DIVIDEND EQUIVALENTS: EQUITY SWAPS; SECURITIES LENDING AND REPOS

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1 DIVIDEND EQUIVALENTS: EQUITY SWAPS; SECURITIES LENDING AND REPOS John M. Staples Burt, Staples & Maner Institute of International Bankers June 21, 2010

2 Overview Section 541 of HIRE ACT Dividend Equivalents: New Section 871(l) Background to Section 871(l) Securities Lending and Repos Total Return Swaps 2

3 Background: Dividend Equivalents Section 541 of the HIRE Act enacts new section 871(l) to treat dividend equivalents as dividends from U.S. sources subject to U.S. withholding taxes. Dividend equivalent means either: 1. A substitute dividend made pursuant to a securities lending or repo transaction that directly or indirectly references a U.S. source dividend, OR 2. From 14 Sept through 18 March 2012, any payment made under a specified notional principal contract that directly or indirectly references a U.S. source dividend; 3. After 18 March 2012, any notional principal contract that references dividends unless regulations provide exception; and 4. Any other payment determined by regulations to be substantially similar to 1 or 2, above. All withholding agents potentially must withhold on dividend equivalents: U.S. withholding agents, QIs, NQIs, or other payors of the deemed U.S. source payment. 3

4 The Reasons for New Section 871(l) Longstanding U.S. concern with transactions structured to potentially avoid U.S. withholding taxes on dividends. Treasury issued regulations in 1997 to address securities lending and repo transactions (Treas. Reg (b)(2); (b)(2): Regulations adopted systemic rather than anti-abuse approach. The problem of cascading withholding on a chain of substitute payments addressed in Notice Notice widely interpreted to require withholding only if the withholding rate applicable to the lender exceeded the withholding rate applicable to the borrower even where no prior withholding was done. IRS and Congress believed this interpretation was contrary to the purpose of Notice to relieve over withholding. 4

5 The Reasons for Section 871(l) Soon after securities lending/repo regulations and Notice issued, some Treasury officials discussed need for similar rules for total return swaps. Such regulations were not issued because: Concerns that rules would be either overly broad or too narrow and easily planned around (i.e., the Notice 98-5 problem ). Difficulty of deconstructing swap to find the appropriate payment for withholding. Potential harm to U.S. as center of swap activity. Senate investigations of these transactions. IRS audit activity. 5

6 HIRE Act: Securities Lending/Repos Repeals Notice effective 14 September For a chain of substitute payments referencing a U.S. dividend, withholding agent may only reduce 30% withholding tax rate if it can establish either: Correct tax has already been paid, OR Additional tax is not due. That is, borrower may only reduce withholding on downstream payments if borrower can establish withholding was done upstream based on evidentiary standards issued in regulations or other guidance. 6

7 Notice Issued 20 May Proposes framework for future regulations as well as transition rules. Confirms withdrawal of Notice for payments made on or after 14 Sept Withholding agents/borrowers may not rely on the Notice before 14 Sept if they know or have reason to know that the securities lending transactions have a principal purpose of reducing or eliminating the gross tax otherwise due. 7

8 Proposed Final Framework In Notice Intent is to replace formulary approach of Notice with a documentation approach. Cascading withholding avoided by Payee documenting that it is exempt from withholding on substitute payment because it is a qualified securities lender ( QSL ), OR Payor documents that prior substitute payment or dividend has been subject to withholding ( Credit Forward ). 8

9 Who can be a QSL? Banks, custodians, broker-dealers or clearing organizations subject to regulatory supervision and regularly engaged in securities lending. Subject to audit by IRS under 7602 or QI external audit (QIA to be amended for this). 9

10 QSL Certification Process Withholding agent relieved of liability from withholding on substitute payment if it receives a written certification from QSL as to its status. QSL must withhold U.S. tax and report on Form 1042-S any offsetting substitute payments with respect to identical securities. QSL remains liable for U.S. tax if the QSL has no offsetting substitute payments with respect to identical securities. 10

11 Credit-Forward (Non-QSL) Option Non-QSL may reduce U.S. withholding tax within a series of securities lending/repo transactions ONLY if it: Receives a dividend or substitute dividend net of U.S. withholding; Receives a written statement from the immediately prior withholding agent setting out the amount of such withholding; Identifies who withheld and the recipient of the payment subject to withholding; Does not know, or have reason to know, the written statement is unreliable. 11

12 Transition Rules Proposed framework expected to be effective 1 Jan Transition rules in effect from 14 Sept to 31 Dec Securities lender can claim QSL status by making annual certification to securities borrowers. QSL must agree to: (i) withhold U.S. tax on substitute dividends; (ii) deposit such withheld tax; and (iii) report on Form 1042-S. Forthcoming guidance will provide that QSLs using this transition relief may be required to identify themselves to IRS by end of Deemed amendment of QIA. 12

13 Transition Rules (Cont d) Borrower may reduce U.S. withholding tax on a substitute payment if the borrower: Receives a substitute or actual dividend that reflects a reduction for U.S. withholding tax; Does not know or have reason to know that U.S. withholding tax was not withheld and deposited; Is subject to IRS audit under 7602 or, in the case of a QI, by an external auditor. 13

14 Anti-Abuse Rules Under proposed final framework, 30% withholding required on any securities lending transactions that have a principal purpose of reducing or eliminating U.S. withholding tax. No transition relief allowed for transactions entered into with a principal purpose of reducing or eliminating the aggregate U.S. tax that would have been due absent the transactions. An entity engaging in one or more of such transactions after 20 May 2010 will not qualify as a QSL for 5 years. 14

15 Some Open Issues How does new regime treat tax gross-up payments which are common on securities lending transactions? What is the relationship of the QSL regime with the credit-forward regime (both seem necessary in many circumstances)? What is the relationship of QSL regime and QI regime? E.g., what rules apply for QI not electing QSL status? Is documentation standard for providing treaty relief the same as under the current QI rules? Does pooled based reporting apply? How will documentation will be provided along a chain of participants in a transaction that have no privity of contract with each other? Any plans to allow NQIs to also elect QSL status if they agree to some sort of compliance mechanism and are also participating FFIs? 15

16 Some Open Issues (Cont d) How to determine which securities were lent if there is a pool of fungible securities? Notice says any reasonable method consistently applied will be acceptable. What does that mean? How to determine what constitutes a series of securities lending/repo transactions for purposes of the credit-forward rules? Does Notice apply to proprietary positions as well as custodial? Does Notice apply to interest payments as well as dividend payments? 16

17 Equity Derivatives From 14 Sept to 18 March 2012, HIRE Act requires withholding on any payment on a specified notional principal contract that that is contingent upon, or determined by reference to, a U.S. source dividend. A specified notional principal contract is any NPC with any one of the following 5 characteristics: 1. On entering contract, a long party transfers underlying security to a short party; 2. On termination, a short party transfers security to a long party; 3. Underlying security not readily tradable; 4. A short party posts underlying security as collateral with a long party; OR 5. Treasury identifies contract as a specified NPC. 17

18 Equity Derivatives (Con td) Index or a fixed basket of securities treated as a single security (hence, all must be readily tradable to potentially avoid withholding). Withholding is on the gross amounts used in computing any net amounts transferred to or from the taxpayer. For payments after 18 March 2012, a specified notional principal contract includes any NPC unless Treasury issues regulations specifying otherwise. Presumably this means equity derivatives and not all derivatives. 18

19 IRS Audit Activity IRS has launched a number of TRS audits for pre-871(l) transactions. IRS s inquiry is to determine if long party remained the beneficial owner of the security at issue and should be subject to withholding tax. LMSB directive to field on how to conduct audits more restrictive than criteria in 871(l). 871(l) stresses that no inference is to be drawn as to legitimacy of prior transactions. IRS document requests ask for extensive information. 19

20 CONTACT INFORMATION John M. Staples Burt, Staples & Maner (202)