated return which imposes a joint and several liability, each taxpayer member in the combined report has an obligation to file its own return and pay its own tax liability on its income from California sources (Rev. and Tax. Code §18601 (obligation to file a return), §23037 (defining the term "taxpayer"), §23151 (imposition of tax), §25101 (measure of tax on California source income), see, Safeway Stores, Inc. v. Franchise Tax Board (1970) 3 Cal.3d 745, 752, fn.8).

Notwithstanding Rev. & Tax. § 25101, a qualified taxpayer which is subject to the franchise tax may elect to determine its income derived from or attributable to sources within California pursuant to a "water's-edge" election in accordance with Rev. & Tax. §§ 25110-25115.

Rev. & Tax. § 25110(a)(4) provides that the income from a foreign bank is included in a water's-edge combined report only to the extent of its income derived from or attributable to sources within the U.S., as determined by federal income tax laws. This is commonly referred to as the "deemed subsidiary" rule since the foreign bank's U.S. branch operation is deemed to be equivalent to a U.S. subsidiary. Rev. & Tax. § 25110(a)(4) further states that the income shall be limited to and determined from the books of account maintained by the bank with respect to its activities conducted within the U.S.

U.S. source income of foreign banks is classified as either fixed or determinable annual or periodical income not attributable to a U.S. trade or business (FDAP) (see Internal Revenue Code (IRC) § 881(a)(1)), or income attributable to a business conducted in the U.S. by the foreign bank (effectively connected income or ECI). (See IRC § 882(a)(1).) A foreign bank which has FDAP or ECI must file a federal tax return on Form 1120F, U.S. Income Tax Return of a Foreign Corporation.

IRC § 585(a)(2)(B) states that in the case of a foreign bank, only loans outstanding, the interest on which is effectively connected with the conduct of a banking business within the U.S., are included in the calculation of the bad debt reserve.

Rev. & Tax. § 24348(a)(1) provides:

There shall be allowed as a deduction either of the following: (A) Debts which become worthless within the income year in an amount not in excess of the part charged off within that income year. (B) In the case of a savings and loan association, bank, or financial corporation, in lieu of any deduction under subparagraph (A), in the discretion of the Franchise Tax Board, a reasonable addition to a reserve for bad debts.

The portion of this statute allowing a reasonable addition to a reserve for bad debts for banks, savings and loan associations and financial corporations, has been augmented by Title 18, California Code of Regulations, § 24348(b) (Reg. § 24348(b)), which provides the procedure by which a taxpayer may calculate a reasonable addition to its bad debt reserve.

A bad debt reserve is an accounting method for absorbing debts reasonably expected to become worthless within the upcoming year. (Roanoke Vending Exchange, Inc. v. Commissioner, (1963) 40 T.C. 735.) A bad debt reserve is not intended to provide for all possible losses a bank might incur, but only for losses arising in the normal course of making customer loans. "Bad debt reserve accounts are intended to handle only normal losses that arise in the ordinary course of a taxpayer's day-to-day operations. Losses which are rare or unpredictable in nature and amount should be handled apart from the taxpayer's bad debt reserve." (Appeal of H-B Investment, Inc., Cal. St. Bd. of Equal., June 29, 1982; see also Rev. Rul. 74-709, 1974-2 C.B. 61.)

Accounting principles provide that accrual of loss contingencies for a bad debt reserve is appropriate only in situations where there is a probable loss and the amount of the loss can be reasonably estimated. (See "Accounting for Contingencies", Statement of the Financial Accounting Standards Board No. 5.)

ANALYSIS

1. MAKING A WATER'S-EDGE ELECTION

If a foreign bank conducts business through the use of U.S. (California) branches and files its California tax returns on a worldwide basis, the ending bad debt reserve reflects the bad debt experience of the entity on a worldwide basis, considering the foreign bank and its domestic branches as a single entity. The ending bad debt reserve of the worldwide entity is a tax attribute, a portion of which relates to the U.S. branch operations. The issue is how much of that tax attribute should be included in the U.S. branch operations' water's-edge return.

The taxpayer's (U.S. branch) method of accounting must clearly reflect income. (See Rev. & Tax Code § 24651.) Generally, using a zero beginning bad debt reserve for the U.S. branches alone will not correctly match income and deductions once a water's-edge election is made because it would ignore that portion of the ending bad debt reserve balance of the worldwide entity attributable to the U.S. branch operations. Therefore using zero as the beginning bad debt reserve for the U.S. branch operations is in most cases not correct because it will not clearly reflect income.

Once a water's-edge election is made, the bad debt reserve should be revised to reflect only the loss history of the U.S. branch operations. A bad debt reserve balance which reflects worldwide loss history is not permissible for use by the U.S. branch operations because such a bad debt reserve would include foreign loss history which did not arise in the normal course of making loans by the U.S. branch operations. (See Rev. & Tax. § 25110(a)(4).) Therefore the ending bad debt reserve of the worldwide entity is not a correct beginning reserve for U.S. branch operations filing on a water's-edge basis.

Accordingly, it is necessary to recalculate the beginning bad debt reserve balance for the U.S. branch operations when a water's-edge election is in effect, as of the date of the water's-edge election. The beginning bad debt reserve must be recalculated, segregating the experience of the U.S. branch operations to reflect only the loan loss experience of the U.S. branch operations. In order to clearly reflect income, the U.S. branch operations must compute its beginning bad debt reserve using a method consistent with the worldwide bad debt reserve computation of the prior year. This results in a "reasonable addition" to a reserve, as required under Rev. & Tax. § 24348(a)(1)(B). By restating the beginning balance to reflect only U.S. eligible loans, charge-offs, and experience, this method avoids distortion of income by correctly matching income and deductions for the U.S. branch operations.

Most taxpayers will compute their beginning water's-edge bad debt reserve using U.S. bad debt loan history and either the three year average, the six year average, or the book reserve which is limited to one percent of the amount of loans outstanding at the close of the income year, consistent with the prior year's ending reserve method. Some taxpayers may have calculated their worldwide beginning bad debt reserve balance using a method other than the three year average, the six year average, or the book reserve with the one per cent limitation. Such taxpayers will compute their beginning water's-edge bad debt reserve based on the following formula:

U.S. Branch loans for bad debt reserve purposes   

X Worldwide bad debt reserve
Worldwide loans for bad debt purposes   

However, a showing of specific facts and circumstances, such as a material difference in type and composition of loans held by the worldwide entity and the U.S. branch operations, may demonstrate that an alternative means of calculating the bad debt reserve should be considered.

Some examples may be helpful to illustrate the discussion of the use of the three year average, six year average, facts and circumstances or another method of calculating the bad debt reserve.

1. Corporation C, a foreign bank with U.S. (California) branch operations, makes a water's-edge election. Prior to its water's-edge election, the bad debt reserve for Corporation C was computed using the 6 year moving average as provided in Reg. § 24348(b)(3)(A)(1). The branch would recalculate its beginning bad debt reserve for the water's-edge year based on the 6 year moving average in accordance with Reg. § 24348(b)(3)(A)(1) using only U.S. branch operations loan history.

2. Corporation D, a foreign bank with U.S. (California) branch operations, makes a water's-edge election. The taxpayer previously used the worldwide book reserve method in accordance with Reg. § 24348(b)(3)(B) (facts and circumstances) to compute the prior year's ending bad debt reserve. The beginning reserve for the first water's-edge return is the U.S. branch's book bad debt reserve, limited to one percent of the amount of U.S. loans outstanding at the close of the income year.

3. Corporation E, a foreign bank with U.S. (California) branch operations, makes a water's-edge election effective January 1, 1996. The taxpayer used a method other than that provided by Reg. § 24348(b) to compute its December 31, 1995 worldwide bad debt reserve of $1000x. The worldwide loans for bad debt reserve purposes on December 31, 1995 were $100,000X and the corresponding branch loans were $1,500x. The branch would compute its beginning bad debt reserve as of January 1, 1996 as:

$ 1,500x     

X $1,000x = $15x
$100,000x     

4. The facts are the same as in example 3, except the U.S. (California) branch is able to provide substantiation that the loans booked to the U.S. branch operations have a lower risk than the worldwide loan portfolio. In fact, the U.S. branch has not experienced a bad debt for the prior six years. In this situation, it would be appropriate for the U.S. branch to begin with a zero beginning balance for the water's-edge bad debt reserve.

A goal of U.S. international tax policy has been to equalize the tax treatment of operations conducted through subsidiaries and through branches. For example, if a foreign-based multinational seeks to establish a business presence in the U.S., it should make no difference in terms of its income tax burden if it does so through the formation of a U.S. subsidiary corporation or through the establishment of a U.S. branch operation. A U.S. subsidiary of a foreign bank would separately compute its own bad debt deduction, based on its own domestic loan loss experience. In a U.S. branch situation, restatement of the beginning bad debt reserve balance to a U.S. basis is consistent with this theory. In essence, the bad debt reserve and resulting bad debt deduction is calculated as if the U.S. branch operations were operating as U.S. subsidiaries. By doing this, under both the branch and subsidiary scenarios, the loss history is calculated on loans that are comparable in nature and risk, which is consistent with Rev. & Tax. § 24348.

The information needed to recalculate the beginning balance of the bad debt reserve upon filing of a water's-edge election should generally be available to the taxpayer. In pre-water's-edge years, for federal purposes, the taxpayer has computed ECI for its U.S. branches and reported it on a Form 1120F. IRC § 585 requires that loans included in the loan base must earn interest, which is ECI. This requires a system of accounting in place to identify the U.S. loans. It is likely this information would be available, even if the taxpayer qualified as a large bank for purposes of IRC § 585(c)(1) and was not allowed to use the reserve method. The banking industry is highly regulated and subject to numerous reporting requirements, thereby increasing the likelihood of sufficient data to compute the beginning reserve for the U.S. branch operations alone.

2. TERMINATING A WATER'S-EDGE ELECTION

If a taxpayer changes from a water's-edge combined reporting basis which only includes the U.S. branch operations of the foreign bank to worldwide combined reporting basis, the bad debt reserve, charge-offs, and bad debt experience should reflect the loss history for the foreign bank's operations on a worldwide basis. In most situations, a beginning bad debt reserve of zero for the worldwide entity would not correctly reflect the bad debt experience of the worldwide entity, and would not correctly match income and deductions.

Unless the beginning bad debt reserve is recalculated on a worldwide basis after termination of the water's-edge election, the beginning bad debt reserve will only include U.S. loan loss history. A bad debt reserve for the worldwide entity reflecting only domestic branch loss history does not provide for the bad debt experience of the worldwide entity and would not correctly match income and deductions. Accordingly, the beginning balance of the bad debt reserve must be recalculated as if the taxpayer had reported on a worldwide basis in the years for which its water's-edge election was in effect to properly reflect the worldwide entity's loss experience.

Therefore, in order to clearly reflect income, the foreign bank must compute its beginning worldwide bad debt reserve using a method consistent with the U.S. branch's bad debt reserve determination of the prior water's-edge income year. This results in a "reasonable addition" to a reserve, as required under Rev. & Tax. § 24348(a)(1)(A). By restating the beginning balance to reflect all worldwide eligible loans and charge-offs, this method avoids the distortion of income and correctly matches worldwide income and deductions for the foreign bank.

Most taxpayers will compute their beginning worldwide bad debt reserve using worldwide bad debt loan history and either the three year average, six year average, or book reserve which is subject to one percent of the amount of loans outstanding at the close of the income year, consistent with the prior year's ending reserve method. Some taxpayers may have calculated their U.S. branch operations beginning bad debt reserve balance using a method other than the three year average, six year average, or book reserve with the one per cent limitation. Although consideration of the past method of calculation of the bad debt reserve by the U.S. branch operations is not considered as significant as when making the water's-edge election because of the typical comparative sizes of the U.S. branch operations and the worldwide foreign bank, the worldwide entity will compute its beginning water's-edge bad debt reserve in a manner consistent with the method used to calculate the bad debt reserve for the U.S. branch operations. However, a showing of specific facts and circumstances, such as a material difference in type and composition of loans held by the worldwide foreign bank and the U.S. branch operations, may demonstrate that an alternative means of calculating the bad debt reserve should be considered.

The compliance burdens that would arise as a result of terminating a water's-edge election may be greater than those experienced by banks first entering into a water's-edge election. Because some foreign countries do not permit reserves, or because the taxpayer may not use the reserve method for foreign tax reporting purposes, worldwide information may be difficult to obtain. However, many foreign corporations have audited financial statements prepared in accordance with U.S. generally accepted accounting principles in response to requirements of the Securities and Exchange commission. The compliance burdens arising from the need to compute worldwide income on a California tax accounting basis are not unique to a water's-edge to worldwide conversion. Prior planning and collection of data in advance of the termination of the water's-edge election is within the control of the taxpayer and will minimize any compliance burden.

CONCLUSIONS

With respect to a water's-edge election, the beginning bad debt reserve must be recalculated on the basis of providing a reasonable addition to a reserve for bad debts to clearly reflect either U.S. or worldwide income. For a taxpayer making the water's-edge election, the beginning bad debt reserve must be recalculated as if the water's-edge election had been in place for prior years, and the experience of the U.S. branch must be segregated and used to calculate the bad debt reserve in accordance with Reg. § 24348(b). If the water's-edge election is terminated, the beginning bad debt reserve for income years beginning after the last year of the water's-edge election must be recalculated as if the water's-edge election had not been in effect, and the experience of the worldwide combined group must be aggregated and used to calculate the bad debt reserve in accordance with Reg. § 24348(b). It is noted that no adjustment is required under Rev. & Tax. § 24721 (IRC §481) when the beginning bad debt reserve balance is recalculated.

HOLDINGS

1. When a foreign bank with U.S. (California) branch operations makes a water's-edge election, the beginning bad debt reserve balance and the resulting bad debt deduction is recalculated to reflect the loan loss experience of the U.S. branch operations only in accordance with Reg. § 24348(b), using a method consistent with the worldwide bad debt reserve determination of the prior year. The beginning bad debt reserve for the U.S. branch operations may require an adjustment after consideration of the method of calculating the actual ending bad debt reserve maintained by the worldwide entity.

2. When a foreign bank with U.S. (California) branch operations terminates a water's-edge election, the beginning bad debt reserve balance and the resulting bad debt deduction is recalculated to reflect the loss experience of the world wide operations in accordance with Reg. § 24348(b), in a manner consistent with the determination for the U.S. branch operations of the prior year. The beginning bad debt reserve for the worldwide entity may require an adjustment after consideration of the method of calculating the actual ending bad debt reserve maintained by the U.S. branch operations.

DRAFTING INFORMATION

The principal authors of this ruling are Debbie Neary and Edward J. Kline of the Franchise Tax Board. For further information regarding this ruling, contact Mr. Kline at P.O. Box 1720, Rancho Cordova, CA 95741-1720.