The taxation of equity total return swaps (TRSs) held by a foreign investor not subject to U.S. federal net income tax has been the subject of many wide-ranging audits in recent years. These audits have canvassed both the financial institutions that offer TRSs and the foreign clients (e.g., hedge funds) that execute them. The issue is whether any dividend-equivalent payments made under the terms of a TRS are subject to the 30% gross withholding tax or to a reduced amount under an applicable tax treaty.
Even though actual dividend payments made by U.S. corporations to foreign investors are generally subject to withholding tax, most financial institutions and other taxpayers contend that dividend-equivalent payments made pursuant to TRSs and other notional principal contracts (NPCs) are not subject to withholding tax and reporting on Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, because such payments are considered to have a foreign source under Regs. Sec. 1.863-7 general sourcing rules. Notwithstanding this disparity of treatment between dividends and swap payments, some iterations of these transactions have recently been identified as dividend withholding minimization transactions pursuant to a new Tier I issue, U.S. Withholding Agents—Reporting and Withholding on U.S. Source FDAP Income.
On March 18, 2010, President Obama signed into law the Hiring Incentives to Restore Employment Act, P.L. 111-147 (the HIRE Act), which enacted new Sec. 871(l). The HIRE Act imposes withholding tax on certain TRSs effective for payments made on or after 180 days from enactment (see more detailed discussion below). The act applies to new and existing transactions as long as dividend-equivalent payments are made on or after the effective date of the law. In addition, the IRS recently issued an industry directive that discusses the taxation of TRSs held by foreign investors. The directive provides guidance to field agents as to the specific types of TRSs that should be recharacterized into another type of arrangement (e.g., an agency relationship or securities loan) that would subject the dividend-equivalent payments to withholding tax. The directive is currently effective and applies to both new and existing transactions executed prior to its issuance.
On January 14, 2010, the IRS issued an industry directive (LMSB-4-1209-044) regarding the examination of U.S. financial institutions—defined in the attachments to the directive as “domestic organization[s] that provide financial services and financial products” and U.S. branches of foreign banks—with respect to transactions using TRSs to avoid withholding tax. IRS agents may also use the directive as a resource in examinations of foreign investors in TRSs. The directive recommends “further coordination and guidance with the Technical Advisor and Industry Counsel for Hedge Funds and Private Equity funds” in such situations.
The directive focuses principally on transactions in which a foreign investor terminates its investment in a U.S. dividend-paying stock while retaining identical economic exposure to the stock through a TRS. Subsequently, the TRS is terminated, and the foreign investor reacquires the physical position in the same stock. In the interim, a dividend is paid on the stock, and the foreign investor receives a dividend-equivalent payment under the TRS that is not subject to withholding tax, assuming the form of the transaction is respected. However, the directive also addresses situations in which the foreign investor never makes a physical investment in the equity or equities underlying the TRS.
The directive provides field agents guidance for the examination of four fact patterns to determine whether the transactions should be recast as “an agency agreement, repurchase agreement, lending transaction, or some other form of economic benefit” by the foreign investor. The first three fact patterns are:
- Cross-in/cross-out (with the same two parties executing both the TRS and the purchase/sale of the underlying equity);
- Cross-in/IDB out (involving a third-party inter-dealer broker as intermediary to effectuate a cross-out); and
- Cross-in/foreign affiliate out (involving an affiliate of the dealer-counterparty to effectuate a cross-out).
For these three fact patterns, the directive provides templates for IRS agents to request information from taxpayers; these templates are known as information document requests (IDRs). The directive also discusses the types of facts that indicate that the form of a TRS should not be respected. For example, it discusses the use of market on close and market on open pricing for both the termination payment under the TRS and the foreign investor’s reacquisition of the underlying equity from the TRS counterparty. The IRS views this risk-elimination pricing strategy as the equivalent of a cross-out because the buyer and seller in these markets “know that their respective sales price and purchase price will be exactly the same.” The directive also indicates that the IRS views the use of an inter-dealer broker as prima facie evidence of a cross-out and that it maintains a list of such brokers that have participated in these transactions.
The fourth fact pattern addresses the situation when the foreign investor never owns the equity or equities underlying the TRS. The directive states (in bold print) that, as a general rule, examining agents should not pursue cases in which the foreign investor never owns the equity underlying the TRS. However, when the facts indicate that the foreign investor exercises control over the TRS counterparty’s hedge, the directive encourages IRS agents to pursue such transactions. Finally, the directive instructs the field to examine transactions in which the equity underlying a TRS is in a privately held U.S. corporation or partnership.
The IDR for the fourth fact pattern requires the party to which the IDR is directed to provide specified information if it has engaged in a transaction (a responsive transaction) that satisfies one or more of eight listed criteria, including:
- The U.S. financial institution required 50% or more initial margin on the TRS; and
- The TRS refers to an underlying security that is an equity interest in U.S. corporations or partnerships that are not widely held.
Foreign investors may begin to see increased audit activity as a result of the directive’s instruction that agents coordinate the examinations of the financial institutions with the examinations of the foreign investors. Any such audits, however, should potentially become more focused and predictable as a result of the directive. Notwithstanding this greater clarity, financial institutions and hedge funds should proceed with caution when considering the types of swaps they execute and when preparing or considering appropriate guidelines for this activity. Although the directive discusses only TRSs on equity, the IRS could apply the criteria set out in the directive to nonequity TRSs. As such, taxpayers might look to the various rules and safe harbors put forth in the directive, recently enacted legislation (the HIRE Act), and the red flags that were highlighted in the September 2008 report Dividend Tax Abuse of the Senate Permanent Subcommittee on Investigations. (For the list of red flags, see U.S. Senate, Committee on Homeland Security and Governmental Affairs, Dividend Tax Abuse: How Offshore Entities Dodge Taxes on U.S. Stock Dividends 6 (September 11, 2008).)
Legislative Development: The HIRE Act
The HIRE Act includes a revenue offset provision that is part of a group of provisions generally known as the Foreign Account Tax Compliance Act (FATCA). The provision addressing dividend-equivalent payments imposes withholding taxes on substitute dividends under a stock-lending arrangement or a sale-repurchase transaction, dividend-equivalent payments under a specified NPC, and any other payment determined by the IRS to be a substantial equivalent. The HIRE Act classifies a contract as a specified NPC (and subjects dividend-equivalent payments to withholding taxes) if any one of the following four facts exists:
- In connection with entering into an NPC, any long party transfers the underlying security to any short party to the contract (i.e., there is a cross-in);
- In connection with termination of an NPC, any short party transfers the underlying security to any long party to the contract (i.e., there is a cross-out);
- The underlying equity is not readily tradable on an established securities market; or
- In connection with entering into an NPC, the underlying security is posted as collateral by any short party to the NPC with any long party to the NPC.
In addition, Treasury is authorized to identify other contracts as specified NPCs. The withholding tax would apply on the gross amount of the dividend-equivalent payment even if such amounts were reduced under a netting provision of the NPC and even if the non-U.S. party received no payments under the NPC.
The HIRE Act is effective for payments made on or after 180 days from the date of enactment, March 18, 2010. For payments made after two years from the date of enactment, the provisions apply to dividend-equivalent payments on all NPCs, except any contract determined by Treasury not to have the potential for tax avoidance. Thus, unless the IRS issues guidance under the HIRE Act by March 18, 2012, the act will have effectively eliminated the general sourcing rule in Regs. Sec. 1.863-7 for dividend-equivalent payments on equity swaps.
The act also contains a provision to prevent overwithholding with respect to a chain of dividend-equivalent payments, one or more of which is subject to tax. The IRS may reduce the withholding tax,
but only to the extent that the taxpayer can establish that such tax has been paid with respect to another dividend-equivalent in such chain, or is not otherwise due, or as the Secretary determines is appropriate to address the role of financial intermediaries in such chain.
This provision appears to have eliminated the ability of taxpayers to rely on Notice 97-66, which was perceived to have been abused by taxpayers who believed that its formulaic approach allowed withholding taxes to be reduced to zero.
The HIRE Act and the directive provide insight into the specific types of TRSs that the government deems abusive and whose dividend-equivalent payments the IRS believes should be treated as U.S.-source income for withholding tax purposes. While the directive cannot be affirmatively relied upon by taxpayers for penalty protection, it provides insight as to whether the government believes that payments under an NPC should be subject to withholding and a potential road map for the issuance of regulations to identify additional contracts that are specified NPCs. As such, financial institutions and hedge funds alike should be mindful of the directive and the FATCA provisions of the HIRE Act when structuring a TRS. Further, the directive should provide much-needed guidance to agents who are currently auditing these transactions and should introduce greater certainty to taxpayers under examination.
Editor: Mary Van Leuven, J.D., LL.M.
Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.
For additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or firstname.lastname@example.org.
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This article represents the views of the author or authors only and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.