Proposed regulations from the U.S. Treasury to eliminate avoiding U.S. taxes on dividend payments by engaging in offshore total return swaps cast too a wide a net, according to industry watchers.
The proposals, which cover Rule 871(m), a law passed in 2010, say ‘dividend equivalent’ payments on U.S.-based equity swap agreements will receive a different withholding treatment. This would cover total return swaps, repurchase agreements, securities loans, and possibly more if the rules remain unchanged. Primarily, the withholding tax will affect non-U.S. entities involved in these agreements. The tax will even be levied when both counterparties are non-U.S., or when one is American and neither is hedged.
There is no set date for final implementation of the rules. By law, the complete regulations had been set to be imposed on March 18, 2012, but the Treasury passed temporary regulation in February allowing the status quo to continue for the rest of the year.
U.S. Congress and the Treasury are looking to capture, for example, non-U.S. entities who are selling (or buying) a U.S. stock at the same time they enter into (or terminate) a swap that provides them the return of that company’s dividends. In other words, these non-U.S. swap counterparties would receive essentially the same dividends, except they would be untaxed.
Thomas Prevost, attorney with Credit Suisse, submitted a comment letter to the Treasury on April 6 on behalf of the International Swaps and Derivatives Association and the North American Tax Committee outlining 10 recommendations for changes to the proposed regulations. Among them, he cautioned that the Treasury should add the words ‘in connection with’ to the standard that defines when two transactions should be considered in avoidance of the tax. He and others feel that without those words, unrelated transactions will be unnecessarily taxed.
“Hopefully, Treasury will provide a clear and workable ‘in connection with’ test for what it means to be in the market,” concurred Ilene Froom, partner at Jones Day in New York. “This would avoid 871(m) concern for an entity that is engaged in market activity that isn't connected with the derivative. I think that Treasury should aim to capture the appropriate trades without being overreaching and inadvertently hampering unconnected market activity.”
Prevost added that only swaps with a delta-one exposure should be included in the product scope of taxable swaps. “I think it's important that the final regulations reflect a narrower range of products than what is included in the proposed regulations,” Froom concurred. “For example, a collar with a real band between the put and call strikes or an option with a delta that is less than one by the right percent should not be treated the same as a delta one swap under 871(m).”