In September of 2008, the Senate Homeland Security and Governmental Affairs Permanent Investigations Subcommittee conducted hearings and issued a report on perceived abuses in the use of total return swaps (“TRSs”) and stock lending transactions to avoid withholding taxes on U.S source dividends. The report strongly recommended legislative, regulatory, and enforcement action be taken to stop transactions the report viewed as abusive. Revenue proposals for fiscal 2011 and legislation currently pending in Congress (for example “Hiring Incentives to Restore Employment Act”) appear to follow the report’s recommendation.
Now the IRS has issued an industry directive (the “Directive”) that indicates the IRS will aggressively pursue TRS transactions to determine which should be selected for enforcement action. The Directive, designed to assist IRS field agents in gathering information regarding TRSs on U.S equities, addresses the issue of when a TRS may represent actual ownership of the underlying equities for U.S. dividend withholding purposes or in substance constitutes a stock loan subject to withholding.
The stakes are simple to understand. Dividends paid by U.S. corporations to foreign investors in non-treaty jurisdictions (think Cayman Islands domiciled hedge funds) generally are subject to a 30 percent withholding tax. However, for foreign persons that do not otherwise have a business connected to the U.S., any income from a swap that qualifies as a notional principal contract (“NPC”) is treated as non-U.S. source income under U.S. Treasury regulations, and, accordingly, is not subject to the 30 percent withholding tax. Thus, a TRS can seek to replicate economics of U.S. stock ownership (subject to counterparty risk) without the 30 percent withholding tax being imposed on the payments in respect of the dividend leg of the TRS.
The IRS, in the Directive, is advising its field agents to look for TRSs that the IRS can contend are, in substance, agency arrangements, repos, or stock lending transactions, and thus should be subject to the 30 percent withholding tax on the dividend payments. The IRS describes four different fact patterns of concern. The first three are variations on the theme of crossing in and out around a dividend date. That fact pattern is a foreign investor sells a U.S. equity it owns prior to a dividend payment date, reacquires the stock after the dividend payment date, and enters into a TRS to bridge the period it did not actually own the stock. The fact patterns differ depending on whether the foreign investor sells the stock directly to the U.S. financial institution with which it enters into the TRS, sells the stock indirectly to the U.S. financial institution through the use of an inter-dealer broker, or enters into the TRS with a foreign affiliate of the U.S. financial institution to whom it sold the stock.
A critical concern is how the IRS seeks to define “crossing out.” The IRS defines any price that is tradable by the parties as essentially being the equivalent of trading the stock directly. Thus, if a foreign person can actually buy the stock in the market for the price it will be paid by its counterparty upon the termination of the TRS, the IRS appears to want to treat this the same as a direct sale of the stock from the counterparty to the foreign person. The premise is that the parties can assure themselves that all price risk can be eliminated if certain pricing metrics are used to set pricing in the TRS. The IRS accordingly considers market on close, market on open, and volume-weighted average price-based TRSs as the equivalent of trading the underlying equity. It is not at all clear what pricing metric, if any, the IRS would consider acceptable for a TRS on a U.S. equity where the foreign investor trades the equity around the TRS.
The fourth category of TRSs is given a pass by the IRS, but subject to exceptions that may render the pass very narrow. This category is what is described as “fully synthetic” TRSs, i.e., TRSs in which the foreign investor never owns the underlying U.S. equity. The exceptions include TRSs:
Also excepted are TRSs where the U.S. financial institution hedged the TRS “by retaining the physical underlying reference securities on its books.” Given that it is not unusual for a TRS to be hedged through a long position in the underlying equity, this exception, if read broadly, may capture many TRSs not otherwise captured under the Directive. In addition, in one of the first three examples, (sale to the counterparty, reacquisition of same equity securities from a third party), the IRS states that if there is not an arrangement to reacquire the equity securities the exam should be concluded. However, this statement should be read in light of the admonishment following the fourth example for field agents to look for additional exceptional facts showing the TRS itself gave the foreign person sufficient control over the counterparty’s hedge to be considered the beneficial owner of the equity securities. Thus, even when the foreign person does not cross back into the equity securities, it should be expected that field agents will be looking for facts that the TRS alone made the foreign person the beneficial owner of the equity securities referenced in the TRS.
The IRS will, in the first instance, be trying to uncover target TRSs through the audit of banks and other financial institutions, which presumably are onshore counterparties to the TRS. Field agents are advised to consider whether relevant information may be obtained through methods including, but not limited to, the use of third-party summons, such as the foreign investor’s prime brokerage account, and interviews of parties, including members of the U.S. financial institution’s information technology departments, to identify the computer programs used to execute TRSs and acquire and dispose of the reference securities. Once the IRS finds TRSs that concern it, that information may be used to contact the foreign counterparties to those TRSs to see what other TRSs they have entered into.
This all presents interesting and somewhat troubling issues. NPCs are defined in the tax regulations and market participants have engaged in significant volumes of TRSs with U.S. equities as the underlying reference stock in reliance on, among other things, the exemption from withholding for NPCs. Much analysis and consideration has been directed to the question of how to structure TRSs to come within the NPC category. The IRS, through the mechanism of a directive to field agents, is broadening the investigative attack it has been pursuing against TRSs on equity derivatives issued by banks for at least the past couple of years and encouraging its agents to challenge many TRS transactions that had been thought by market participants to be legitimate NPC structures.
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This article was originally published by Bingham McCutchen LLP.