The U.S. and Japanese competent authorities recently entered into an agreement regarding the definition of "investment bank" for purposes of the 2003 U.S.-Japan income tax treaty. The term is important because investment banks, along with other specified financial institutions such as banks and registered securities dealers, are entitled under the treaty to an exemption from withholding tax on interest payments received from residents of the other country. The agreement provides a definition of "investment bank" based on the character of the income earned over the preceding three years, provides rules for determining whether entities within an investment banking group qualify as investment banks, and provides a procedure for obtaining certainty on the issue from the competent authorities.

Definition of Investment Bank

In general, the agreement provides that an "investment bank" is any person regularly engaged in one or more specified "investment bank activities" if 60% or more of its gross income for each of the three preceding taxable years arises from such activities. Investment bank activities include (1) underwriting activities, (2) financial, investment, and other advisory services, (3) financing, broker-dealer, and security-lending activities, and (4) the repackaging of financial assets. An entity that does not meet the 60% gross income test on a stand alone basis may take into account the gross income of 50%-or-more owned affiliates IF the entity is affiliated with a registered securities dealer resident in Japan or the United States. However, an entity will NOT be considered an investment bank unless (1) its affiliated group would meet the 60% gross income test on an aggregate basis, (2) the gross income of the affiliated group from underwriting activities, financial, investment, and other advisory services, and the repackaging of financial assets exceeds 10% of the gross income of the group other than income from financing, broker-dealer, and security-lending activities, and (3) the entity or an affiliate is engaged in underwriting or financial advisory activities, is a member of a specified stock exchange, or is a market maker in one or more OTC markets. An entity may take advantage of the agreement only if it or an affiliate is an issuer of public debt or equity.

Process for Confirming Benefits

The competent authority agreement provides a procedure for confirming entitlement to benefits. As a part of the confirmation procedure, the competent authorities have agreed to publicize a list of confirmed investment banks.

Implications of Agreement

Although the competent authority agreement appears aimed towards providing relief to investment banking groups based in the United States or Japan that finance operations in the other country with parent company or other related-party loans, it could provide treaty benefits in many other cases as well. For example, European-based investment banks may find it advantageous in certain cases to route through the United States related party financing to fund their Japanese operations. Although it is not clear whether a person must go through the confirmation procedure to claim entitlement to treaty benefits under the agreement, it would probably be advisable for an investment bank to do so to avoid scrutiny by the U.S. or Japanese tax authorities and to avoid over-withholding by unrelated-party withholding agents.

For further information, please contact any of the following lawyers:

Rocco Femia, rfemia@milchev.com, 202-626-5823

Kimberly Majure

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