Character and source of substitute payments on cross-border securities lending and sale-repurchase transactions.

On Oct. 6, 1997, the IRS issued final regulations on the source (and in some cases, the character) of substitute payments received in body cross-border securities lending and sale-repurchase transactions. In a typical sale-repurchase transaction, the owner of securities (stocks or bonds) purports to sell them to an unrelated party (such as a bank), typically in exchange for cash. The original owner is obligated to pay the bank interest and to buy back those securities (or substantially identical securities) from the bank at the same price as the original sale. Although the bank takes legal title to the securities, the transaction is treated as a cash loan to the original owner by the bank collateralized by the securities. While it holds the securities, the bank must pay the original owner a "substitute payment" equal to dividends or interest it receives on those securities.

In a securities lending transaction (defined in Sec. 1058), a securities owner, such as a financial institution, will transfer securities (stocks or bonds) to a transferee, such as a securities dealer. The transferee is required at a future date to return to the owner identical securities and make "substitute payments" to the owner equal to all dividends and interest received in the interim. The final regulations make the following prospective changes:

1. A substitute interest or dividend payment received by the security's original owner will be treated for all purposes of the Code as having the same source as the actual dividends or interest paid on that security, regardless of whether the recipient of the substitute payment is a foreign or U.S. person. Thus, for example, a substitute payment received on a foreign security by a U.S. person would be treated as foreign-source income for foreign tax credit purposes.

2. When received only by a foreign person, the regulations characterize a substitute interest or dividend payment as an actual interest or dividend payment for withholding tax withholding under Secs. 871(a) and 881(a), for purposes of claiming a reduced rate of withholding tax under a treaty, and for purposes of determining whether foreign-source substitute payments are effectively connected with a U.S. trade or business. This transparency rule has the following consequences:

a. A substitute interest payment will qualify for the portfolio interest exemption from withholding if the foreign recipient otherwise satisfies the conditions for that exemption.

b. A substitute interest or dividend payment made to a foreign person in a securities lending transaction will no longer be treated as a fee for the temporary use of property; see Prop. Regs. Sec. 1.1058-1(d). Thus, U.S. withholding tax on such a payment made to a foreign person in a securities lending or a sale-repurchase transaction will now be governed by the interest or dividend articles of the recipient's treaty country of residence. This may cause a higher or lower U.S. withholding tax to be imposed on this payment under a treaty. For U.S. clients making these payments or foreign clients receiving these payments, the tax consequences should be reviewed immediately.