Certain Payments Made Pursuant to a Securities Lending Transaction

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.

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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