International Tax Alert. Executive summary

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1 19 May 2015 International Tax Alert EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Services/Tax/International- Tax/Tax-alert-library#date US District Court holds that US taxpayer s foreign tax credit claim under UK-US Tax Treaty for withholding tax on substitute dividend payments is disallowed under Section 901(k) Executive summary In its 8 May 2015 decision in the case of Lehman Brothers Holdings Inc. v. US, 115 AFTR 2d 2015-XXXX, (DC NY, 05/08/2015), the US District Court for the Southern District of NY (the Court) dismissed a complaint contending that plaintiff Lehman Brothers Holding Inc. (Lehman) was entitled, under Article 23 of the US UK Income Tax Treaty 1 (the Treaty), to claim foreign tax credits (FTCs) for taxes imposed by the UK on substitute dividend payments (SDPs) received by a wholly held US subsidiary, Lehman Brothers, Inc. (LBI), from a UK subsidiary, Lehman Brothers International Europe plc (LBIE), under multiple back-to-back stock loan transactions. Under the back-to-back stock loan transactions, LBI borrowed stock in numerous UK corporations from third-party lenders and on-lent that stock to LBIE over the stocks respective dividend record dates. For dividends received by LBIE from the UK corporations, LBIE made an SDP to LBI, which in turn made an SDP to the third-party lenders. At issue was whether SDPs paid by LBIE to LBI, which are generally not treated as dividends under US domestic tax law, should nonetheless be treated as dividends for US FTC purposes, and whether Section 901(k)(1)(A)(ii) applies to deny Lehman FTCs with respect to UK withholding tax on those SDPs. The Court held that the SDPs should be treated as dividends for US FTC purposes and that Section 901(k)(1)(A)(ii) should therefore apply to disallow any claim for FTCs by LBI under the back-to-back stock loan transactions.

2 Detailed discussion Lehman is a US corporation and the common parent of a group of corporations including LBI and LBIE. During 1999 and 2000, LBI entered into multiple stock loan transactions with LBIE, under which LBI borrowed stock in UK corporations from thirdparty, US-based lenders over the stock s respective dividend record dates (i.e., the dates on which the record owners of the stock became entitled to receive dividends declared by the stock issuers). Immediately thereafter, LBI on-lent the borrowed stock to LBIE, which received the actual dividend payments. Under the terms of the stock loan transactions, whenever a dividend was paid to LBIE on borrowed stock, LBIE was required to pay its immediate lender (LBI) in an amount equal to the dividend (an SDP); LBI, in turn, made a corresponding payment (also an SDP) to the third-party US lender on the same business day. On its 1999 and 2000 US tax returns, Lehman recorded as income the SDPs that LBI received from LBIE, along with a payment that LBI received from the UK Government under Article 10(a)(2)(ii) of the Treaty (the UK Payment). During that time, the UK Payment represented a tax credit to which UK individual residents would have been entitled had they received the dividend in question. The amount of the UK Payment equaled tax paid on the dividend in the UK by the distributing company and, under Article 10(2)(a)(ii) of the Treaty, subject to withholding tax that was capped at the amount of the UK Payment (the UK Deduction). Lehman also deducted from its SDP income the amount of the SDPs it paid to the third-party lenders and claimed a US FTC for the UK withholding tax under Article 23(1) of the Treaty. Article 23(1) of the Treaty provided that, [i]n accordance with the provisions and subject to the limitations of the law of the United States, the United States shall allow to a [US shareholder of UK corporation stock] as a [foreign tax] credit the appropriate amount of [the UK Deduction] paid to the United Kingdom, and that the UK Deduction would be treated as an income tax imposed on the dividend received by the US shareholder (for Section 901 and other purposes). The IRS disallowed Lehman s claim for FTCs, which prompted the complaint by Lehman. In its filings with the Court, the IRS contended that, based on of the plain language of Article 10(2)(a)(iii) of the Treaty, the sum of the substitute dividends LBIE paid LBI, plus the UK Payment, should be treated as dividends for US FTC purposes. Further, Section 901(k)(1)(A)(ii) should apply to disallow any FTCs for UK dividend withholding tax because LBI had obligations to make related corresponding payments (the SDPs to the third-party lenders) under the terms of the stock loan agreements. In reaching it conclusion that the SDPs should be treated as dividends for US FTC purposes, the Court first reviewed the language of the Treaty, holding that a plain reading of it compels the conclusion that the [SDPs] plus the UK Payment received by LBI are properly treated as dividend(s) under US tax law. Indeed, this appears to be the only reasonable meaning of Article 10(2)(a)(iii). The Court sided with the IRS on its argument that references in Article 10(2)(a)(i), (ii), and (iii) to the aggregate of the amount or value of the dividend and the amount of the tax credit are to the same amount and that, in each such case, the phrase refers to both the [UK defined] dividend paid by the UK issuer to the USresident shareholder and the UK Payment received by the US-resident shareholder with respect to that dividend. The Court rejected Lehman s argument that, for purposes of interpreting Article 10(2)(a)(iii) only (and not Articles 10(2)(a)(i) and (ii)), the US law definition of a dividend, which does not include an SDP, should be used. The Court explained that such an interpretation contradicted the clear language and meaning of Article 10(2)(a), as well as the established canon of construction that similar language contained within the same section of a [statute or treaty] must be accorded a consistent meaning; additionally, the Court viewed 2 International Tax Alert

3 Lehman as cherry picking among various Treaty provisions to achieve a desired tax result by applying different interpretations of the term dividend to become entitled to the UK Payment and the corresponding FTC for deemed withholding tax under Articles 10(2)(a)(ii) and 23(1) on the one hand, while avoiding the negative ramifications of US limitations on FTCs under Article 10(2)(a)(iii) on the other. In reaching its conclusion, the Court cited the interpretation of Article 10(2)(a)(iii) of the Treaty in CCA , 2 which dealt with a nearly identical set of facts. In CCA , the IRS concluded that the taxpayer s position was contrary to the plain language of Article 10 of the Treaty, and observed that the Treaty explicitly provides that a distribution that entitles a US shareholder to benefits under Article 10(2)(a) of the Treaty will be treated as a dividend in the United States for US foreign tax credit purposes. The Court noted that the unequivocal interpretation of the term dividend under Article 10(2)(a)(iii) as including both the amount or value of the dividend and the amount of the UK Payment, can also find support, for example, in Section 871(m) (which states that for purposes of [certain provisions,] a dividend equivalent, including any substitute dividend made pursuant to a securities lending transaction, shall be treated as a dividend ). Finally, the Court found additional support for that interpretation in a Senate Foreign Relations Committee Report, dated 25 April 1978, which states that the proposed treaty provides that for US foreign tax credit purposes the US shareholders are to be treated as having received a dividend equal to the distribution paid plus an amount equal to the full refund payable to UK shareholders. After having interpreted the term dividend for Article 10(a)(iii) purposes, the Court moved to analyze the application of Section 901(k) to the transactions. Section 901(k)(1)(A)(ii) provides that, in no event shall a [foreign tax] credit be allowed for any withholding tax on a dividend with respect to stock in a corporation if the recipient of the dividend is under an obligation to make related payments with respect to positions in substantially similar or related property. Based on the language of Section 901(k) and with further reference to the reasoning in CCA , the Court concluded that Lehman s FTC claims for the deemed UK withholding tax on the imputed UK Payment were properly disallowed due to LBI s obligation to make corresponding SDPs to the third-party lenders under the terms of the stock loan agreements. In a footnote to its opinion, the Court mentions that the IRS contended that, for most of the transactions in question, Lehman had no profit motive behind its borrowing of the stock of the UK corporations but for the ability to generate FTCs under the Treaty. While Lehman, in turn, provided several counter-arguments, the Court noted that its resolution of the case was based principally upon the plain language of the Treaty; no conclusion was reached by the Court on the applicability of the economic substance doctrine to the transactions at issue. Implications While Lehman took the position that the term dividend has to be defined under US law and excludes substitute dividend payments when applying the domestic rules for foreign tax credits and their limitations relying, among other arguments, on the express definition of dividends in Article 10(3) of the Treaty, which states that [t]he term dividends for United Kingdom tax purposes includes any item which under the law of the United Kingdom is treated as a distribution and for United States tax purposes includes any item which under the law of the United States is treated as a distribution out of earnings and profits the Court nonetheless applied the UK meaning of the term dividend in order to, in its view, uphold a consistent interpretation of the term within the relevant article of the Treaty. The Court s approach highlights the potential limits of the principle that, unless otherwise expressly provided, treaty terms are interpreted under the domestic law of the jurisdiction applying the Treaty. International Tax Alert 3

4 Regarding its use of CCA , the Court acknowledged that neither Lehman nor the IRS had included CCA in their briefs and that the CCA was not binding on the Court. The Court did not address whether CCA was prepared by the IRS in direct response to, and addressing the specific facts of, the Lehman stock loan transactions. The Court s use of the CCA raises the question of whether the IRS can strengthen its litigating position by issuing internal memoranda, such as a CCA, in connection with an IRS challenge of a taxpayer position. Endnotes 1. Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital Gains, United States-United Kingdom, 31 December 1975, 31 U.S.T The Treaty was replaced by a new convention in 2001 and is no longer in force. 2. Chief Counsel Advice Memorandum , 3 March International Tax Alert

5 For additional information with respect to this Alert, please contact the following: Ernst & Young LLP, International Tax Services, Washington, DC Natan Leyva Ernst & Young LLP, International Tax Services, New York Ilona Kahl Alon Kritzman Ernst & Young LLP, International Tax Services, San Francisco Zachary Perryman International Tax Services Global ITS, Alex Postma, London ITS Director, Americas, Jeffrey Michalak, Detroit National Director of ITS Technical Services, Jose Murillo, Washington Member Firm Contacts, Ernst & Young LLP (US) Northeast Johnny Lindroos, McLean, VA Financial Services Phil Green, New York Central Mark Muktar, Detroit Southeast Scott Shell, Charlotte, NC Southwest Amy Ritchie, Austin West Frederick Round, San Jose, CA Canada - Ernst & Young LLP (Canada) Albert Anelli, Montreal Kost Forer Gabbay & Kasierer (Israel) Sharon Shulman, Tel Aviv Mancera, S.C. (Mexico) Koen Van t Hek, Mexico City Central America - Ernst & Young, S.A. Rafael Sayagues, San José South America - Ernst & Young Serviços Tributários S.S. Gil F. Mendes, São Paulo International Tax Alert 5

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