Rev. Rul. 87-5

1987-1 C.B. 180, 1987-3 I.R.B. 6.

TAX CONVENTIONS; INDUSTRIAL AND COMMERCIAL PROFITS; INTEREST RATE SWAP

Published: January 20, 1987

Section 894-Income Affected By Treaty, 26 CFR 1.894-1 Income Affected By Treaty

(Also Part II-United States-Netherlands Income Tax Convention)

  Tax Conventions; industrial and commercial profits; interest rate swap. A cross border U.S. dollar denominated interest rate swap between a U.S person and a Netherlands bank results in industrial and commercial profits to the bank that are exempt from U.S. tax under the U.S.-Netherlands Income Tax Convention.

ISSUE

  What is the proper federal income tax treatment of income derived from a cross-border U.S. dollar denominated interest rate swap between a United States person and a Netherlands bank?

FACTS

  A is a United States corporation. B is a Netherlands bank which constitutes a Netherlands enterprise within the meaning of Article II(g) of the United States-Netherlands Income Tax Convention, 1950-1 C.B. 92, as amended by the Protocol of December 30, 1965, 1967-2 C.B. 472, (the Convention) and is engaged in the active conduct of a banking business in the Netherlands. B does not have a permanent establishment in the United States under the Convention.

  B has United States dollar interest rate exposure because it has short-term variable rate dollar-denominated liabilities and long- term fixed rate dollar- denominated financial assets. Thus, if interest rates were to rise, B's liabilities will be more costly and the value of its assets will decline. A is in the opposite position because it has fixed rate liabilities and variable rate financial assets. In order to effect asset/liability management with respect to its banking activity in the Netherlands, B enters into a United States dollar interest rate swap with A. Under the swap agreement, A agrees to pay semi-annually to B variable rate United States dollar amounts and B agrees to pay semi-annually to A fixed rate United States dollar amounts, each determined by reference to a percentage of a notional United States dollar denominated principal amount specified in the agreement.

LAW AND ANALYSIS

  Section 61 of the Code provides that gross income means all income from whatever source derived. Section 894(a) provides that income of any kind, to the extent required by any treaty obligation of the United States, shall not be included in gross income and is exempt from taxation by the United States.

  Article III(1) of the Convention provides that the industrial or commercial profits of a Netherlands enterprise are exempt from United States taxation unless those profits are attributable to a permanent establishment which the Netherlands enterprise has in the United States or are derived from transactions in the United States or are derived from transactions in the United States of the same kind as those effected through the permanent establishment. Article III(5) of the Convention defines 'industrial or commercial profits' as income derived from the active conduct of a trade or business but does not include income specifically covered by certain other articles.

  Under the Convention, any payments received by B (pursuant to its swap agreement with A) are industrial and commercial profits of a Netherlands enterprise because they are derived from the active conduct of a trade or business and are not covered by any other article of the Convention. In this regard, see Rev. Rul. 86-156, 1986-52 I.R.B., 18.

HOLDING

  Amounts received by B under its swap agreement with A are exempt from United States tax.

Rev. Rul. 87-5, 1987-1 C.B. 180, 1987-3 I.R.B. 6