Stock Lending Transactions and U.S. Withholding Tax

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By Philip D. Morrison, Esq.  

Deloitte Tax LLP, Washington, DC

About 20 years ago, the IRS and Treasury started paying attention to the avoidance of U.S. withholding tax on dividends via lending transactions.1 The classic transaction in those days was quite simple: an owner of U.S. stock who could not obtain an exemption from withholding tax under a treaty would "loan" his stock to a U.S. or foreign person over a dividend payment date in exchange for a payment that would replicate the dividend (and also get a payment to reflect the time value of money on the value of the "loaned" stock). If the borrower was the beneficial owner of the dividend payment and was a U.S. person, no withholding tax would be due on the dividend. And the substitute dividend payment would not be characterized as a dividend under the Code2 or treaties.3

Although U.S. guidance did not provide a specific characterization of substitute dividend payments, under common industry practices that emerged, cross-border substitute dividend payments might have qualified under a domestic exemption or treaty exemption for interest or "other income." If the borrower was a foreign person in a favorable treaty jurisdiction, the withholding tax on the dividend payment could be reduced to 15% and the substitute payment, assuming it was foreign-source, would be exempt from U.S. withholding tax. More complex transactions using swaps could avoid even the 15% withholding tax where the borrower was a foreign person.

In 1997, final regulations were published providing that substitute dividend payments in such transactions, as well as similar transactions, would be treated as dividends subject to withholding tax.4 Under those regulations, substitute dividend payments are sourced and characterized by reference to the dividends for which they substitute for purposes of §§871, 881, and 4948(a).5 Thus, a payment that substitutes for a U.S.-source dividend will itself be characterized as a U.S.-source dividend, regardless of the residence of its payor.6 These rules applied on a transaction-by-transaction basis and did not provide for any withholding relief for serial, multiple transactions, each of which was subject to U.S.-source treatment even where such payments were with respect to a single dividend payment.

Almost immediately the IRS published a notice to alleviate the problem of "cascading" withholding taxes on a series of multiple substitute payments with respect to a single dividend. Under Notice 97-66,7 unless a second, third, or later substitute payment recipient was not entitled to as low a treaty rate as the first recipient, no further withholding tax would be collected on the later substitute payments.

Because Notice 97-66 was intended as an emergency measure to cut off cascading withholding until more specific withholding rules could address the treatment of serial stock loans, the notice was not drafted as rigorously as it might have been.8 With no specific withholding regulations addressing the cascading U.S.-source treatment of substitute dividends forthcoming, taxpayers apparently engaged in transactions that may have met the literal terms of the notice but resulted in the avoidance of U.S. withholding tax on dividends and substitute payments altogether.  As described by the staff of the Senate Permanent Subcommittee on Investigations in 2008:After reviewing practices at nearly a dozen financial institutions and hedge funds, the Subcommittee uncovered substantial evidence that U.S. financial institutions knowingly developed, marketed, and implemented a wide range of transactions aimed at enabling their non-U.S. clients to dodge U.S. dividend taxes. Using a variety of complex financial instruments, primarily involving equity swaps and stock loans, these U.S. financial institutions structured transactions to enable their non-U.S. clients to enjoy all of the economic benefits of owning shares of U.S. stock, including receiving dividends, without paying the tax applicable to those dividends. These structured transactions increased the amount of dividend returns obtained by some of their non-U.S. clients by 30% or more.

As a result, new §871(l) (now (m)) was added to the Code in 2010. Section 871(l)(6) (now (m)(6)) limited the IRS's ability to reduce cascading withholding taxes to situations where a taxpayer could establish that one withholding tax was paid or none was due in the first place.

Notice 2010-46 was promptly promulgated to implement the new law modifying Notice 97-66, effective for payments between May 20, 2010, and the effective date of §871(l) (now (m)), and withdrawing it for payments after. Notice 2010-46 also promulgated a moderately detailed set of rules for the implementation of §861(l) (now (m)), including an anti-abuse rule for transactions or a series of transactions entered into with a principal purpose of reducing or eliminating U.S. withholding tax.

With the enactment of new legislation and implementing administrative guidance, one might have thought the strategies for applying Notice 97-66 to avoid withholding tax that were identified by the Senate Permanent Subcommittee on Investigations not only were stopped prospectively but, given the explicit anti-abuse rule, that any debate regarding their prior efficacy was also put to bed by implication.  One would have been wrong.

In December 2012, Chief Counsel Memorandum AM 2012-009 was made public. That memo sets forth the IRS's legal analysis for pre-May 20, 2010 securities lending transactions. Not surprisingly, given the number of recent successes in asserting an expanded application of the economic substance doctrine (ESD), the memo suggests attacking pre-§871(m) and pre-Notice 2010-46 stock lending transactions under the ESD, regardless of compliance with Notice 97-66.

The memo runs through several points regarding the ESD. For purposes of "subjective" economic substance, it makes several points. First, it declares that the only motives that are relevant are those of the foreign customer (the original owner of the shares the dividend is paid upon) of the financial institution that provides the substitute payment. Second, and somewhat contradictorily, the memo declares that the foreign financial institution's lack of any legitimate business reasons for borrowing its customer's shares demonstrates that the foreign financial institution participated in the stock loan solely to facilitate the customer's tax avoidance.  Third, the fact that the customer and the financial institution shared the claimed withholding tax savings demonstrates, the memo declares, that the stock loan had off-market terms. Fourth, the memo explains that a lack of objective economic substance itself implies a lack of subjective economic substance. Fifth, and perhaps tellingly, a customer's reliance on the financial institution's marketing materials that emphasize the withholding tax savings, together with the customer's failing to analyze profit potential beyond the tax savings, demonstrates the lack of subjective economic substance.

The memo also addresses "objective" economic substance. In the example used, the memo concludes that the only pre-tax economic effect of the stock loan was to reduce the customer's entitlement to the dividend (or an equivalent).

As a result, because the stock loan had no economic substance apart from federal withholding tax reduction, the stock loan should be disregarded and the customer treated as if he still owned the loaned shares at the time the dividend was paid. It is unclear whether the related swaps entered into by the financial institution would also be disregarded.

The memo provides no discussion of the formulary approach taken in Notice 97-66 and whether U.S. withholding tax could ever be imposed on foreign-to-foreign loans where the foreign borrower was not subjected to any withholding in its cash flows for on-lending or otherwise disposing of the borrowed stock. It suggests, therefore, that 100% compliance with that formulary approach provides no protection.  While this might not be remarkable where there is no purpose for the stock loan other than U.S. withholding tax avoidance, it is at least mildly troubling that the foreign financial institution's desire to borrow the shares for its possibly bona fide business purposes (e.g., such as a traditional stock borrowing to cover short sales entered into on its equity trading desk) is, in at least one statement in the memo, irrelevant (even though the memo then also tries to maintain that there were no such purposes, which is unusual given that they are declared to be irrelevant).

It is also somewhat misleading that the IRS thought it necessary in Notice 2010-46 to provide an anti-abuse rule if a principal purpose of a stock loan was the avoidance or reduction of withholding tax and, critically, to apply that anti-abuse rule to transactions entered into only after May 19, 2010.  Given this aspect of Notice 2010-46, one might have erroneously concluded that the ESD was irrelevant to stock loans. The memo makes it clear that the IRS does not think so.

As in many other arenas, if the IRS aggressively pursues ESD in the substitute payment arena and has success in the courts, then opinions that relied upon the law as it stood a decade ago may not be worth much. One hopes, however, that those opinions may, given the state of the ESD law at the time rendered, be effective to prevent the successful imposition of any penalties. For what it's worth (probably little), at least AM 2012-009 does not suggest that IRS agents impose penalties on the sort of stock lending transactions it addresses.

This commentary also will appear in the June 2013 issue of the  Tax Management International Journal.  For more information, in the Tax Management Portfolios, see Tello, 915 T.M., Payments Directed Outside the United States - Withholding and Reporting Provisions Under Chapters 3 and 4, and Nauheim and Scott, 938 T.M., U.S. Income Tax Treaties - Income Not Attributable to a Premanent Establishment, and in Tax Practice Series, see ¶7160, U.S. Income Tax Treaties, and ¶7170, U.S. International Withholding and Reporting Requirements.

  1 57 Fed. Reg. 860 (1/9/92).

  2 Rev. Rul. 60-177, 1960-1 C.B. 9. See also Rev. Rul. 80-135, 1980-1 C.B. 18 (finding that substitute interest payments with respect to municipal bond loans were not treated as interest).

  3 See, e.g., 1975 U.S.-United Kingdom Income Tax Treaty, Article 10(3) (stating, "The term `dividends' for … United States tax purposes includes any item which under the law of the United States is treated as a distribution out of earnings and profits" (emphasis added)).

  4 T.D. 8735 (Oct. 7, 1997).

  5 Regs. §§1.871-2(b)(2) and 1.881-2(b)(2), which are also applicable to substitute interest payments.

  6 Regs. §1.861-3(a)(6). Substitute interest payments are sourced under Regs. §1.861-2(a)(7).

  7 1997-2 C.B. 328.

  8 Notice 97-66, §1, provided that Treasury's and the IRS's intentions were as follows:

[T]he Treasury and the Service intend to propose new regulations to provide specific guidance on how substitute dividend payments made by one foreign person to another foreign person ("foreign-to-foreign payments") are to be treated. Until the proposed regulations are promulgated, this Notice clarifies how the amount of the tax imposed under sections 1.871-7(b)(2) and 1.881-2(b)(2) will be determined with respect to foreign-to-foreign payments.

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