[Federal Register Volume 63, Number 113 (Friday, June 12, 1998)]
[Proposed Rules]
[Pages 32164-32166]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-15452]


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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 <a href="http://www.irs.ustreas.gov/prod/tax_regs/
comments.html">http://www.irs.ustreas.gov/prod/tax_regs/
comments.html</a>. 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

[[Page 32165]]

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.

[[Page 32166]]

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