Countries continue to enter into FACTA agreements with the U.S. rather than be shut out of the international banking system and U.S. markets. U.S. Senators rail against Apple, Google and Microsoft for not repatriating profits earned from overseas operations. Bills are introduced in Congress that will attempt to prevent inversions whereby domestic corporations attempt to realign ownership so that the entity becomes foreign.

Hidden in the background is the relentless assault against past practices through the issuance of more restrictive regulations. One example concerns notational principal contracts (NPC). One type of NPC, known as Total Return Swap, was designed to pass U.S. source dividend to a non-U.S. investor without causing income tax withholding to be imposed on the outbound payment.

In 2010, Congress, enacted IRC§871(m) to impose a withholding obligation on dividend equivalent payments. Such payments include substitute dividend payments and certain NPCs. The seven factor test contained in the 2010 draft regulations has been replaced with an objective test which measures certain changes. In the most elementary terms, if the derivative contract produces substantially the same economic result as outright ownership, the contract is subject to these rules.

The objective test applies to equity linked investments (ELI) that produce the same return without income tax withholding as would direct ownership of the underlying stock and receipt of the dividend net of withholding.

The essence of NPCs and ELI’s is that a foreign customer contacts a bank and states that it wants to buy shares in a domestic corporation. The bank constructs a contract that takes into account charges at the price of a stock over time and its dividend. This contract simulates ownership of the security itself but does not suffer withholding taxes because the dividend is received by the bank, a domestic taxpayer. The new rules evaluate the payments to be made based on changes in price and dividends received to classify these contracts as being subject to withholding. The new regulations apply to other investments, as well.

It remains to be seen what impact this will have on domestic banks and what other techniques evolve.

If you have any questions about this post or would like to discuss your company’s tax,trust, and estate matters , please contact me, James F. McDonough at ScarinciHollenbeck.com.