[Federal Register Volume 62, Number 198 (Tuesday, October 14, 1997)]
[Rules and Regulations]
[Pages 53498-53502]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-25999]
-----------------------------------------------------------------------
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 8735]
RIN 1545-AP71
Certain Payments Made Pursuant to a Securities Lending
Transaction
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
-----------------------------------------------------------------------
SUMMARY: This document contains final Income Tax Regulations relating
to the taxation of certain payments made pursuant to a cross-border
securities lending transaction. These regulations provide guidance
concerning the source, character, and income tax treaty treatment of
such payments and affect
[[Page 53499]]
United States payors and recipients and foreign payors and recipients.
DATES: These regulations are effective October 14, 1997.
Applicability: These regulations are applicable to payments made
after November 13, 1997.
FOR FURTHER INFORMATION CONTACT: Ramon Camacho or Paul Epstein at (202)
622-3870 (not a toll-free number) of the Office of Associate Chief
Counsel (International), within the Office of Chief Counsel, Internal
Revenue Service, 1111 Constitution Avenue, NW., Washington, DC 20224.
SUPPLEMENTARY INFORMATION:
Background
On January 9, 1992, the IRS published proposed amendments (INTL-
106-89) to the Income Tax Regulations (26 CFR part 1) under sections
861, 871, 881, 894, and 1441 of the Internal Revenue Code of 1986
(Code) in the Federal Register (57 FR 860). A public hearing was
scheduled but was subsequently cancelled because no one requested to
testify. However, several written comments were received. After
consideration of all of the comments, the regulations proposed by INTL-
106-89 are adopted by this Treasury decision, as modified.
Explanation of Provisions
I. The 1992 Proposed Regulations
On January 9, 1992, the Internal Revenue Service (IRS) issued
proposed regulations that provided guidance on the source and character
of substitute payments made in cross-border securities lending
transactions. In general, the regulations proposed to source substitute
payments by reference to the source of the payments (dividend or
interest) for which they substitute. In addition, the regulations
proposed to characterize substitute payments under a transparency rule.
Under the transparency rule, substitute payments are treated as having
the same character as the dividend or interest income for which they
substitute.
Under the proposed regulations, the source rule applies for all
purposes of the Code in cross-border securities lending transactions.
In contrast, the transparency rule addressing the character of
substitute payments applies only for purposes of determining the tax
liability under sections 871 and 881 and nonresident alien withholding
under chapter 3 of the Code and for treaty purposes. Generally, public
comments welcomed the transparency rule because it eliminated
unjustifiable tax biases between similar economic investments. After
considering all the public comments, the proposed regulations are
adopted as final regulations by this Treasury decision, substantially
as proposed.
II. The Final Regulations
1. General rule
The final regulations, like the proposed regulations, provide that
a substitute payment made with respect to a securities lending or sale-
repurchase transaction is sourced using the general rules governing the
source of interest or dividend income contained in sections 861 and
862. The definitions of securities lending transactions and sale-
repurchase transactions are provided in Secs. 1.861-2(a)(7) and 1.861-
3(a)(6) of the regulations. These provisions define a substitute
payment as a payment made to the transferor of a security of an amount
equal to any distributions of dividends or interest which the owner of
the transferred security would normally receive. The regulations also
provide that substitute interest or dividend payments have the same
character as interest or dividend income, respectively, for purposes of
applying sections 864(c)(4)(B), 871, 881, 894, 4948(a) and the
withholding provisions under chapter 3 of the Internal Revenue Code.
2. Scope of regulation
Some commentators questioned whether a sale-repurchase transaction
is considered a transaction that is substantially similar to a
securities lending transaction for purposes of the proposed
regulations. They noted that most sale-repurchase transactions
contractually permit the purchaser to deal freely with the underlying
securities, specifying only that substantially identical securities be
returned on the repurchase date. In such cases the purchaser must also
make substitute payments to the seller. The final regulations clarify
that substitute payments made in a sale-repurchase transaction are
sourced and characterized in the same manner that substitute payments
are sourced and characterized in securities lending transactions.
The final regulations only address the tax treatment of substitute
payments received by the transferor in securities lending or sale-
repurchase transactions. The regulations do not address the treatment
of fees or interest paid to the transferee in such transactions. For
example, the transparency rule does not extend to characterize the
interest component of the repurchase price of a sale-repurchase
agreement, which is treated as interest and sourced under the general
source rules for interest contained in sections 861 and 862. See Rev.
Rul. 74-27 (1974-1 C.B. 24); Rev. Rul. 77-59 (1977-1 C.B. 196);
Nebraska Department of Revenue v. Loewenstein, 115 S. Ct. 557 (1994).
In response to comments, the final regulations apply for purposes
of determining the source of substitute payments, regardless of whether
the recipient of the income is U.S. or foreign. When source is
determined under these regulations, it applies for all purposes of the
Code (e.g., foreign tax credit limitations under sections 904 and 906).
However, with respect to the characterization of substitute payments,
the IRS and Treasury believe that it is appropriate, and more
consistent with existing guidance regarding the treatment of substitute
payments, to apply the transparency rule only with respect to foreign
taxpayers and only for limited purposes. Accordingly, the transparency
rule applies to determine character only for certain purposes of
sections 864, 871, 881, 894, 4948(a) and chapter 3 of the Code. For
example, under this rule, substitute payments to a foreign person with
respect to stocks and securities that, absent the securities lending
transaction, would give rise to foreign source effectively connected
income in the hands of such person, will retain their character as
dividend or interest income for purposes of determining whether the
income is effectively connected to the U.S. trade or business of such
person.
The transparency rule does not apply, however, to characterize the
U.S. source income of U.S. trades or businesses of foreign taxpayers.
Accordingly, U.S. source effectively connected income of foreign
taxpayers and U.S. source income of U.S. taxpayers will be treated the
same. In this regard, the final regulations do not affect existing
guidance applicable to both U.S. and foreign taxpayers concerning the
characterization of substitute payments for purposes of other sections
not specifically identified in these final regulations. See, e.g., ev.
Rul. 60-177 (1960-1 C.B. 9), (substitute payments are ineligible for
the dividends received deduction under section 243); Rev. Rul. 80-135
(1980-1 C.B. 18), (substitute payments are ineligible for the tax-
exemption on state and local bonds under section 103).
Because the transparency rule does not apply for purposes of
sections 901 and 903, nothing in the final regulations affects the
determination required under Sec. 1.901-2(f) concerning the identity of
the person by whom a foreign tax is considered paid for purposes of
sections 901 and 903.
[[Page 53500]]
3. Substitute payments on portfolio debt instruments
Under the final regulations, substitute interest payments made with
respect to a debt instrument, the interest on which qualifies as
portfolio interest under section 871(h) or section 881(c) in the hands
of the lender, is characterized as portfolio interest if, in the case
of an obligation in registered form, the lender provides the
withholding agent with a beneficial owner withholding certificate or
documentary evidence in accordance with Sec. 1.871-14(c) and no
exception from the portfolio interest exemption applies. For example,
if a bank lends securities in a transaction that the facts and
circumstances indicate in substance is an extension of credit pursuant
to a loan agreement in the ordinary course of the bank's trade or
business, the substitute payment may be characterized as interest which
would not qualify as portfolio interest under section 881(c)(3)(A).
4. Tax treaties
Some commentators noted that the transparency rule adversely
affects foreign taxpayers that might otherwise rely on a different
characterization of substitute payments in order to claim benefits
under certain income tax treaties. The transparency rule would
eliminate these benefits in a number of cases. Those commentators
questioned the government's authority to issue regulations that would
characterize substitute payments as dividend or interest income in
light of U.S. income tax treaty provisions.
The IRS and Treasury believe that the transparency rule in general
is properly issued pursuant to the general grant of authority under
section 7805 because it eliminates opportunities for abuse that arise
from a rule that would characterize substitute payments in a manner
different from the treatment of the underlying payment. A transparency
approach provides uniform results for economically similar investments.
Moreover, the IRS and Treasury believe that, in the absence of a
transparency rule, many taxpayers would use securities lending
transactions in order to avoid tax under tax treaties or under the
Code. For this reason, authority to characterize substitute payments
for Code and treaty purposes in the manner proposed in 1992 also is
amply provided in section 7701(l), which was enacted after these
comments were received. Section 7701(l) provides a broad grant of
authority to issue regulations recharacterizing multiple party
financing arrangements to prevent the avoidance of any tax.
In this regard, the legislative history provides that ``the
committee seeks to bolster the Treasury's ability to prevent
unwarranted avoidance of tax through multiple-party financial
engineering as well as to provide a mechanism for issuing additional
guidance to taxpayers entering into financial transactions.'' See H.R.
Rep. No. 103-111, 103rd Cong., 1st Sess. 729 (1993). The committee also
made clear that this authority was not limited to the types of back-to-
back loan transactions addressed in prior rulings. See Rev. Rul. 84-152
(1984-2 C.B. 381); Rev. Rul. 84-153 (1984-2 C.B. 383); Rev. Rul. 87-89
(1987-2 C.B. 195). Section 7701(l) in fact has been applied to a broad
range of financial transactions. See, e.g., Prop. Regs. Sec. 1.7701(l)-
2 (treatment of obligation-shifting transactions); and Notice 97-21
(IRB 1997-11, March 17, 1997), (tax avoidance using self-amortizing
investments in conduit financing entities).
The 1992 proposed regulation under section 894 provided that where
an income tax convention refers to United States law, the relevant law
is the section or sections of the Internal Revenue Code and regulations
thereunder governing the tax which is the subject of the provision.
Some commentators have suggested that the proposed securities lending
regulations would be invalid for purposes of characterizing dividends
that are specifically defined by treaties. However, under conduit
principles and additional authority to characterize payments pursuant
to section 7701(l), the regulations adopted under Sec. 1.894-1(c)
address the identity of the owner of dividend and interest income for
treaty purposes as opposed to the character of the payments received
under varying treaty definitions. These regulations therefore are
consistent with the government's authority under treaties to determine
the identity of the beneficial owner of income.
Special Analyses
It has been determined that this Treasury decision is not a
significant regulatory action as defined in EO 12866. Therefore, a
regulatory assessment is not required. It is hereby certified that
these regulations will not have a significant economic impact on a
substantial number of small entities. Accordingly, a regulatory
flexibility analysis is not required. This certification is based on
the information that follows. These regulations affect entities engaged
in cross-border multiple-party financing arrangements. These
regulations affect the tax treatment of substitute payments made with
respect to stocks and debt securities. The primary participants who
engage in cross-border multiple party financing arrangements of this
type are large regulated commercial banks and brokerage firms. In
addition, comments received in response to the notice of proposed
rulemaking were from law associations, other associations that
represent large regulated financial companies or from individuals.
Accordingly, Treasury and IRS do not believe that a substantial number
of small entities engages in cross-border multiple party financing
arrangements of the type covered by these regulations. Pursuant to
section 7805(f) of the Code, the notice of proposed rulemaking
preceding these regulations was submitted to the Small Business
Administration for comment on its impact on small business.
Drafting Information: The principal author of these regulations is
Ramon Camacho of the Office of the Associate Chief Counsel
(International).
However, other personnel from the IRS and Treasury Department
participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 is amended by adding
entries in numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.861-2 also issued under 26 U.S.C. 863(a).
Section 1.861-3 also issued under 26 U.S.C. 863(a). * * *
Section 1.864-5 also issued under 26 U.S.C. 7701(l). * * *
Section 1.871-7 also issued under 26 U.S.C. 7701(l). * * *
Section 1.881-2 also issued under 26 U.S.C. 7701(l). * * *
Section 1.894-1 also issued under 26 U.S.C. 7701(l). * * *
Par. 2. Section 1.861-2 is amended by adding a sentence at the end
of paragraph (a)(1); adding paragraph (a)(7); and revising paragraph
(e) to read as follows:
Sec. 1.861-2 Interest.
(a) * * * (1) * * * See paragraph (a)(7) of this section for
special rules concerning substitute interest paid or
[[Page 53501]]
accrued pursuant to a securities lending transaction.
* * * * *
(7) A substitute interest payment is a payment, made to the
transferor of a security in a securities lending transaction or a sale-
repurchase transaction, of an amount equivalent to an interest payment
which the owner of the transferred security is entitled to receive
during the term of the transaction. A securities lending transaction is
a transfer of one or more securities that is described in section
1058(a) or a substantially similar transaction. A sale-repurchase
transaction is an agreement under which a person transfers a security
in exchange for cash and simultaneously agrees to receive substantially
identical securities from the transferee in the future in exchange for
cash. A substitute interest payment shall be sourced in the same manner
as the interest accruing on the transferred security for purposes of
this section and Sec. 1.862-1. See also Secs. 1.864-5(b)(2)(iii),
1.871-7(b)(2), 1.881-2(b)(2) and for the character of such payments and
Sec. 1.894-1(c) for the application tax treaties to these transactions.
* * * * *
(e) Effective dates. Except as otherwise provided, this section
applies with respect to taxable years beginning after December 31,
1966. For corresponding rules applicable to taxable years beginning
before January 1, 1967, (see 26 CFR part 1 revised April 1, 1971).
Paragraph (a)(7) of this section is applicable to payments made after
November 13, 1997.
Par. 3. Section 1.861-3 is amended by adding a sentence at the end
of paragraph (a)(1); adding paragraph (a)(6); and removing the first
sentence of paragraph (d) and adding three sentences in its place to
read as follows:
Sec. 1.861-3 Dividends.
(a) * * * (1) * * * See also paragraph (a)(6) of this section for
special rules concerning substitute dividend payments received pursuant
to a securities lending transaction.
* * * * *
(6) Substitute dividend payments. A substitute dividend payment is
a payment, made to the transferor of a security in a securities lending
transaction or a sale-repurchase transaction, of an amount equivalent
to a dividend distribution which the owner of the transferred security
is entitled to receive during the term of the transaction. A securities
lending transaction is a transfer of one or more securities that is
described in section 1058(a) or a substantially similar transaction. A
sale-repurchase transaction is an agreement under which a person
transfers a security in exchange for cash and simultaneously agrees to
receive substantially identical securities from the transferee in the
future in exchange for cash. A substitute dividend payment shall be
sourced in the same manner as the distributions with respect to the
transferred security for purposes of this section and Sec. 1.862-1. See
also Secs. 1.864-5(b)(2)(iii), 1.871-7(b)(2) and 1.881-2(b)(2) for the
character of such payments and Sec. 1.894-1(c) for the application of
tax treaties to these transactions.
* * * * *
(d) * * * Except as otherwise provided in this paragraph this
section applies with respect to dividends received or accrued after
December 31, 1966. Paragraph (a)(5) of this section applies to certain
dividends from a DISC or former DISC in taxable years ending after
December 31, 1971. Paragraph (a)(6) of this section is applicable to
payments made after November 13, 1997. * * *
Par. 4. Section 1.864-5 is amended by redesignating paragraph
(b)(2)(ii) as paragraph (b)(2)(iii) and adding new paragraph (b)(2)(ii)
to read as follows:
Sec. 1.864-5 Foreign source income effectively connected with U.S.
business.
* * * * *
(b) * * *
(2) * * *
(ii) Substitute payments. For purposes of this paragraph (b)(2), a
substitute interest payment (as defined in Sec. 1.861-2(a)(7)) received
by a foreign person subject to tax under this paragraph (b) pursuant to
a securities lending transaction or a sale-repurchase transaction (as
defined in Sec. 1.861-2(a)(7)) with respect to a security (as defined
in Sec. 1.864-6(b)(2)(ii)(c)) shall have the same character as interest
income paid or accrued with respect to the terms of the transferred
security. Similarly, for purposes of this paragraph (b)(2), a
substitute dividend payment (as defined in Sec. 1.861-3(a)(6)) received
by a foreign person pursuant to a securities lending transaction or a
sale-repurchase transaction (as defined in Sec. 1.861-3(a)(6)) with
respect to a stock shall have the same character as a distribution
received with respect to the transferred security. This paragraph
(b)(2)(ii) is applicable to payments made after November 13, 1997.
* * * * *
Par. 5. Section 1.871-7 is amended by redesignating the text of
paragraph (b) as paragraph (b)(1); adding a paragraph heading for newly
designated paragraph (b)(1); adding paragraph (b)(2); and removing the
first sentence of paragraph (f) and adding two sentences in its place
to read as follows:
Sec. 1.871-7 Taxation of nonresident alien individuals not engaged in
U.S. business.
* * * * *
(b) Fixed or determinable annual or periodical income--(1) General
rule. * * *
(2) Substitute payments. For purposes of this section, a substitute
interest payment (as defined in Sec. 1.861-2(a)(7)) received by a
foreign person pursuant to a securities lending transaction or a sale-
repurchase transaction (as defined in Sec. 1.861-2(a)(7)) shall have
the same character as interest income paid or accrued with respect to
the terms of the transferred security. Similarly, for purposes of this
section, a substitute dividend payment (as defined in Sec. 1.861-
3(a)(6)) received by a foreign person pursuant to a securities lending
transaction or a sale-repurchase transaction (as defined in Sec. 1.861-
3(a)(6)) shall have the same character as a distribution received with
respect to the transferred security. Where, pursuant to a securities
lending transaction or a sale-repurchase transaction, a foreign person
transfers to another person a security the interest on which would
qualify as portfolio interest under section 871(h) in the hands of the
lender, substitute interest payments made with respect to the
transferred security will be treated as portfolio interest, provided
that in the case of interest on an obligation in registered form (as
defined in Sec. 1.871-14(c)(1)(i)), the transferor complies with the
documentation requirement described in Sec. 1.871-14(c)(1)(ii)(C) with
respect to the payment of the substitute interest and none of the
exceptions to the portfolio interest exemption in sections 871(h) (3)
and (4) apply. See also Sec. 1.861-2(b)(2) and 1.894-1(c).
* * * * *
(f) * * * Except as otherwise provided in this paragraph, this
section shall apply for taxable years beginning after December 31,
1966. Paragraph (b)(2) of this section is applicable to payments made
after November 13, 1997. * * *
Par. 6. Section 1.881-2 is amended by redesignating the text of
paragraph (b) as paragraph (b)(1); adding a paragraph heading for newly
designated paragraph (b)(1); adding a paragraph (b)(2); and removing
the first sentence of paragraph (e) and adding two sentences in its
place to read as follows:
[[Page 53502]]
Sec. 1.881-2 Taxation of foreign corporations not engaged in U.S.
business.
* * * * *
(b) Fixed or determinable annual or periodical income--(1) General
rule.
(2) Substitute payments. For purposes of this section, a substitute
interest payment (as defined in Sec. 1.861-2(a)(7)) received by a
foreign person pursuant to a securities lending transaction or a sale-
repurchase transaction (as defined in Sec. 1.861-2(a)(7)) shall have
the same character as interest income received pursuant to the terms of
the transferred security. Similarly, for purposes of this section, a
substitute dividend payment (as defined in Sec. 1.861-3(a)(6)) received
by a foreign person pursuant to a securities lending transaction or a
sale-repurchase transaction (as defined in Sec. 1.861-2(a)(7)) shall
have the same character as a distribution received with respect to the
transferred security. Where, pursuant to a securities lending
transaction or a sale-repurchase transaction, a foreign person
transfers to another person a security the interest on which would
qualify as portfolio interest under section 881(c) in the hands of the
lender, substitute interest payments made with respect to the
transferred security will be treated as portfolio interest, provided
that in the case of interest on an obligation in registered form (as
defined in Sec. 1.871-14(c)(1)(i)), the transferor complies with the
documentation requirement described in Sec. 1.871-14(c)(1)(ii)(C) with
respect to the payment of substitute interest and none of the
exceptions to the portfolio interest exemption in sections 881(c) (3)
and (4) apply. See also Secs. 1.871-7(b)(2) and 1.894-1(c).
* * * * *
(e) * * * Except as otherwise provide in this paragraph, this
section applies for taxable years beginning after December 31, 1966.
Paragraph (b)(2) of this section is applicable to payments made after
November 13, 1997. * * *
Par. 7. Section 1.894-1 is amended by revising paragraph (c) and
adding paragraph (d) to read as follows:
Sec. 1.894-1 Income affected by treaty.
* * * * *
(c) Substitute interest and dividend payments. The provisions of an
income tax convention dealing with interest or dividends paid to or
derived by a foreign person include substitute interest or dividend
payments that have the same character as interest or dividends under
Sec. 1.864-5(b)(2)(ii), 1.871-7(b)(2) or 1.881-2(b)(2). The provisions
of this paragraph (c) shall apply for purposes of securities lending
transactions or sale-repurchase transactions as defined in Sec. 1.861-
2(a)(7) and Sec. 1.861-3(a)(6).
(d) Effective dates. Paragraphs (a) and (b) of this section apply
for taxable years beginning after December 31, 966. For corresponding
rules applicable to taxable years beginning before January 1, 1967,
(see 26 CFR part 1 revised April 1, 1971). Paragraph (c) of this
section is applicable to payments made after November 13, 1997.
Sec. 1.7701(l)-1 [Amended]
Par. 10. Section 1.7701(l)-1 is amended as follows:
1. Paragraph (a) is amended by removing the paragraph designation
(a) and the heading.
2. Paragraph (b) is removed.
Michael P. Dolan,
Acting Commissioner of Internal Revenue.
Approved: August 28, 1997.
Donald C. Lubick,
Acting Assistant Secretary of the Treasury.
[FR Doc. 97-25999 Filed 10-6-97; 8:45 am]
BILLING CODE 4830-01-P