Internal Revenue Service Directive to Examiners on Equity Swaps The Internal Revenue Service Outlines its Approach for Examining Equity Swaps That May Have Been Executed to Avoid U.S. Withholding Tax SUMMARY On January 14, 2010, the Internal Revenue Service (the IRS ) issued an Industry Director Directive (the Directive ) to its field examiners providing guidance and information document requests ( IDRs") to assist in examining equity swaps that may have been executed in order to avoid tax with respect to U.S. source dividends paid to non-resident alien individuals, foreign partnerships, and foreign corporations[.] The Directive provides guidance for fact development and potential arguments to recharacterize an equity swap between a U.S. financial institution and a foreign investor and treat the foreign investor as owning the relevant underlying equities, thereby exposing the foreign investor (and, in its capacity as a withholding agent, the U.S. financial institution) to dividend withholding tax liability. The Directive focuses on three types of transactions: (i) so-called cross-in/cross-out transactions (i.e., transactions in which the foreign counterparty transfers the underlying equity securities to the U.S. financial institution upon entrance into the swap and reacquires the equities from the U.S. financial institution on termination of the swap); (ii) swaps over privately-held U.S. equities or large, illiquid equity positions; and (iii) swaps where a foreign investor has control over whether and how the relevant U.S. financial institution hedges its position, including the case of certain automated trading programs. The Directive implies that a cross-in transaction will not be challenged if there is no cross-out, but it also implies that a foreign investor s reacquisition of U.S. equities from the market may be treated as a cross-out if the foreign investor is not exposed to any pricing risk. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com
DISCUSSION As summarized above, on January 14, 2010 the IRS issued the Directive to address certain equity swap transactions that may have been executed to avoid dividend withholding tax. The Directive instructs field examiners to examine such transactions, effectively implying that field examiners may seek to recharacterize the swaps in appropriate cases and treat the foreign investor as owning or lending the equities referenced by the swaps. The Directive makes it clear that the IRS is not seeking to recharacterize all equity swaps. Although the IRS apparently recognizes that a foreign investor s long position in an equity swap over U.S. equities is economically equivalent to a leveraged position in the relevant underlying equities, the Directive nevertheless accepts the notion that under current law, the former (unlike the latter) does not give rise to U.S. withholding tax on outbound dividend payments. According to the Directive, The existing notional principal contract rule, found in Treas. Reg. Sec. 1.863-7, is clear on its face; taxpayers and withholding agents may rely on that rule when their investment is in substance and form a notional principal contract. 1 However, the Directive also makes clear that in the view of the IRS, certain transactions that are equity swaps in form are better viewed as the actual ownership of U.S. equities by foreign investors in substance, and field examiners should seek to impose U.S. withholding tax in such cases on what is in substance the payment of U.S. source dividends to foreign investors by U.S. financial institutions acting as agents or stock borrowers. 2 The Directive instructs examiners to issue detailed IDRs to U.S. financial institutions (and U.S. branches of foreign financial institutions) in any case where examiners think transactions might appropriately be subject to recharacterization. The IDRs generally request all relevant documentation, marketing materials, e-mails and correspondence, legal opinions and pricing information in whatever form they are available. The apparent intent is to potentially hold the relevant U.S. financial institution liable for the relevant U.S. withholding tax under the authority of Section 1461 of the Internal Revenue Code, which effectively imposes such liability on U.S. tax withholding agents. It is possible, however, that the IRS will also seek to assess foreign investors. The IRS appears to be focusing on three cases in particular: (i) a so-called cross-in/cross-out transaction; (ii) a swap over privately-held U.S. equities or large, illiquid equity positions; and (iii) a swap 1 2 Under Treasury Regulations Section 1.863-7, a foreign investor treats income from equity swaps and other notional principal contracts (including so-called substitute dividend income ) as foreign source income which, unlike U.S. source dividend income, is not subject to U.S. withholding tax. Therefore, while a foreign investor is generally subject to 30 percent gross income tax and withholding (subject to reduction by treaty) with respect to U.S. source dividends, a foreign investor in an equity swap is generally not subject to U.S. federal income tax on payments received under the swap. The mere fact that the IRS seeks to recharacterize a transaction under any particular set of facts does not necessarily mean that the IRS would prevail if the matter were ultimately litigated. -2-
where a foreign investor has control over whether and how the relevant U.S. financial institution hedges its position, including the case of certain automated trading programs. In a cross-in/cross-out transaction, a foreign investor that already holds a U.S. equity (a) sells the U.S. equity to a U.S. financial institution and simultaneously enters into a long swap position on the underlying U.S. equity (the so-called cross-in ) and sometime later (presumably after a dividend has been paid on the underlying U.S. equity) terminates the equity swap and simultaneously buys the underlying U.S. equity back from the U.S. financial institution. The IRS s assertion in these cases will presumably be that the foreign investor continues to own the relevant U.S. equity and is merely borrowing from the U.S. financial institution on a collateralized basis, or else that the transaction is in substance a stock loan. The Directive implies that the IRS may allow a foreign investor to cross-in provided that there is no cross-out. In other words, the Directive implies that an equity swap does not cross the line between form and substance if the foreign investor has no ability to get the relevant U.S. equities back without taking pricing risk. This is in contrast to the recently proposed Tax Extenders Act of 2009, which effectively provided that 90 days after enactment, withholding tax would be imposed in respect of such an equity swap if there was either a cross-in or a cross-out. 3 The Directive also implies, however, that the IRS may seek to treat a sale by the U.S. financial institution and a substantially simultaneous purchase by the foreign investor as a cross-out (notwithstanding the absence of an actual sale from the former to the latter) if the foreign investor does not incur meaningful pricing risk when it closes out the equity swap and reacquires the relevant underlying U.S. equities. This may include (a) certain market on close or market on open transactions, where the swap closing price, the broker s sales price, and the foreign investor s purchase price are all keyed to the same objective and readily available market price, (b) sales to (and purchases from) an interdealer broker that is effectively acting as an intermediary for the U.S. financial institution and the foreign investor, and (c) certain highvolume sales in low-volume trading markets, where the U.S. financial institution and the foreign investor 3 See Tax Extenders Act of 2009, H.R. 4213, at Sec. 541. The proposal would affect equity swaps by treating dividend equivalent payments on certain specified notional principal contracts as U.S. source (and therefore subjecting such payments to withholding tax). The proposal defines specified notional principal contract as including contracts in which (i) a cross-in has occurred in connection with entering into the contract, (ii) a cross-out has occurred in connection with terminating the contract, (iii) the reference security is not readily tradable on an established securities market, (iv) the party making dividend equivalent payments on the swap posts the reference security as collateral in connection with entering into the contract, or (v) the Secretary has identified the contract as a specified notional principal contract. The proposal would also presumptively treat any payments made two years after enactment as being made with respect to a specified notional principal contract unless the Secretary has determined that the contract is of a type which does not have the potential for tax avoidance. Further discussion of this proposal and the Tax Extenders Act of 2009 generally can be found in the Sullivan & Cromwell LLP Publication entitled Revised FATCA Plus Carried Interest Taxation: Tax Extenders Act of 2009 Introduced to Congress and Passed by House (December 10, 2009) which can be obtained by following the instructions at the end of this publication. -3-
might effectively be the only sellers and buyers in the market. It might also include other cases, depending on the nature of the facts revealed through the examination process. Even in the absence of any cross-in or cross-out, the Directive directs field examiners to examine transactions where The position in U.S. equities is so large or so illiquid that a U.S. financial institution acting as the swap counterparty must acquire the underlying security to hedge its position, The relevant equity swap references an equity security issued by a privately-held U.S. corporation, The relevant foreign investor has effective control over when and how the relevant U.S. financial institution acquires a hedge, or The foreign investor makes use of certain automated trading programs that may allow the foreign investor to control the hedging activity of the relevant U.S. financial institution where the latter assumes no pricing risk. Finally, the Directive instructs field examiners to seek technical assistance in the case of transactions in which the relevant equity swap references a basket or portfolio of U.S. Equity Securities, rather than the securities of a single issuer. * * * Copyright Sullivan & Cromwell LLP 2010-4-
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