Withholding on Interest in the Case of Sales of Obligations Between Interest Payment Dates

SUMMARY: This notice of proposed rulemaking provides guidance regarding

the obligation to withhold on interest paid with respect to obligations

in the case of the sale of obligations between interest payment dates.

These regulations would affect United States and foreign withholding

agents and recipients. This document also provides notice of a public

hearing on these proposed regulations.

DATES: Comments and outlines of oral comments to be presented at the

public hearing scheduled for January 26, 1998, at 10 a.m. must be

received by January 5, 1998.

ADDRESSES: Send submission to: CC:DOM:CORP:R (REG-114000-97), room

5226, Internal Revenue Service, POB 7604, Ben Franklin Station,

Washington DC 20224. Submissions may be hand delivered between the

hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-114000-97), Courier

desk, Internal Revenue Service, 1111 Constitution Avenue, NW.,

Washington DC. Alternatively, taxpayers may submit comments

electronically via the internet by selecting the ``Tax Regs'' option on

the IRS Home Page, or by submitting comments directly to the IRS

internet site at http://www.irs.ustreas.gov/prod/tax__regs/

comments.html. The hearing scheduled for January 26, 1998, will be held

in the Commissioner's Conference Room, room 3313, Internal Revenue

Service, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Lilo

Hester at (202) 622-3840 (not a toll-free number); concerning

submissions and the hearing, Evangelista Lee, (202) 622-7180 (not a

toll-free number).

SUPPLEMENTARY INFORMATION:

Background

In this issue of the Federal Register, the IRS and Treasury are

publishing final withholding and reporting regulations under chapter 3

of the Internal Revenue Code (Code) and other sections of the Code.

Section 1.1441-3(b)(2) of the final regulations provides that no

withholding is required upon interest accrued on the date of a sale of

debt obligations when the sale occurs between two interest payment

dates, even though the amount is treated as interest under Sec. 1.61-7

(c) or (d) and is subject to tax under section 871 or 881. In contrast,

Sec. 1.1441-2(b)(3) of the final regulations provides that withholding

is required on amounts of original issue discount in the event of a

sale of an original issue discount obligation or a payment on such an

obligation, subject to certain exceptions. The IRS and Treasury believe

that, in view of these provisions, the exemption from withholding on

non-OID amounts is no longer justified. A withholding agent that pays

amounts to a foreign person in connection with the sale of an

obligation between interest payments dates is in the same position as a

withholding agent that pays amounts to a foreign person in connection

with the sale of an original issue discount obligation. The withholding

exemption for sale of debt obligations between interest payment dates

provides an easy avenue for the avoidance of the documentation

requirements imposed under sections 871(h) and 881(c) for purposes of

qualifying interest on registered debt obligations as portfolio

interest. For this reason, and in order to create parity with the tax

treatment of original issue discount obligations under chapter 3 of the

Code, it is no longer appropriate to continue this exemption.

Under Sec. 1.1441-2(b)(3), a withholding agent must withhold on an

amount of original issue discount to the extent that it has actual

knowledge of the proportion of the amount of the payment that is

taxable to the beneficial owner under section 871(a)(1)(C) or

881(a)(3)(A). A withholding agent has actual knowledge if it knows how

long the beneficial owner has held the obligation, the terms of the

obligation, and the extent to which the beneficial owner purchased the

obligation at a premium. A withholding agent is treated as having

knowledge if the information is reasonably available. Special rules are

provided for withholding agents with which the beneficial owner does

not maintain a direct account relationship. Further, the regulations

under Sec. 1.1441-2(b)(3) dealing with original issue discount provide

that, in the case of an obligation that would qualify as portfolio

interest if documentation were provided to the withholding agent,

withholding is required on the entire amount of stated interest, if

any, and original issue discounts, if no such documentation is

provided, irrespective of whether the withholding agent has knowledge

of the portion of the payment representing taxable original issue

discount. For this purpose, the withholding agent may rely upon the IRS

List of Original issue Discount Instruments contained in IRS

Publication 1212 (available from the IRS Distribution Centers).

In response to comments, the provisions in Sec. 1.1441-3(b)(1) are

proposed to be modified to reduce the amount upon which withholding is

required. No obligation to withhold is imposed under current law on the

payment of stated interest on an obligation that was purchased between

interest payment dates. Under Sec. 1.61-7(c), interest received on the

interest payment date is treated as a return of basis to the extent it

represents accrued unpaid interest as of the date of purchase as

reflected in the new holder's basis for the obligation. Therefore, when

the new holder receives a payment of the stated interest, the holder s

tax liability is limited to the amount of interest accrued after the

date of purchase (subject to additional adjustments reflecting possible

acquisition premiums or market discounts). Because of the difficulty

for a withholding agent to determine the amount accrued to the holder

and other adjustments affecting the actual amount taxable to the

holder, withholding on the entire amount of stated interest is required

under the current withholding regulations under Sec. 1.1441-3(b)(1).

Commentators have asked that the withholding agent be permitted to

withhold on the amount that it knows is taxable. The final withholding

regulations did not modify the proposed regulations on this point

because the Treasury and IRS consider that withholding on the entire

amount is justified if withholding on sales of obligations between

interest payment dates is not required. However, because these proposed

regulations require withholding, the regulations permit a withholding

agent to adjust the amount of withholding at the time of payment of

stated interest to account for earlier withholding.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It also has been determined

that section 553(b) of the Administrative Procedure Act (5

[[Page 53504]]

U.S.C. chapter 5) does not apply to these regulations, and because the

regulation does not impose a collection of information on small

entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not

apply. Pursuant to section 7805(f) of the Internal Revenue Code, this

notice of proposed rulemaking will be submitted to the Chief Counsel

for Advocacy of the Small Business Administration for comment on its

impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any comments that are submitted timely

to the IRS. All comments will be available for public inspection and

copying.

A public hearing has been scheduled for January 26, 1998, at 10

a.m. in the Commissioner's Conference Room, room 3313, Internal Revenue

Building, 1111 Constitution Ave, NW., Washington DC. Because of access

restrictions, visitors will not be admitted beyond the Internal Revenue

Building lobby more than 15 minutes before the hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons who wish to present oral comments at the hearing must

submit comments and an outline of the topics to be discussed and the

time to be devoted to each topic by January 5, 1998.

A period of 10 minutes will be allotted to each person for making

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority for part 1 continues to read in part as

follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. In Sec. 1.1441-3, paragraph (b) is revised to read as

follows:

Sec. 1.1441-3 Determination of amount to be withheld.

* * * * *

(b) Withholding on payments on certain obligations--(1) Withholding

at time of payment of interest. When making a payment on an interest-

bearing obligation, a withholding agent must withhold under

Sec. 1.1441-1 upon the gross amount of stated interest payable on the

interest payment date, regardless of whether the payment constitutes a

return of capital or the payment of income within the meaning of

section 61, unless the withholding agent has knowledge of the actual

amount of interest paid. For this purpose, the withholding agent may

rely on information provided by the issuer (or its paying agent), on a

representation from the beneficial owner, or on information that the

withholding agent has in its records. To the extent an amount was

withheld on an amount of capital rather than interest, see rules for

adjustments, refunds, or credits under Sec. 1.1441-1(b)(8).

(2) No withholding between interest payment dates--(i) General

rule. A withholding agent is not required to withhold under

Sec. 1.1441-1 upon interest accrued on the date of a sale of debt

obligations when that sale occurs between two interest payment dates

(even though the amount is treated as interest under Sec. 1.61-7(c) or

(d) and is subject to tax under section 871(a) or 881(a)), unless the

withholding agent has knowledge of the amount paid as interest. For

purposes of this paragraph (b)(2)(i), a withholding agent is treated as

having knowledge in the same manner as a withholding agent has

knowledge for purposes of Sec. 1.1441-2(b)(3)(ii), dealing with

withholding on original issue discount. In addition, notwithstanding

lack of knowledge (within the meaning of Sec. 1.1441-2(b)(3)(ii)),

withholding is required on the entire amount of stated interest paid

with respect to the obligation as determined as of the date of original

issue if the withholding agent, pursuant to the provisions in

Sec. 1.1441-1(b)(3), treats the payment as made to a foreign payee

because it cannot associate the payment with required documentation and

the amount would qualify as portfolio interest. See Sec. 1.1441-1(b)(8)

for adjustments to any amount that has been overwithheld as a result of

this provision.

(ii) Applicable rules. Any exemption from withholding pursuant to

paragraph (b)(2)(i) of this section applies without a requirement that

documentation be furnished to the withholding agent. However,

documentation may have to be furnished for purposes of the information

reporting provisions under section 6049 and backup withholding under

section 3406. See Sec. 1.6045-1(c) for reporting requirements by

brokers with respect to sale proceeds. Any exemption from withholding

under paragraph (b)(2)(i) of this section is not a determination that

the accrued interest is not fixed or determinable annual or periodical

income. See Sec. 1.61-7(c) regarding the character of payments received

by the acquirer of an obligation subsequent to such acquisition (that

is, as a return of capital or interest accrued after the acquisition).

Michael P. Dolan,

Acting Commissioner of Internal Revenue.

[FR Doc. 97-26000 Filed 10-6-97; 8:45 am]

BILLING CODE 4830-01-P