The Internal Revenue Service continues its scrutiny of the favorable tax treatment currently afforded to hedge funds and private equity firms. In recent months, Congress has responded to the IRS’s concern that hedge funds and private equity firms – and their managers – are paying tax at lower rates than corporations and most individuals. First, House Democrats introduced bills that would impose corporate-level tax on publicly traded partnerships (PTPs) that derive income from investment adviser or asset management services; under current law, certain PTPs with predominantly passive-type income are taxed only once, at the partner level. Congress is also concerned that the managers of hedge funds and private equity firms are able to receive their compensation through partnership carried interests, thereby paying tax at the capital gains rate of 15 percent, rather than the maximum ordinary rate of 35 percent.

The IRS has now turned its attention to the actual investment and hedging techniques used by foreign hedge funds or U.S. hedge funds with offshore operations. One area in which the Service has focused involves publicly traded dividend-paying U.S. stocks. Generally, dividends paid on these stocks are considered to come from sources within the United States. Such dividends, and most other U.S.-source periodic payments (but not foreign-source payments) that are paid to foreign investors are generally subject to a 30 percent gross basis withholding tax. As discussed below, however, certain derivative products may avoid this 30 percent withholding tax by avoiding the production of U.S. source income. As reported by The Wall Street Journal,1 the IRS has issued information document requests to a number of investment banks that are believed to have entered into these derivative products with their hedge fund clients.

Tax Treatment of Total Return Swaps

The IRS is apparently focusing on the use of an equity derivative product called the total return swap. In a classic total return swap, one party (investment bank B) agrees to pay the foreign counterparty (hedge fund H) an amount equal to the dividends paid on specified shares of publicly traded stock for a specified duration. B also pays to H the appreciation in fair market value of the shares at the close of the trade. In turn, H agrees to pay amounts to B at either a fixed or variable rate on the value of the stock determined on the date B and H enter into the contract, plus the amount of any decline in the value of the stock. In effect, H has replicated the economic equivalent of a synthetic, fully-leveraged position in the underlying equity.

Why would a foreign investor enter into a total return swap? Increased leverage is one reason; another reason relates to the tax rule for sourcing income from total return swaps. As noted above, only U.S. source income is subject to the 30 percent withholding tax. Under the Treasury regulations, a classic total return swap based on publicly traded stock is a notional principal contract (NPC). The Treasury regulations source income from NPCs to the residence of the recipient of the income (e.g., H). Because H is a resident of a foreign country, H would not be liable for the 30 percent gross withholding tax imposed on U.S. source dividends and similar payments.

Variations on a Theme

While the source rule for NPCs clearly applies to the classic total return swap described above, there are factual variations on the basic equity swap that may bring other rules into play. In one variation, H may own the stock prior to entering into the equity swap and may sell it to B upon execution of the swap. Alternatively, H and B may enter into the equity swap as described above, and H may buy the shares from B at the conclusion of the swap. As a third alternative, H may both sell the stock to B at the beginning of the swap and purchase the stock at the end of the swap.

In cases where H never owns the stock, or where H either sold it and did not repurchase it or acquired it at the conclusion of the swap without previously having owned it, the Service would be unlikely to challenge the taxpayer’s claimed exemption from the 30 percent tax. In the case where H sells the stock to B and repurchases it from B at the conclusion of the swap, however, the Service could assert under tax common law that the equity swap should be ignored and that H should be treated as owning the underlying stock throughout the term of the swap. Alternatively, the Service could assert that, even if H has sold the stock, such sale was pursuant to a sale-repurchase transaction within the meaning of certain Treasury regulations. Under those Treasury regulations, a dividend equivalent payment received by the seller under a sale-repurchase transaction is sourced the same way the dividend on the underlying stock would be sourced. Because the dividend here would have a U.S. source, if the Service prevailed on either of these two arguments, H would be ensnared by the 30 percent gross withholding tax.

Looking Forward

The Treasury and the IRS are well aware of the anomaly created by the disparate treatment of classic total return swaps, on the one hand, and economically similar sale-repurchase transactions, on the other hand. We understand that government officials are actively considering whether the sourcing rules for NPCs should be changed, or other steps taken, in order to eliminate the disparity. Interested investors should closely monitor this area of the law.