M E M O R A N D U M
September 23, 2008
TO: Distribution
FROM: Dan Burt and John Staples
RE: U.S. Senate Focuses on Dividend Withholding Tax Abuse: Are Changes on the Way?
Background:
The U.S. Senate Permanent Subcommittee on Investigations (the "Subcommittee") held a hearing on September 11, 2008, entitled "Dividend Tax Abuse: How Offshore Entities Dodge Taxes on U.S. Stock Dividends." The hearing focused on equity swap transactions marketed by U.S. financial institutions that enable non-U.S. persons to reduce or eliminate U.S. dividend withholding taxes.
The "Approved Loophole"
The Subcommittee criticized both the Internal Revenue Service ("IRS") and the U.S. Treasury ("Treasury") for creating what the Subcommittee called an "approved loophole" in the tax law. According to expert testimony, the residence of the taxpayer sourcing rule in Treas. Reg. §1.863-7(b) for notional principal contracts, including income from swaps, has created a market in which only the most unsophisticated foreign portfolio investor would invest directly in U.S. stock and be subject to the dividend withholding tax.
During its investigation, the Subcommittee found that phrases like "dividend enhancement," "yield enhancement," and "dividend uplift" were used to describe products it views as abusive. Examples of "red flags" of abusive products include a short-term transaction, fees tied to tax savings, sham market sales, and offshore shell companies, with specific Subcommittee emphasis on the Cayman Islands. The Subcommittee also expressed concern with marketing strategies focused primarily on the ability to plan around U.S. withholding tax.
Possible changes suggested to the Subcommittee include:
- A "portfolio dividend exception"
- Revision to Treas. Reg. §1.863-7(b) to source single stock swap payments like actual dividends for withholding purposes [e.g., Treas. Reg. §1.861-3(a)(6)];
- Use of the "substantially similar or related property" standard for dividend equivalents on baskets of stock; and
- Amendment to Notice 97-66 to explicitly condition its application on the taxpayer showing that a U.S. withholding tax was applied in the same series of transactions to which Notice 97-66 is being applied.
The IRS Response:
IRS Commissioner Douglas Shulman’s brief testimony reiterated his commitment to making international tax issues a top priority; however, Shulman would not comment on any IRS position regarding equity swap and stock loan transactions in light of ongoing examinations. Shulman told the Subcommittee that Notice 97-66 is currently under review by both IRS and Treasury. While guidance on Notice 97-66 has been promised for many years, Treasury may feel a new sense of urgency since the Subcommittee promised a legislative solution if the IRS fails to act by spring 2009.
Recommendation:
The Subcommittee’s focus on withholding tax abuse is just part of a comprehensive effort by Congress, Treasury and the IRS to ensure compliance with U.S. withholding tax requirements. As we have stated in other client letters, any U.S. or foreign person with U.S. withholding tax obligations should verify that their withholding procedures are complete and accurate (in our experience, many are not and potential tax exposure can be significant). The IRS has promised that withholding tax checks will become a part of standard audits and our recent experience shows this promise should be taken seriously. As for financial institutions engaged in derivative transactions designed to reduce or eliminate dividend withholding taxes, they should assess the heightened risk of IRS challenge before deciding to enter into these transactions.
IRS personnel, from its executives to its field auditors, are quite sensitive to Congressional criticism. One can expect various forms of "dividend enhancement" deals to come under the microscope and be challenged. Affected withholding agents should determine whether their transactions can withstand IRS scrutiny and possible challenge.