[Federal Register Volume 75, Number 235 (Wednesday, December 8, 2010)]
[Rules and Regulations]
[Pages 76262-76263]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2010-30895]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9508]
RIN 1545-BJ85


Source of Income From Qualified Fails Charges

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

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SUMMARY: This document contains temporary regulations which set forth 
the source of income attributable to qualified fails charges. The 
temporary regulations provide guidance about the treatment of fails 
charges for purposes of sections 871 and 881, which generally require 
gross-basis taxation of foreign persons not otherwise subject to U.S. 
net-basis taxation and the withholding of such tax under sections 1441 
and 1442. The text of the temporary regulations also serves as the text 
of the proposed regulations set forth in the notice of proposed 
rulemaking on this subject in the Proposed Rules section in this issue 
of the Federal Register.

DATES: Effective Date. These regulations are effective on December 8, 
2010.
    Applicability Date. These regulations apply to qualified fails 
charges paid or accrued on or after December 8, 2010.

FOR FURTHER INFORMATION CONTACT: Sheila Ramaswamy or Anthony J. Marra, 
Office of Associate Chief Counsel (International) (202) 622-3870 (not a 
toll free call).

SUPPLEMENTARY INFORMATION: 

Background

    In response to persistent delivery failures in delivery-versus-
payment transactions involving U.S. Treasury securities (Treasury 
securities), a trading practice governing failed deliveries of Treasury 
securities was published in 2008 by the Treasury Market Practices Group 
(TMPG) and the Securities Industry and Financial Markets Association 
(SIFMA). This trading practice, which was recommended by the Federal 
Reserve Bank of New York in addition to TMPG and SIFMA, has 
subsequently been voluntarily adopted by almost every participant in 
the Treasury securities market. Transactions that involve delivery-
versus-payment include a sale, a purchase, a sale and repurchase 
transaction (commonly known as a ``repo''), a securities lending 
transaction, and an option.
    The trading practice addresses the problem that in certain 
situations, including a low interest rate environment, a party to a 
delivery-versus-payment transaction may lack the economic incentive to 
deliver Treasury securities in a timely manner. Under the trading 
practice, the parties to a contract that provides for delivery-versus-
payment of Treasury securities agree that if one party fails to deliver 
Treasury securities at the time specified in the contract, the failing 
party will pay an amount (a ``fails charge'') to the party entitled to 
receive the Treasury securities. The fails charge is calculated using a 
formula that takes into account current interest rates and trade 
proceeds, and accrues each day that the failure to deliver continues. 
The trading practice is generally expected to impose a fails charge 
whenever the interest rate on a repo that can be settled with any of a 
variety of securities (referred to in the market as the ``general 
collateral rate'') falls below a certain level.
    As noted in this preamble, the delivery-versus-payment market 
encompasses a variety of transactions, each of which can generate a 
fails charge. Some transactions, such as a repo, where delivery is 
required both at inception and at settlement, can produce more than one 
fails charge. In back-to-back transactions, it can also be difficult to 
determine whether a party that incurs a fails charge is acting as an 
intermediary or a principal. As a result, there is considerable 
uncertainty about the treatment of fails charges for purposes of 
sections 871 and 881, which generally impose gross-basis taxation at a 
rate of 30 percent on certain U.S. source income of foreign persons 
that is not effectively connected with the conduct of a trade or 
business in the United States and the withholding of such tax under 
sections 1441 and 1442.
    Notice 2009-61, (2009 IRB 181), issued in July 2009, addressed the 
issue temporarily by providing that the Internal Revenue Service (IRS) 
will not challenge the position taken by a taxpayer or a withholding 
agent that a fails charge that is paid on or before December 31, 2010 
is not subject to U.S. gross-basis taxation. Notice 2009-61 further 
announced that the Treasury Department and the IRS were considering 
issuing prospective guidance on the circumstances, if any, that would 
cause a fails charge to be subject to U.S. gross-basis taxation. These 
temporary regulations provide further guidance on the treatment of 
fails charges. The text of the temporary regulations also serves as the 
text of the proposed regulations set forth in the notice of proposed 
rulemaking on this subject in the Proposed Rules section of this issue 
of the Federal Register. See Sec.  601.601(d)(2).

Explanation of Provisions

    In order to provide certainty and consistency in the treatment of 
fails charges for purposes of sections 871, 881, 1441 and 1442, these 
temporary regulations establish source rules for qualified fails 
charges that arise in the delivery-versus-payment market for Treasury 
securities. The temporary regulations provide that the source of income 
from a qualified fails charge is generally determined by reference to 
the residence of the taxpayer that is the recipient of the qualified 
fails charge income, with two exceptions. Qualified fails charge income 
earned by a qualified business unit (QBU) of a taxpayer is sourced to 
the country in which the QBU is engaged in a trade or business, and 
qualified fails charge income that arises from a transaction that is 
effectively connected to a United States trade or business is sourced 
in the United States and treated as effectively connected to the 
conduct of a United States trade or business.
    The temporary regulations provide a source rule only for income 
from a qualified fails charge. In order to be a qualified fails charge, 
the fails charge must satisfy two requirements. First, it must be paid 
pursuant to a trading practice or similar guidance approved by a U.S. 
government agency or the Treasury Market Practices Group (which is 
sponsored by the Federal Reserve Bank of New York), or published in 
separate guidance by the IRS. Second, the transaction that generates 
the fails charge must be with respect to a bill, note, or other 
evidence of indebtedness issued by the United States Treasury 
Department. These temporary regulations do not address the source of 
any other type of damages payment, including a fails charge that is not 
a qualified fails charge.
    Although there is not currently a fails charge trading practice 
relating to securities other than Treasury securities, one may be 
considered in the future for agency securities (including mortgage-
backed securities). If a fails charge trading practice pertaining to 
agency securities is endorsed by the Treasury Market Practices Group or 
an agency of the United States government and widely adopted, the 
Treasury Department and the IRS will consider

[[Page 76263]]

whether fails charges paid with respect to such a trading practice 
should be sourced under these regulations.

Effective/Applicability Date

    These regulations apply to qualified fails charges paid or accrued 
on or after December 8, 2010.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It has also 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 
these regulations do not impose a collection of information on small 
entities, the provisions of the Regulatory Flexibility Act (5 U.S.C. 
chapter 6) do not apply. Pursuant to section 7805(f) of the Internal 
Revenue Code, these temporary regulations will be submitted to the 
Chief Counsel for Advocacy of the Small Business Administration for 
comment on its impact on small business.

Drafting Information

    The principal authors of these regulations are Sheila Ramaswamy and 
Anthony J. Marra, Office of the Associate Chief Counsel 
(International). However, other persons from the Office of Associate 
Chief Counsel (International) and the Treasury Department have 
participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 863(a) and 7805 * * *


0
Par. 2. Section 1.863-10T is added to read as follows:


Sec.  1.863-10T  Source of income from a qualified fails charge 
(temporary).

    (a) In general. Unless paragraph (b) or (c) of this section 
applies, the source of income from a qualified fails charge shall be 
determined by reference to the residence of the taxpayer as determined 
under section 988(a)(3)(B)(i).
    (b) Qualified business unit exception. The source of income from a 
qualified fails charge shall be determined by reference to the 
residence of a qualified business unit of a taxpayer if--
    (1) The taxpayer's residence, determined under section 
988(a)(3)(B)(i), is the United States;
    (2) The qualified business unit's residence, determined under 
section 988(a)(3)(B)(ii), is outside the United States;
    (3) The qualified business unit is engaged in the conduct of a 
trade or business in the country where it is a resident; and
    (4) The transaction to which the qualified fails charge relates is 
attributable to the qualified business unit. A transaction will be 
treated as attributable to a qualified business unit if it satisfies 
the principles of Sec.  1.864-4(c)(5)(iii) (substituting ``qualified 
business unit'' for ``U.S. office'').
    (c) Effectively connected income exception. Income from a qualified 
fails charge that arises from a transaction that under the principles 
described in Sec.  1.864-4(c) is effectively connected with a United 
States trade or business shall be sourced in the United States and the 
income from the qualified fails charge shall be treated as effectively 
connected to the conduct of a United States trade or business to the 
same extent as the transaction from which it arises.
    (d) Definitions.--(1) Qualified fails charge. For purposes of this 
section, a qualified fails charge is a payment that
    (i) Compensates a party to a transaction that provides for delivery 
of a Treasury security in exchange for the payment of cash (delivery-
versus-payment settlement) for another party's failure to deliver the 
specified Treasury security on the settlement date specified in the 
relevant agreement; and
    (ii) Is made pursuant to:
    (A) A trading practice or similar guidance approved or adopted by 
either an agency of the United States government or the Treasury Market 
Practices Group, or
    (B) Any trading practice, program, policy or procedure approved by 
the Commissioner in guidance published in the Internal Revenue 
Bulletin.
    (2) Treasury security. For purposes of this section, a Treasury 
security is any bill, note, or other evidence of indebtedness issued by 
the United States Treasury Department.
    (e) Effective/applicability date. This section applies to qualified 
fails charges paid or accrued on or after December 8, 2010.
    (f) Expiration date. This section expires on December 9, 2013.

Steven T. Miller,
Deputy Commissioner for Services and Enforcement.
    Approved: December 2, 2010.
Michael Mundaca,
Assistant Secretary of the Treasury.
[FR Doc. 2010-30895 Filed 12-7-10; 8:45 am]
BILLING CODE 4830-01-P