[Federal Register Volume 62, Number 198 (Tuesday, October 14, 1997)]
[Rules and Regulations]
[Pages 53498-53502]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-25999]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8735]
RIN 1545-AP71


Certain Payments Made Pursuant to a Securities Lending 
Transaction

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final Income Tax Regulations relating 
to the taxation of certain payments made pursuant to a cross-border 
securities lending transaction. These regulations provide guidance 
concerning the source, character, and income tax treaty treatment of 
such payments and affect

[[Page 53499]]

United States payors and recipients and foreign payors and recipients.

DATES: These regulations are effective October 14, 1997.
    Applicability: These regulations are applicable to payments made 
after November 13, 1997.

FOR FURTHER INFORMATION CONTACT: Ramon Camacho or Paul Epstein at (202) 
622-3870 (not a toll-free number) of the Office of Associate Chief 
Counsel (International), within the Office of Chief Counsel, Internal 
Revenue Service, 1111 Constitution Avenue, NW., Washington, DC 20224.

SUPPLEMENTARY INFORMATION:

Background

    On January 9, 1992, the IRS published proposed amendments (INTL-
106-89) to the Income Tax Regulations (26 CFR part 1) under sections 
861, 871, 881, 894, and 1441 of the Internal Revenue Code of 1986 
(Code) in the Federal Register (57 FR 860). A public hearing was 
scheduled but was subsequently cancelled because no one requested to 
testify. However, several written comments were received. After 
consideration of all of the comments, the regulations proposed by INTL-
106-89 are adopted by this Treasury decision, as modified.

Explanation of Provisions

I. The 1992 Proposed Regulations

    On January 9, 1992, the Internal Revenue Service (IRS) issued 
proposed regulations that provided guidance on the source and character 
of substitute payments made in cross-border securities lending 
transactions. In general, the regulations proposed to source substitute 
payments by reference to the source of the payments (dividend or 
interest) for which they substitute. In addition, the regulations 
proposed to characterize substitute payments under a transparency rule. 
Under the transparency rule, substitute payments are treated as having 
the same character as the dividend or interest income for which they 
substitute.
    Under the proposed regulations, the source rule applies for all 
purposes of the Code in cross-border securities lending transactions. 
In contrast, the transparency rule addressing the character of 
substitute payments applies only for purposes of determining the tax 
liability under sections 871 and 881 and nonresident alien withholding 
under chapter 3 of the Code and for treaty purposes. Generally, public 
comments welcomed the transparency rule because it eliminated 
unjustifiable tax biases between similar economic investments. After 
considering all the public comments, the proposed regulations are 
adopted as final regulations by this Treasury decision, substantially 
as proposed.

II. The Final Regulations

1. General rule
    The final regulations, like the proposed regulations, provide that 
a substitute payment made with respect to a securities lending or sale-
repurchase transaction is sourced using the general rules governing the 
source of interest or dividend income contained in sections 861 and 
862. The definitions of securities lending transactions and sale-
repurchase transactions are provided in Secs. 1.861-2(a)(7) and 1.861-
3(a)(6) of the regulations. These provisions define a substitute 
payment as a payment made to the transferor of a security of an amount 
equal to any distributions of dividends or interest which the owner of 
the transferred security would normally receive. The regulations also 
provide that substitute interest or dividend payments have the same 
character as interest or dividend income, respectively, for purposes of 
applying sections 864(c)(4)(B), 871, 881, 894, 4948(a) and the 
withholding provisions under chapter 3 of the Internal Revenue Code.
2. Scope of regulation
    Some commentators questioned whether a sale-repurchase transaction 
is considered a transaction that is substantially similar to a 
securities lending transaction for purposes of the proposed 
regulations. They noted that most sale-repurchase transactions 
contractually permit the purchaser to deal freely with the underlying 
securities, specifying only that substantially identical securities be 
returned on the repurchase date. In such cases the purchaser must also 
make substitute payments to the seller. The final regulations clarify 
that substitute payments made in a sale-repurchase transaction are 
sourced and characterized in the same manner that substitute payments 
are sourced and characterized in securities lending transactions.
    The final regulations only address the tax treatment of substitute 
payments received by the transferor in securities lending or sale-
repurchase transactions. The regulations do not address the treatment 
of fees or interest paid to the transferee in such transactions. For 
example, the transparency rule does not extend to characterize the 
interest component of the repurchase price of a sale-repurchase 
agreement, which is treated as interest and sourced under the general 
source rules for interest contained in sections 861 and 862. See Rev. 
Rul. 74-27 (1974-1 C.B. 24); Rev. Rul. 77-59 (1977-1 C.B. 196); 
Nebraska Department of Revenue v. Loewenstein, 115 S. Ct. 557 (1994).
    In response to comments, the final regulations apply for purposes 
of determining the source of substitute payments, regardless of whether 
the recipient of the income is U.S. or foreign. When source is 
determined under these regulations, it applies for all purposes of the 
Code (e.g., foreign tax credit limitations under sections 904 and 906). 
However, with respect to the characterization of substitute payments, 
the IRS and Treasury believe that it is appropriate, and more 
consistent with existing guidance regarding the treatment of substitute 
payments, to apply the transparency rule only with respect to foreign 
taxpayers and only for limited purposes. Accordingly, the transparency 
rule applies to determine character only for certain purposes of 
sections 864, 871, 881, 894, 4948(a) and chapter 3 of the Code. For 
example, under this rule, substitute payments to a foreign person with 
respect to stocks and securities that, absent the securities lending 
transaction, would give rise to foreign source effectively connected 
income in the hands of such person, will retain their character as 
dividend or interest income for purposes of determining whether the 
income is effectively connected to the U.S. trade or business of such 
person.
    The transparency rule does not apply, however, to characterize the 
U.S. source income of U.S. trades or businesses of foreign taxpayers. 
Accordingly, U.S. source effectively connected income of foreign 
taxpayers and U.S. source income of U.S. taxpayers will be treated the 
same. In this regard, the final regulations do not affect existing 
guidance applicable to both U.S. and foreign taxpayers concerning the 
characterization of substitute payments for purposes of other sections 
not specifically identified in these final regulations. See, e.g., ev. 
Rul. 60-177 (1960-1 C.B. 9), (substitute payments are ineligible for 
the dividends received deduction under section 243); Rev. Rul. 80-135 
(1980-1 C.B. 18), (substitute payments are ineligible for the tax-
exemption on state and local bonds under section 103).
    Because the transparency rule does not apply for purposes of 
sections 901 and 903, nothing in the final regulations affects the 
determination required under Sec. 1.901-2(f) concerning the identity of 
the person by whom a foreign tax is considered paid for purposes of 
sections 901 and 903.

[[Page 53500]]

3. Substitute payments on portfolio debt instruments
    Under the final regulations, substitute interest payments made with 
respect to a debt instrument, the interest on which qualifies as 
portfolio interest under section 871(h) or section 881(c) in the hands 
of the lender, is characterized as portfolio interest if, in the case 
of an obligation in registered form, the lender provides the 
withholding agent with a beneficial owner withholding certificate or 
documentary evidence in accordance with Sec. 1.871-14(c) and no 
exception from the portfolio interest exemption applies. For example, 
if a bank lends securities in a transaction that the facts and 
circumstances indicate in substance is an extension of credit pursuant 
to a loan agreement in the ordinary course of the bank's trade or 
business, the substitute payment may be characterized as interest which 
would not qualify as portfolio interest under section 881(c)(3)(A).
4. Tax treaties
    Some commentators noted that the transparency rule adversely 
affects foreign taxpayers that might otherwise rely on a different 
characterization of substitute payments in order to claim benefits 
under certain income tax treaties. The transparency rule would 
eliminate these benefits in a number of cases. Those commentators 
questioned the government's authority to issue regulations that would 
characterize substitute payments as dividend or interest income in 
light of U.S. income tax treaty provisions.
    The IRS and Treasury believe that the transparency rule in general 
is properly issued pursuant to the general grant of authority under 
section 7805 because it eliminates opportunities for abuse that arise 
from a rule that would characterize substitute payments in a manner 
different from the treatment of the underlying payment. A transparency 
approach provides uniform results for economically similar investments.
    Moreover, the IRS and Treasury believe that, in the absence of a 
transparency rule, many taxpayers would use securities lending 
transactions in order to avoid tax under tax treaties or under the 
Code. For this reason, authority to characterize substitute payments 
for Code and treaty purposes in the manner proposed in 1992 also is 
amply provided in section 7701(l), which was enacted after these 
comments were received. Section 7701(l) provides a broad grant of 
authority to issue regulations recharacterizing multiple party 
financing arrangements to prevent the avoidance of any tax.
    In this regard, the legislative history provides that ``the 
committee seeks to bolster the Treasury's ability to prevent 
unwarranted avoidance of tax through multiple-party financial 
engineering as well as to provide a mechanism for issuing additional 
guidance to taxpayers entering into financial transactions.'' See H.R. 
Rep. No. 103-111, 103rd Cong., 1st Sess. 729 (1993). The committee also 
made clear that this authority was not limited to the types of back-to-
back loan transactions addressed in prior rulings. See Rev. Rul. 84-152 
(1984-2 C.B. 381); Rev. Rul. 84-153 (1984-2 C.B. 383); Rev. Rul. 87-89 
(1987-2 C.B. 195). Section 7701(l) in fact has been applied to a broad 
range of financial transactions. See, e.g., Prop. Regs. Sec. 1.7701(l)-
2 (treatment of obligation-shifting transactions); and Notice 97-21 
(IRB 1997-11, March 17, 1997), (tax avoidance using self-amortizing 
investments in conduit financing entities).
    The 1992 proposed regulation under section 894 provided that where 
an income tax convention refers to United States law, the relevant law 
is the section or sections of the Internal Revenue Code and regulations 
thereunder governing the tax which is the subject of the provision. 
Some commentators have suggested that the proposed securities lending 
regulations would be invalid for purposes of characterizing dividends 
that are specifically defined by treaties. However, under conduit 
principles and additional authority to characterize payments pursuant 
to section 7701(l), the regulations adopted under Sec. 1.894-1(c) 
address the identity of the owner of dividend and interest income for 
treaty purposes as opposed to the character of the payments received 
under varying treaty definitions. These regulations therefore are 
consistent with the government's authority under treaties to determine 
the identity of the beneficial owner of income.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in EO 12866. Therefore, a 
regulatory assessment is not required. It is hereby certified that 
these regulations will not have a significant economic impact on a 
substantial number of small entities. Accordingly, a regulatory 
flexibility analysis is not required. This certification is based on 
the information that follows. These regulations affect entities engaged 
in cross-border multiple-party financing arrangements. These 
regulations affect the tax treatment of substitute payments made with 
respect to stocks and debt securities. The primary participants who 
engage in cross-border multiple party financing arrangements of this 
type are large regulated commercial banks and brokerage firms. In 
addition, comments received in response to the notice of proposed 
rulemaking were from law associations, other associations that 
represent large regulated financial companies or from individuals. 
Accordingly, Treasury and IRS do not believe that a substantial number 
of small entities engages in cross-border multiple party financing 
arrangements of the type covered by these regulations. Pursuant to 
section 7805(f) of the Code, the notice of proposed rulemaking 
preceding these regulations was submitted to the Small Business 
Administration for comment on its impact on small business.
    Drafting Information: The principal author of these regulations is 
Ramon Camacho of the Office of the 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.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
entries in numerical order to read as follows:

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

Section 1.861-2 also issued under 26 U.S.C. 863(a).
Section 1.861-3 also issued under 26 U.S.C. 863(a). * * *
Section 1.864-5 also issued under 26 U.S.C. 7701(l). * * *
Section 1.871-7 also issued under 26 U.S.C. 7701(l). * * *
Section 1.881-2 also issued under 26 U.S.C. 7701(l). * * *
Section 1.894-1 also issued under 26 U.S.C. 7701(l). * * *

    Par. 2. Section 1.861-2 is amended by adding a sentence at the end 
of paragraph (a)(1); adding paragraph (a)(7); and revising paragraph 
(e) to read as follows:


Sec. 1.861-2  Interest.

    (a) * * * (1) * * * See paragraph (a)(7) of this section for 
special rules concerning substitute interest paid or

[[Page 53501]]

accrued pursuant to a securities lending transaction.
* * * * *
    (7) A substitute interest payment is a payment, made to the 
transferor of a security in a securities lending transaction or a sale-
repurchase transaction, of an amount equivalent to an interest payment 
which the owner of the transferred security is entitled to receive 
during the term of the transaction. A securities lending transaction is 
a transfer of one or more securities that is described in section 
1058(a) or a substantially similar transaction. A sale-repurchase 
transaction is an agreement under which a person transfers a security 
in exchange for cash and simultaneously agrees to receive substantially 
identical securities from the transferee in the future in exchange for 
cash. A substitute interest payment shall be sourced in the same manner 
as the interest accruing on the transferred security for purposes of 
this section and Sec. 1.862-1. See also Secs. 1.864-5(b)(2)(iii), 
1.871-7(b)(2), 1.881-2(b)(2) and for the character of such payments and 
Sec. 1.894-1(c) for the application tax treaties to these transactions.
* * * * *
    (e) Effective dates. Except as otherwise provided, this section 
applies with respect to taxable years beginning after December 31, 
1966. For corresponding rules applicable to taxable years beginning 
before January 1, 1967, (see 26 CFR part 1 revised April 1, 1971). 
Paragraph (a)(7) of this section is applicable to payments made after 
November 13, 1997.
    Par. 3. Section 1.861-3 is amended by adding a sentence at the end 
of paragraph (a)(1); adding paragraph (a)(6); and removing the first 
sentence of paragraph (d) and adding three sentences in its place to 
read as follows:


Sec. 1.861-3  Dividends.

    (a) * * * (1) * * * See also paragraph (a)(6) of this section for 
special rules concerning substitute dividend payments received pursuant 
to a securities lending transaction.
* * * * *
    (6) Substitute dividend payments. A substitute dividend payment is 
a payment, made to the transferor of a security in a securities lending 
transaction or a sale-repurchase transaction, of an amount equivalent 
to a dividend distribution which the owner of the transferred security 
is entitled to receive during the term of the transaction. A securities 
lending transaction is a transfer of one or more securities that is 
described in section 1058(a) or a substantially similar transaction. A 
sale-repurchase transaction is an agreement under which a person 
transfers a security in exchange for cash and simultaneously agrees to 
receive substantially identical securities from the transferee in the 
future in exchange for cash. A substitute dividend payment shall be 
sourced in the same manner as the distributions with respect to the 
transferred security for purposes of this section and Sec. 1.862-1. See 
also Secs. 1.864-5(b)(2)(iii), 1.871-7(b)(2) and 1.881-2(b)(2) for the 
character of such payments and Sec. 1.894-1(c) for the application of 
tax treaties to these transactions.
* * * * *
    (d) * * * Except as otherwise provided in this paragraph this 
section applies with respect to dividends received or accrued after 
December 31, 1966. Paragraph (a)(5) of this section applies to certain 
dividends from a DISC or former DISC in taxable years ending after 
December 31, 1971. Paragraph (a)(6) of this section is applicable to 
payments made after November 13, 1997. * * *
    Par. 4. Section 1.864-5 is amended by redesignating paragraph 
(b)(2)(ii) as paragraph (b)(2)(iii) and adding new paragraph (b)(2)(ii) 
to read as follows:


Sec. 1.864-5  Foreign source income effectively connected with U.S. 
business.

* * * * *
    (b) * * *
    (2) * * *
    (ii) Substitute payments. For purposes of this paragraph (b)(2), a 
substitute interest payment (as defined in Sec. 1.861-2(a)(7)) received 
by a foreign person subject to tax under this paragraph (b) pursuant to 
a securities lending transaction or a sale-repurchase transaction (as 
defined in Sec. 1.861-2(a)(7)) with respect to a security (as defined 
in Sec. 1.864-6(b)(2)(ii)(c)) shall have the same character as interest 
income paid or accrued with respect to the terms of the transferred 
security. Similarly, for purposes of this paragraph (b)(2), a 
substitute dividend payment (as defined in Sec. 1.861-3(a)(6)) received 
by a foreign person pursuant to a securities lending transaction or a 
sale-repurchase transaction (as defined in Sec. 1.861-3(a)(6)) with 
respect to a stock shall have the same character as a distribution 
received with respect to the transferred security. This paragraph 
(b)(2)(ii) is applicable to payments made after November 13, 1997.
* * * * *
    Par. 5. Section 1.871-7 is amended by redesignating the text of 
paragraph (b) as paragraph (b)(1); adding a paragraph heading for newly 
designated paragraph (b)(1); adding paragraph (b)(2); and removing the 
first sentence of paragraph (f) and adding two sentences in its place 
to read as follows:


Sec. 1.871-7  Taxation of nonresident alien individuals not engaged in 
U.S. business.

* * * * *
    (b) Fixed or determinable annual or periodical income--(1) General 
rule. * * *
    (2) Substitute payments. For purposes of this section, a substitute 
interest payment (as defined in Sec. 1.861-2(a)(7)) received by a 
foreign person pursuant to a securities lending transaction or a sale-
repurchase transaction (as defined in Sec. 1.861-2(a)(7)) shall have 
the same character as interest income paid or accrued with respect to 
the terms of the transferred security. Similarly, for purposes of this 
section, a substitute dividend payment (as defined in Sec. 1.861-
3(a)(6)) received by a foreign person pursuant to a securities lending 
transaction or a sale-repurchase transaction (as defined in Sec. 1.861-
3(a)(6)) shall have the same character as a distribution received with 
respect to the transferred security. Where, pursuant to a securities 
lending transaction or a sale-repurchase transaction, a foreign person 
transfers to another person a security the interest on which would 
qualify as portfolio interest under section 871(h) in the hands of the 
lender, substitute interest payments made with respect to the 
transferred security will be treated as portfolio interest, provided 
that in the case of interest on an obligation in registered form (as 
defined in Sec. 1.871-14(c)(1)(i)), the transferor complies with the 
documentation requirement described in Sec. 1.871-14(c)(1)(ii)(C) with 
respect to the payment of the substitute interest and none of the 
exceptions to the portfolio interest exemption in sections 871(h) (3) 
and (4) apply. See also Sec. 1.861-2(b)(2) and 1.894-1(c).
* * * * *
    (f) * * * Except as otherwise provided in this paragraph, this 
section shall apply for taxable years beginning after December 31, 
1966. Paragraph (b)(2) of this section is applicable to payments made 
after November 13, 1997. * * *
    Par. 6. Section 1.881-2 is amended by redesignating the text of 
paragraph (b) as paragraph (b)(1); adding a paragraph heading for newly 
designated paragraph (b)(1); adding a paragraph (b)(2); and removing 
the first sentence of paragraph (e) and adding two sentences in its 
place to read as follows:

[[Page 53502]]

Sec. 1.881-2  Taxation of foreign corporations not engaged in U.S. 
business.

* * * * *
    (b) Fixed or determinable annual or periodical income--(1) General 
rule.
    (2) Substitute payments. For purposes of this section, a substitute 
interest payment (as defined in Sec. 1.861-2(a)(7)) received by a 
foreign person pursuant to a securities lending transaction or a sale-
repurchase transaction (as defined in Sec. 1.861-2(a)(7)) shall have 
the same character as interest income received pursuant to the terms of 
the transferred security. Similarly, for purposes of this section, a 
substitute dividend payment (as defined in Sec. 1.861-3(a)(6)) received 
by a foreign person pursuant to a securities lending transaction or a 
sale-repurchase transaction (as defined in Sec. 1.861-2(a)(7)) shall 
have the same character as a distribution received with respect to the 
transferred security. Where, pursuant to a securities lending 
transaction or a sale-repurchase transaction, a foreign person 
transfers to another person a security the interest on which would 
qualify as portfolio interest under section 881(c) in the hands of the 
lender, substitute interest payments made with respect to the 
transferred security will be treated as portfolio interest, provided 
that in the case of interest on an obligation in registered form (as 
defined in Sec. 1.871-14(c)(1)(i)), the transferor complies with the 
documentation requirement described in Sec. 1.871-14(c)(1)(ii)(C) with 
respect to the payment of substitute interest and none of the 
exceptions to the portfolio interest exemption in sections 881(c) (3) 
and (4) apply. See also Secs. 1.871-7(b)(2) and 1.894-1(c).
* * * * *
    (e) * * * Except as otherwise provide in this paragraph, this 
section applies for taxable years beginning after December 31, 1966. 
Paragraph (b)(2) of this section is applicable to payments made after 
November 13, 1997. * * *
    Par. 7. Section 1.894-1 is amended by revising paragraph (c) and 
adding paragraph (d) to read as follows:


Sec. 1.894-1  Income affected by treaty.

* * * * *
    (c) Substitute interest and dividend payments. The provisions of an 
income tax convention dealing with interest or dividends paid to or 
derived by a foreign person include substitute interest or dividend 
payments that have the same character as interest or dividends under 
Sec. 1.864-5(b)(2)(ii), 1.871-7(b)(2) or 1.881-2(b)(2). The provisions 
of this paragraph (c) shall apply for purposes of securities lending 
transactions or sale-repurchase transactions as defined in Sec. 1.861-
2(a)(7) and Sec. 1.861-3(a)(6).
    (d) Effective dates. Paragraphs (a) and (b) of this section apply 
for taxable years beginning after December 31, 966. For corresponding 
rules applicable to taxable years beginning before January 1, 1967, 
(see 26 CFR part 1 revised April 1, 1971). Paragraph (c) of this 
section is applicable to payments made after November 13, 1997.


Sec. 1.7701(l)-1  [Amended]

    Par. 10. Section 1.7701(l)-1 is amended as follows:
    1. Paragraph (a) is amended by removing the paragraph designation 
(a) and the heading.
    2. Paragraph (b) is removed.
Michael P. Dolan,
Acting Commissioner of Internal Revenue.

    Approved: August 28, 1997.
Donald C. Lubick,
Acting Assistant Secretary of the Treasury.
[FR Doc. 97-25999 Filed 10-6-97; 8:45 am]
BILLING CODE 4830-01-P