PwC alternatives alert, January 29, 2010

IRS industry directive on total return swaps used to avoid dividend withholding tax

Audits of hedge funds and private equity funds have steadily increased since 2009. This increase in audits is attributable to a significant investment by the IRS in the creation of a special examination team focused on hedge funds and private equity funds. The IRS also has designated attorneys to provide increased legal and case support for the revenue agents assigned to these audits.

Either as a direct result of ongoing investment fund audits or dedicated legal attention and support, the IRS has begun to release targeted guidance to field agents on specific industry issues. For example, a few months ago the IRS issued a General Legal Advice Memo (GLAM) concerning loan origination and the tax treatment to off-shore lenders with dependent agents in the United States.

Another issue the IRS is focusing on is the use of swaps to avoid US withholding tax on US-source dividend income. On January 14, 2010, the IRS published an industry director directive (IDD) to provide guidance to its field agents for the development of audits involving withholding tax on total return swaps (TRS) over US equities. The IDD focuses on audits of financial institutions acting as counterparties to these swaps, but it also provides valuable insight on the IRS' approach to these transactions, which is relevant to investors as well.

Background

If a foreign taxpayer directly owns stock in a US corporation, dividends paid on the stock generally are considered to be from US sources and are subject to US withholding tax. When a foreign taxpayer enters into a properly structured TRS over stock of a US corporation, all payments received by the foreigner (including dividend-equivalent amounts with respect to the US stock) generally are treated as foreign source income, and are not subject to US withholding tax.

For the past few years, the IRS, Treasury Department, and Congress have been concerned that foreign taxpayers can achieve different tax results in these two situations, which are economically identical for many practical purposes. Furthermore, the government has been greatly concerned that many TRSs were not properly structured as derivatives for tax purposes but rather conveyed ownership of the US stock to the foreigner under general tax principles (such that payments designated as foreign source dividend-equivalent amounts under a TRS are more properly characterized as US-source dividends routed through an agent via the TRS arrangement).

These withholding tax considerations are part of a wider set of issues designated by the IRS as "Tier I" issues, which requires that they be raised on audit.

Pending legislative proposals would change, by statute, the sourcing of payments on TRSs over US equities to US source (and, therefore, clearly subject them to the US withholding tax regime). Because these proposals are only pending, IRS is continuing to audit existing transactions under current law.

Summary of the IDD on total return swaps

The IDD provides specific instructions to IRS field agents with respect to the audit of certain TRS transactions entered into by financial institutions acting as counterparties on TRS. The IDD considers four specific TRS fact patterns and provides guidance to the IRS field agents with respect to each kind of transaction.

The four situations of transactions identified by the IDD are:

(1) Cross-in, cross-out: The foreign taxpayer begins the transaction as the owner of the relevant US equity interest. It sells the US equity to a financial institution (the cross-in) and simultaneously enters into a TRS with the purchaser over that same US equity. The sales price on the cross-in is used as the beginning price for determining the parties' entitlements under the TRS. Subsequently, the foreign taxpayer terminates the TRS and simultaneously repurchases the stock back from the same counterparty (the cross-out). The sales price on the cross-out is used as the settlement price for determining the parties' entitlements under the TRS.

(2) Cross-in, IDB out: As in Situation 1, the foreign taxpayer crosses in with a financial institution at the time it executes a TRS. When the foreigner subsequently terminates the TRS, it simultaneously repurchases the US equity from a third party, an interdealer broker (IDB), with whom an arrangement has been made to facilitate a cross-out. That is to say, rather than crossing out directly with each other, the foreign taxpayer and the financial institution interpose a cooperative IDB to assist them in achieving the same result, minus a small fee.

(3) Cross-in, foreign affiliate out: The facts are the same as in Situation 1, except that the foreign taxpayer executes the cross-in sale with an affiliate of the party with which it executes the TRS. (In other words, rather than using an IDB to facilitate a cross-in or cross-out, the parties simply use an affiliate of the financial institution.)

(4) Fully synthetic: The foreign taxpayer enters into a TRS over a US equity without owning the US equity before or after.

The IDD directs field agents to challenge transactions described in Situations 1, 2, and 3, and to develop the facts in these situations to support the legal conclusion that the foreign taxpayer retained tax ownership of the US equity during the term of the TRS.

Notably, the IDD provides (in its discussion of Situation 2), that if the field does not, after examination, find a cross-out (or evidence of an arrangement with an IDB designed to achieve the same result), then the examination of the transaction should be concluded.

Furthermore, with respect to the fully synthetic transactions described in Situation 4, the IRS indicated that, absent "exceptional facts," these transactions should not be pursued as tax avoidance transactions. The IRS notes, however, that particular scrutiny should be given to whether these transactions should be respected as derivatives or recast as a leveraged investment in the underlying US equity (a recast that would result in US-source dividend payments). The factors that the IDD specifically considers include (1) the ability of the swap counterparty to directly or indirectly determine the manner in which the US equity shares are voted; and (2) the extent to which the swap counterparty's return is determined not by market information, but the cost of the financial institution's hedging transaction (including whether the financial institution retains the referenced security on its books and records as its hedge).

The IDD also instructs field agents to examine any transactions in which a foreign taxpayer enters into a TRS over privately held US corporations. The IDD also instructs field agents to examine any transaction in which the foreign taxpayer entered into a TRS using "automated program trading" offered by the US financial institution, based on the IRS' concern that the financial institution did not assume any price risk (i.e., execution risk) with respect to the underlying US equities.

The IDD provides sample information document requests for its field agents to send to financial institutions to uncover abusive TRS transactions.

Observations

It is no surprise that the IRS would issue the IDD to coordinate its efforts with respect to a Tier 1 issue, and the issuance of the IDD does not change current law. Furthermore, it is not surprising that the IDD targets transactions that most tax advisers (including PwC) viewed as presenting tax risk. However, the analysis by which the IRS pursues the transactions is noteworthy. The IDD demonstrates that the IRS has developed a good understanding of the manner in which the parties to a TRS can shift "price execution risk" between them. (It remains to be seen whether this understanding is, or will be, broadly developed among the many agents called upon to deal with this issue.) The IRS is focusing on the location of this risk in developing its analysis with respect to tax ownership.

The IDD is also noteworthy because it explicitly acknowledges that TRSs can be used by foreign taxpayers to achieve a different US federal income tax result than holding a US equity directly. As noted above, the IDD acknowledges that TRSs that are accompanied by cross-ins but that do not involve cross-outs with the TRS counterparty (or an IDB or affiliate) are not to be challenged. Furthermore, TRSs that are not accompanied by cross-ins (or sales to third parties) are not problematic except in "exceptional" circumstances. This is good news and demonstrates a degree of integrity on the part of the IRS.

In the main, the IDD's target and analytical approach are quite reasonable, although the document production requests appear to be overkill and will prove highly burdensome to affected taxpayers. Hedge funds and private equity funds are specifically mentioned in the IDD, and the IRS recommends coordination with the lead advisor of the IRS investment fund audit group. It appears through this IDD and the recent GLAM on loan origination that the IRS is identifying specific issues to audit and is providing field agents with the tools to easily examine certain industry issues rather than advancing a broad generic audit approach. Funds should consider preparing audit-ready support files in connection with swap-related investments, not only to get ready for a potential audit but also to evaluate the risk for potential US income tax withholding liabilities on dividend-equivalent payments on TRSs, which is relevant for FIN 48.

Please consult your PwC Tax Advisor if you have further questions in this area. Alternatively, you may contact Lou Carlow, the main PwC contact regarding the IRS investment funds audit initiative, at (646) 471-0591.