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Window of opportunity for tax-exempt repatriation of substitute payments in cross border securities lending transactions.

The IRS has issued proposed regulations under Secs. 861, 871, 881, 894 and 1441 on the source, character and income tax treaty treatment of substitute interest and dividend payments made pursuant to cross-border securities lending transactions. Securities lenders from countries that have treaties with the United States containing a provision to exempt "other income" from source country taxation (most notably, the United Kingdom) may have small window in which to avoid U.S. withholding tax on substitute payments made before the proposed regulations are finalized. This opportunity may be most valuable to pension trusts or other exempt entities in another treat country.

Sec. 1058 provides, under certain conditions, for nonrecognition of gain or loss by the owner of securities on a transfer of securities to a borrower when identical securities will be returned. One condition requires the borrower to make "substitute payments" to the lender equal to all interest, dividends and other distributions that the owner of the securities would be entitled to receive during the lending period. Under Prop. Regs. Sec. 1.1058-1(d) (issued in 1983), the "substitute payments" are treated by the lender as a fee for the temporary use of property. Until the new proposed regulations were issued, there had been no guidance on the borrower's treatment of the payments or their characterization for U.S. withholding tax purposes.

Generally, payments to non- U.S. recipients of interest, dividend and other fixed and determinable annual or periodical income are subject to a 30% U.S. withholding tax unless the payment is effectively connected to the payee's U.S. trade or business. The tax rate may be reduced by a tax treaty between the payee's country of residence and the United States. The characterization of payments is important; different treaty tax rates apply to different types of payments.

U.S. tax authorities have, on at least two occasions, refrained from providing specific guidance on the source and character of substitute payments. In IRS Letter Ruling 8822060, a cross-border Sec. 1058 securities lending transaction required the borrower to pay the lender two separate amounts: (1) a fee in consideration for the loan and (2) an amount equal to all distributions in respect of loaned securities (i.e., substitute payments). The amount of the fee payable (the first item) varied depending on market conditions and the securities involved. For example, the more scarce the supply of securities available for borrowing, the higher the fee the lender would demand.

The Service characterized the first item received under the arrangement as the lender's business profits; such profits were exempted by treaty from U.S. taxation because they were not attributable to a U.S. place of business maintained by the lender. In an action that appears to be backing away from the proposed regulation position, the IRS declined to express an opinion on the tax treatment of the substitute payments, including their source and character under the treaty and the Code.

(The Service later announced that determination letters would not ordinarily be issued on the source and character of substitute payments (Rev. Proc. 90-6).)

Taxpayers have analogized the source and character of substitute payments with other authorities available, and have argued that substitute payments should be treated as rental profits, as business profits or as other income for U.S. withholding tax purposes, to avoid U.S. withholding tax imposed on cross-border transactions.

The author understands that the IRS believes only an analogy to other income can be validly asserted. There is authority to the effect that payments made by a borrower of a stock or bond as dividend or interest equivalents to the lender are not treated as dividend or interest; see Rev. Ruls. 60-177 and 80-135. Although the immediate result of these rulings was to deny the recipients certain tax benefits available to the owners of the underlying stock, bond or similar securities (such as a dividends-received deduction), they are support for the position that substitute payments are really income other than dividends and interest.

"Other income" is accorded special treatment in the source country under a handful of bilateral income tax treaties, including U.S. treaties with the United Kingdom, Hungary, Italy and Malta. For example, Article 22 of the U.S.-U.K. income tax treaty provides that items of income received by a resident of either country that are not dealt with in other articles of the treaty are taxable only in the taxpayer's home country. In other words, such income would be exempt from tax in the source country.

Residents of the United Kingdom that are lenders in a cross-border securities lending transaction could therefore use Article 22 to convert U.S.-source dividend income that is otherwise subject to a 15% withholding tax into other income exempt from U.S. tax. This situation is apparently viewed as abusive by the Service.

This unintended benefit, however, will no longer be available once the new proposed regulations become final. These regulations stipulate that, for purposes of determining the source and character of cross-border substitute payments, the payment will be treated as interest or dividend income received with respect to the transferred security. (The new proposed regulations would not change the existing rule that substitute dividend payments are not eligible for the tax benefits that would be available to the owner of the securities.)

These regulations are proposed to be effective 30 days after they are published in final form in the Federal Register. The treatment of substitute payments prior to the effective date of these regulations will be determined under all the facts and circumstances of a particular situation. This raises the question of whether, under the appropriate circumstances, taxpayers can avoid U.S. taxation on substitute payments if they are residents of a country whose bilateral tax treaty with the U.S. exempts other income.
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Author:Yu, Angela
Publication:The Tax Adviser
Date:Jun 1, 1992
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