On January 14, 2010, the IRS issued an industry directive (the “Directive”) to its field examiners providing guidance on examining total return swaps that may have been executed in order to avoid tax with respect to U.S. source dividends paid to foreign persons.
Under current law, generally, the source of payments on swaps that qualify as notional principal contracts is the recipient’s country of residence. Accordingly, payments on swaps to foreign persons generally are treated as foreign source payments not subject to U.S. withholding tax.
In September 2008, the Senate Permanent Subcommittee on Investigations released a report on the use of equity swaps by foreign persons to avoid withholding tax on U.S. source dividends. The IRS also has identified withholding tax compliance as a “Tier 1” issue (i.e., an issue that has been designated as a top priority for IRS auditors). Pending legislative proposals would change, by statute, the sourcing of payments on total return swaps over U.S. equities as U.S. source income (and therefore, clearly subject them to U.S. withholding tax). Because these proposals are only pending, the IRS is continuing to audit existing transactions under current law.
The Directive provides guidance to recharacterize an equity swap between a U.S. financial institution and a foreign investor in order to treat the foreign investor as owning the relevant underlying equities, thereby exposing the foreign investor to dividend withholding tax liability.
The Directive focuses on four types of transactions:
- Cross-In/Cross-Out: The first situation involves a foreign person who owns a U.S. equity security and transfers that U.S. equity security to a U.S. financial institution while, at the same time, entering into a total return swap with the financial institution that references the same security (a “cross-in”). After the dividend record date, the foreign person terminates the swap and, at the same time, reacquires the security from the U.S. financial institution (a “cross-out”).
- Cross-In/Inter-Dealer Broker Out: The second situation involves facts that are the same as the first, except that when the foreign person terminates the swap, it reacquires the security from a third party that is not an affiliate of the financial institution. In one variation, the unaffiliated third party is an inter-broker dealer.
- Cross-In/Foreign Affiliate Out: The third situation involves facts that are the same as the first, except that the foreign person enters into the swap with a foreign affiliate of the U.S. financial institution, and the foreign affiliate enters into a back-to-back swap with the U.S. financial institution.
- Fully Synthetic: The fourth situation involves facts that are the same as the first, except that the foreign person has never owned the U.S. security referenced by the swap, the U.S. financial institution hedges its risk under the swap, and the foreign person does not purchase the referenced security when it terminates the swap.
The Directive instructs auditors to pursue examinations of total return swaps with facts similar to Situations 1 through 3. However, absent additional exceptional facts, auditors are instructed not to pursue total return swaps similar to Situation 4.
The Directive also identifies two circumstances which appear to be of interest to the IRS: (i) swaps over privately held U.S. equities; and (ii) swaps executed using an “automated trading program” offered by a U.S. financial institution.