IRS Issues Guidance To Prevent Overwithholding, U.S. Tax Avoidance For Some Substitute Dividend Payments.

Part III -- Administrative, Procedural, and Miscellaneous

I. SUMMARY AND MODIFICATION AND WITHDRAWAL OF NOTICE 97-66

Some taxpayers expressed concern that the total U.S. gross-basis tax paid with respect to a series of Securities Lending Transactions (that is, a chain of related Securities Lending Transactions with respect to identical securities) could be excessive under the final regulations. For example, a series of Securities Lending Transactions could give rise to multiple substitute payments, each of which would be treated as equivalent to a dividend under the final regulations. If a dividend distribution on the transferred security were U.S.-source income, each substitute dividend payment in the series would be treated as U.S.-source income and potentially subject to gross-basis taxation under §§ 871 and 881 and withholding of tax under §§ 1441 and 1442. Thus, a series of Securities Lending Transactions could result in "cascading" taxation that might, in the aggregate, exceed 30 percent of the amount of the dividend distribution on the underlying transferred security.

To allow relief for taxpayers unable to structure transactions to avoid excessive or cascading taxation, the Treasury Department and the Service issued Notice 97-66, 1997-2 C.B. 328 (1997), on November 12, 1997. Notice 97-66 provides guidance that generally limits the aggregate U.S. gross-basis tax on a series of Securities Lending Transactions to no more than 30 percent of the amount equivalent to the dividend distribution on the underlying transferred security. To implement this limitation, Notice 97-66 provides a formulary method to calculate the amount of U.S. tax to be imposed on a foreign-to-foreign substitute dividend payment. Under this method,

It has been widely reported that some taxpayers have relied on Notice 97-66 to avoid U.S. gross-basis taxation of foreign lenders of U.S. dividend-paying stocks in transactions undertaken primarily to enhance the after-tax yield of U.S. dividend-paying stocks held by foreign persons.¹

On March 18, 2010, the Hiring Incentives to Restore Employment Act, Pub. L. No. 111-147, 124 Stat. 71 (2010) ("HIRE Act") was enacted. Section 541 of the HIRE Act added new § 871(l) to the Code, which provides that certain dividend equivalent payments are treated as U.S.-source dividends, effective for payments made on or after the date that is 180 days after the date of enactment. The term "dividend equivalent" is defined for this purpose to include "any substitute dividend made pursuant to a securities lending or sale-repurchase transaction that (directly or indirectly) is contingent upon, or determined by reference to, the payment of a dividend from sources within the United States." § 871(l)(2)(A). Section 871(l)(6) authorizes the Secretary to reduce tax with respect to a chain of dividend equivalents "but only to the extent that the taxpayer can establish that such tax has been paid with respect to another dividend equivalent in such chain, or is not otherwise due, or as the Secretary determines is appropriate to address the role of financial intermediaries in such chain."

II. PROPOSED WITHHOLDING AND REPORTING FRAMEWORK

The Treasury Department and the Service intend to issue regulations exercising the authority described in § 871(l)(6). These regulations will coordinate the tax imposed on substitute payments under § 871(l) and §§ 1.871-7(b)(2) and 1.881-2(b)(2) with the withholding and reporting requirements under §§ 1441, 1442 and 1461 and the regulations thereunder to ensure that the appropriate amount of tax is paid and reported. Generally, the regulations, as described below, are expected to replace the formulary approach previously adopted by Notice 97-66 with a documentation-based system under which withholding agents will be able to reduce withholding to the extent that withholding is shown to have been made on another substitute payment or dividend with respect to identical securities. Additionally, to reduce instances of potential excessive or cascading taxation and to properly account for the role of financial intermediaries in Securities Lending Transactions, this proposed system is expected to exempt certain financial institutions from being subject to withholding at source on receipt of substitute dividend payments provided that they assume responsibility and liability for properly withholding, reporting, depositing, and paying U.S. tax with respect to substitute dividend payments. This system will also permit the Service to administer compliance by market participants more effectively by disqualifying noncompliant taxpayers from eligibility for the relief provided in this Notice in appropriate cases.

Treatment of Qualified Securities Lender. The regulations will coordinate the obligation of a Qualified Securities Lender to withhold on substitute dividend payments that it makes, pay and deposit tax on substitute dividends it receives, and report on substitute dividends it makes (on behalf of itself or any other person). The regulations are expected to define these obligations in terms of two distinct categories of substitute dividends that Qualified Securities Lenders pay or receive.

In circumstances where a Qualified Securities Lender receives a substitute dividend payment (the "first substitute dividend payment") and is obligated to make an offsetting substitute dividend payment with respect to identical securities (the "second substitute dividend payment"), the regulations are expected to provide that a Qualified Securities Lender: (A) will not be liable for U.S. gross-basis tax on the first substitute dividend payment under § 871(a) or 881(a); and (B) must properly withhold under §§ 1441 and 1442 and report with respect to the second substitute dividend payment.

In circumstances where a Qualified Securities Lender receives a substitute dividend payment for which it has no obligation to make an offsetting substitute dividend payment with respect to identical securities, the Qualified Securities Lender remains liable for tax under § 871(a) or 881(a) by virtue of the receipt of such substitute dividend payment.

The Service intends to monitor Qualified Securities Lenders for compliance with all applicable rules described in this Notice and may revoke an institution's status as a Qualified Securities Lender for noncompliance. Such noncompliance may include, for example, circumstances in which an institution structures or participates in arrangements designed to facilitate the avoidance of U.S. gross-basis taxation by foreign persons that hold or held U.S. equities, as well as circumstances in which an institution does not withhold and deposit tax at the proper rate when it acts as a custodian on behalf of both a borrower and lender in the same Securities Lending Transaction.

• it is a bank, custodian, broker-dealer, or clearing organization that is subject to regulatory supervision by a governmental authority in the jurisdiction in which it was created or organized, and is regularly engaged in a trade or business that includes the borrowing of securities of domestic corporations (as defined in § 7701(a)(4)) from, and lending of securities of domestic corporations to, its unrelated customers;

• it is subject to audit by the Service under § 7602 or, in the case of a Qualified Intermediary (QI) that appropriately amends its QI agreement with the Service, by an external auditor. Further guidance will specify the requirements of such an amendment to the QI agreement. In general, however, the amendment will require the QI to report, withhold, deposit, and pay U.S. tax as described in Parts II.A and D of this Notice; and

• it files an annual statement on a form prescribed by the Service certifying that it satisfies the conditions necessary to be a Qualified Securities Lender.

• ii. Certifications by a Qualified Securities Lender

The regulations are expected to provide that withholding agents may relieve excessive tax on substitute dividends by reducing withholding on a substitute dividend payment that the withholding agent is obligated to make by an amount not to exceed the amount that has been previously withheld within the same series of Securities Lending Transactions, but only to the extent that there is sufficient evidence that tax was actually withheld on a prior dividend and/or substitute dividend paid to the withholding agent or a prior withholding agent within the same such series. No payee in a series of Securities Lending Transactions may claim a refund (or claim a credit against any other liability) solely because a prior payee in the same series was subjected to a higher rate of gross-basis U.S. tax. Moreover, no taxpayer or withholding agent in a series of Securities Lending Transactions may credit any tax withheld with respect to a substitute dividend payment in such series against any tax imposed with respect to a substitute dividend payment in a different series of Securities Lending Transactions.

III. TRANSITION RULE

Generally, the transition rules described in this Part III provide that the maximum aggregate U.S. gross-basis tax due, if any, with respect to a series of Securities Lending Transactions and any related dividend payment is the amount determined by the tax rate paid by the foreign taxpayer (other than in the case of a Qualified Securities Lender that is obligated to make an offsetting substitute dividend payment) bearing the highest rate of U.S. gross-basis tax in the series. Accordingly, the aggregate U.S. gross-basis taxes paid in such transactions generally should not exceed the 30 percent statutory rate applicable to U.S.-source dividends paid to foreign persons.

• The withholding agent receives a substitute dividend or dividend payment with respect to identical securities that reflects a reduction for withholding of U.S. gross-basis tax;

• The withholding agent does not know or have reason to know that tax was not withheld and deposited or paid. For this purpose, a withholding agent has a reason to know that tax was not withheld if, for example, the amount of any lending fee or similar fee is increased directly or indirectly, in whole or in part, by the difference between the gross amount of the substitute dividend and the net amount received; and

• The withholding agent is a person subject to audit under § 7602, or in the case of a QI, by an external auditor.

Withholding agents will be required to perform information reporting as specified in Part II.D above.

IV. EFFECTIVE DATES

The modification of Notice 97-66 described in Part I is effective for amounts paid on or after May 20, 2010 and before September 14, 2010. The transition rules described in Part III are effective for amounts paid on or after September 14, 2010.

V. PAPERWORK REDUCTION ACT

The collections of information contained in this Notice have been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under control number 1545-1566.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid control number.

The collection of information contained in this Notice is in Part III. The information is required to prevent excessive taxation under §871(l) during the transition period. The information will be used for the same purpose described in the preceding sentence. The collections of information are required to obtain a benefit. The likely respondents are businesses or other for-profit institutions.

The estimated total annual reporting and/or recordkeeping burden is 1,000 hours.

The estimated annual burden per respondent/recordkeeper varies from 1 minute to 15 minutes, depending on individual circumstances, with an estimated average of 10 minutes. The estimated number of respondents and/or recordkeepers is 6,000.

The estimated frequency of responses (used for reporting requirements only) is once.

Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

VI. EFFECT ON OTHER DOCUMENTS

Notice 97-66 is modified as provided in Part I.

VII. REQUEST FOR COMMENTS

The Treasury Department and the Service invite comments on the guidance described in this Notice. In particular, comments are requested on the following issues.