Repos, the Technical Taxpayer Rules, and Foreign Tax Credit Splitter Rules (Section 909)

Sale-and-repurchase transactions (“repos”) are financing transactions used primarily to transfer cash from one party, typically a party that wants to lend money on a short-term secured basis, to a second party, in exchange for (usually) highly rated and very liquid securities like U.S. Treasury obligations that are temporarily transferred from the second party to the first party. They are an essential component of the capital markets, regularly used by the Federal Reserve Bank of New York, financial institutions and institutional investors. Trillions of dollars worth of repos are outstanding at any moment in time. One might think, as a result, that the U.S. tax rules for repos are well-established and non-controversial.In the case of repos on securities that are subject to non-U.S. withholding tax, however, that is not the case. Examples of repos of this kind are repos on stock that pays dividends subject to withholding tax and repos on corporate bonds that pay interest subject to withholding tax. An important question for repos of this kind is which party to the repo is treated as paying the withholding tax, because that is the taxpayer that is entitled to credit or otherwise benefit from the tax. Ordinarily the tax rules treat the same taxpayer that earns income that is subject to withholding tax as the taxpayer liable for the tax – that is, the income and the related tax are both attributable to the same taxpayer. This article first discusses the current U.S. tax rules that apply to repos of this kind. It then describes a proposal that the government has made to change (or, arguably, clarify) current law (under section 901 of the Internal Revenue Code) in a way that could prevent the taxpayer that earns the interest or dividends on a repoed security from obtaining a credit or other benefit from the related withholding tax, by treating different taxpayers as earning the income and paying the tax (a “foreign tax credit splitter”). Foreign tax credit splitters are generally considered contrary to good tax policy. The article then discusses several other provisions of the Code that the government might use to fix the foreign tax credit splitter problem that it has proposed to create (sections 901(k), 901(l) and newly enacted section 909), and concludes that these rules do not solve the problem. The article ends by recommending a modest change to the government’s section 901 proposal to clarify the law and provide appropriate rules for conventional repo transactions.