Further Thoughts on the Proposed Regulations Dealing with Public
Self-Tender Transactions
By David R. Tillinghast,
Esq.
Baker & McKenzie, New York, NY
In October, the IRS issued proposed regulations relating to the
withholding of tax on amounts payable to foreign shareholders as the
result of a publicly traded corporation's tender for its own shares.
REG-140206-06, 72 Fed. Reg. 58781 (10/17/07). Edward Tanenbaum's
thoughtful comments on these regulations appeared in the February
issue of the Tax Management International Journal. With
apologies for some unavoidable duplication, I would like to make some
further comments.
These proposed regulations would address uncertainties which have
existed for some time over how self-tender payments should be treated.
The dilemma is, of course, that amounts paid in redemption may be
treated as a dividend, constituting fixed or determinable annual or
periodical income (FDAP) subject to withholding under §1441, or
as gain from the sale or exchange of stock under §302(b), which
is not FDAP and therefore not subject to §1441 withholding.
See Regs. §1.1441-2(b)(2). This depends, of course, on
whether there is a substantial change in, or elimination of, the
shareholder's direct, indirect, and attributed interest in the
corporation, determined by comparing that interest as a percentage of
the total before and after the transaction. There is no a
priori way to know whether this will be true, since no shareholder
is obliged to tender, and preferences may differ.
The proposed regulations would flesh out provisions of the existing
regulation which are relatively sparse. Regs. §1.1441-3(c)
generally requires withholding on the full amount of any corporate
distribution, but paragraph (c)(2)(i)(B) provides that the withholding
agent “may elect not to withhold on a distribution to the extent
that it represents a distribution in part or full payment in exchange
for stock.” How the withholding agent would know this is not
specified. Moreover, under Regs. §1.1441-3(d)(1) a withholding
agent may make a reasonable estimate of the amount of income that will
be subject to tax, set aside “a corresponding portion” of
the amount to be paid, “and hold such portion in escrow until
… the taxable amount is determined.” Again, how this is to
be accomplished remains unclear. The Preamble to the Proposed
Regulations observes tersely that in the case of redemptions
“the means of compliance with [the withholding rules] is
varied” and that “the discretion permitted by the current
regulations, and the different treatment of similar transactions is
not appropriate.”
The IRS proposal would add a new paragraph (5) to Regs.
§1.1441-3(c). This would require a U.S. financial institution
acting as a withholding agent to withhold tax from payments made to
foreign persons on the assumption that the payment will be treated as
a dividend, but to place the amount withheld in an escrow account. The
withholding agent would be required to provide to the foreign holder
information concerning the total number of outstanding shares of the
tendering corporation before and after the tender, an explanation of
the §302 rules, and a request that within 60 days of the making
of the payment the holder provide a certificate attesting whether the
payment is to be treated as a dividend or as a sale or exchange of
stock. If the stock is held through one or more Qualified
Intermediaries or non-Qualified Intermediaries, the information would
be passed up the chain into the hands of the ultimate owner.
If within the 60-day period the U.S. institution receives a
certification that the transaction is treated as a sale or exchange
(and it does not know or have reason to know that the information in
the certificate is “unreliable or incorrect”), it will
credit the escrowed amount to the holder's account. If the
certification indicates that the amount is to be treated as a
dividend, the institution will remit the amount withheld to the IRS.
If on the 61st day the institution has received no
certification, it will treat the payment as a dividend as of that
date. If a certification arrives late, the institution can avail
itself of the reimbursement or set-off procedures set forth in Regs.
§1.1461-2(a).
Several features of this proposal are notable. It is limited to
self-tenders by corporations that are publicly traded under the
definition of Regs. §1.1092(d)-1. It also applies only to
withholding agents that are U.S. persons described in Regs.
§1.1441-1(c)(13), which defines an “intermediary.”
Tenders that are made by non-publicly traded corporations (which may,
nevertheless, have a considerable number of shareholders) may, of
course, raise similar withholding issues. In such cases, the
withholding agent may be the corporation itself or its transfer agent,
either of which would not qualify as an intermediary. While
information on the holding of such a corporation's shares may be more
readily available and not continually changing, there may be relevant
information that the corporation and its transfer agent do not
possess--most notably the application of the §318 attribution of
ownership rules, which of course often affect the determination of the
status of a payment. I, at least, have not identified a reason why the
proposal is so limited, and the Preamble gives no explanation. Perhaps
it is the perception that it is the publicly traded cases that involve
the huge numbers of holders and huge amounts of money.
There may be a more pedestrian explanation--that the IRS had the
system in the can and simply published it as a proposed regulation. In
PLR 20052007 (12/30/05), the IRS issued to a taxpayer a ruling
adopting the system now issued in regulatory form (or actually one
that does the job a little bit better). Perhaps others were clamoring
for rulings and the IRS just decided to go public.
The second notable feature of the proposal is that it does not
permit the escrow procedure to be implemented through a foreign
Qualified Intermediary. Again, there is no explanation, and it is not
clear why the IRS would not be content to rely on a QI to operate this
system when it is content to rely on it for other withholding
obligations. The IRS may, however, have thought that this would
require amendment of the agreements that the QIs have entered into
with the IRS; and this may have been considered administratively too
burdensome a task to undertake. If stock is held by a foreign holder
through a QI, the certification process will of course proceed through
the QI, which will deal with its customers in the normal course.
There is one glitch here, however. Subparagraph (ii)(D) of the
proposal, relating to the required certification as to the treatment
of the payment to be made, requires the U.S. withholding agent to
obtain a certificate from the foreign holder, which among other things
specifies the identity of the holder. One reason, though certainly not
the only one, for creating QIs was the reluctance of foreign holders
to make their identities known in the United States.
In this respect PLR 20052007 seems to have gotten it right. Under
it, the U.S. withholding agent sends a request for certification to a
QI, the QI deals with its customers, and the QI sends aggregate
information to the U.S. withholding agent in accordance with Section
6.02 of Rev. Proc. 2000-12, as modified subsequently. The information
furnished by the ultimate holders to the QI is to be examined in the
required audit of the QI.
The proposed regulations provide no information regarding the terms
of the required escrow accounts. Presumably the financial institution
will simply designate an account in its own books. But, in these
unsettling days, will the funds still be subject to the claims of its
creditors? The funds withheld will be escrowed for 60 days. Will the
balance accrue any interest? This would presumably be income to the
holder if later credited to its account, potentially subject to
withholding, although it may qualify as bank deposit interest or
portfolio interest.
One thing is clear, however--this is going to be a compliance
nightmare. In a large number of cases, ownership will have to be
traced not only through intermediaries but also through many
intervening entities. One can just imagine foreign holders all over
the globe trying to figure out the impact of the §§301, 302,
and 318 rules. (One cannot really imagine a holder qualifying for the
complete termination of interest rule of §302(b)(3) by filing
with the IRS the agreement contemplated by §302(c)(2)). The
Preamble requests comments on alternative procedures that could be
applied by withholding agents that maintain a large number of customer
accounts, and many of these have been submitted.
The Preamble refers to Rev. Rul. 76-385, 76-2 C.B. 92, in which the
reduction of a holder's direct and indirect ownership from 0.0001118%
to 0.0001081% was considered a “meaningful reduction”
within the scope of the Davis decision. Presumably the
instructions that U.S. institutions will send out will refer to this.
That will probably determine the answer that most holders will come
back with. But that is probably no different from what happens within
the United States. Perhaps the IRS is just gunning for large holders
that may be more visible and really can figure all of this out.
One footnote: The proposed regulations are stated to be effective
for distributions made after December 31, 2008. However, in the
Preamble (of all places) the statement is made that “a
withholding agent may, at its option, rely on these proposed
regulations for a redemption of stock that occurs before January 1,
2009.” I am not sure what legal authority there is for such a
permission or whether a statement made in the Preamble is considered
an effective proposed rule.
This commentary also will appear in the March 14, 2008, issue of
the Tax Management International Journal. For more information,
in the Tax Management Portfolios, see Tello, 915 T.M., U.S.
Withholding and Reporting Requirements for Payments of U.S. Source
Income to Foreign Persons, and in Tax Practice Series, see
¶7150, Withholding and Compliance.
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