The IRS has a new target in its battle to shut down U.S. withholding tax transactions that it perceives to be aggressive. On January 14, 2010, the IRS issued an industry directive (the "Directive") aimed at identifying and pursuing cases related to certain total return swap ("TRS") transactions. The industry directive is the latest salvo from the IRS as part of a concerted government effort to eliminate arrangements that use cross-border, equity-based TRSs to avoid U.S. withholding tax.

The Directive identifies circumstances in which Exam Teams should pursue factual development of cross-border TRSs in which a foreign party holds a long position in a TRS that is referenced to U.S. equities. The Directive instructs Exam to determine whether the foreign long party should be considered the "beneficial owner" of the referenced equities. Although a long position under a TRS referencing a U.S. equity may provide an investor with economic returns that are similar to ownership of that security (i.e., payments of or based on dividends and capital appreciation), the two arrangements have very different sourcing and U.S. withholding tax consequences. U.S. equities pay U.S. source dividends subject to U.S. withholding tax, while payments pursuant to cross-border TRS are foreign source (and thus not subject to U.S. withholding tax) under rules dealing with notional principal contracts ("NPCs").

There has been significant legislative activity related to this issue over the last two years. In September 2008, the Senate Permanent Subcommittee on Investigations issued a report outlining its investigation of the issue and recommending legislative and other action to curb perceived abuses. Early in 2009, Congress introduced legislation in both houses (as part of the Stop Tax Haven Abuse Act) that would apply the dividend sourcing rule to all "dividend equivalent amounts" from certain NPC arrangements. Several months later, the Obama Administration proposed similar but narrower legislation that would apply the dividend source rule to dividend equivalent amounts from NPCs featuring one of a list of specified factors.

The Congressional tax-writing committees included related proposals in the Foreign Account Tax Compliance Act ("FATCA," which was introduced in October 2009 and included as part of the Tax Extenders Act of 2009). The most recent version would apply the dividend sourcing rule to dividend-equivalent amounts from certain equity-based NPCs. For the first two years post-enactment, the special sourcing rule would apply to an equity NPC that has any of the features from a non-exclusive list. These features—which include crossing in (where the long party transfers the referenced equities in connection with the arrangement), crossing out (where the short party transfers the referenced equities to the long party upon termination of the arrangement), use of illiquid equities, and a short party's use of the referenced equities as collateral—appear to be deemed indicative of the long party having beneficial ownership over the referenced equities, and therefore meriting application of the dividend-sourcing rules. After two years, the proposal would reverse its own operating presumptions and apply to any equity-based NPC that is not explicitly excluded under regulations. Finally, the proposal takes a draconian view of the withholdable payment amount, and taxes the gross, dividend-equivalent amount, notwithstanding that the NPC may entitle a foreign party to only a net periodic payment.

From the enforcement side, based on reports in the financial press, the IRS has been examining the U.S. withholding tax consequences of certain U.S. equity-based TRS arrangements for several years. The focus on these transactions was part of the impetus for designating cross-border withholding tax issues as Tier I issues in January 2009. (See "IRS Identifies Cross-Border Withholding as Tier I Issue"). The new Industry Directive coordinates IRS field exam efforts to implement the Tier I objectives, and provides guidance—including model Information Document Requests—for assessing whether a purported NPC is in substance an agency agreement, a repurchase agreement, a lending transaction, or some arrangement to which the dividend (and not the NPC) sourcing rules would apply.

The Directive describes several variations of suspect TRS transactions. The Directive recommends that Exam consider specific factors that indicate that the foreign swap party may have maintained beneficial ownership of the referenced equities. The Directive also directs the field to examine any other evidence that the foreign party beneficially owned the referenced equities during the TRS term (or had an arrangement to acquire the equities after termination of the TRS), that the form of the TRS did not match its substance, or that a U.S. party, in holding the referenced securities, acted as an agent for the foreign party.

Notably, the Directive distinguishes between suspect variations and a "fully synthetic" total return swap. The Directive describes such a total return swap as one in which the foreign long party neither owned the referenced equities before the entering into the swap nor acquired the equities after termination of the swap, despite that the U.S. party hedged its short position. Absent evidence that the foreign person exercised control with respect to the U.S. party's hedge, the Directive concludes that the transaction constitutes an NPC in both substance and form and that the NPC sourcing rule should apply.

The federal government's multi-prong attack on equity TRS transactions sends a clear message to taxpayers: The government is on a shut-down mission. If enacted in its proposed form, FATCA's draconian measures would prospectively eliminate certain equity-based NPCs. By designating equity TRS transactions as Tier I issues, the IRS is marshalling Exam to target these transactions and severely limiting taxpayers' ability to avoid adjustments or even penalties at the audit level. Proposed tax deficiencies could be staggering in magnitude; as U.S. withholding agents, U.S. parties could be strictly liable for foregone 30 percent withholding tax plus interest on payments found subject to the dividend sourcing rules. Taxpayers that may have entered transactions identified by the Directive and are not yet under audit would be well advised to prepare for audit. They should identify transaction variations within their portfolios, collect and assess the documents and information that would be requested under the model IDRs provided in the Directive, and develop the facts relevant to determining the extent to which the foreign counterparty had or maintained an ownership interest in the referenced equities.

For further information, please contact the following lawyers:

Rocco Femia, rfemia@milchev.com, 202-626-5823

George Clarke

Kimberly Majure

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