IRS Scrutiny of Equity Swaps Could Impact Offshore Funds

March 5, 2010

In late January, the US Internal Revenue Service (“IRS”) directed its field examiners to scrutinize the use of equity swaps to minimize tax on US source dividends paid to non-US resident individuals and non-US partnerships and corporations. Such equity swaps, also known as “total return swaps,” have been used to provide yield enhancement by converting ordinary dividend payments subject to a 30% US withholding tax into swap payments not subject to US withholding. The strategy has also been known as “dividend arbitrage.”

Although the IRS guidance to its field examiners focused on US financial institutions and US subsidiaries of foreign banks, investigations of those entities will include demands for the identity of non-US clients employing the strategies. These could include offshore hedge funds and private equity funds. In addition, the guidance calls for coordination with IRS personnel examining non-US investors.

Non-US investors are therefore potentially subject to efforts by US tax authorities to recover dividend withholding tax avoided by these equity swap transactions. Under US law, both the US financial institution and the non-US client are jointly and severally liable for the tax that was not paid. The risk for any particular fund will depend on, among other factors, the specifics of the equity swap transaction employed by the fund and on the laws and treaty status of the country in which the fund is domiciled.

Of particular concern to the IRS are three variations of the equity swap transaction:

    • The “cross-in/cross-out” transaction involves a non-US investor selling a US equity to a US financial institution and, at the same time, entering into an equity swap transaction under which payments equivalent to dividends of the equity are paid out to the non-US investor. The security is then reacquired by the foreign investor.

    • A variation called “cross-in/IDB out” is similar to the cross-in/cross-out but involves an unaffiliated third party such as an inter-dealer broker to facilitate the cross-out transaction.

    • A third variant, known as “cross-in/foreign affiliate out,” resembles the first except that the equity swap is entered into with a foreign affiliate of the US financial institution.
While these and closely related situations appear to be the principal focus of the IRS attention, the guidance suggests that transactions outside these three scenarios should be examined in certain circumstances.

Funds domiciled in jurisdictions with certain tax treaties may be particularly at risk of IRS action. Some tax treaties now require the foreign jurisdiction to assist the IRS in its efforts to collect taxes. In addition, the IRS has formidable collection powers and any assets a fund has within the jurisdiction of the US may be seized to collect the unpaid tax.

The taxation of equity swaps and similar derivative transactions is a complex area of tax law. Non-US persons, partnerships and corporations who are contacted by the IRS or notified by a US financial institution that their equity swap or other derivative transactions are under scrutiny should immediately seek professional advice.





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March 2010

This article is designed to give general information on the developments covered, not to form an attorney-client relationship with the reader or to serve as legal advice related to specific situations or as a legal opinion. Counsel should be engaged and consulted if legal advice is sought.