IRS Releases Guidance on Substitute Interest and Dividend Payments

The Service has released guidance (Notice 97-66) on complying with the section 871(h)(5) statement requirement for substitute interest payments made between November 13, 1997, and January 1, 1999. At the same time, Notice 97-66 also clarifies how to calculate the amount of tax imposed on foreign-to-foreign payments under reg. sections 1.871-7(b)(2) and 1.881-2(b)(2).

According to the Service, the guidance in Notice 97-66 relates to the final regulations (T.D. 8735) on the source and character of substitute payments made in cross-border securities lending transactions. (For a summary of T.D. 8735, see Tax Notes, Oct. 13, 1997, p. 163; for the full text, see Doc 97-27930 (19 pages).) Under the final regs, substitute interest and dividend payments that are U.S. source are characterized as interest and dividends for purposes of (1) determining the fixed or determinable annual or periodical income of foreign residents and corporations subject to tax under sections 871, 881, 4948(a), and chapter three of the code; and (2) granting tax treaty benefits.

Because the regulations on statement requirements are not generally applicable until January 1, 1999, Notice 97-66 provides interim requirements for satisfying the section 871(h)(5) statement requirement. Under the notice, any written, electronic, or oral statement that reasonably establishes that the payee is a foreign person will satisfy the requirement, so long as the payer receives it before payment, or reasonably soon after payment. To reasonably establish that the payee is a foreign person, the payer must follow the jurisdiction's rules for establishing the identity of a customer.

While T.D. 8735 was designed to eliminate unjustifiable differences between the taxation of similar economic investments, the Service recognizes that the final regs could result in the payment of excessive U.S. withholding tax on a securities loan, sale-repurchase transaction, or series of transactions. To address the problem, Notice 97-66 outlines a formula for determining the amount of U.S. withholding tax imposed on a foreign-to-foreign payment under reg. sections 1.871(b)(2) and 1.881-2(b)(2). Under that formula, the amount of tax equals the amount of the underlying dividend multiplied by a rate equal to the excess of the rate of U.S. withholding tax that would be applicable to U.S. source dividends paid by a U.S. person directly to the recipient of the substitute payment over the rate of U.S. withholding that would be applicable to U.S. source dividends paid by a U.S. person directly to the payer of the substitute payment. To the extent that the total U.S. tax actually withheld on the underlying dividend and any previous substitute payments is greater than the amount of U.S. withholding tax that would be imposed on U.S. source dividends paid by a U.S. person directly to the payer of the substitute payment, the tax may be reduced or eliminated.

The Service warns recipients of substitute payments not to disregard the transaction's form in order to reduce their withholding tax. It also advises that recipients of foreign-to-foreign payments will not be entitled to a refund or tax credit against any other U.S. tax liability.

If substitute payments on foreign-to-foreign securities loans and sale-repurchase transactions do not reduce the overall U.S. withholding tax generally, they will not be subject to withholding tax. For example, the Service says, situations where the transactions occur between residents of the same country don't require a withholding tax.

To illustrate the principles outlined in the notice, the Service includes examples. Those examples cover a same country securities loan; a nonsame country securities loan; increased treaty benefits; and multiple country securities loans.

Finally, Notice 97-66 specifies that each person who makes a foreign-to-foreign payment will be treated as a withholding agent under reg. section 1.1441-7.

For purposes of applying T.D. 8735, the provisions of Notice 97- 66 are effective November 14, 1997. Those withholding agents who need additional time to incorporate both sets of requirements may, however, elect to defer application of the final regs (not including reg. section 1.864-5(b)(2)(ii)) and the notice until January 1, 1998. To make that election, the withholding agent must attach a statement deferring application of the final regs and the notice to a timely filed tax return (Form 1042) for the period that includes November 14, 1997. If no return is required for that period, the withholding agent must attach the election statement to a timely filed return for the period that includes January 1, 1998. Those agents who decide to make the election must apply the provisions of T.D. 8735 and Notice 97-66 for substitute payments made after December 31, 1997.

Individuals interested in commenting on Notice 97-66 may send their comments to the Internal Revenue Service, PO Box 7604, Ben Franklin Station, Attention: CC:CORP:T:R: (Notice 97-66), Room 5228, Washington, DC 20044. Comments are due by January 12, 1998.

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Part III -- Administrative, Procedural, and Miscellaneous

Certain Payments Made Pursuant to a Securities Lending Transaction.

Notice 97-66

SECTION 1. SUMMARY

[1] On October 14, 1997, final regulations were published in the Federal Register [TD 8735], RIN 1545-AP71, (the "final regulations") which source substitute interest and substitute dividend payments that are made pursuant to a securities lending or sale-repurchase transaction by reference to the income that would be earned with respect to the underlying transferred debt security or stock. The final regulations also provide that substitute interest and dividend payments that are U.S. source under the regulations are also characterized as interest and dividends for purposes of determining the fixed or determinable annual or periodical income of foreign resident individuals and corporations subject to tax under sections 871, 881, 4948(a) and Chapter 3 of the Internal Revenue Code and for purposes of granting tax treaty benefits with respect to interest and dividends. As promulgated, the final regulations were made applicable in all respects for substitute interest (as defined in section 1.861-2(a)(7) of the income tax regulations) and substitute dividend payments (as defined in section 1.861-3(a)(6)) made after November 13, 1997.

[2] This Notice provides guidance on complying with the statement requirement of section 871(h)(5) for substitute interest payments made after November 13, 1997, and before January 1, 1999. In addition, the Treasury and the Service intend to propose new regulations to provide specific guidance on how substitute dividend payments made by one foreign person to another foreign person ("foreign-to-foreign payments") are to be treated. Until the proposed regulations are promulgated, this Notice clarifies how the amount of the tax imposed under sections 1.871-7(b)(2) and 1.881-2(b)(2) will be determined with respect to foreign-to-foreign payments. The Treasury and the Service request comments on the treatment of foreign-to-foreign payments provided in this Notice.

SECTION 2. SUBSTITUTE INTEREST PAYMENTS

[3] Substitute interest payments made by a foreign person that are U.S. source interest under the final regulations must satisfy the statement requirement of section 871(h)(5) to qualify as portfolio interest. The final regulations refer taxpayers to section 1.871- 14(c) for this purpose, but those regulations are not generally applicable until January 1, 1999. Under this Notice, the statement requirement of section 871(h)(5) will be satisfied with respect to substitute interest payments made after November 13, 1997 and before January 1, 1999, if any written, electronic, or oral statement that reasonably establishes that the payee is a foreign person is given or made to the payor prior to, or within a reasonable period of time after, the payment. The statement requirement of the preceding sentence is deemed to be satisfied if the payor is subject to, and satisfies with respect to the payee, the regulatory rules in the jurisdiction in which the payor is operating regarding establishing the identity of a customer (i.e., "know your customer" rules). Also, if a taxpayer makes an election under section 1.1441-1(f)(2)(ii), such election will be effective, pursuant to this Notice, to allow a withholding agent to apply retroactively the documentation requirements of section 1.871-14(c) with respect to one or more substitute interest payments made after November 13, 1997. Treas. Reg. section 1.871- 14(c)(3) allows a withholding agent to collect a certificate or documentary evidence at any time until the expiration of the beneficial owner's period of limitation for claiming a refund of tax with respect to portfolio interest.

SECTION 3. SUBSTITUTE DIVIDEND PAYMENTS

[4] The final regulations were adopted to eliminate unjustifiable differences between the taxation of similar economic investments. It has been brought to the attention of the Treasury and the Service, however, that, in certain circumstances, the total U.S. withholding tax paid with respect to a securities loan or sale- repurchase transaction, or series of such transactions, could be excessive due to the application of the final regulations. The Treasury and the Service believe that taxpayers can avoid such excessive withholding taxes in the vast majority of cases by structuring their transactions appropriately. In some circumstances, however, such structuring may be difficult or impossible.

[5] To address these concerns, under this Notice, the amount of U.S. withholding tax to be imposed under sections 1.871-7(b)(2) and 1.881-2(b)(2) with respect to a foreign-to-foreign payment will be the amount of the underlying dividend multiplied by a rate equal to the excess of the rate of U.S. withholding tax that would be applicable to U.S. source dividends paid by a U.S. person directly to the recipient of the substitute payment over the rate of U.S. withholding tax that would be applicable to U.S. source dividends paid by a U.S. person directly to the payor of the substitute payment. This amount may be reduced or eliminated to the extent that the total U.S. tax actually withheld on the underlying dividend and any previous substitute payments is greater than the amount of U.S. withholding tax that would be imposed on U.S. source dividends paid by a U.S. person directly to the payor of the substitute payment. The recipient of a substitute payment may not, however, disregard the form of its transaction in order to reduce the U.S. withholding tax. Therefore, a recipient of a foreign-to-foreign payment will not be entitled to a refund or tax credit against any other U.S. tax liability to reflect the fact that the rate of U.S. withholding tax that would be applicable to a U.S. source dividend paid by a U.S. person directly to such recipient is less than the rate of U.S. withholding tax that would be applicable to a U.S. source dividend paid by a U.S. person directly to the payor of the substitute payment (or any payor of a previous substitute payment or the underlying dividend).

[6] As a result of this formula, substitute payments with respect to foreign-to-foreign securities loans and sale- repurchase transactions that do not reduce the overall U.S. withholding tax generally will not be subject to withholding tax. For example, no withholding tax is required in situations where transactions are entered into between residents of the same country. The Treasury and the Service believe that this Notice adequately addresses the concerns of those foreign persons who are required by their local regulators to enter into transactions only with residents of the same country. Conversely, to the extent a foreign-to-foreign securities loan or sale-repurchase transaction would reduce the overall U.S. withholding tax, an incremental amount of U.S. withholding tax is imposed on the substitute payment.

SECTION 4. LIABILITY OF WITHHOLDING AGENTS

[7] Each person who makes a foreign-to-foreign payment shall be treated as a withholding agent under section 1.1441-7 with respect to such payment. If a U.S. withholding agent withholds the highest rate of tax which would be imposed on all foreign recipients of dividends and substitute payments in a chain of such payments, each foreign withholding agent will be treated as having satisfied its withholding obligation under section 1.1441-7.

SECTION 5. EXAMPLES

[8] The following examples illustrate the principles of this Notice:

[9] Example 1. Same Country Securities Loan. FP, a pension fund resident in Country X, owns stock issued by USCo, a corporation resident in the United States. An income tax treaty between Country X and the United States limits the U.S. withholding tax on gross dividends to 15 percent. USBroker, a U.S. broker- dealer, needs to borrow the stock owned by FP. Under Country X rules intended to safeguard the interests of workers, however, FP is required to deal only with Country X residents in connection with its investment activities. Accordingly, FP enters into a securities loan with FBroker, a broker-dealer also resident in Country X. FBroker then enters into a securities loan with USBroker. USCo pays a dividend of $100 on March 15, 1998. USBroker is the shareholder of record with respect to the dividend. Since USBroker is a U.S. person, USCo does not withhold on the dividend. USBroker makes a substitute payment of $100 to FBroker from which USBroker withholds $15. The rate of withholding tax that would be applicable to a U.S. source dividend payment made by a U.S. person directly to FP is the same as the rate of withholding tax that would be applicable to a U.S. source dividend payment made by a U.S. person directly to FBroker. Accordingly, no U.S. withholding tax is imposed under section 1.871-7(b)(2) or section 1.881-2(b)(2) on the substitute payments made by FBroker to FP.

[10] Example 2. Non-Same Country Securities Loan. A, a resident of Country X, owns shares of USCo, a U.S. resident corporation. Country X has a treaty with the United States which limits the United States tax on gross dividends to 15 percent. A enters into a securities loan with B, a resident of Country Y, whose treaty with the United States also limits the United States tax on gross dividends to 15 percent. USCo pays a dividend of $100 on March 15, 1998. B is the shareholder of record with respect to the dividend. USCo withholds $15 and pays B a net dividend of $85. B makes a substitute payment of $85 to A. The rate of withholding tax that would be applicable to a U.S. source dividend payment made by a U.S. person directly to A is the same as the rate of withholding tax that would be applicable to a U.S. source dividend payment made by a U.S. person directly to B. Accordingly, no U.S. withholding tax is imposed under section 1.871- 7(b)(2) or section 1.881-2(b)(2) on the substitute payments made by B to A.

[11] Example 3. Increased Treaty Benefits. The facts are the same as in example 2, except that Country X has no treaty with the United States. Since a dividend payment made by a U.S. person directly to A would have been subject to a 30-percent withholding tax, B must withhold an additional $15 ((30 percent - 15 percent) x $100) on the substitute payment it makes to A. Alternatively, USCo could have withheld 30 percent from the dividend payment made to B, thereby satisfying B's withholding liability under section 1.1441-7.

[12] Example 4. Multiple Country Securities Loans. A, a resident of Country W, owns shares of USCo, a U.S. resident corporation. Country W has an income tax treaty with the United States that limits the United States tax on gross dividends to 15 percent. B, a resident of Country X, enters into a securities loan with A. Country X does not have an income tax treaty with the United States. C, a resident of Country Y, enters into a securities loan with B. Country Y has an income tax treaty with the United States which limits the United States tax on gross dividends to 10 percent. D, a resident of country Z, enters into a securities loan with C. Country Z has an income tax treaty with the United States which limits the United States tax on gross dividends to 15 percent.

[13] USCo pays a dividend of $100 on March 15, 1998. D is the shareholder of record with respect to the dividend. USCo withholds $15 and pays D a net dividend of $85. D makes a substitute payment of $85 to C. The rate of withholding tax that would be applicable to a U.S. source dividend payment made by a U.S. person directly to C is less than the rate of withholding tax that would be applicable to a U.S. source dividend payment made by a U.S. person directly to D. Accordingly, no U.S. withholding tax is imposed under section 1.871- 7(b)(2) or section 1.881-2(b)(2) on the substitute payments received by C. However, C is not entitled to a refund or tax credit against any other U.S. tax liability for the additional 5-percent tax reflected in its substitute payment from D over the amount to which C would have been subject had C received a dividend directly from USCo.

[14] C makes a substitute payment of $85 to B from which C withholds $15. Since a dividend payment made by a U.S. person directly to B would have been subject to a 30-percent withholding tax, C generally would be required to withhold an additional $20 ((30 percent - 10 percent) x $100) on the substitute payment it makes to B. However, because $15 actually was withheld with respect to a $100 gross dividend paid to D, C may reduce by $5 ((15 percent - 10 percent) x $100) the $20 withholding obligation on its substitute payment to B.

[15] B makes a substitute payment of $70 to A. The rate of withholding tax that would be applicable to a U.S. source dividend payment made by a U.S. person directly to A is less than the rate of withholding tax that would be applicable to a U.S. source dividend payment made by a U.S. person directly to B. Accordingly, no U.S. withholding tax is imposed under section 1.871- 7(b)(2) or section 1.881-2(b)(2) on the substitute payment received by A. However, A is not entitled to a refund or tax credit against any other U.S. tax liability for the additional 15-percent tax reflected in its substitute payment from B over the amount to which A would have been subject had A received a dividend directly from USCo.

[16] Alternatively, USCo could have withheld 30 percent from the dividend payment made to D, thereby satisfying C's withholding obligation under section 1.1441-7.

SECTION 6. EFFECTIVE DATE OF REGULATIONS

[17] The provisions of this Notice are effective for purposes of applying the final regulations as of November 14, 1997, the effective date of those regulations. Because some withholding agents may require additional time to adjust their business practices to implement the provisions of the final regulations and this Notice, a withholding agent can elect to defer the application of the final regulations, other than Treas. Reg. section 1.864-5(b)(2)(ii), and this Notice until January 1, 1998. A withholding agent makes such an election by attaching a statement to such effect to a timely filed tax return (Form 1042) for the period that includes November 14, 1997, or if no such return is otherwise required for the period including that date, on a timely filed return (Form 1042) for the period that includes January 1, 1998. Withholding agents making this election must apply the provisions of the final regulations and this Notice for substitute payments made after December 31, 1997.

SECTION 7. REQUEST FOR COMMENTS

[18] Treasury and the Service invite comments on the guidance provided by this Notice. Written comments should be submitted by January 12, 1998 to the Internal Revenue Service, P.O. Box 7604 Ben Franklin Station, Attention: CC:CORP:T:R: (Notice 97-66) Room 5228, Washington, D.C. 20044. Alternatively, comments may be submitted via the internet at: http://www.irs.ustreas.gov/prod/tax_regs/comments.html. The comments submitted will be available for public inspection and copying.

SECTION 8. PAPERWORK REDUCTION ACT

[19] The collections of information contained in this Notice have been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under control number 1545-1566.

[20] An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid control number.

[21] The collections of information contained in this Notice are in Sections 2 and 6. The information is required to qualify substitute interest payments as portfolio interest and to defer, on election by the taxpayer, the effective date of this Notice and the final securities lending regulations (TD 8735, 62 FR 53498) for substitute payments made after December 31, 1997. The information will be used for the same purpose described in the preceding sentence. The collections of information are required to obtain a benefit. The likely respondents are businesses or other for-profit institutions.

[22] The estimated total annual reporting and/or recordkeeping burden is 61,750 hours.

[23] The estimated annual burden per respondent/recordkeeper varies from 1 minute to 15 minutes, depending on individual circumstances, with an estimated average of 10 minutes. The estimated number of respondents and/or recordkeepers is 377,500.

[24] The estimated frequency of responses (used for reporting requirements only) is once.

[25] Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

SECTION 9. CONTACT INFORMATION

[26] The principal author of this Notice is Paul Epstein of the Office of the Associate Chief Counsel (International) within the Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C. 20224. For further information regarding this Notice contact Milton Cahn or Paul Epstein at 202-622- 3870 (not a toll-free call).