Section of Taxation Publications
  VOL. 60
NO. 2

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Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.

David P. Hariton*

* Partner, Sullivan & Cromwell LLP, New York, New York; Stanford University, B.A., 1981; Stanford Law School, J.D., 1985


Once upon a time, after the Great War, foreign persons invested in the portfolio stocks of U.S. corporations, and the U.S. corporations paid them dividends. If a foreign investor’s capital was thus invested, it was presumably being used to conduct business in the United States. Congress therefore retained taxing jurisdiction over the fruits of the investment ( i.e., the dividends received by the foreign investor). More specifically, Congress treated such dividends as derived from U.S. sources, unless less than 20% of the taxpayer’s gross income was from U.S. sources.

Congress realized, however, that it would be complex and impractical to require foreign portfolio investors to apportion part of their worldwide expenses to the dividends they earned from their investments in U.S. stocks (unless they were already doing so because they were already engaged in business in the United States). Congress therefore imposed a so-called “in lieu of” tax on their gross U.S. source dividend income. Such a tax is generally intended to approximate the amount of tax that would have been imposed on net income if the allocation of deductions were more practical. The tax was initially imposed (in 1936) at a rate of 10% and was subsequently increased to 30%, but the Treasury sought to reduce bilaterally the rate to 15% through the negotiation of tax treaties. This meant, of course, that Congress was denying foreign investors the right to reduce their dividend income by an allocable portion of their investment expenses, including, most importantly, interest expense. But in those days of high marginal rates of tax (imposed as late as 1963 at rates of 91% on income in excess of $200,000 per annum), these rates seemed sparing for even a tax imposed on gross income.

Congress likewise imposed a 30% outbound withholding tax on the gross interest income that foreign portfolio investors earned from bonds issued by U.S. corporations. Such capital was likewise presumably used to conduct business within the United States, and Congress therefore likewise treated the resulting interest income as derived from U.S. sources. But fixed income investments were obviously more fungible than investments in common stock. Moreover, so-called “Eurobonds” were generally issued in bearer form, which meant, as a practical matter, that foreign investors were not reporting and paying tax on their interest income in their local jurisdictions and were therefore not in a position to credit an outbound withholding tax against their local income tax. Foreign investors could therefore be expected to respond to an outbound withholding tax by lending their money elsewhere, in which case the incidence of the tax (if the bonds were issued at all) would land squarely on the U.S. borrower. Moreover, the Treasury recognized that the bilateral imposition of outbound withholding taxes on payments of interest tended to impede the free flow of debt capital across borders and was not a good idea as a matter of financial policy.

The Treasury therefore sought to eliminate the outbound withholding tax on payments of interest through the negotiation of bilateral tax treaties. In the absence of a treaty, moreover, the Treasury encouraged U.S. borrowers to bypass the technical imposition of an outbound U.S. withholding tax by borrowing funds through an intermediary Netherlands Antilles finance company. Published rulings expressly condoned this type of treaty shopping, so long as the intermediate finance corporation maintained some minimum amount of equity capital. Then in 1984, when the Treasury threatened to abrogate the Netherlands Antilles treaty because it allowed for too much treaty shopping, Congress unilaterally repealed the outbound withholding tax on portfolio interest as an anti-competitive measure that did little more than prevent U.S. corporations and governmental entities from gaining access to international capital markets. Congress did not anticipate much revenue loss because the government had long since been condoning effective elimination of the tax, as described above.

One might well ask why Congress and the Treasury did not in those years seek to eliminate the outbound withholding tax on portfolio dividends as well. After all (as discussed in Part VII infra), because U.S. corporations may not deduct dividends, Congress effectively maintains taxing jurisdiction (at the corporate level) over any income that is distributed to foreign investors as dividends. By contrast, because payments of interest are deductible, Congress loses taxing jurisdiction over inbound debt capital when it gives up its outbound withholding tax. Did Congress not likewise want to help U.S. corporations obtain access to foreign equity capital markets and encourage inbound foreign investment in U.S. equities? Did Congress not wish to protect its opportunity to impose corporate-level tax on such foreign equity capital? Congress may have been motivated in part by xenophobia; at that time the economies of Germany and Japan were thought to be eclipsing those of the United States, and the public seemed to view foreign acquisitions of U.S. property as territorial incursions. But portfolio investors were rarely in a position to take control of a corporation, and no one sought to eliminate the withholding tax on non-voting stock, such as preferred stock. The more compelling explanation is that unlike the case of interest, the incidence of the outbound withholding tax on dividends did not fall primarily on U.S. corporations, for equity capital was not as mobile as debt capital, and equity was in any case not issued in bearer form. Yet the mere fact that one can impose a tax does not mean that one should. And indeed the Treasury itself apparently believed in 1976 that the outbound withholding tax on dividends should also be eliminated.

And ironically, the financial circumstances that appear to have prevented Congress and the Treasury from also eliminating the outbound withholding tax on portfolio dividends have since withered away to a point that it is unclear that the Service collects any significant amount of this tax. For like Scarlett O’Hara’s south, the post-war financial world that I have been describing is now gone with the wind. Modern capital markets are driven by computers and characterized by complex and flexible financial relationships. As a result, the distinction between inbound debt and equity capital has become increasingly tenuous. But more importantly, it is no longer necessary for a foreign investor to invest capital in a U.S. corporation to obtain the burdens and benefits of ownership of U.S. stocks. There are numerous derivative financial instruments and relationships—including equity swaps, forward contracts and all sorts of options—that allow foreign investors to obtain the economic equivalent of a leveraged position in U.S. equities.

In light of this development, and in light of the policy considerations discussed in Part VII infra, it arguably does not make sense for Congress to continue to impose an outbound withholding tax on dividends. But unless and until the tax is repealed, we must do our best to help the Treasury understand when, and why, it should seek to impose this tax in respect of equity derivative transactions. This is particularly important because, as we shall soon see, the Treasury has already promulgated a highly dubious rule to govern the treatment of derivative payments that foreign investors receive in respect of inbound stock loans, and the Treasury has at various times toyed with the idea of extending this rule to payments received by foreign investors under equity swaps. Clearly the Treasury is in need of a model for analyzing what is happening when foreign investors take derivative positions in U.S. stocks.

This model must serve first to determine whether and when a foreign person has income by reason of having entered into an equity derivative transaction. For example, if a foreign person pays a U.S. counterparty $300,000 during the first year of an equity swap, should the Treasury nevertheless conclude that the foreign person has income subject to outbound U.S. withholding tax because of the way in which payments under the swap are measured ( i.e., because the foreign person’s $300,000 payment is actually based on the excess of a $500,000 notional interest payment over a $200,000 notional dividend receipt)?

This model must serve second to determine whether such income is properly treated as dividend income rather than as something else. For under current law, gain is generally sourced by reference to the residence of the taxpayer (even if it is gain from the sale of U.S. stocks) unless it is effectively connected with the conduct of business in the United States, and this includes gain from the termination of a derivative contract under section 1234A. Moreover, the Treasury has already extended residence-based sourcing to income from so-called “notional principal contracts,” and relevant income tax treaties likewise generally exempt from the imposition of U.S. tax any “other income” received by foreign persons from U.S. persons. Thus, any effort by the Treasury to impose an outbound withholding tax on amounts received by foreign persons in respect of equity derivative transactions must presumably be based on an assertion that these amounts are in fact dividends received by such foreign persons from U.S. corporations. In other words, it must be bottomed on the Treasury’s willingness and ability to characterize (or recharacterize) a foreign person’s position in an equity derivative transaction as a leveraged ownership of underlying U.S. equities.

In case there is any confusion, I make the following clarification: the analysis set out below is not an explication of what the tax treatment of equity derivative transactions is under current law. Rather, it is a means of conceptualizing what is happening in these transactions for purposes of helping the Treasury determine whether and when it should seek to impose an outbound withholding tax, given the current statutory framework and the presumed objectives of Congress. Hopefully the Treasury will issue new guidance in this area, sooner rather than later. For as this analysis should help make clear, given modern developments in equity capital markets, any real imposition of outbound withholding tax on dividends must for now turn largely on how the Commissioner and the courts choose to characterize various equity derivative transactions, and thus, in the absence of any coherent analytic model, the outcome in any particular case is a matter of sheer speculation.


Published by
Section of Taxation, American Bar Association
With the Assistance of
Georgetown University Law Center


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