IRS Applies Economic Substance Doctrine To Securities Lending Transaction

The IRS released a memorandum (AM 2012-009) applying the economic substance doctrine to a securities lending transaction. Although certain of the underlying statutory and administrative rules for securities lending transactions have changed, AM 2012-009 provides current insight into IRS thinking on the relevance and application of the economic substance doctrine.

The memorandum addresses securities lending transactions entered into by foreign individuals or companies (the foreign customer) that owned stock in a U.S. corporation and a foreign affiliate of a U.S. financial institution (the foreign affiliate). In general, a foreign individual or foreign company is subject to a 30% tax on any dividends received from a U.S. corporation under sections 871 or 881. This tax must generally be withheld by the U.S. corporation paying the dividend under sections 1441, 1442 and 1461. In a typical securities lending transaction marketed by certain financial institutions, however, the foreign customer enters into a transaction with the foreign affiliate of a U.S. financial institution that does not change the overall financial position of the participating parties, but nonetheless in the view of the IRS inappropriately avoids the 30% withholding tax.

In a securities lending transaction, the following steps typically occur:

The foreign customer loans the underlying shares of the U.S. corporation to the foreign affiliate. The foreign affiliate sells the shares. The foreign affiliate enters into a total return equity swap whereby it acquires the rights to dividends, appreciation and depreciation in the sold shares. These steps occur after the U.S. corporation declares a dividend but before the record date or payment date of such a dividend. When the dividend is paid, neither the foreign customer nor the foreign affiliate actually holds the underlying shares in the U.S. corporation. Instead, the foreign affiliate collects the equivalent of the paid dividend under the total return swap. The underlying economic arrangement generally provides that the foreign affiliate keeps approximately 10% of the dividend amount and remits 90% back to the foreign customer. In addition, the foreign affiliate repurchases the shares in the U.S. corporation and returns such shares to the foreign customer. Thus, the foreign affiliate and the foreign customer, relying on Notice 97-66, treat the dividend and substitute dividend as exempt from the 30% withholding tax and share the...