Withholding Tax on Substitute Dividends

[Pages:8]May 24, 2010

Withholding Tax on Substitute Dividends

IRS and Treasury Outline New Rules for Withholding on Substitute Dividends

SUMMARY

On May 20, 2010 Treasury and the IRS issued Notice 2010-46 (the "Notice"), providing interim rules for reporting and withholding on substitute dividend payments and setting forth the anticipated framework for future regulations. The rules set forth in the Notice are intended to provide taxpayers relief from excessive or cascading levels of withholding tax where the same securities are lent multiple times in a series of transactions. The Notice was issued pursuant to new Code Section 871(l) (enacted in March of this year as part of The Hiring Incentives to Restore Employment Act, see the Sullivan & Cromwell LLP publication entitled "Hiring Incentives to Restore Employment Act Enacted" March 24, 2010). Code Section 871(l) requires taxpayers to treat certain "dividend equivalent" payments (including substitute dividends paid pursuant to a stock lending transaction) as U.S. source dividends. As a result, dividend equivalent payments made on or after September 14, 2010 (the effective date of new Code Section 871(l)) are subject to the withholding and information reporting rules applicable to regular dividends if paid in respect of U.S. securities.

The Notice sets forth the framework that future regulations will follow in order to address withholding tax and reporting on dividend equivalent payments. Under those future regulations, the primary approach will be a qualified securities lender program (somewhat similar to the qualified intermediary program that currently exists) that will allow qualifying foreign financial institutions to receive substitute dividend payments free of withholding tax provided that they agree to withhold and report on the payments they make to people who have lent securities to them. The IRS and Treasury believe that this system will solve most cases of cascading withholding tax. As a backup to this system, the regulations will allow a withholding agent to reduce or eliminate the amount of tax it must withhold if it has reliable documentary evidence that a withholding tax has been paid by a prior withholding agent in the chain of payments.

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For payments made during the period prior to September 14, 2010, withholding agents will not be permitted to rely on existing Notice 97-66 where the "withholding agent or foreign lender knows, or has reason to know that a securities lending transaction or series of such transactions, has a principal purpose of reducing or eliminating the amount of gross-basis tax that would have been due in the absence of such transaction or transactions." During the period from September 14, 2010 until the date that the final regulations are in effect (anticipated to be January 1, 2012), withholding agents must apply a modified version of the document-based backup system noted above or, if they so choose, they may adopt a modified version of the qualified securities lender system.

The Notice also provides an extension of time for withholding agents to report payments and remit withholding taxes related to payments made in 2010.

BACKGROUND

Current law generally requires withholding agents to collect a 30% withholding tax on payments of U.S.source dividends and other fixed or determinable annual or periodical income unless the rate is reduced by a tax treaty. In addition to the withholding tax on dividends, current tax law imposes withholding tax on so-called substitute dividend payments made in a securities loan involving U.S. stock. These rules led to a concern that a single dividend payment could give rise to multiple layers of tax in transactions where the same stock was lent and re-lent in a series of transactions. In response to this concern the IRS had previously issued Notice 97-66, which generally limits the extent to which withholding tax will be imposed on substitute dividend payments made between foreign persons in order to prevent "cascading withholding tax" in instances where the same securities were lent more than once in a series of transactions.

In September 2008, Congressional hearings were held addressing concerns that Notice 97-66 was being used to permit tax avoidance transactions, including transactions in which a foreign person would: (i) lend U.S. stock to a foreign financial institution, which would then sell that stock to a related U.S. person; and (ii) simultaneously enter into a total return equity swap with respect to the loaned stock with the related U.S. person, either directly or indirectly. (The hearings also addressed concerns that foreign investors (including foreign hedge funds) were avoiding U.S. withholding tax by transferring U.S. stocks to U.S. broker-dealers (either directly or indirectly) shortly before a dividend payment date, entering into economically equivalent equity swaps during the dividend payment period and then reacquiring the relevant U.S. stocks after the dividend was paid.)

In response to these concerns Congress enacted Code Section 871(l) (added in March of this year as part of The Hiring Incentives to Restore Employment Act) requiring taxpayers to treat certain "dividend equivalent" payments as U.S.-source dividends. As a result, such payments are potentially subject to

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withholding tax if paid to a non-U.S. person.1 Code Section 871(l) is effective for certain dividend equivalent payments made on or after September 14, 2010 and, beginning on March 18, 2012, effective with respect to dividend equivalent payments pursuant to any notional principal contract that is not specifically exempted by Treasury guidance.

Because new Code Section 871(l) will treat all dividend equivalent payments in respect of U.S. equities as if they are U.S.-source dividends, it has been assumed that once that provision became effective the anti-cascading tax rule of Notice 97-66 would effectively be void. In Code Section 871(l)(6), however, Congress specifically granted Treasury the authority to prevent over-withholding where there is a chain of dividend equivalent payments.

THE NOTICE

New Withholding and Reporting Framework for Final Rules The new rules will replace the formulaic approach of Notice 97-66 with a qualified securities lender program somewhat similar to the current qualified intermediary program with respect to U.S. source interest and dividends. The new program would allow certain eligible foreign financial institutions to receive substitute dividends free of withholding tax provided that the foreign financial institution agrees to assume responsibility for proper withholding and reporting with respect to the substitute dividend payments it makes. Any cascading taxation not remedied by the qualified securities lender program would be relieved under a document-based "credit forward" system that would allow a withholding agent to reduce withholding on a substitute dividend payment by an amount that has been previously withheld, but only to the extent there is sufficient evidence that the tax was actually withheld.

1. Qualified Securities Lender Under regulations to be issued, certain foreign financial institutions will have the opportunity to be certified as Qualified Securities Lenders (each a "QSL"). A withholding agent making a substitute dividend payment to a QSL will not be required to withhold on that payment. Instead, as described below, the QSL will be obligated to withhold and report on the substitute dividend payments that it makes and pay withholding tax on substitute dividends it receives for its own account.

1 Under new Code Section 871(l) a "dividend equivalent," which will be subject to withholding, includes: (i) any substitute dividend made pursuant to a securities lending or a 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; (ii) any payment made pursuant to a "specified notional principal contract" that is directly or indirectly contingent upon, or determined by reference to, the payment of a U.S.-source dividend; and (iii) any payment determined by the Treasury Department to be "substantially similar" to either a substitute dividend or a payment made on a "specified notional principal contract" that is contingent on, or determined by reference to, a U.S.-source dividend.

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In order for a withholding agent to be exempt from its obligation to withhold on a substitute dividend payment to a QSL the withholding agent must receive a certified statement (on a form or in the manner prescribed by regulation or the Treasury) from the QSL that the QSL will withhold and remit the proper amount of U.S. withholding tax with respect to the payment of substitute dividends it receives or makes.

In situations where a QSL receives a substitute dividend payment and is required to make a corresponding substitute dividend payment with respect to the same securities, the QSL will not itself be liable for US withholding tax. Instead it will be required to take on the role of a withholding agent with respect to the corresponding payment it makes and comply with the withholding and information reporting rules applicable to payments of U.S.-source dividend income to a foreign person. This means that the QSL generally will be required to collect the appropriate IRS Form W-8 from the payee, apply the appropriate withholding rate and comply with information reporting on IRS Forms 1042 and 1042-S.

Where the QSL has entered into a securities lending transaction for its own account, it is liable for and must remit the withholding tax applicable to it as the beneficial owner of the payment.

To qualify as a QSL a foreign financial institution must:

? be a bank, custodian, broker-dealer or clearing organization that is subject to regulatory supervision by a government authority in the jurisdiction in which it was created and be regularly engaged in a trade or business that includes borrowing and lending U.S. securities to unrelated customers,

? be subject to the summons and audit power of the IRS or be a qualified intermediary ("QI") that is subject to an audit by an external auditor and appropriately amend its QI agreement, and

? comply with annual IRS certification requirements.

The Service intends to monitor QSLs for compliance with these rules and may revoke an institution's QSL status for non-compliance. Non-compliance may include having participated in transactions designed to help foreign investors avoid US withholding tax.

2. Document Based Credit Forward System

The IRS and Treasury believe that the QSL program described above should solve most of the cascading tax problems. Where cascading tax problems remain, a withholding agent may reduce withholding on a substitute dividend payment by an amount that has been previously withheld provided that the withholding agent has sufficient evidence that the tax was actually withheld on a prior dividend or substitute dividend paid to the withholding agent (or a withholding agent earlier in the same chain of payments). It is anticipated that under the future regulations, sufficient evidence would exist where there is written documentation of amounts previously withheld by another withholding agent on actual dividends or substitute dividends in the same series of securities lending transactions. For example, it is expected that the regulations will provide that a withholding agent that (i) receives a payment net of U.S. withholding tax, (ii) receives a written statement from the immediately prior withholding agent that sets forth the amount of such tax, and identifies the person who withheld the tax and the recipient on whom

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the tax was withheld and (iii) does not know or have reason to know that the statement is unreliable will have sufficient evidence that that the tax was actually withheld.

No payee will be entitled to a refund because a prior payee was subject to a higher rate of tax than the current payee would be required to pay. As a result, a substitute dividend will be subject to the highest rate applicable to anyone in the chain of payments (i.e. possibly as high as 30%). In addition, no withholding agent or taxpayer may credit any tax withheld on a series of payments to a tax withheld on a different series of payments.

3. Information Reporting of Substitute Payments A withholding agent must generally report the payment of substitute dividend payments on Forms 1042 and 1042-S. In instances where a withholding agent has been permitted to reduce or eliminate withholding, the withholding agent must report (i) the gross amount of the substitute dividend to which the recipient would otherwise have been entitled and (ii) the amount of withholding tax withheld by that withholding agent and by other withholding agents in the series of transactions.

4. Anti-Abuse Rules The future regulations are expected to have an anti-abuse rule, pursuant to which a withholding agent may not rely on the rules that allow it to reduce withholding, and must instead withhold at a 30% rate if it knows, or has reason to know, that the securities lending transaction (or series of transactions) has a principal purpose of reducing or eliminating the amount of U.S. withholding tax that would otherwise be due.

Interim Rules 1. Anti-Abuse Rule for Pre-Effective Date Period (Prior to September 14, 2010)

For payments made during the period prior to September 14, 2010 (i.e. prior to the effective date of new Code Section 871(l)) a withholding agent or foreign lender may continue to rely on Notice 97-66 except where the "withholding agent or foreign lender knows, or has reason to know that a Securities Lending Transaction or series of such transactions, has a principal purpose of reducing or eliminating the amount of gross-basis tax that would have been due in the absence of such transaction or transactions." By way of example, the Notice provides that a person may not rely on Notice 97-66 if that person must make a payment of dividends or substitute dividends to a foreign securities lender in a transaction where (i) the lender borrowed shares of a U.S. company from a foreign person after the declaration of a dividend, (ii) the lender sells the stock to a related U.S. person prior to the ex-dividend date, and (iii) the lender enters into a total return swap with the U.S. person to hedge its risk.

The Notice specifies that it does not address whether transactions entered into prior to the date of the Notice are entitled to the benefits of Notice 97-66. Notice 97-66 is withdrawn for payments made on or after September 14, 2010.

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2. Transition Period Rules a. General Rule

For the transition period (from September 14, 2010 to January 1, 2012),2 during which Code Section 871(l) will be in effect but for which regulations are not expected to have been finalized, withholding agents may follow a modified version of the documents-based credit forward system as described below. Under these rules the maximum U.S. withholding tax due with respect to a series of securities lending transactions (and any related dividend payments) will be the tax rate paid by the foreign payee with the highest tax rate in the chain or series of payments. As a result there should collectively be a maximum withholding of 30%. A withholding agent making a substitute dividend payment may only presume an amount of U.S. withholding tax has been paid if:

? the withholding agent receives a substitute dividend or dividend payment that reflects a reduction for U.S. withholding tax,

? the withholding agent does not know or have reason to know that the tax was not withheld and deposited or paid, and

? the withholding agent is a person subject to the audit and summons power of the IRS or is a QI that is subject to an audit by an external auditor.

b. Modified Qualified Service Lender Program During the transition period withholding agents may also use a system that reasonably implements the principles of the QSL program described above. Under this modified system a withholding agent will not be required to withhold on a payment to a counterparty if the withholding agent receives an annual statement from the counterparty certifying that it substantially satisfies the requirements to be a QSL (i.e., that (i) it is a bank, custodian, broker-dealer or clearing organization that is subject to regulatory supervision by a government authority in the jurisdiction in which it was created and it is regularly engaged in a trade or business that includes borrowing and lending U.S. securities to unrelated customers and (ii) it is subject to the summons and audit power of the IRS or is a QI that is subject to audit by an external auditor). A QI that provides such a statement will be deemed to have amended its QI agreement to agree to withhold and report as required under the QSL program. It is anticipated that future guidance may require QIs that take advantage of this program to identify themselves before the end of this year.

2 Although the rules of Code Section 871(l) become effective on September 14, 2010 and taxpayers may only rely on Notice 97-66 for payments made prior to September 14, 2010, technically under the Notice the transition rule does not become effective until September 15, 2010. Presumably this will be corrected.

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According to the Notice, a QSL may use any reasonable method to determine which securities out of a pool of fungible securities have been borrowed and lent, provided that method is consistently applied.3

3. Anti-Abuse and QSL Eligibility Rule Anti-abuse rules deny transitional relief with respect to securities lending transactions that were entered into with the principal purpose of reducing or eliminating the amount of U.S. tax that would have been due absent the transaction. Perhaps most significantly, a financial institution that is determined to have structured or entered into such an abusive transaction on or after May 20, 2010 will not be eligible to be a QSL for a period of five years after that determination.

4. Refunds No payee will be entitled to a refund because a prior payee was subject to a higher rate of tax than the current payee would be required to pay. In addition no withholding agent or taxpayer may credit any tax withheld on a series of payments to a tax withheld on a different series of payments.

Extensions In order to give withholding agents sufficient time to make the changes needed to comply with new Code Section 871(l), the Notice grants withholding agents a six-month extension of time to file information returns on IRS Form 1042-S for calendar year 2010 (provided that the time for filing form 1042-S shall not be extended beyond the time the withholding agent provides a copy of the form to the recipient of the payment). In addition, the Notice gives withholding agents until January 1, 2011 to deposit withheld tax for such substitute dividend payments made in 2010.

Significantly, these extensions seem to apply only to payments made pursuant to securities lending or sale repurchase transactions and do not seem to apply to payments made pursuant to those specified notional principal contracts that are subject to Code Section 871(l) after September 14, 2010.

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Copyright ? Sullivan & Cromwell LLP 2010

3 It is not clear from the Notice whether this rule applies only during the transition period or will also apply under the final regulations.

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