Window of opportunity for tax-exempt repatriation of substitute payments in cross border securities lending transactions.

• Author: Yu, Angela

The IRS has issued proposed regulations under Secs. 861, 871, 881, 894 and 1441 on the source, character and income tax treaty treatment of substitute interest and dividend payments made pursuant to cross-border securities lending transactions. Securities lenders from countries that have treaties with the United States containing a provision to exempt "other income" from source country taxation (most notably, the United Kingdom) may have small window in which to avoid U.S. withholding tax on substitute payments made before the proposed regulations are finalized. This opportunity may be most valuable to pension trusts or other exempt entities in another treat country.

Sec. 1058 provides, under certain conditions, for nonrecognition of gain or loss by the owner of securities on a transfer of securities to a borrower when identical securities will be returned. One condition requires the borrower to make "substitute payments" to the lender equal to all interest, dividends and other distributions that the owner of the securities would be entitled to receive during the lending period. Under Prop. Regs. Sec. 1.1058-1(d) (issued in 1983), the "substitute payments" are treated by the lender as a fee for the temporary use of property. Until the new proposed regulations were issued, there had been no guidance on the borrower's treatment of the payments or their characterization for U.S. withholding tax purposes.

Generally, payments to non- U.S. recipients of interest, dividend and other fixed and determinable annual or periodical income are subject to a 30% U.S. withholding tax unless the payment is effectively connected to the payee's U.S. trade or business. The tax rate may be reduced by a tax treaty between the payee's country of residence and the United States. The characterization of payments is important; different treaty tax rates apply to different types of payments.

U.S. tax authorities have, on at least two occasions, refrained from providing specific guidance on the source and character of substitute payments. In IRS Letter Ruling 8822060, a cross-border Sec. 1058 securities lending transaction required the borrower to pay the lender two separate amounts: (1) a fee in consideration for the loan and (2) an amount equal to all distributions in respect of loaned securities (i.e., substitute payments). The amount of the fee payable (the first item) varied depending on market conditions and the securities involved. For example, the more scarce...