NEW YORK - U.S. tax policy on currency and rate hedging may discourage foreign banks from participating in capital markets activity here, said an association that represents those banks.

IRS treatment of interbranch transactions result in severe tax distortions for international banks with U.S. trading operations, according to a recently released position paper from the New York-based Institute of International Bankers.

The institute represents foreign banks in the United States.

"If left unaddressed, this approach would seriously impede further participation of international banks in the U.S. financial markets and adversely affect the depth and competitive strength of U.S. markets," the position paper said.

The position paper, which focuses on what it terms "the adverse economic impact of these distortions on the banks and U.S. financial markets," follows a technical memorandum submitted by the institute to the Treasury Department and the Internal Revenue Service in February.

The paper was drafted and released in response to an IRS ruling that, according to the institute, does not "properly measure the income derived by an international bank's U.S. branches from cross-border trading in certain financial instruments."

The IRS ruling mainly affects foreign currency and interest rate hedge transactions between the U.S. branches of foreign banks and their home offices:

The IRS does not recognize the branch as a separate entity from the parent company and therefore excludes any gains or losses on trading transactions with the bank's home office when calculating tax due on income derived in the United States.

Foreign banks frequently hedge swaps or foreign exchange trades with a counterparty by carrying out the opposite transaction with their home office.

But if the branch gains on a trade with a U.S. counterparty and loses on another trade with its home office, only the U.S. transaction is taken into account by the IRS.

"As a result, the U.S. taxable income attributed to the inter- national bank is substantially and unpredictably different from the U.S. branch's actual economic income from cross-border trading," the institute noted.

"This tax distortion impedes participation by international banks in the U.S. markets and thus hinders the full development and efficient working of these markets."

The paper goes on to point out that the issue of cross-border interbranch trading arises because international banks, as well as U.S. banks, do business outside their home countries in large part through branches, rather than through separately incorporated subsidiaries.

Inconsistency Seen

The paper also notes that "current policy of the Treasury and the Federal Reserve is to ensure that international banks continue to have the ability to do business in the United States though branches."

"Cross-border interbranch trading tax rules, which subject U.S. branches of international banks to anomalous and unpredictable tax results, are inconsistent with this important policy," the institute added.

As a solution to the tax problem, the institute has urged Treasury and the IRS to allow international banks to include trading transactions with their home offices for tax purposes.

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