Proposed regulations on swap payments sound like bad news for foreign taxpayers who have used them to avoid paying U.S. withholding taxes. But there are ways to structure a swap and still take advantage of the favorable tax treatment.
A total return swap is a cash-settled bilateral contract, in which each party agrees to make certain payments to the other depending on the value and distribution performance of the underlying asset. An investor can enter into a total return swap to simulate an investment in the underlying equity without actually acquiring it.
For example, assume a foreign taxpayer believes that ABC Inc. stock will appreciate and generate high yields over the next several years. For tax and other considerations, instead of investing directly in the shares of ABC, the foreign taxpayer enters into a five-year total return equity swap with an investment bank with respect to 1,000 shares of ABC stock.
At the end of each year the bank pays the foreign taxpayer an amount equal to the sum of any distributions paid with respect to the ABC shares during the year and the increase, if any, in the fair market value of the ABC shares over the course of the year. The foreign taxpayer pays the bank an amount equal to the sum of an interest rate (e.g., the London Interbank Offered Rate or LIBOR) multiplied by the value of the shares at the beginning of the year, and the decrease, if any, in the fair market value of the shares over the course of the year.
Although it is not required to do so, the bank will purchase a certain number of shares of the stock to hedge its position under the swap.
Historically, foreign taxpayers, such as hedge funds, have benefitted greatly from the use of equity swaps.
For U.S. federal income tax purposes, swap payments received by a foreign taxpayer generally are exempt from U.S. withholding tax. The reason is that payments made pursuant to a swap typically are sourced according to the residence of the recipient, and, therefore, would generate foreign source income. This is a much better after-tax result than a foreign taxpayer would achieve if it invested directly in the shares of a U.S. corporation because any U.S. source dividend payments generally would be subject to a 30 percent U.S. withholding tax unless reduced by an applicable income tax treaty.
While the source rule for cross-border swap payments has been in existence for more than 20 years, the IRS has become increasingly concerned about the potential that exists for taxpayers to abuse this rule in the cross-border setting.
After increased audit activity of a number of hedge funds and banks, the IRS determined that some foreign taxpayers were relying on the special source rule for swap payments to avoid U.S. withholding tax by entering into transactions. These transactions include selling shares of a U.S. company to a U.S. financial institution prior to the ex-dividend date, entering into a total return swap with the financial institution that is tied to the value of the shares sold, receiving a dividend-equivalent payment from the financial institution pursuant to the total return swap when the underlying dividend is paid, and terminating the total return swap after receiving the dividend-equivalent payment and reacquiring shares in the same U.S. corporation.
In the earlier example of a total return swap, the financial institution typically would hedge its swap position by simultaneously holding shares in the U.S. corporation. This arrangement effectively passed the U.S. source dividend through to the foreign taxpayer without triggering a U.S. withholding tax obligation. This led to the enactment of Section 871(m) of the Internal Revenue Code in 2010 and more recently the issuance of proposed regulations — the effective date of which was just pushed back from January of 2013 until January of 2014.
Under the proposed regulations, certain swap payments that would otherwise be exempt from U.S. withholding tax under the special source rule would instead be subject to a 30 percent U.S. withholding tax.
A swap that has any of the following characteristics will no longer be subject to the favorable tax treatment in the cross-border setting: (1) the long party (e.g., the foreign taxpayer) is "in the market" on the same day that the parties price the swap or when the swap terminates; (2) the underlying security is not regularly traded on a qualified exchange; (3) the short party (e.g., the bank) posts the underlying security as collateral and the underlying security represents more than 10 percent of the collateral posted by the short party; (4) the term of the swap has fewer than 90 days; (5) the long party controls the short party's hedge; (6) the notional principal amount of the swap is greater than 5 percent of the total public float of the underlying security or greater than 20 percent of the 30-day daily average trading volume, as determined at the close of business on the day immediately preceding the first day of the term of the swap; or (7) the swap is entered into on or after the announcement of a special dividend and prior to the ex-dividend date.
Although these proposed regulations introduce several new concepts that generally will work to foreign taxpayers' disadvantage, it is important to note that these regulations do not take any measures to prevent foreign taxpayers from continuing to take advantage of the special source rule for equity swap payments. Therefore, if structured correctly, foreign taxpayers will continue to benefit from the use of cross-border equity swaps to obtain a more efficient after-tax return in dividend-paying U.S. stocks than a direct investment in the underlying stocks would provide.
Jeffrey L. Rubinger is a partner at Bilzin Sumberg Baena Price & Axelrod and focuses his practice on domestic and international taxation.