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Cross-border equity swaps

As we have previously discussed in this column, in September 2008 the US Senate Permanent Subcommittee on Investigations released a report entitled Dividend Tax Abuse: How Offshore Entities Dodge Taxes on US Stock Dividends. The report describes a range of transactions allegedly employed by financial institutions aimed at enabling non-US clients to avoid US withholding taxes on dividends paid with respect to US equities. Such dividends, if paid to a non-US person, are generally subject to a 30% US withholding tax since they are US sourced. As described in the report, US withholding taxes on dividends are allegedly avoided through the use of, among other financial arrangements, equity swaps.

These swap transactions rely on a US Treasury regulation which provides that the source of payments made under a swap is determined by reference to the country of residence of the person receiving the payment. As a result, payments made on a swap to a non-US person would not be considered US sourced and therefore not subject to US withholding tax. Legislation is pending in the US Congress that would treat the payment of any "dividend equivalent amounts" with respect to swaps as a "dividend" for US withholding tax purposes and as US sourced if such amounts are with respect to stock of a domestic US corporation. As such, these amounts would be subject to US withholding tax like any dividends paid with respect to US securities. In that situation, the counterparty under the swap – the payer of the dividend equivalent amount – would be considered a withholding agent and would be required to withhold and remit US withholding taxes to the Internal Revenue Service (IRS).

Thomas A Humphreys  Remmelt A Reigersman  Shamir Merali

On January 14 2010, the IRS issued an Industry Director Directive on Total Return Swaps Used to Avoid Dividend Withholding Tax. The Directive provides audit guidance to IRS field agents auditing financial institutions and contains six forms of Iºnformation Document Requests for them to use to obtain information from financial institutions that have engaged in equity swap transactions. The purpose of the Directive is to assist IRS field agents in uncovering and developing cases related to total-return swap transactions that may have been executed to avoid US withholding tax with respect to US-sourced dividend income paid to non-US persons.

It seems that the IRS is looking to assert deficiencies against the financial institutions that facilitated the equity swap transactions, in their capacity as a withholding agent, rather than against the non-US persons that have the substantive tax liability. The Directive includes a description of several transactions perceived to be potentially abusive involving equity swaps: cross-in and cross-out transactions, cross-in and interdealer broker-out transactions, cross-in and foreign affiliate-out transactions, and "fully synthetic" transactions. The IRS encourages its field agents to develop cases where it could be concluded that, in substance, the non-US person retained ownership of the US equities referenced by the swap transactions. As such, the non-US person would be treated as having received a payment of a US source dividend, instead of a payment under a swap which would be foreign source, and which would be subject to US withholding tax.

The financial institution, as a financial intermediary, would be considered a withholding agent with respect to those payments and would be liable for the withholding tax if it failed to withhold and remit the withholding tax to the IRS. To avoid this liability, the financial institution would be expected to argue that the form of the swap transaction should be respected. It is not possible to predict the impact of the Directive on the equity swap market or the ultimate outcome of the transactions described in the Directive if litigated. We understand, however, that a number of financial institutions in the US are already under audit on this issue.

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