Withholding on U.S. Equity Swaps under the HIRE Act

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1 ABA Section of Taxation Investment Management Friday, January 21, 2011 Withholding on U.S. Equity Swaps under the HIRE Act Panelists: Thomas A. Humphreys, Morrison & Foerster, New York, NY Puneet Arora, PricewaterhouseCoopers LLP, New York, NY Mark S. Perwien, Special Counsel, Office of Associate Chief Counsel (Financial Institutions and Products), Internal Revenue Service, Washington, DC Moderator: Dominique Padilla Gallego, Schulte Roth & Zabel LLP, New York, NY 1 Introduction Background Prior to the HIRE Act, the income of foreign taxpayers that entered into equity swaps (respected as notional principal contracts) on U.S. companies was treated as foreign source income and was not subject to U.S. withholding tax IRS was concerned about the abusive use of equity swaps by foreign taxpayers to avoid U.S. withholding on U.S. source dividend income especially those cases where foreign taxpayers were crossing in and crossing out close to dividend payment dates 2 1

2 Overview of Section 871(m) The HIRE Act was enacted on March 18, 2010 New Section 871(m) Any dividend equivalent will be treated as a U.S. source dividend A dividend equivalent includes any payment made pursuant to a specified notional principal contract that (directly or indirectly) is contingent upon, or determined by reference to, the payment of a dividend from sources within the U.S. 3 Specified Notional Principal Contract under Section 871(m) For payments made from September 14, 2010 through March 18, 2012, a specified NPC means any NPC if: In connection with entering into such contract, any long party to the contract transfers the underlying security to any short party to the contract (a cross in ) In connection with the termination of such contract, any short party to the contract transfers the underlying security to any long party to the contract (a cross out ) The underlying security is not readily tradable on an established securities market In connection with entering into such contract, the underlying security is posted as collateral by any short party to the contract with any long party to the contract, or such contract is identified by the Secretary as a specified NPC 4 2

3 Specified Notional Principal Contract under Section 871(m) For payments made after March 18, 2012, any NPC is a specified NPC UNLESS the Secretary determines that such contract is of a type which does not have the potential for tax avoidance. 5 Dealer Perspective Scope of Section 871(m) Underlyings? Single-Name U.S. Equities Stock Baskets Indices Crossing-In/Crossing-Out Crossing-In: Dealer buys 100 shares of $100 per share from foreign counterparty and strikes a swap at $100 per share Crossing-Out: Dealer sells 100 shares of IBM to foreign $110 per share and terminates swap at $110 per share March 18, 2012/Second Phase Now One Year Away Was this a legislative attempt to broaden the statute or narrow the statute? Today s view: narrow it View in 2012 depends, of course, on whether regulations are issued 6 3

4 What Are the Dealer s Current Exposures? Context: unhelpful September 2008: Report by Senate Permanent Subcommittee on Investigations: Dividend Tax Abuse: How Offshore Entities Dodge Taxes on U.S. Stock Dividends IRS Audits on Cross-Border Equity Swaps January 2010: IRS Industry Directive on Total Return Swaps Used to Avoid Dividend Withholding Tax Anti-Wall Street Environment Great Concern About Withholding and Gross-Up Obligations For Existing Swaps No Grandfather For New Swaps Dealer Withholding System Readiness Current Litigation Arbitex Master Fund L.P. (filed in Tax Court March 12, 2010) Whether payments under TRS are substitute dividends or otherwise subject to U.S. withholding tax Underlyings were convertible bonds, equity units and trust preferreds 7 Dealers Minimize Risk, Maximize Compliance Rationale for ISDA Protocol Long-Form and ISDA Protocol Lite Popularity with Sell Side Reason for Reps/Dynamic Hedging Problems Market on Open Market on Close Entry/Exit Price based on Volume Weighted Average Price ( VWAP ) GWAP Websites ISDA Protocol Long-Form ISDA Protocol Lite ctprot.html 8 4

5 Déjà vu in Reverse Mid 1990s: U.S. Dealers Moved Swap Books to UK in Order to Minimize Regulation Today: U.S. Dealers May be Moving Swap Books in the UK Back to U.S. Dealer Affiliates Why? 9 No Way Out Withholding Requirement Applies to Type of Income (e.g., U.S. Source Dividends) Not Identity of Withholding Agent U.S. Dealers: No Benefit to Having Foreign Clients Face a Foreign Subsidiary Foreign Dealers: No Competitive Advantage Because Withholding Obligation Still Applies Collection of tax against U.S. assets UBS enforcement precedent 10 5

6 Audit Activity Tier I audit issue Recent audit experience ADRs expansive and comprehensive very burdensome Audit of foreign funds in addition to the dealers IRS system for distinguishing good swaps vs bad swaps not clear IDR from January 2010 helpful? Experience in non US jurisdiction in auditing swaps Really a swap / derivative vs direct ownership Abusive situations look through (eg. Spain) 11 Buyer-Side Issues Prior to March 2012 avoiding characterization as a specified notional principal contract steps for funds QSL documentation for short sales Review of new ISDA protocol Comfortable making these representations? Comfortable with other rights, such as bank / counterparty to terminate the swap if the IRS provides the bank / counterparty with written notification of its intention to assess tax? New Swaps vs. Existing Swaps Review confirmations No safe harbor for existing swaps under the HIRE Act? Determine if existing swaps are outside the scope of the early effective date for statute and respected under the IRS recent guidance. 12 6

7 What to Expect? Broader underlying policy to encourage investments into the U.S. Prior experience Rules that apply to OID Eurobond interest and PIE Interest rate and currency swaps Treasury effort in 1976 to repeal withholding as applied to portfolio dividends Impact of disclosure for regulatory purposes on tax analysis 13 Approaches by Other Countries - Examples Australia sourcing rules based on payor Germany stringent treaty shopping rules and beneficial ownership requirements Spain substance over form and look through approach India controversy over P-notes and taxation of indirect transfers China Circular 698 and indirect transfers 14 7

8 Industry Director Directive (IDD) on Total Return Swaps Used to Avoid Dividend Withholding Tax Published on January 14, 2010 Provides examination guidance to field agents on four situations: Cross-in/Cross-out Cross-in/Inter-dealer broker out Cross-in/Foreign affiliate out Fully synthetic Does Section 871(m) only cover the 1 st situation (Cross-in/Cross-out)? 15 Prospective Guidance on Section 871(m) How will the IDD impact prospective guidance under Section 871(m)? Will Treasury consider the potential reduction in U.S. equity investments in guidance? Looking at other countries experiences Are U.S. substance rules the most stringent to date? How will the gov t utilize common law rules with Section 871(m)? Estimated timing on guidance on good vs. bad swaps under Section 871(m)? 16 8

9 Discussion Topics Should you sign up for the ISDA short form protocol? For existing swaps For new swaps Will FIN 48 analysis require adherence to protocol? 17 Discussion Topics What role should the common law play? Notice : Cascading withholding concerns Will this be addressed in the initial gov t guidance? 18 9

10 Discussion Topics Issues of statutory interpretation: Can underlying security be posed as collateral in certain circumstances? When is a payment indirectly contingent or determined by reference to a U.S. dividend? Will Treasury consider creating safe harbors in situations where there is no intent to avoid U.S. equity withholding on U.S. source dividends and tracking any dividend equivalent would be unduly burdensome? 19 Discussion Topics Issues of statutory interpretation: Does a basket or index with a few U.S. securities trigger Section 871(m)? If yes, should any percentage threshold apply? How will the withholding tax be calculated? How should bullet swaps on U.S. equities be treated? What rules ought to be used in determining what is/is not readily tradable on an established securities market? What constitutes a transfer? 20 10