For over 20 years, applicable Treasury regulations have provided that income from an equity swap,1 including dividend equivalent payments, is foreign-source income in the hands of a non-U.S. person who did not enter into the swap in connection with the conduct of a United States trade or business.2 In addition, swap income paid to such non-U.S. persons is not subject to withholding3 or information reporting.4 Given that actual dividends paid to non-U.S. persons who hold U.S. stocks not in connection with a U.S. trade or business are subject to withholding,5 reporting6 and U.S. tax at up to a 30 percent rate7 without reduction for any deductions, non-U.S. persons investing in U.S. stocks had a strong incentive to obtain exposure to U.S. equities through swaps rather than rather acquire the stocks directly.

The disparity in taxation for transactions that can provide economically equivalent exposure to the same asset prompted sellers of swaps to actively market these transactions to non-U.S. persons who could benefit from them. My personal view on this marketing is that it made perfect sense. If a swap provides an IRS-sanctioned greater after-tax receipt than a physical holding of the stock then, of course, sellers of swaps will tout this benefit in selling their product. If Congress and the Internal Revenue Service (IRS) had not wanted to assist the development of financial products in the United States, they would not have provided these beneficial source rules for swaps. Nonetheless, in September 2008, the Senate Permanent Subcommittee on Investigations issued a scathing report on the marketing of equity swaps under the title, “Dividend Tax Abuse.”8

The Dividend Tax Abuse Report signaled a Congressional rethinking as to whether dividend equivalent payments should enjoy a tax benefit over the physical holding of stocks.9 At the current time, there is legislation pending in the Senate that has already passed the House of Representatives,10 that would curtail this benefit beginning 90 days after enactment for most swaps and two years after enactment for certain other swaps.11 The Senate is likely to consider this legislation early this year.12

The IRS has been concerned that financial institutions were overly zealous in their marketing of equity swaps as tax-advantageous alternatives to the holding of physical stocks. It has always been true that the substance of a transaction documented as a swap may not comport with its form.13 In these cases, the IRS has asserted, sometimes successfully, that the transaction should not be taxed in accordance with the rules for notional principal contracts.14 On March 18, 2009, the Large and Mid-Scale Business (LMSB) division of the IRS announced that reporting and withholding on U.S. Source FDAP15 income was a “Tier I Issue.”16 Tier I Issues are those that “pose the highest compliance risk across multiple LMSB Industries and generally include large numbers of taxpayers, significant dollar risk, substantial compliance risk, or are high visibility.”17 In a separate document, the IRS stated more specifically that the compliance initiative represented by designating U.S. Source FDAP income as a Tier I Issue included the “potential use of total return swaps to minimize withholding tax.”18

Prior to the promulgation of the Swap Audit Guidelines (defined below), IRS financial institution tax auditors looked to Section 4.10.21.8.7.6 of the Internal Revenue Manual (IRM)19 to determine whether a financial institution had complied with its reporting and withholding obligations under swaps. This guidance was scant. Specifically, it told auditors to determine if the non-U.S. payee held the swap in connection with the conduct of a U.S. trade or business, in which case Form 1042-S reporting would be required by the financial institution and to look for “[i]ncome on NPC’s that are regarded as embedded interest or recharacterized as certain other payments under U.S. tax principles [that] might be subject to NRA withholding and reporting.”

On January 14, 2010, LMSB issued its “Industry Directive on Total Return Swaps (TRSs) Used to Avoid Dividend Withholding Tax” (the “Swap Audit Guidelines”).20 In addition to providing audit guidance to IRS field agents auditing U.S. financial institutions and U.S. branches of foreign financial institutions, the Swap Audit Guidelines contain six Information Document Requests (IDRs) for agents to use to solicit information from financial institutions that have equity swap operations. The new guidance is substantially more detailed than the IRM guidance. As a result, IRS audits of financial institutions undertaken in accordance with the Swap Audit Guidelines are likely to impose a significant compliance burden on affected companies.

The purpose of the Swap Audit Guidelines is to assist IRS agents in “uncovering and developing cases related to TRS transactions that may have been executed in order to avoid tax with respect to U.S. source dividend income” paid to non-U.S. persons. Since the Swap Audit Guidelines are directed at IRS auditors examining financial institutions, it seems fairly clear that the IRS intends to assert deficiencies against the financial institutions, and not directly against the non-U.S. persons. If the equity swaps constituted disguised agency relations, most likely akin to a broker-client relationship, the IRS has the right to pursue payment of the tax from the financial institutions inasmuch as the financial institutions would have been withholding agents who failed to withhold.21 The financial institutions could also be held liable for failure to properly report the amounts withheld, but these penalties (at $50 per return in the absence of intentional disregard) are modest in comparison to the potential liability for the tax itself.22

The Swap Audit Guidelines then posit four different transaction structures involving equity swaps. If an IRS agent uncovers one of these fact patterns, he is encouraged to “develop facts supporting a legal conclusion that the Foreign Person retained ownership of the reference securities.” Auditors are also advised to look for elements of the facts described in each of the fact patterns. In this way, the IRS can attack transactions that don’t neatly fit into the transactions that it has identified.

  1. Cross-In and Cross-Out Transactions

In a typical cross-in/cross-out transaction, the non-U.S. person sells its U.S. stock position to a U.S. financial institution (the “cross-in”) and enters into an equity swap with the same financial institution. The sale and initiation of the equity swap occur prior to a dividend record date.23 Following the dividend record date, the equity swap is terminated and the non-U.S. person repurchases the stock from the financial institution (the “cross-out”). The Swap Audit Guidelines state that “relatively few” transactions have been executed in this manner. Many seasoned tax professionals would have concerns that the substance of a transaction structured in this manner would be taxed as a disguised agency relationship.

Although the Swap Audit Guidelines are not entirely clear, it appears that the IRS is also concerned about equity swaps that do not entail actual cross-ins and cross-outs but in which ostensible market transactions contain mechanisms that result in cross-ins and cross-outs. For example, suppose the non-U.S. person executes a market sale of the stock at the inception of the swap. At the same time, the financial institution is in the market purchasing stock to hold as a hedge of its obligations under the swap. Notwithstanding the simultaneity of the purchase and sale, if volume in the stock is robust in comparison to the number of shares that are referenced in the swap, it would be coincidence, at best, if the non-U.S. person sold to the financial institution (or vice versa at swap termination).

The Swap Audit Guidelines state that swap pricing mechanisms that assist the parties in avoiding price risk between the holding of the stock and the swap can be viewed as evidence that “the parties are likely to be in the market together upon a cross.” These pricing mechanisms include referencing a single interdealer broker price, market on close (MOC), market on open (MOO) and volume weighted average price (VWAP). This mandate is clearly a case of “no good deed goes unpunished.” The IRS rationale is that each of the pricing mechanisms, if available for the stock purchase or sale, would enable the parties to have certainty as to their purchase and/or sale prices of the stock. Indeed, the IDR for these transactions asks for the identity of transactions in which the swap reference price “and the prices at which the U.S, equity security was sold or purchased in the cross-in or cross-out are the same prices or are based on the same prices, such as MOC or VWAP.” Accordingly, in the view of the IRS, if the equity swaps references these prices, there would not be any slippage in moving between the stock and the swap.

It is interesting to note that many financial institutions began using MOC, MOO and VWAP for swap initiation and termination pricing for the specific purpose of ensuring that there was economic risk inherent for their swap counterparties in moving from a physical stock position to a swap. Without these mechanisms, the non-U.S. person could simply have asked for swap pricing equal to the price at which it sold the stock and the financial institution would price the stock at swap termination at the price at which it disposed of its hedge. The IDR to be provided to financial institutions seeking to find cross-in/cross-out transactions asks whether pricing mechanisms that eliminated price risk were in place with respect to the equity swap. Prior the promulgation of the Swap Audit Guidelines, the author’s own view was that the use of MOC, MOO and VWAP swap pricing would not have mandated a “yes” answer to this question.24 It is much more difficult to obtain a particular price than it is to reference the price at which the parties actually executed purchases and sales.

In addition to pricing, the IDR included in the Swap Audit Guidelines asks about other factors that could indicate an agency relationship. Specifically, it asks (i) whether there was a written or oral agreement for the financial institution to return stock to the non-U.S. person at the swap termination, (ii) whether the non-U.S. person had the right to direct voting of any stock held by the financial institution as a hedge of the swap, (iii) if the financial institution did vote any shares of stock held as a hedge of the swap, were such votes independent of the counterparty’s instructions and (iv) whether there a written or oral agreement by the financial institution to hedge the swap in a particular way.

Again, interestingly, the Swap Audit Guidelines ask whether there was a written or oral agreement for the counterparty to bear the cost of any hedging by the financial institution under the swap. The answer here should always be, “Only if the trader was doing his job correctly.” This question misinterprets the role of financial institutions in the swaps markets. Financial institutions do not generally enter the swaps markets for the purpose of taking any risk other than counterparty risk. The institutions have a unique ability to execute and hedge risks. If the costs of hedging increase, this is a cost that is usually borne by the client, not the financial institution. Accordingly, if a financial institution is acting a dealer, it will price hedging into the swap and retain the ability to either terminate the swap if hedging costs increase or to pass along such costs to its clients.

  1. Cross-In/Interdealer Broker (IDB) Out

In this equity swap transaction variant, the non-U.S. person crosses in the stock that is the subject of the equity stock to the financial institution and repurchases identical stock from an unaffiliated IDB at the termination of the swap. The Swap Audit Guidelines direct auditors to develop facts showing the existence of a written or oral arrangement “with respect to the Foreign Person’s repurchase of the U.S. Equity Securities.” Specifically, this will occur when the financial institution sells to the IDB and the IDB then sells to the non-U.S. person at the same price except for a commission payable to the IDB. If IRS agents find the existence of these arrangements, agents are directed to determine if this represents a “pattern of dealing.” To develop these facts, the IDR for this type of transaction directs agents to find out whether (i) the financial institution received a very small fee, (ii) the U.S. financial institution paid a fee (or received a fee) from the IDB and (iii) there were any side agreements, again written or oral, with respect to the IDB returning stock to the non-U.S. person.

The most important acknowledgement by the IRS in its discussion of cross-in/IDB out equity swaps is the direction that if an agent does not find an arrangement in which the IDB was acting as the proverbial “fig leaf” over the cross-out, “the examination should be concluded.” In other words, this statement is an acknowledgement by the IRS that a one-way cross, without more, should not be viewed as a disguised agency relationship. This implicit determination comports with the position being advocated by most in-house financial institution tax departments that in the absence of a transfer and return of stock, no agency relationship should be considered to exist.

  1. Cross-In/Foreign Affiliate Out

The IRS apparently has determined that an equity swap transaction format that was developed to achieve optimal balance sheet and credit usage is a vehicle for transferring withholding tax risk beyond the reach of the IRS. In this variation of the equity swap transaction, the non-U.S. person enters into a swap with the non-U.S. affiliate of a U.S. financial institution. (In the overwhelming majority of cases, this is the London affiliate or branch of a U.S. bank.) The non-U.S. affiliate of the U.S. bank will then enter into a back-to-back swap with the U.S. operations. The U.S. financial institution will hedge its position by acquiring the stock that is referenced in the swap. The Equity Swap Guidelines posit that the non-U.S. person and the U.S. financial institution cross-in and cross-out.

The Equity Swap Guidelines, citing Treasury Regulation § 1.1441-7(a)(1), note that non-U.S. persons, as well as U.S. persons, can be treated as withholding agents. Implicit in the IRS’s description of this transaction variant is an assumption that financial institutions have executed equity swap transactions from outside of the United States with an intent to circumvent the rules that would apply to U.S. taxpayers and are ignoring the reach of the regulation. In the experience of the author, a great many financial institutions have their London affiliates or branches act as the counterparty for all equity derivative transactions. This execution format is undertaken to have a central booking location for client-facing transactions, and to obtain beneficial capital and balance sheet usage. The transactions are then backed-to-back to the United States for efficient hedge execution and to ensure that U.S.-based business is properly taxed in the U.S. Given the bent of the Swap Audit Guidelines, a number of U.S.-based financial institutions may be facing unwarranted U.S. tax scrutiny of their London operations.

  1. Fully Synthetic Transactions

In a fully synthetic equity swap transaction, the non-U.S. person does not own the stock referenced in the equity swap prior to the initiation of the swap and does not purchase the stock at the termination of the equity swap. The Swap Audit Guidelines, in bold type, state that these transactions comport with existing law and should not be pursued by auditing agents. Notwithstanding the force with which this conclusion is stated, the Swap Audit Guidelines advise auditing agents to pursue whether the fully synthetic equity swap transaction passes through other indices of ownership to the non-U.S. counterparty so that the swap might be recharacterized as a custodial arrangement. Among the factors listed are:

  1. Is the amount of stock referenced in the equity swap so large that the financial institution would be economically compelled to hold the stock as a hedge of its position under the swap?25
  2. Did the financial institution acquire the referenced stock as a hedge?26
  3. Did the equity swap itself, or a formal or unwritten arrangement between the non-U.S. person and the financial institution, pass voting rights on any stock held as a hedge of the financial institution’s swap position to the non-U.S. person?
  4. The IDR to be issued to financial institutions asks whether the non-U.S. person was required to post collateral equal to at least 50 percent of the initial value of the shares referenced in the equity swap.27

The Swap Audit Guidelines implicitly recognize that equity swaps over privately-held stock and securities fit within the definition of notional principal contracts and can be taxed as such.28 Although the Swap Audit Guidelines instruct IRS auditors to “examine any transaction where the Foreign Person entered into a TRS that references an equity security issued by a privately-held U.S. corporation,” they are directed only to pursue transactions described above referencing private securities. Specifically, the Swap Audit Guidelines advise that equity swaps over private securities should be challenged where the non-U.S. person maintains control with respect to the private securities. Conversely, it should be true that if the non-U.S. person does not maintain control over the referenced securities, that the transaction should be respected as a notional principal contract.

A number of financial institutions have been offering so-called “synthetic prime brokerage” platforms. In a synthetic prime brokerage transaction, the financial institution allows the non-U.S. person to access its trading operations through a computer and enter a position that it desires to have economic exposure with respect to. The agreement in place between the financial institution and the non-U.S. person specifically states that each position posted on the system by the non-U.S. person will be treated as a swap transaction. The Swap Audit Guidelines note that synthetic prime brokerage transactions do not pose any price risk to the financial institution. Although, in the author’s view, the taking of market risk is inconsistent with the role that financial institutions take in the equity derivative markets, the IRS’s position is understandable when the non-U.S. person is effectively executing the hedge transaction for the financial institution, on an essentially one-to-one (delta one) basis. This level of execution raises issues as to whether the transaction should be treated as a national principal contract for federal income tax purposes. The Swap Audit Guidance tells IRS agents to consider whether this absence of involvement by the financial institution causes the non-U.S. person to be treated as the owner of the hedge. In fact, the Swap Audit Guideline tell auditing agents to consider subpoenaing prime brokerage account statements for non-U.S. persons who have used this technique.

In summary, the Swap Audit Guidelines evidence a sophisticated approach to when swaps should be taxed as custodial arrangements. Although the IRS does have additional work to do, it clearly has learned a lot about the over-the-counter securities business through the audits that it has conducted and through industry personnel who have joined the IRS in recent years. The Swap Audit Guidelines, however, are likely to substantially increase the duration and complexity of financial product audits.