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Levin, Whitehouse, McCaskill and Nelson Propose Legislation to Tax Offshore Private Investment Funds
March 20, 2009
Senators Carl Levin (D-Michigan), Sheldon Whitehouse (D-Rhode Island), Claire McCaskill (D-Missouri) and Bill Nelson (D-Florida) recently proposed the Stop Tax Haven Abuse Act (the "Act") in the U.S. Senate. Although the Act is intended to stop offshore tax evasion, if enacted, the Act would have significant tax consequences for certain offshore private investment funds and their U.S. managers.
As discussed in our January 29, 2009 Client Alert, earlier this year Senator Levin introduced the Hedge Fund Transparency Act, that, if passed, would require certain private investment funds to register with the Securities and Exchange Commission (the "SEC"), establish anti-money laundering programs and report suspicious transactions.
The Act is an updated version of the Stop Tax Haven Abuse Act introduced in February 2007, by Senators Carl Levin, Coleman (R-Minnesota) and then Senator Barak Obama, and that Congressmen Lloyd Doggett (D-Texas) and Rahm Emanuel (D-Illinois) introduced in the House with the support of 47 co-sponsors. No action was taken on either bill. The Act, although similar to its predecessor, includes three new sections that would impact the structure and operations of offshore private investment funds and their U.S. managers:
- Section 103 of the Act seeks to treat foreign corporations that are managed and controlled in the U.S. as domestic corporations for U.S. income tax purposes;
- Section 108 of the Act seeks to subject dividend equivalent payments made pursuant to swap agreements and substitute dividend payments made pursuant to securities lending and sale-repurchase transactions to U.S. income tax and withholding requirements; and
- Section 109 of the Act seeks to expand reporting requirements for U.S. persons who benefit from passive foreign investment corporations.
Each of these sections of the Act is discussed in greater detail below.
Section 103—Treatment of Foreign Corporations Managed and Controlled in the U.S. as Domestic Corporations
If enacted, Section 103 of the Act would treat certain foreign corporations as domestic corporations for U.S. income tax purposes when the management and control of the corporation occurs, directly or indirectly, primarily within the United States. Foreign corporations that would become subject to the Act generally would include corporations with:
- stock regularly traded on an established securities market; or
- aggregate gross assets of $50 million or more, including assets under management for investors, whether held directly or indirectly, at any time during the taxable year or any preceding taxable year.
The provisions of Section 103 would not apply to private corporations that met the Section 103 test for treatment as a domestic corporation in the preceding tax year, but then fell below the $50 million gross assets test, do not expect to exceed that threshold again, and are granted a waiver by the Secretary of the Treasury. Section 103 would also not apply to certain controlled foreign corporations with U.S. parents with substantial assets held for use in the active conduct of a trade or business in the United States.
To implement the provisions of Section 103, the Secretary of the Treasury is directed to issue regulations for determining whether the management and control of a corporation will be treated as occurring primarily within the United States. However, Section 103 expressly states that the management and control of a corporation will be treated as occurring primarily within the U.S. if substantially all of the executive officers and senior management of the corporation who exercise day-to-day responsibility for making decisions involving strategic, financial, and operational policies of the corporation are located primarily within the United States. Individuals who are not executive officers and senior management of the corporation (including individuals who are officers or employees of other corporations in the same chain of corporations as the corporation) will be treated as executive officers and senior management if such individuals exercise the day-to-day responsibilities of the corporation described above.
The Treasury regulations must also provide that the management and control of a corporation will be treated as occurring primarily within the U.S. if:
- the assets of such corporation (directly or indirectly) consist primarily of assets being managed on behalf of investors; and
- decisions about how to invest the assets are made in the United States.
If the Act is enacted, the provisions of Section 103 will apply to taxable years beginning on or after the date which is 2 years after the date of the enactment of the Act.
Section 108—Closing the Offshore Dividend Tax Loophole
Section 108 seeks to tax payments made to non-U.S. persons in three types of financial transactions—equity swaps, securities lending and sale-repurchase transactions. Although under current law, stock dividends from U.S. companies are treated as U.S. source income subject to U.S. income tax, dividend equivalent payments made under a swap agreement for the same stock are treated as being from foreign sources, and therefore exempt from U.S. tax to the extent the foreign person is not engaged in a U.S. trade or business. If Section 108 is enacted, dividend equivalent payments will be treated as U.S. source income subject to U.S. income tax.
Under current law, substitute dividend payments made by borrowers to lenders under securities lending or a sale-repurchase transactions are subject to U.S. income tax. However, recognizing that a single security can be lent multiple times (and thereby generate multiple substitute dividend payments), Notice 97-66 was issued to prevent the multiple (or “cascading”) imposition of tax on an amount that is economically attributable to a single dividend distribution. In general, Notice 97-66 exempted foreign-to-foreign substitute payments where the U.S. withholding tax had been collected on the payment of the actual dividend to a foreign party.
If Section 108 is enacted, foreign-to-foreign substitute dividend payments relating to dividends from U.S. companies will be treated as U.S. source income subject to U.S. income tax unless the Treasury Department promulgates regulations that exempt such substitute dividend payments to the extent the foreign parties can prove the withholding tax was collected on the actual dividend payment or a U.S.-to-foreign substitute dividend payment down the chain.
Section 108 directs the Secretary of the Treasury to issue, not later than 90 days after the date of the enactment of the Act, proposed regulations relating to Section 108. Final regulations must be issued not later than 150 days after the date of the enactment of the Act. The regulations must require the imposition of withholding:
- in cases where dividend equivalent payments under swap agreements are netted with other payments under the same instrument;
- in cases where fees and other payments are netted to disguise the characterization of a payment as a substitute dividend; and
- in cases where option or forward contracts (or similar arrangements) achieve the same or substantially similar economic results as swap agreements.
The provisions of Section 108 will apply to payments made on or after the date that is 90 days after the date of the enactment of the Act.
Section 109—Reporting of Activities with Respect to Passive Foreign Investment Companies
If enacted, Section 109 of the Act would increase the disclosure requirements for passive foreign investment companies ("PFIC") to include not only U.S. persons who are shareholders in a PFIC, but also each U.S. person who is a shareholder of, or who directly or indirectly forms, transfers assets to, is a beneficiary of, has a beneficial interest in, or receives money or property or the use thereof from, a PFIC. Section 109 would take effect on the date of the enactment of the Act.
Bracewell & Giuliani is committed to keeping clients and friends immediately apprised of new legislative proposals as the 1st session of the 111th Congress demonstrates that sweeping reform of the financial services industry, and private investment funds and their general partners and investment managers, will be at the center of the agenda.