Forthcoming Proposed Regulations Would Exempt Many Securities Lending “Borrow Fees” from U.S. Withholding Taxes

Authors: Vadim Novik (New York, NY), Colin Kelly (New York, NY)

On October 23, the IRS released a notice (the "Notice") announcing that Treasury and the IRS intend to issue proposed regulations providing that certain fees, commonly referred to as "borrow fees," payable with respect to securities lending agreements and sale-repurchase transactions (also known as "repos") are sourced based on the residence of the recipient, which would ensure such borrow fees generally would not be subject to U.S. withholding taxes if paid to a non-U.S. person.

Background

1. Securities Lending Transactions

In a securities lending transaction, a securities lender lends securities to a securities borrower in exchange for an obligation by the securities borrower to return equivalent securities. In turn, the securities borrower typically posts collateral in the form of cash or securities to secure its obligation to return equivalent securities.

1. Rebate and Borrow Fees

The securities lender typically pays the securities borrower a fee (commonly referred to as "rebate") to compensate the securities borrower for posting the collateral.[1] In turn, the securities borrower economically incurs borrow fees, also known as "negative rebate," to compensate the securities lender for making the securities available.

If a securities borrower posts cash collateral, the borrow fee incurred by the securities borrower is generally netted against rebate payable by the securities lender. Under those circumstances, the securities borrower generally does not pay an explicit borrow fee. In certain circumstances, however, the securities borrower is required to pay an explicit borrow fee-for example, if the rebate amount payable with respect to cash collateral is relatively low (e.g., because interest rates are low), if the securities borrower posts non-cash collateral, or if the particular securities borrowed are in high demand (known as "hard to borrow" securities).

1. Sale-Repurchase Transactions

In a sale-repurchase transaction, a repo buyer purchases securities from a repo seller in exchange for an agreement by the repo seller to repurchase equivalent securities in the future. A sale-repurchase transaction can function as a collateralized loan extended by the repo buyer to the repo seller. Alternatively, a sale-repurchase transaction can function as a loan of securities from the repo seller (functionally, the securities lender) to the repo buyer (functionally, the securities borrower), in which case the repo buyer may be required-under certain circumstances-to pay an explicit borrow fee.

1. Sourcing of Borrow Fees

The sourcing of borrow fees has long been a concern for market participants. In this regard, the Notice states that neither the Internal Revenue Code (the "Code") nor the Treasury regulations directly address the proper source of borrow fees for U.S. federal income tax purposes. Specifically, because borrow fees are likely "fixed or determinable annual or periodical" income, if they are treated as U.S. source (and not "effectively connected income"), borrow fees payable to a non-U.S. person would be subject to gross U.S. withholding tax at a 30% rate (or, in certain cases, a lower treaty rate). This concern frequently arises when banks borrow securities from offshore hedge funds.

Proposed Guidance

As noted above, the Notice states that the proposed regulations will provide that a "borrow fee" paid with respect to a "securities lending transaction" or a "sale-repurchase transaction" will be sourced by the residence of the recipient. This means that such fees generally would not be subject to withholding tax if paid by a bank (or other market participant) to an offshore hedge fund. This is welcome guidance.

The Notice provides that, for this purpose, "securities lending transaction" and "sale-repurchase transaction" will have the definitions set forth in Treas. Reg. §§ 1.861-2(a)(7) and 1.861-3(a)(6), respectively. Those rules define a "securities lending transaction" as "a transfer of one or more securities that is described in Code Sec. 1058(a) or a substantially similar transaction," and a "sale-repurchase transaction" as "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."

The Notice provides that the proposed regulations will define a "borrow fee" as a fee that is:

1. paid pursuant to a securities lending or sale-repurchase transaction that is (i) documented on an industry-standard master agreement and confirmation (or electronic equivalent thereof) with standard market terms and (ii) entered into in the ordinary course of the taxpayer's and counterparty's trades or businesses or pursuant to their normal investment activities or objectives, and
   
   
2. paid in substance to compensate the lender of the securities (including a cash borrower in a sale-repurchase transaction) for making its securities available to the borrower of the securities (including a repo buyer in a sale-repurchase transaction).

The Notice specifies that the residence of the recipient will be determined under Code Sec. 988(a)(3)(B). Accordingly, in the case of a partnership, under the Code Sec. 988 Treasury regulations, if the recipient is a partnership that is not engaged in a U.S. trade or business on account of the "trading" safe harbor in Code Sec. 864(b)(2), the source of the borrow fee will be determined at the partner level.[2]

For U.S. federal income tax purposes, a sale-repurchase transaction can be characterized either as a collateralized borrowing or as a securities lending transaction, depending on the terms of the transaction (including whether the repo buyer has the right to rehypothecate the purchased securities). The Notice appears to apply to any sale-repurchase transaction, as defined in the Notice, regardless of how the transaction is characterized for U.S. federal income tax purposes.

The Notice cautions that it does not address the source of any other payments payable with respect to a securities lending or sale-repurchase transaction, including payments described as borrow fees that do not satisfy the definition above. The Notice states that whether or not a payment is a "borrow fee" as defined above will be determined based on the substance of the fee.

Note: Because the Notice states that it will apply only to transactions documented on industry-standard master agreements and confirmations, market participants that use bespoke documentation for securities lending or sale-repurchase transactions should discuss their particular facts with their tax advisors.

Applicability Dates

The Notice states that the proposed regulations will apply prospectively to taxable years ending after the proposed regulations are published in the Federal Register. However, taxpayers would be able to apply the regulations (once finalized) before the applicable date. Moreover, the Notice provides that taxpayers can rely on the Notice with respect to securities lending transactions and sale-repurchase transactions entered into before the proposed regulations are published.

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