Notice 97-661 created an opportunity for non-United States financial institutions to participate in the securities lending markets for stocks of U.S. corporations without suffering burdensome U.S. federal withholding taxes. Congress perceived, however, that the withholding tax relief provided by Notice 97-66 created an opportunity for an avoidance of such withholding taxes.2 The first shoe fell in March 2010, when Congress repealed Notice 97-66, effective for substitute dividend payments made on or after September 14, 2010.3 On May 20, 2010, the other shoe fell when the Internal Revenue Service (the “IRS”) released Notice 2010-46. Notice 2010-46 substantially restricts the application of Notice 97-66 effective immediately, that is, for substitute dividend payments made on or after May 20, 2010. Notice 2010-46 also provides relief from cascading withholding in limited circumstances. This White Paper describes the new Notice and its effect on both pre- and post-September 14, 2010 securities lending transactions.  

  1. Background

The United States imposes a flat 30% withholding tax on U.S.-source dividend payments paid to a foreign person not in connection with the conduct of a U.S. trade or business by such foreign person.4 The withholding tax applies whether the dividend is paid in cash or property. Dividends paid by U.S. corporations generally are treated as U.S.-source income and, thus, are subject to the U.S. withholding tax.5 Substitute dividend payments made by a stock borrower with respect to stock of a U.S. corporation in a stock lending transaction follow the source rule for the stock itself. Accordingly, the substitute dividend payments are considered U.S.- source income.6 A substitute dividend payment is a payment made to a lender of a security in a securities lending transaction or a sale-repurchase transaction of an amount equivalent to a dividend distribution which the owner of the transferred security is entitled to receive during the term of the transaction.7 The statutory withholding tax rate of 30% may be reduced by the terms of an applicable income tax treaty.8

Generally, any person that meets the definition of a withholding agent is required to withhold the applicable withholding tax and deposit it with the U.S. Treasury.9 The term “withholding agent” means any person, whether U.S. or foreign, that has the control, receipt, custody, disposal, or payment of an item of income of a foreign person subject to withholding (e.g., U.S. source dividends).10 The applicable regulations do not require that the withholding agent otherwise be subject to U.S. jurisdiction. Although it can be argued that the regulations are overbroad and attempt to impose withholding obligations on persons without U.S. contacts, we do not know of any instance in which a foreign person has challenged the withholding rules as being an extraterritorial assertion of taxing authority.

Accordingly, foreign stock borrowers who borrow U.S. stocks from non-U.S. stock lenders are treated as withholding agents.

In Notice 97-66, the IRS announced that it intended to propose new regulations to address foreign-to-foreign withholding with respect to substitute dividend payments. Notice 97-66 provided, however, that until such regulations were issued, the amount of U.S. withholding tax to be imposed with respect to a foreign-to-foreign substitute dividend payment would be (x) the amount of the underlying dividend multiplied by (y) a rate equal to (i) the excess of the rate of U.S. withholding tax that would be applicable to U.S.-source dividends paid by a U.S. person directly to the receipient of the substitute payment over (ii) the rate of U.S. withholding tax that would be applicable to U.S. source dividends paid by a U.S. person directly to the payor of the substitute payment.

Without a rule similar to that contained in Notice 97-66, foreign-to-foreign securities lending transactions could result in overwithholding:

Click here to view the diagram.

The Notice 97-66 formula can be easily illustrated by an example.11 Assume during the term of a securities loan from a non-tax treaty eligible foreign stock lender to another non-tax treaty eligible stock borrower, the borrowed stock pays a US$1.00 dividend. Assuming that 1,000 shares are loaned and the borrower is required to pass-through the full amount of the dividend to its lender, the borrower would make a $1,000 substitute dividend payment. The rate of withholding tax that would be imposed if borrower received the dividend directly would be 30%. The withholding tax rate on a U.S.-source dividend paid directly to the lender also would be 30%. Accordingly, the withholding tax rate on the foreign-to-foreign substitute dividend payment should be zero:

Click here to view the example.

As a result of the formula set forth in the Notice, substitute dividend payments with respect to foreign-toforeign securities loans that do not reduce the overall U.S. withholding tax generally were not be subject to withholding tax. For example, no withholding tax was required in situations where stock lending transactions were entered into between residents of the same country,12 or between resident of countries that were subject to equivalent U.S. withholding rates.13

In September 2008, the Senate Permanent Subcommittee on Investigations issued a scathing report on securities lending transactions (and equity swaps) under the title, “Dividend Tax Abuse.”14 The Dividend Tax Abuse Report signaled a Congressional rethinking as to whether Notice 97-66 had gone too far in providing relief from cascading withholding taxes. Congress was concerned that Notice 97-66 did not simply eliminate overwithholding, it provided an opportunity to completely ameliorate any withholding taxes.

On March 18, 2010, U.S. President Obama signed P.L. 111-137, the Hiring Incentives to Restore Employment Act (the “HIRE Act”), into law. Section 541 of the HIRE Act added a new provision to the Code, denominated as Code § 871(l). Code § 871(l) generally is effective “on or after the date that is 180 days after the date of enactment of this Act.”15 This date is September 14, 2010.

Code § 871(l) has the effect of repealing the rules contained in Notice 97-66. Specifically, Code § 871(l)(1) provides the dividend equivalents are treated as dividends sourced within the United States. Code § 871(l)(2) provides that a dividend equivalent includes any substitute dividend payment made pursuant to a salerepurchase agreement or a securities loan involving U.S. stock. The legislative history accompanying the enactment of the new rule states that dividend equivalents include direct or indirect payments that are contingent upon or determined by reference to the payment of a dividend on a U.S. stock.16 Although one would have hoped for a more direct statement that Code § 871(l)(1) has supplanted the “30-30” and “15-15” rules contained in Notice 97-66, it is well-recognized that this is the intended effect of the new legislation. Code § 871(l)(6) grants authority to the IRS to prevent overwithholding “but only to the extent that the taxpayer can establish that such tax has been paid with respect to another dividend equivalent in such chain, or is not otherwise due, or as the Secretary determines is appropriate to address the role of financial intermediaries in such chain.”

  1. Notice 2010-46

Notice 2010-46 circumscribes the ability of stock borrowers and lenders to rely on Notice 97-66 by providing that the relief afforded by Notice 97-66 is limited to persons who have no reason to know that a securities lending transaction avoids all withholding taxes. Notice 2010-46 revokes Notice 97-66 for substitute dividend payments made on or after September 14, 2010. Last, the new Notice provides rules for when cascading withholding taxes can be avoided. The anti-cascading rules provided in the Notice are effective until final regulations are issued. Notice 2010-46 states that final regulations are expected to be made applicable for transactions entered into on or after January 1, 2012. The anti-cascading rules in Notice 2010-46 should have the effect of reducing the withholding tax rate to the highest rate applicable to a person in the chain of stock loans.  

  1. Limitation on the Ability of Persons to Rely on Notice 97-66 Prior to September 14, 2010

Notice 2010-46 begins by modifying the application of Notice 97-66 for the period between May 20, 2010 and September 14, 2010. It states that a foreign securities borrower (or lender) may not rely on Notice 97-66 if it “knows or has reason to know that a securities lending transaction, or series of such transactions, has a principal purpose of reducing or eliminating the amount of gross-basis tax that would have been due in the absence of such transaction or transactions.” It then provides an example in which a stock borrower would be presumed to have knowledge that a stock lending transactions has such a principal purpose:  

  1. The non-U.S. borrower borrows shares of a domestic corporation from another non-U.S. person in a securities lending transaction after a dividend declaration;
  2. The borrower sells that stock to a related U.S. person before the ex-dividend date; and
  3. The borrower enters into a total return swap agreement with that related person in order to hedge its risk under the stock loan.  

It seems fairly clear that if the securities borrower is net short the borrowed stock, the prohibited purpose should not be present. In other words, if the stock borrower sells the borrowed shares short over a securities exchange and retains the short position, the transaction should not be considered to have a principal purpose of avoiding withholding taxes. It is unclear, however, whether the IRS intends to reach an arm’s length sale of borrowed securities by the securities borrower, coupled with a third party equity swap in which the borrower becomes the long counterparty. The result could depend upon whether (i) the transactions are undertaken as part of a regular business that occurs around dividend dates, (ii) the hedge was put on after the borrower sold the stock or simultaneous with the stock sale and (iii) the shares were sold in a negotiated transaction or anonymously over a securities exchange.

The Notice then goes on to saber-rattle by stating that no inference is intended as to whether any transaction entered into prior to May 20, 2010 is eligible for Notice 97-66 relief and that the IRS could challenge transactions that is finds abusive under existing law.

  1. New Anti-Cascading (Anti-Overwithholding) Rules

The anti-cascading rules effectively break down into three new regimes. First, in a manner similar to the new foreign account compliance section of the HIRE Act,17 dealers who enter into agreements with the IRS in which they promise to ensure proper withholding are exempted from withholding. Second, parties to securities lending transactions that obtain certifications that there has been prior withholding in the chain (referred as a “series”) are exempted from withholding. Last, in circumstances where the amount passed through reflects proper withholding, no further withholding is required.

1. Foreign Dealer-to- Foreign Dealer Securities Loans

Dealer-to-dealer securities lending transactions are exempted from withholding provided that the stock lender assumes responsibility and liability for proper withholding or the payment of tax. Specifically, the dealer must agree to withhold if it is obligated to make offsetting substitute dividend payments or, if it is not obligated to make offsetting substitute dividend payments, to remit the tax directly to the IRS. These rules will apply only to “Qualified Securities Lenders.”

A Qualified Securities Lender is a foreign financial institution only if it satisfies all of the following conditions:

  1. It is a bank, custodian, broker-dealer, or clearing organization that is subject to regulatory supervision by a governmental authority in the jurisdiction in which it was created or organized, and is regularly engaged in a trade or business that includes the borrowing of securities of domestic corporations (as defined in Code § 7701(a)(4)) from, and lending of securities of domestic corporations to, its unrelated customers;
  2. It is (i) subject to audit by the IRS under Code § 7602 or (ii) is subject to audit by an external auditor and is a Qualified Intermediary (a “QI”) that appropriately amends its QI agreement with the IRS to report, withhold, deposit, and pay U.S. tax on securities lending transactions; and
  3. It files an annual statement on an IRS Form (not yet released) certifying that it satisfies the conditions necessary to be a Qualified Securities Lender.  

Parties to securities lending transactions must receive certifications from each other (at least annually) that their counterparties are Qualified Securities Lenders in order to take advantage of these rules. Notice 2010-46 provides that all persons who intend to treat themselves as Qualified Securities Lenders must identify themselves to the IRS before the end of 2010. If a person is considered to have structured transactions to avoid proper withholding, it will be prevented from being treated as a Qualified Securities Lender for five (5) years from such time. Qualified Securities Lenders may use any reasonable method to determine from whom they have borrowed securities, but any method must be consistently applied.

2. Documentation Rules for Persons Other than Qualified Securities Lenders

If party to a securities lending transaction is not a Qualified Securities Lender, the IRS follows the mandate provided by Code § 871(l)(6) by providing relief from over-withholding “with a document-based system.” Under the document-based system, the amount that a securities borrower must withhold is equal to the excess of the amount of withholding that the lender would be subject to if it held the stock directly minus the amount that was actually withheld on a prior dividend or substitute dividend within the same series. The IRS will not provide refunds for withholding if a prior person in the chain (series) bore a higher withholding tax. For example, assume that a taxpayer that is subject to a 15% withholding tax lends stock to a person subject to 30% withholding tax. The borrower holds the stock over the dividend record date and the issuer (or its agent) withholds 30% of the amount of the dividend. The borrower then makes a substitute dividend payment to the stock lender. Although the stock borrower is not required to make any additional withholding on the substitute dividend payment to the lender, no refund is available to the parties.  

Notice 2010-46 prescribes a four-party documentation substantiation test to determine if there has been prior withholding in a series:

  1. The lender receives a substitute dividend net of U.S. withholding taxes;
  2. The lender receives a written statement from the immediately prior withholding agent setting out the amount of such taxes (proof that the stock has been on-sold is not evidence of prior withholding);
  3. The borrower identifies the person who withheld such tax and the recipient of the payment against which such tax was withheld; and
  4. The lender does not know or have reason to know that the written statement is unreliable.  

The fourth prong is reinforced by an anti-abuse rule. If a withholding agent or Qualified Securities Lender “knows or has reason to know” that a securities lending transaction has a principal purpose of reducing or eliminating withholding tax, it must withhold notwithstanding compliance with the documentation requirements.

Taxpayers who rely on the document-based system must report that they relied on prior withholding on an IRS Form 1042-S. The reporting must show the maximum amount that would have been subject to withholding and the amount of the prior credit.

3. The Net Payment (Presumption) Rules

Lastly, Notice 2010-46 provides a set of rules under which a party to a securities lending transaction may presume that there has been sufficient prior withholding in a transaction. In order to take advantage of the presumption three conditions must be met:

  1. The withholding agent receives a substitute dividend or dividend payment with respect to identical securities that reflects a reduction for withholding of U.S. gross-basis tax;
  2. The withholding agent does not know or have reason to know that tax was not withheld and deposited or paid. For this purpose, a withholding agent has a reason to know that tax was not withheld if, for example, the amount of any lending fee or similar fee is increased directly or indirectly, in whole or in part, by the difference between the gross amount of the substitute dividend and the net amount received; and
  3. The withholding agent is a person subject to audit under Code § 7602, or in the case of a QI, by an external auditor.

As is the case under the other rules, no refund is available to a person because a prior borrower in the chain was subject to a higher rate of withholding tax. In addition, taxpayers may not count withholding against one set of transactions against another.

  1. Reporting and Tax Remittance Relief for HIRE Act Transactions

The Notice grants parties to securities lending transactions an automatic 6-month extension for Form 1042-S reporting for post-September 14, 2010 securities lending transactions in order to provide securities dealers with adequate time to implement the new rules. If, however, a person provides information to its counterparties prior to such time, the extension is cut short as of such date. In addition, the time for making deposits of amounts withheld for post-September 13, 2010 (and pre-January 1, 2011) in securities lending transactions has been extended to January 31, 2011.  

  1. Requests for Comments

Notwithstanding the comprehensive nature of Notice 2010-46, the IRS has designated six areas for comments:

  1. The definition of a Qualified Securities Lender.
  2. The treatment of substitute dividends paid to a Qualified Securities Lender where that entity holds the relevant position in a proprietary account.
  3. Whether additional rules are required to address abusive securities lending transactions;
  4. The treatment of substitute dividends paid with respect to securities transferred from a commingled account containing securities held by a Qualified Securities Lender in its proprietary capacity and other securities held in connection with transactions for customers.
  5. Whether a Qualified Intermediary with Qualified Securities Lender status (a “Lender QI”) should be required to provide the withholding rate pool information of its customers to another Qualified Intermediary (a “Borrower QI”) that has borrowed securities in a securities lending transaction and whether a Borrower QI should be required to withhold and carry out information reporting on a substitute dividend payment made to a Lender QI based upon the withholding information provided by a Lender QI with respect to its customers.
  6. The definition of a series of securities lending transactions, and how related securities loans in a series should be identified, including appropriate methods pursuant to which a Qualified Securities Lender may determine which securities within a pool of fungible securities are attributable to particular securities lending transactions.