Rethinking the Tax Treatment of Cross

Border Derivatives Under U.S. Tax Law

and Treaties

International Tax Institute, Inc.

April 17, 2013

Mark E. Erwin Chief, Branch 5, Office of Associate Chief Counsel

(INTL), Internal Revenue Service

Yoram Keinan Greenberg Traurig LLP

Anthony Tuths WithumSmith+Brown, PC

The 1995 IFA Report on Derivatives

• There seems to be an "international consensus" concerning taxation

of cross-border derivatives.

• The forty-ninth Congress of the International Fiscal Association

("IFA") focused on tax aspects of derivatives and issued its

recommendations with respect to cross-border aspects of

derivatives.

• The IFA Report (1995) that resulted from the conference set forth

that the international consensus for taxation of cross-border

derivatives is that the source country generally does not impose tax

earned by non-resident on income from derivatives.

• The IFA Report concluded that countries should not impose source

basis taxation on income derived by non- residents from derivative

instruments in the absence of a branch or permanent establishment

to which such income is attributable.

1

U.S. Source Rules for

Derivatives

2

Options, Forwards and Futures • Gain on the disposition of an option, forward or futures contract generally is

sourced according to the residence of the contract holder receiving the gain.

• Thus, gain recognized by a foreign holder of an option, forward or futures contract would be foreign-source gain not subject to U.S. tax, unless the foreign holder is engaged in a U.S. trade or business with which the gain is connected.

• Generally similar treatment for foreign currency derivatives (regardless of election to treat as capital) and for derivatives used for hedging.

• Certain payments made under forwards (e.g., contract adjustment payments) are thought to be FDAP and banks currently withhold on such payments.

• Section 865(j)(2) authorizes Treasury to promulgate regulations governing the source of gain from dispositions of forward contracts, futures, options, and other financial products. These regulations have yet to be promulgated.

3

Notional Principal Contracts

• The source rules for NPCs were first established by the IRS in 1987. Rev.

Rul. 87-5, 1987-1 C.B. 180 (in the context of treaties). Four years later, in

1991, Treas. Reg. 1.863-7(b) was issued.

• Although not stated formally by the IRS, it appears that the reason for the

special rule was to permit cross-border NPCs without the impediment of a

withholding tax.

• Periodic payments under NPCs are sourced according to the residence of

the recipient. Treas. reg. sections 1.863-7(b)(1) (except where the swap

calls for accelerated or uneven payments that are treated as embedded

loans).

• Thus, periodic payments received by a foreign holder are foreign-source

income not subject to U.S. withholding tax, assuming the foreign holder is

not engaged in a U.S. trade or business. Preamble to Treas. reg. section

1.446-3, T.D. 8491, 1993-2 C.B. 215.

• Payments other than periodic payments (e.g., non-periodic and termination

payments) are subject to the general source and withholding rules. 4

NPCs Entered into in Connection with a U.S.

Trade or Business

• Separate rules apply when a foreign party to an NPC is engaged in a U.S. trade or business and has entered into the contract in connection with such business.

• In that case, income from the NPC is U.S.-source income to the foreign party. Treas. reg. section 1.863-7(b)(3).

• Periodic payments would constitute U.S.-source income if the U.S. activities of the foreign party were a "material" (although not necessarily “principal”) factor in realizing the income. Treas. reg. section 1.864-4(c).

• Example: Many offshore funds engaging in NPCs on a clearing exchange are required to pay an upfront payment, which is an embedded loan. As a result, the fund may be viewed as conducting U.S. loan origination activity, which is a U.S. trade or business. Presumably, the Section 864 securities trading safe harbor (including derivatives under proposed regs) would provide protection in many such cases.

5

Recent Developments on NPCs

• The Dodd-Frank Act calls for swaps to be centrally cleared. Section 1256(b)(2)(B) was intended to prevent such cleared swaps from becoming subject to Section 1256 tax treatment. However, it remains unclear how Dodd Frank will affect the tax treatment of derivatives.

• Proposed regs under Section 446 issued in 2011 have the potential to shift certain instruments into NPC treatment – which would include the residence based source rule as well as the loan bifurcation treatment for significant non-periodic payments. Prop. Reg. 1.446-3.

• Treasury issued regulations in May 2012 to exclude certain upfront payments on cleared swaps from Section 956. Temp. Treas. Reg. 1.956-2T.

6

Credit Default Swaps (CDS)

• Under the 2011 proposed regs, CDSs will be treated as NPCs and, thus, be subject to the residence based source rule. Prop. Reg. 1.446-3(c)(1)(iii).

• Single premium payment CDSs would still be outside the NPC definition. Such CDSs may be characterized as options, guarantees or insurance contract, each of which is subject to different source and withholding rules.

• Guarantee contracts are specifically excluded from NPC treatment.

• Guarantee fees paid by U.S. person are generally treated as U.S. source income (but not treated as interest). Section 861(a)(9) (added in 2010 to counter Container Corp decision). Guarantee fees paid to a treaty resident fall under “other income” article and are not treated as U.S. source under most treaties.

7

Derivatives Referencing Real Estate

or REITs

• Derivatives referencing real property indices, REITs or REIT indices raise FIRPTA issues.

• FIRPTA captures all derivatives due to expansive definition of “interest in real property” located in Treas. Reg. section 1.897-1(d)(2)(i) (“The term also includes any direct or indirect right to share in the appreciation in the value, or in the gross or net proceeds or profits generated by, the real property.”)

• Treasury ruled that a swap on index referencing data from a broad range of U.S. properties is not a USRPI under Section 897. Rev. Rul. 2008-31 (index was too broad based to constitute a USRPI)

8

Derivatives referencing Real Estate

or REITs

• FIRPTA permits non-U.S. investment in, (i) domestically controlled REITs; and (ii) 5% or less investments in publicly traded corporations that would otherwise be real property holding companies

• No similar “de minimis” rule for joint ownership of U.S property outside of REIT / public corporation

• Obama 2014 budget proposal calls for FIRPTA exemption for non-U.S. pension funds as part of infrastructure initiative

• Even in absence of FIRPTA, Section 871(m) would pick up dividend equivalents paid under derivatives referencing REITs and real property holding companies.

9

Cross-Border Securities

Loans

10

Overview

• Securities loan involves the transfer of securities from the security lender to the security borrower. The security borrower typically posts collateral (e.g., cash), with the security lender.

– In essence, one party is borrowing a security and the other party is borrowing money

• Each security loan has ongoing net cash flows comprised of the following components:

– Borrow Fee: Compensation paid to the security lender for giving up title to its securities

– Substitute Payments or Payments in Lieu: Payments made to the security lender which mimic payments on the underlying securities which were lent

– Rebate: Interest paid to the security borrower with respect to the cash it posted as collateral (or earnings on any non-cash collateral)

11

Taxation of Securities Loan

• Substitute payments (aka, payments in lieu) are treated as ordinary income for the use of property and do not retain the character of the underlying payment for which they substitute. Rev. Rul. 80-135; Treas. Reg. 1.1058-1(d) (Sec lender treats payments as “a fee for the temporary use of property”)

– Substitute dividends do not qualify for DRD or QDI treatment.

– Substitute payments do retain their character as dividends or interest for purposes of determining source and withholding. Treas. Regs. 1.861-2(a)(7); 1.861-3(a)(6); Section 871(m); Prop. Treas. Reg. 1.871-15.

– The same is true with respect to substitute payments under a repo transaction.

12

Taxation of Securities Loan

• The substitute payments are treated as dividends or interest, as appropriate, for tax treaty purposes where such treaty refers to U.S. definitions of dividend or interest. Treas. Reg. 1.894-1(c).

• Payments made under a securities loan are generally deductible under Section 162 or 212

– Payments made by a non-corporate taxpayer – if related to a short sale – are generally treated as “investment interest” and deductible to extent of investment income. Section 163(d)(3)(C)

– Substitute dividend payments – related to a short sale – are either currently deducted or added to basis depending on the time the short sale is held open. Section 263(h).

• Borrow fees have no clear authority in a cross border context. T.D. 8735, 1997-2 C.B. 73, preamble (requesting comments). See SIFMA comments to Treasury 2013 TNT 25-15

• Rebate fees have historically been treated as U.S. source interest (if from cash collateral), or as earnings directly from the underlying collateral (if from non-cash collateral)

13

Taxation of Securities Loan • AM 2012-009 (Nov. 5, 2012), found that the economic substance

doctrine was relevant to a securities lending transaction

– Transactions occurred prior to 2010 enactment of Section 7701(o)

– For examination guidance regarding the codified economic substance doctrine, see the Directive for Industry Directors regarding "Guidance for Examiners and Managers on the Codified Economic Substance Doctrine and Related Penalties" (LB&I-4-0711-015 (July 15, 2011)) and the Office of Chief Counsel Notice regarding "Coordination Procedures for the Economic Substance Doctrine and Related Penalties" (CC-2012-008).

• Notice 2010-46 (modifying and withdrawing Notice 97-66), officially closes off the transaction described in the GLAM

– Where are we on the issue of cascading withholding?

– Notice 2010-46 introduced the idea of Qualified Securities Lender (QSL)

– Can the QSL regime accommodate Section 871(m) withholding (i.e., any chain of dividend equivalents not just securities loans) 14

Fails Charges

• When the borrower of Treasury or agency securities fails to redeliver the same upon demand, it is charged a cost commonly entitled as “fails charge.”

• Such payments are contracted for in connection with repos, securities loans and purchase versus cash transactions over Treasury and agency debt.

• Treasury regulation 1.863-10 (effective 2/21/2012), provides that the source of a qualified fails charge is the residence of the recipient.

• Industry participants argue that negative rebate and borrow fees should be sourced similarly to fails charges. See SIFMA comments to Treasury 2013 TNT 25-15.

15

Section 871(m) A Narrow Resourcing Provision

16

Overview

• In March 2010, Congress enacted Code § 871(m), effective for “dividend equivalent payments” on “specified NPCs” made on or after September 14, 2010.

• Importantly, section 871(m) does not change the source rules for all other NPCs.

• Congress provided the IRS with the authority to write new rules for dividend equivalents paid on or after March 18, 2012.

• Similar rules will apply to substitute payments under securities lending and repo transactions.

• Section 871(m) may cause U.S. withholding on foreign to foreign payments.

17

Dividend Equivalent Payments

• Dividend equivalent payments include payments

contingent upon or determined by reference to dividends

that would be treated as U.S. source dividends. Code §

871(m)(2)(B).

• US equity indices are generally treated as US stocks for

this purpose.

• Dividend equivalent payments are determined on a

gross basis. Thus, the counterparty may be obligated to

withhold and remit tax on the gross amount of a dividend

equivalent payment even though, as a result of netting,

the counterparty would not be required to make an

actual payment to the foreign investor. 18

Specified NPC

• Under the legislation, a “Specified NPC” is any NPC that has one of the following five elements:

– in connection with entering into such contract, the “long party” transfers the “underlying security” to the “short party.”

– in connection with the termination of the contract, the short party transfers the underlying security to the long party.

– the underlying security is not readily tradable on an established securities market.

– the short party posts the underlying security as collateral.

– the Secretary identifies the contract as a specified NPC.

19

Proposed Regulations under

Section 871(m)

20

Overview

• Expand the types of equity-linked contracts subject to

section 871(m). The 4 existing categories of “Specified

NPCs” increase into 7 categories.

• Amend the withholding regulations promulgated under

Code § 1441. Provide that a dividend equivalent

payment is considered made when the gross amount

used to compute a net amount is transferred.

• Withholding is required if (i) the withholding agent

“receives no payment because the net payment equals

zero” or (ii) the withholding agent receives a payment.

• Gross up payments are also treated as dividend

equivalent payments.

21

Contracts Subject to Section 871(m)

• Futures Contracts

• Forward Contracts

• Options

• Equity-Linked Notes (including Exchange

Traded Notes – “ETNs”)

• Other Contractual Arrangements

22

Revised Categories of Specified

NPCs

• Long Party is in the Market

• Thinly-Traded Stocks

• Short Party Posts the Underlying Stock as Collateral.

• Swaps with Durations of 90 days or less

• Swaps Where the Long Party Controls the Hedges Entered into by

the Short Party

• Swaps Over a More Than 5% of the Public Float (or 20% of 30-day

ADTV)

• Swaps on US Stocks Providing for Exposure to a Special Dividend

23

Taxation of Cross-Border

Derivatives Under Treaties

24

Overview

• The characterization of a payment for treaty purposes is important

because different characterization could mean different rates

imposed on the income.

• In addition, special issues may arise if the payment is characterized

inconsistently in the country of source and the country of residency.

• Theoretically, income from derivatives could fall under one of the

following articles: (i) business income, (ii) dividends, (iii) interest

income, (iv) capital gains, or (v) other income.

• Under all these articles, according to both the U.S. and OECD

Treaty models, the income would generally be taxable only in the

residency country.

25

Business Income

• There is little doubt that when income from derivatives is

attributable to the non-resident's permanent

establishment in the source country, such income should

be taxed by the source country

• This will require a two-step determination of whether the

non-resident has a permanent establishment in the

source country and if so, whether the income is

attributable to such permanent establishment.

26

Dividends

• The dividend article of many U.S. tax treaties generally

defines dividends as "income from shares . . . as well as

income from other corporate rights which is subjected to

the same taxation treatment as income from shares" in

the country where the distributing company resides.

• The recently enacted section 871(m) (discussed above)

treats dividend equivalent payments under certain

equity-linked derivatives as dividends under US tax law.

• If the section 871(m) model is adopted under treaties, all

payments in connection with equity-linked derivatives

could be subject to the dividends article of the treaty.

27

Interest

• In general, payments under a derivative are not treated

as interest because they are not compensation for the

use of money.

• A case where payments under a derivative could be

subject to the interest provision (under US tax law) is in

the case of a significant non-periodic payment in a

notional principal contract that could be treated as an

embedded loan under the source country's domestic

laws.

• In addition, the fee income (interest) from a repo is

treated as interest income (although any payments in

lieu are subject to the transparency regs). 28

Other Income

• If income from a derivative does not fall under any specific article, it

generally must fall into the “other income” article.

• Under this article, income is taxed based on the residency of the

recipient of income.

• However, not all treaties follow the existing treaty models as far as

the "other income" article is concerned, or do not contain an "other

income” article at all.

• Thus, there is no uniformity with respect to the proper tax treatment

of income from derivatives under treaties

29

Proposal • As of today, there is no specific provision in any tax treaty that allocates the

tax on income from derivatives.

• Technical Explanation to 2006 US Model Treaty notes that income from

derivatives is covered under “other income” unless it arises in conduct of

trade or business.

• It is, therefore, strongly suggested that countries will consider adopting a

specific provision in their tax treaties to address this issue.

• Consistent with the international consensus over the appropriate treatment

of income from derivatives discussed in 1995 by IFA, such a provision

should specify that income from a derivative transaction, if not attributed to

a permanent establishment in the source country, should generally be taxed

by the residency country, unless it falls under other treaty provisions such

as interest (e.g., in the case of embedded loans), dividend (e.g., under

concepts similar to section 871(m)) or business income.

• Obviously, the U.S., OECD, and U.N. must assist in revising their treaty

models to include specific rules for derivatives. 30

Derivatives and FATCA

31

FATCA Withholdable Payments

• “Withholdable payments” under FATCA generally

constitute (i) U.S. source FDAP and (ii) gross proceeds

from disposition of property giving rise to U.S. source

interest or dividends.

• Thus, to the extent that periodic and non-periodic

payments with respect to derivatives do not have a U.S.

source, such payments should not be “withholdable

payments” under FATCA.

• In addition, termination payments, even if considered

“gross proceeds” for FATCA purposes, should not be

“withholdable payments” as long as such payments do

not result from disposition of property that gives rise to

“interest” or “dividend.”

32

FATCA Withholdable Payments (cont.)

• Furthermore, all payments connected to a trade or business should

not be subject to withholding because payments in connection with

a trade or business are not FDAP.

• However, in Treas. Reg. 1473-1(a)(4)(iii), under the main heading

of “Payments not treated as withholdable payments”, there is a

caveat in “excluded nonfinancial payments” that says

“Notwithstanding the preceding sentence [and except for

grandfathered payments] withholdable payments include: payments

in connection with a lending transaction (including loans of

securities), a forward, futures, option or NPC, or similar financial

instrument . . ”

• It is unclear whether this statement signals that withholdable

payments include payments under derivatives unless they are

specifically excluded, or whether it is a mistake. Either way, the

IRS should clarify this point.

33

Section 871(m) and FATCA • Because section 871(m) has changed the source rules

for certain dividend equivalent payments, all payments

made in connection with “specified NPCs” would

generally be withholdable payments under FATCA.

• This will include payments in respect to securities loans

and repo transactions.

• The final FATCA regulations provide that the particular

FATCA withholding rules for derivatives subject to

section 871(m) will be issued only after final regulations

are issued under section 871(m) (now still in proposed

form).

• It is recommended that the withholding rules under

FATCA and section 871(m) will be consolidated. 34

Embedded Loans and FATCA

• As discussed above, some derivatives contain

embedded loans that result in interest payments.

• Thus, a disposition of such a contract may result in

withholdable payment beginning 2017 as a payment of

gross proceeds.

• It is possible that a termination payment in connection

with such a derivative would also give rise to FATCA

withholding.

• The IRS should clarify this point in the FATCA

regulations.

35

Ways and Means Proposed

Reform for Derivatives

36

Overview

• On January 24, 2013, David Camp, Chairman of House Ways and

Means Committee, released a Tax Reform Proposal on Financial

Instruments , that, among other things, would provide uniform tax

treatment of derivatives.

• The Draft would require taxpayers engaged in “speculative”

financial activity (as opposed to hedging) to mark certain derivative

positions to market, thus triggering the recognition of gain or loss for

tax purposes.

• According to the Committee, “[b]roadly extending mark-to-market

accounting treatment to derivatives would provide a more accurate

and consistent method of taxing these financial products and make

them less susceptible to abuse, without affecting most small

investors who normally do not invest in these products.”

37

Mark-to-Market

• Gain or loss from derivatives would generally be recognized under a

mark-to-market rule, and such gains or losses would be treated as

ordinary. The character provision is critical because many

derivatives that have been subject to the so called 60/40 rule (under

section 1256) would now be taxed simply as ordinary. In addition,

the gains and losses would be treated as attributable to a trade or

business of the taxpayer.

• Mark-to-market and ordinary treatment would also apply to the

termination or transfer of a taxpayer’s rights or obligations with

respect to a derivative. Such termination or transfer is broadly

defined to include offsetting, taking or making delivery, exercise or

being exercised, assignment or being assigned, lapse, expiration,

settlement, or otherwise.

38

Definition of “Derivative” – any evidence of an interest in, or any derivative instrument with

respect to, any (a) share of stock in a corporation, (b) partnership

interest or beneficial ownership interest in a partnership interest

or trust, (c) note, bond, debenture, or other evidence of

indebtedness, (d) certain real property, (e) actively traded

commodity, or (f) currency

– any NPC

– Any derivative instrument with respect to any interest or

instrument described above

• The definition is intended to be broad in several aspects. It will

includes options, forwards, or futures with respect to any stock,

partnership interest, or debt regardless of whether the contract or

interest, (or the underlying contract or interest) is privately held or

publicly traded.

• It will also include short sales and short securities futures contracts. 39

NPCs • An NPC will be any instrument requiring two or more payments at specified

intervals calculated by reference to a specified index upon one or more

notional amounts.

• An amount will not fail to be treated as a “payment” merely because it is

fixed on one date but paid (or otherwise taken into account) on a different

date.

• A “specified index” will be any one or more of (or a combination of) (1) a

rate, price, or amount (whether fixed or variable); (2) any index based on

any information that is not in the control of any of the parties to the

instrument and not unique to any of the parties’ circumstances; and (3) any

other index as determined under Regulations.

• The Committee noted that the definition of NPC is broader than the

definition under Reg.1.446-3. For example, a specified index includes

indices other than those based on objective financial information, such as

temperature, precipitation, snowfall, or frost.

40

Embedded Derivatives

• A “derivative” would also include any embedded derivative

component of a debt instrument.

• An embedded derivative for this purpose means any term of a debt

instrument that affects some or all of the cash flows or the value of

other payments on the instrument in a manner similar to a derivative.

• A common example is convertible debt.

• The Draft would treat convertible debt as two instruments, non-

convertible debt (not subject to the mark-to-market rule), and an

option to acquire stock of the issuer (subject to mark-to-market).

• This proposed rule is in contrast to the traditional treatment of

convertible debt as a single instrument for tax purposes.

• To implement this rule, revisions to the OID rules (which currently do

not allow separate treatment of the conversion feature) will be

necessary. 41

Possible Cross Border Consequences

of the Reform • The Ways and Means Committee proposed an overhaul

reform with respect to timing and character of payments on

derivatives, but was silent on source.

• However, commentators have responded and urged

Congress to include a unified source rule for derivatives as

part of the reform.

• Even if the source rules are later added, the proposed timing

and character principles could have a significant impact on

cross border derivatives in certain ways.

• The expansion of certain terms such as “derivative” including

embedded derivatives and “NPCs” would result in more

contracts being treated as derivatives and therefore more

cross border contracts will be impacted.

42

Cross border Impact (cont.)

• In addition, the consolidation of the rules for periodic, non-periodic and

termination payments into a single ordinary income/deduction regime

could result in treatment of all payments on derivatives (regardless of

upon termination or pursuant to the terms of the contract) as potentially

being subject to withholding.

• Furthermore, the proposed reform states that all mark-to-market gains

and losses will be treated as connected to a trade or business in

accordance with section 172. While there is no reference to the cross

border aspects of a U.S. trade or business, it may be implicit that

Congress wants to treat all gains earned by non-U.S. residents as

earned as part of a U.S. trade or business.

• The Administration’s Fiscal 2014 Budget Proposal has a similar mark-

to-market proposal but advocates having the source of income as

“determined under current law.”

43