The HIRE Act and the IRS address dividend equivalent payments on equity swaps.

• Author: Schwieger, Denise
• Position: Hiring Incentives to Restore Employment Act

The taxation of equity total return swaps (TRSs) held by a foreign investor not subject to U.S. federal net income tax has been the subject of many wide-ranging audits in recent years. These audits have canvassed both the financial institutions that offer TRSs and the foreign clients (e.g., hedge funds) that execute them. The issue is whether any dividend-equivalent payments made under the terms of a TRS are subject to the 30% gross withholding tax or to a reduced amount under an applicable tax treaty.

Even though actual dividend payments made by U.S. corporations to foreign investors are generally subject to withholding tax, most financial institutions and other taxpayers contend that dividend-equivalent payments made pursuant to TRSs and other notional principal contracts (NPCs) are not subject to withholding tax and reporting on Form 1042-S, Foreign Person's U.S. Source Income Subject to Withholding, because such payments are considered to have a foreign source under Regs. Sec. 1.863-7 general sourcing rules. Notwithstanding this disparity of treatment between dividends and swap payments, some iterations of these transactions have recently been identified as dividend withholding minimization transactions pursuant to a new Tier I issue, U.S. Withholding Agents--Reporting and Withholding on U.S. Source FDAP Income.

On March 18, 2010, President Obama signed into law the Hiring Incentives to Restore Employment Act, P.L. 111-147 (the HIRE Act), which enacted new Sec. 871(1). The HIRE Act imposes withholding tax on certain TRSs effective for payments made on or after 180 days from enactment (see more detailed discussion below). The act applies to new and existing transactions as long as dividend-equivalent payments are made on or after the effective date of the law. In addition, the IRS recently issued an industry directive that discusses the taxation of TRSs held by foreign investors. The directive provides guidance to field agents as to the specific types of TRSs that should be recharacterized into another type of arrangement (e.g., an agency relationship or securities loan) that would subject the dividend-equivalent payments to withholding tax. The directive is currently effective and applies to both new and existing transactions executed prior to its issuance.

IRS Directive

On January 14, 2010, the IRS issued an industry directive (LMSB-4-1209-044) regarding the examination of U.S. financial institutions--defined in the attachments to the...