Trading Safe Harbors

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-106031-98]

RIN 1545-AW13

Trading Safe Harbors

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed rules for the treatment of

foreign taxpayers trading in derivative financial instruments for their

own account. These proposed rules provide that foreign taxpayers who

effect transactions in derivative financial instruments for their own

accounts are not thereby engaged in a trade or business in the United

States if they are not dealers in stocks, securities, commodities or

derivatives. These proposed rules affect foreign persons that conduct

such trading for their own account either directly through U.S. offices

or indirectly through partnerships or other agents. This document also

provides notice of a public hearing on these proposed regulations.

DATES: Written comments must be received by September 10, 1998.

Outlines of oral comments to be discussed at the public hearing

scheduled for September 9, 1998, must be received by August 19, 1998.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-106031-98), room

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

Washington, DC 20044. Submissions may be hand delivered between the

hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-106031-98), Courier's

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 public hearing will be held in room 2615, Internal

Revenue Building, 1111 Constitution Avenue NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Milton Cahn of the Office of Associate

Chief Counsel (International), (202) 622-3870; concerning submissions

and the hearing, LaNita Van Dyke, (202) 622-7190 (not toll-free

numbers).

SUPPLEMENTARY INFORMATION:

Background

Section 864(b) of the Code provides that the phrase ``trade or

business within the United States'' generally includes the performance

of personal services within the United States at any time during the

taxable year but, under certain circumstances, does not include trading

in stocks, securities, or commodities through an independent agent or

for a taxpayer's own account (the ``trading safe harbors'').

Regulations regarding certain aspects of the trading safe harbors

were promulgated in 1972. Since the promulgation of these regulations,

the use of derivative financial instruments has increased

significantly. This is due in large measure to the overall expansion

and growing sophistication of global capital markets. Although guidance

concerning the tax treatment of derivatives and notional principal

contracts has been issued under other provisions of the Code (see,

e.g., Secs. 1.446-3, 1.863-7(b)), the section 864(b) regulations have

not been modernized to take into account the manner in which taxpayers

customarily use derivative transactions.

Explanation of Provisions

1. In General

These proposed regulations provide that foreign taxpayers who are

not dealers with respect to any derivative transactions, who are not

otherwise dealers in stocks, securities, or commodities, and who enter

into derivative transactions for their own

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accounts are not engaged in trade or business within the United States

solely by reason of those transactions. The term ``derivative'' is

defined as an interest rate, currency, equity or commodity notional

principal contract or an evidence of an interest in, or derivative

financial instrument in, any commodity, currency, or any of the items

described in Code section 475(c)(2)(A)-(D).

For purposes of these proposed regulations, the term ``currency''

is limited to those currencies that are of a kind customarily dealt in

on an organized commodity exchange. No inference is intended, however,

as to whether currencies that are not traded on an organized commodity

exchange are ``of a kind'' customarily dealt in on an organized

commodity exchange. Comments are solicited on this issue.

Under the statutory safe harbors, taxpayers who are dealers in

stocks and securities but not commodities may avail themselves of the

commodities trading safe harbor of section 864(b)(2)(B)(ii), and

likewise, dealers in commodities but not stocks and securities may

avail themselves of the stocks and securities trading safe harbor of

section 864(b)(2)(A)(ii). The proposed regulations, however, do not

specify into which statutory safe harbor any particular derivative

transaction falls. Accordingly, dealers in stocks, securities,

commodities, or derivatives may not avail themselves of the benefits of

these proposed regulations.

Treasury and the IRS are considering the appropriate application of

both the stocks and securities safe harbor of section 864(b)(2)(A)(ii)

and the commodities safe harbor of section 864(b)(2)(B)(ii) with

respect to a dealer in a derivative which arguably might be classified

as both a security and a commodity. Treasury and the IRS are also

considering the appropriate application of the section 864(b)(2)(A)(ii)

and (B)(ii) safe harbors to dealers in either stocks and securities or

commodities who enter into a derivative transaction which arguably

might be classified within both sections. Comments are solicited on

these points including the classification of specific derivatives for

purposes of the safe harbors.

Comments are also solicited regarding whether the final regulations

should include derivative transactions in either the stocks and

securities, or commodities trading safe harbors under sections

864(b)(2)(A)(i) and (B)(i). In particular, the IRS solicits comments as

to whether certain dealers could inappropriately avoid the limitations

of section 864(b)(2)(C) with respect to derivative transactions

effected through independent agents in the United States.

2. Eligible Nondealer

Until Treasury and the IRS determine whether particular derivative

transactions should be classified under the stocks and securities or

commodities safe harbors, the proposed regulations provide that

derivative transactions (including hedging transactions) do not

constitute a U.S. trade or business if the taxpayer meets the newly

proposed definition of an ``eligible nondealer.''

An eligible nondealer is defined as a foreign resident taxpayer who

is not a dealer in stocks, securities, commodities or derivatives at

any time during the taxable year. Dealer status is determined on a

worldwide basis and disqualifies a taxpayer from the safe harbor of the

proposed regulations even if no dealing activities are conducted in the

United States. For example, if a taxpayer is a dealer in commodities

through its home country office and conducts no dealing activities

through its U.S. office, but enters into derivative transactions for

its own account through the U.S. office, the taxpayer fails to be an

eligible nondealer.

Under the proposed regulations, the definition of dealer in stocks

or securities refers to Sec. 1.864-2(c)(2)(iv) and the definition of

dealer in commodities refers to the use of that term in Sec. 1.864-

2(d). The definition of eligible nondealer contains language based on

the definition of dealer in securities in 475(c)(1)(B), including

regularly holding oneself out, in the ordinary course of one's trade or

business, as being willing and able to enter into either side of a

derivative transaction. See Sec. 1.475(c)-1(a)(2).

Treasury and the IRS are considering issuing additional guidance

with respect to the definition of a dealer for purposes of applying the

trading safe harbors generally. Comments are solicited regarding the

definition of a dealer, including the adequacy of the present rules in

Sec. 1.864-2(c)(2)(iv) and Sec. 1.864-2(d), possible rules for

identifying derivative transactions entered into with customers in the

``ordinary course,'' and the appropriateness of adopting a definition

similar to that provided in section 475(c)(1).

3. Swaps on U.S. Equities

Treasury and the IRS are aware that in order to avoid the tax

imposed on U.S. source dividends under sections 871 and 881 and Chapter

3 of the Code, some foreign investors use notional principal contract

transactions based on U.S. equities (``U.S. based equity swaps'').

Accordingly, Treasury and the IRS are considering whether rules should

be developed to preserve the withholding tax with respect to such

transactions. Specifically, Treasury and the IRS are evaluating whether

conduit (e.g., section 7701(l)) or other principles should be invoked

in regulations, to characterize payments made with respect to U.S.

based equity swaps as subject to U.S. withholding tax.

Treasury and the IRS are considering whether or not finalization of

the proposed regulations as they relate to U.S. based equity swaps

should await guidance concerning the application of the withholding

rules to such transactions. Broadening the section 864(b)(2)(A)(ii) and

(B)(ii) safe harbors to include derivatives could impair the ability of

the United States to tax U.S. source dividend payments.

Congress enacted the stocks and securities trading safe harbor in

1936 to provide certainty that foreign persons who merely trade stocks

and securities would not be subject to the net income tax regime.

Section 211(b), Revenue Act of 1936, Pub. L. 74-740, 49 Stat. 1648,

1714-15 (1936); S. Rep. No. 2156, 74th Cong., 2d Sess. 21 (1936).

Congress' decision to include the safe harbor was premised on the

fundamental assumption that ordinary income from U.S. stocks and

securities would be appropriately subject to U.S. taxation through the

withholding tax on fixed and determinable or annual and periodic income

(``FDAP''), and that activities beyond the scope of the safe harbor

would remain subject to net tax if the taxpayer was engaged in a trade

or business or had an office in the United States. Id. The Foreign

Investors Tax Act of 1966, which expanded the trading safe harbors to

include trading activities conducted by or on behalf of a non-U.S.

resident taxpayer through a U.S. office for the foreign taxpayer's own

account, built upon the same principles reflected in the Revenue Act of

1936. See Section 102(d), Foreign Investors Tax Act of 1966, Pub. L.

89-809, 80 Stat. 1539, 1544 (1966); S. Rep. No. 1701, 99th Cong., 2d

Sess. 16-17, 22-23, 32-33 (1966).

Treasury and the IRS request comments regarding the U.S. taxation

of non-U.S. persons investing in derivatives generally in addition to

the treatment of derivatives under the trading safe harbors. Comments

are also solicited concerning the appropriate source of payments made

pursuant to U.S. based equity swaps and whether conduit or other

principles should be invoked for purposes of sections 871, 881 and

Chapter 3 of the Code, including the circumstances under which such

payments between non-U.S.

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resident counterparties (i.e., foreign-to-foreign payments) may be

included in such regulations. In addition, comments are also solicited

concerning the appropriate treatment of swaps or other derivative

transactions on property (other than stocks and securities) that

produce FDAP income, e.g., rents and royalties.

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 impact analysis is not required. It also has been

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

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. Therefore, a Regulatory Flexibility Analysis under the

Regulatory Flexibility Act (5 U.S.C. Chapter 6) is not required.

Pursuant to section 7805(f) of the Code, this notice of proposed

rulemaking will be submitted to the Chief Counsel for Advocacy of the

Small Business Administration for comment on their impact on small

business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments that are submitted

timely to the IRS (a signed original and eight (8) copies). All

comments will be available for public inspection and copying.

A public hearing has been scheduled for September 9, 1998, at 10:00

A.M., in room 2615, Internal Revenue Building, 1111 Constitution Avenue

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

that wish to present oral comments at the hearing must submit written

comments by September 10, 1998, and submit an outline of the topics to

be discussed and the time to be devoted to each topic by August 19,

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.

Proposed Effective Date

These regulations are proposed to be effective for taxable years

beginning 30 days after the date final regulations are published in the

Federal Register. Taxpayers may elect to apply the provisions of the

final regulations to taxable years beginning before the date which is

30 days after these regulations are published as final in the Federal

Register. No inference is intended regarding the treatment of

derivative transactions under sections 864(b)(2)(A)(ii) and (B)(ii) and

the current regulations. For periods prior to the effective date,

taxpayers engaged in derivative transactions may take any reasonable

position with regard to the section 864(b)(2)(A)(ii) and (B)(ii) safe

harbors. Positions consistent with these proposed regulations will be

considered reasonable.

Drafting Information

The principal author of these regulations is Milton Cahn of the

Office of 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.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

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

part as follows:

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

Par. 2. Section 1.864(b)-1 is added to read as follows:

Sec. 1.864(b)-1 Trading in derivatives.

(a) Trading for taxpayer's own account. As used in part I (section

861 and following) and part II (section 871 and following), subchapter

N, chapter 1 of the Internal Revenue Code (Code), and chapter 3

(section 1441 and following) of the Code, and the regulations

thereunder, if a taxpayer is an eligible nondealer, the term engaged in

trade or business within the United States does not include effecting

transactions in derivatives for the taxpayer's own account, including

hedging transactions within the meaning of Sec. 1.1221-2.

(b) Definitions--(1) Eligible nondealer. For purposes of this

section, an eligible nondealer is a person that is not a resident of

the United States and is not, at any place (domestic or foreign), nor

at any time during that person's taxable year, any of the following--

(i) A dealer in stocks or securities as defined in Sec. 1.864-

2(c)(2)(iv)(a);

(ii) A dealer in commodities as that term is used in Sec. 1.864-

2(d); or

(iii) A person that regularly offers to enter into, assume, offset,

assign or otherwise terminate positions in derivatives with customers

in the ordinary course of a trade or business, including regularly

holding oneself out, in the ordinary course of one's trade or business,

as being willing and able to enter into either side of a derivative

transaction.

(2) Derivative. For purposes of this section, the term derivative

includes--

(i) An interest rate, currency (as defined in paragraph (b)(3) of

this section), equity, or commodity (as the term is used in section

864(b)(2)(B) and Sec. 1.864-2(d)) notional principal contract (as the

term is used in section 475(c)(2)); or

(ii) An evidence of an interest, or a derivative financial

instrument (including any option, forward contract, short position and

any similar financial instrument), in any--

(A) Commodity (as the term is used in section 864(b)(2)(B) and

Sec. 1.864-2(d));

(B) Currency (as defined in paragraph (b)(3) of this section);

(C) Share of stock (as the term is used in Sec. 1.864-2(c)(2));

(D) Partnership or beneficial ownership interest in a widely held

or publicly traded partnership or trust;

(E) Note, bond, debenture, or other evidence of indebtedness; or

(F) Notional principal contract described in paragraph (b)(2)(i) of

this section.

(3) Limitation. For purposes of this section, the term currency is

limited to currencies of a kind customarily dealt in on an organized

commodity exchange.

Michael P. Dolan,

Deputy Commissioner of Internal Revenue.

[FR Doc. 98-15452 Filed 6-11-98; 8:45 am]

BILLING CODE 4830-01-P