On January 14, the Internal Revenue Service issued swap audit guidelines (Guidelines) in an industry director directive to its field agents identifying the factors that the agents should apply in determining when dividend-equivalent payments made to a non-U.S. person under a total return swap (TRS) should be subject to U.S. withholding tax. The general rule is that payments to a non-U.S. person under a “notional principal contract” (which would include most TRSs), including “dividend equivalent payments,” are not subject to U.S. withholding tax, while payments of dividends to such non-U.S. persons are subject to withholding at a 30% rate (unless the rate has been reduced by bilateral treaty). The IRS previously announced that it was concerned TRSs were being used improperly to circumvent U.S. withholding tax on dividends paid to non-U.S. persons.
The Guidelines confirm that, in general, no withholding tax is imposed on payments, including “dividend equivalent payments,” made under a qualifying TRS to a non-U.S. person, where such person did not own the underlying stock before entering into the TRS and does not acquire the underlying stock after terminating the TRS. The Guidelines, however, specify the following transaction fact patterns as requiring additional audit scrutiny and potential imposition of withholding tax:
- a non-U.S. person sells its stock position to a U.S. financial institution, enters into a TRS with that financial institution indexed to such stock position, and then re-acquires the stock from the U.S. financial institution after terminating the TRS (a “cross-in/cross-out transaction”);
- an indirect cross-in/cross-out transaction where a non-U.S. affiliate of a U.S. financial institution acts as an intermediary between the non-U.S. customer and the U.S. financial institution by entering into a TRS with the non-U.S. customer and then entering into a mirror TRS with the U.S. financial institution, the U.S. financial institution purchases the underlying stock to hedge the exposure under the TRS, and the non-U.S. customer re-acquires the stock from the U.S. financial institution or its non-U.S. affiliate; and
- an indirect cross-in/cross-out transaction where a non-U.S customer re-acquires the stock underlying a TRS from an independent third-party broker-dealer that is not affiliated with the U.S. financial institution counterparty on the TRS after termination of the TRS and the surrounding facts indicate that there was a side agreement between the independent broker-dealer and the non-U.S. customer or the U.S. financial institution arranging such purchase.
The Guidelines also identified TRSs on equity of privately held U.S. corporations and TRSs entered into with a U.S. financial institution if the non-U.S. customer is using an automated trading program offered by the U.S. financial institution as transactions warranting additional audit scrutiny. They further direct field agents to seek the assistance of industry specialists within the IRS in the case of TRSs that reference a basket of U.S. stocks, but give no guidance as to the specific factors that would cause payments under such equity basket swaps to be subject to withholding tax.
To read the industry director directive click here.