Friday, June 3, 2011

Good News for Foreign Investors in U.S. Treasuries: Favorable Rules for Sourcing Fails Charge Income Adopted

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With the holiday season in full swing and a gush of last-minute Congressional activity, one would not be remiss for having overlooked the adoption of T.D. 9508 (75 Fed. Reg.76262 (12/8/10)). However, the temporary/proposed rules represent welcome news for foreign holders of U.S. Treasuries. More specifically, foreign investors in the secondary market for Treasury securities can breathe a collective sigh of relief now that the IRS has decided to apply a residency test for sourcing "fails charges." This basically means that these payments will be characterized as foreign-source income and thereby avoid the 30% U.S. gross-basis withholding tax imposed on certain categories of non-effectively connected U.S.-source income, namely under the catch-all rubric of fixed or determinable annual or periodical (FDAP) income.

The equivalent of a late fee in the world of securities trading, a "fails charge" stems from the failure to "settle" (i.e., deliver) Treasury securities by the scheduled date of a transaction. The penalty accrues daily at a variable rate of 0% to 3% per annum of the invoice price of a transaction, with the rate fluctuating in inverse to the target federal funds rate, and is collected according to a monthly claims process. Various transactions are affected by the practice including cash market sales, options, loans, and repurchase agreements.

The voluntary practice was devised by the New York Fed-sponsored Treasury Market Practice Group (TMPG), in the wake of the mid-2008 collapse of Lehman Brothers, which had threatened the all-important perception of the Treasury market as an investor safe haven. The mechanism is thus designed to thwart episodes of severe settlement failures triggered by a plunge in short-term market interest rates, which in turn offsets the economic cost to short sellers to timely deliver securities. By imposing a potentially higher cost for financing a short position, the underpinning logic is that sellers will be more inclined to effect a settlement or complete a purchase.

Since its adoption in May 2009, the practice has been almost universally adopted by market participants. And although spikes in settlement fails continue to crop up and fails due to technical glitches are not uncommon, the convention has, by and large, proven to be a success. According to the New York Fed, over the January to April 2009 period average daily settlement fails amounted to roughly $14.4 billion, followed by a decline to $4.2 billion from May 2009 to July 2010. Data from the Depository Trust and Clearing Corp. for the rest of 2010 confirms this trend.

In the preamble to T.D. 9508, the IRS attributed the decision to apply a residency test in this instance due to a need for consistent treatment in view of the difficulty in identifying the responsible party for withholding U.S. taxes in certain transactions. Undoubtedly U.S. traders were relieved to learn that they generally will not have any withholding obligations in this respect.

Be that as it may, however, the tax treatment of fails charges of course takes on added significance given the current fiscal environment and the fact that foreign/international ownership of U.S. Treasuries is second only to the U.S. government itself. This is to say that U.S. creditors presumably are among the primary recipients of fails charges. Thus, viewed in this context, the issuance of T.D. 9508 is also important because by exempting the fails charge income of foreign parties from the 30% flat tax on FDAP income, the rules likely will provide a timely boost to cross-border investment in and lending of Treasury securities.

Furthermore, it bears noting that additional exceptions to FDAP income of this type may be on the horizon. In the preamble the IRS raises this possibility by expressing a willingness to consider sourcing fails charges paid in relation to other agency securities under the new rules, should a related trading practice be endorsed by the TMPG (or a federal agency) and become widely adopted in the marketplace. In particular, the IRS states that its stance extends to the massive and troubled mortgage-backed securities market. This process may, in fact, be already underway, since, for its part, the TMPG announced back in March that it was expanding its scope to cover trading and settlement in agency debt and agency mortgage-backed securities.

For a detailed discussion of the T.D. 9508, see T.M. 915: Payments Directed Outside the United States—Withholding and Reporting Provisions Under Chapters 3 and 4.

Tome Tanevski, U.S. International Tax Law Editor

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