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The Past, Present, and Future of Equity Swaps  

Author:  Yoram  Keinan.

Source: Volume 28, Number 03, Spring 2011 , pp.3-24(22)

Journal of Taxation of Investments

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The taxation rules for total return equity swaps (a TRS or an “equity swap”) in particular have been subject to growing criticism in since the 90s. Many non-residents synthetically invest in U.S. equity using equity swaps, and as Congress, Treasury, the IRS and commentators have argued, such synthetic investments--as opposed to direct long investments--have been mainly tax-motivated. The primary tax benefit for non-residents generally was the result of the preferential source rules for notional principal contracts (NPCs) under U.S. tax law, pursuant to which the source of payments under an NPC is the residency of the recipient. Congress urged its members, and called on Treasury and the IRS, to take immediate action to shut down what it titled as “Dividend Tax Abuse,” in a report issued by the Senate Permanent Subcommittee on Investigations in 2008 (the “Dividend Abuse Report”). The IRS responded by issuing detailed guidelines to IRS field agents auditing U.S. financial institutions and their U.S. branches dealing with equity swaps (the “Swap Audit Guidelines”). On March 18, 2010, Congress added a new section to the tax code (currently Section 871(m)) that generally provides for withholding on substitute payments made to non-residents on what it titled as “specified notional principal contracts”(the scope of which will be significantly expanded in 2012). This article traces the evolution, and outlines the contents of, the Dividend Abuse Report, the Swap Audit Guidelines and Section 871(m), and analyses and criticizes these authorities.

Keywords:  total return equity swap; IRC Section 871(m); dividend equivalent payments; notional principal contracts; abusive transactions; Swap Audit Guidelines

Affiliations:  1: Greenberg Traurig.

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