October 24, 2007


TO: Distribution

FROM: Philip Garlett, John Staples

RE: Proposed NRA Withholding Regulations on Redemptions of Actively Traded Stock

The Treasury and the IRS issued proposed regulations (“Prop. Regs.”) on October 17, 2007, regarding a U.S. financial institution’s NRA withholding and reporting obligations on distributions in redemption of actively traded stock. Specifically, the Prop. Regs. provide an escrow procedure that a U.S. financial institution must apply to a redemption distribution while determining whether the distribution is subject to NRA withholding as a dividend or is exempt from withholding as a capital gain. Absent the escrow procedures, the financial institution must withhold on the entire distribution. The Prop. Regs. would apply to redemptions on or after January 1, 2009, but the preamble states that U.S. financial institutions may elect to apply the Prop. Regs. before that date.

Summary of the Prop. Regs.

In general, under the Prop. Regs., a U.S. financial institution must set aside in escrow 30 percent (or the applicable treaty rate) of the amount of a redemption distribution and provide foreign beneficial owners with information they will need to determine if the redemption constitutes a dividend or a capital gain. That information includes a written explanation of rules for determining whether the distribution is a dividend or a payment in exchange for stock. The U.S. financial institution must also request a certification from the foreign beneficial owner to be provided within 60 days that contains a statement regarding proper treatment of the distribution and supporting factual information. If the foreign beneficial owner certifies that the distribution is a payment in exchange of stock, the amount set aside in escrow can be released and the entire distribution must be reported as capital gains on Form 1042-S. If the foreign beneficial owner certifies that the distribution is a dividend, then the amount set aside is treated as tax withheld and the distribution reported as a dividend on Form 1042-S. If the U.S. financial institution does not receive a certification within 60 days, or the certification is unreliable or incorrect, the U.S. financial institution must treat the amount set aside in escrow as tax withheld as of the 61st day and report the amount as a dividend on Form 1042-S. The escrow procedures cannot be used by qualified intermediaries, withholding foreign partnerships, and withholding foreign trusts even though they may have primary withholding responsibility.

Implementation Issues for U.S. Financial Institutions

  • Implement Now or Wait: U.S. financial institutions will need to analyze the pros and cons of whether they should implement the procedures immediately or wait for possible changes to the rules. In making this determination, financial institutions should note that the preamble suggests that the IRS position is that withholding is required unless the procedures of the Prop. Regs. are followed.
  • Identifying Affected Transactions: While the preamble to the Prop. Regs. focuses on self-tenders, the language of the regulation makes it applicable to any transaction involving a redemption under IRC §302. Thus, financial institutions will need to determine what transactions beyond self-tenders are affected by the regulations and how they will determine when such transactions occur.
  • Drafting Required Explanation: U.S. financial institutions will have to draft explanations for non-U.S. customers regarding when a redemption distribution is a dividend or a payment in exchange of stock. The explanation must include a description of the IRC §318 constructive ownership rules. Financial institutions will have to balance providing enough information to meet the IRS requirement without providing so much information that the customer is confused or the financial institution is placed at a competitive disadvantage.
  • Treatment of U.S. Non-Exempt Shareholders: U.S. financial institutions must treat U.S. non-exempt recipients that hold stock through foreign intermediaries or flow-through entities in accordance with the rules applicable to foreign shareholders. This seems to preclude the option of reporting redemption distributions entirely on Form 1099-B for such U.S. non-exempt recipients 1. Systems changes may be required.
  • Reporting of Capital Gains: Redemption distributions that are treated as capital gains must be reported on Form 1042-S. This may require systems changes, as capital gains on stock are generally not subject to reporting.
  • Notifying Distributing Corporation: The U.S. financial institution must notify the distributing corporation in writing of the aggregate amount of the distribution treated as capital gains and as dividends by the filing date of Form 1042-S. U.S. financial institutions will need to put procedures in place to meet this requirement.
  • Inconsistencies between Prop. Regs. and PLR: There are some inconsistencies between the Prop. Regs. and PLR 2000552007, upon which the Prop. Regs. are modeled, such as whether the U.S. financial institution must do a mathematical calculation verifying a reduction in ownership and whether the person signing a shareholder certification on behalf of an entity must provide his or her capacity. U.S. financial institutions must decide whether these were oversights or deliberate changes, and whether to apply the PLR’s additional requirements in interpreting the standards of the Prop. Regs.
  • Interest on Escrows: U.S. financial institutions will need to decide whether to pay interest on amounts set aside in escrow and ultimately released to customers.


1 See PLRs 9115019, 9015012, 8920007


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