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Trust Company Expresses Support For Cross-Border Transaction Regs.

FEB. 23, 1996

Trust Company Expresses Support For Cross-Border Transaction Regs.

DATED FEB. 23, 1996
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Terence J. Toth of Northern Trust Company, Chicago, has written Treasury urging that the proposed regs on cross-border securities lending transactions under sections 861, 871, 881, 894, and 1441 be placed on the business plan for 1996. "It is in the long-term interest of the United States, as both a substantial user and provider of debt and equity capital, to promote an efficient global securities lending market," Toth writes.

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February 23, 1996

The Honorable Leslie B. Samuels

 

Assistant Secretary (Tax Policy)

 

Department of the Treasury

 

Room 3120

 

1500 Pennsylvania Avenue NW

 

Washington, DC 20220

RE: Proposed Regulations Concerning Cross-Border Securities Lending

 

Transactions (INTL-106-89)

Dear Mr. Samuels:

[1] On behalf of The Northern Trust Company, I respectfully request that the Internal Revenue Service place the adoption of the proposed regulations on cross-border securities lending transactions (the "Proposed Regulations") issued on January 8, 1992 under sections 861, 871, 881, 894, and 1441 of the Internal Revenue Code high on the business plan for 1996.

[2] The Northern Trust Company supports development of clear and objective tax rules with respect to cross-border transactions, such as the look-through rule announced in the Proposed Regulations with respect to cross-border substitute payments.

[3] It is in the long-term interest of the United States, as both a substantial user and provider of debt and equity capital, to promote an efficient global securities lending market. In addition, the current lack of clarity with respect to the tax treatment of substitute payments is causing The Northern Trust Company to turn away business that otherwise would increase revenue opportunities in the United States. The Northern Trust Company urges the Treasury Department and the Internal Revenue Service to press for international consensus and cooperation regarding the taxation of securities lending transactions.

[4] Securities loans generally are initiated by brokers, dealers and banks seeking to borrow securities primarily for one of three reasons: 1) to cover a failure to deliver securities to another counterparty, 2) to cover a short sale of securities, or 3) for the purposes of arbitrage or derivative trading strategies. Lenders' agents manage securities loans of both U.S. and foreign, corporate and government securities belonging to their trust and custody customers. Securities lending programs operated by participants in the U S. market have daily averages in excess of $250 billion, in aggregate, in securities loans in multiple markets. Moreover, agent lenders continue to expand their global securities lending networks.

[5] As global securities lending expands, the importance of clear tax rules becomes increasingly important. The size of the lending pool and resulting payment flows through lender's agents requires that a lending program be conducted in a uniform manner with a minimal risk of unanticipated withholding tax liability. Because of the narrow spreads earned by the lender and the lender's agent in these transactions, uncertainty of withholding tax effects can obstruct legitimate, non-tax motivated cross-border transactions that enhance the overall efficiency of global capital markets.

OBJECTIVES FOR CROSS-BORDER SECURITIES LENDING TAX RULES

A. GLOBAL PRINCIPLES

1. PROMOTE CERTAINTY

[6] From the perspective of most market participants, the primary objective for the rules that determine tax treatment of cross-border securities lending transactions is certainty of result. This is particularly true for lender's agents, since they can be subject to liability as withholding agents for payments made to both lenders and borrowers of securities. As described in the preceding sections, most securities lending consists of high-volume standardized transactions. The position taken by the lender's agent on withholding tax issues requires a high degree of certainty -- if that position is determined to be incorrect in a subsequent controversy with tax authorities, the potential tax liability could far outweigh any income earned by the lender and its agent from the loan transaction.

[7] Accordingly, lenders and their agents are required to take risk averse positions in this area. Where the law is unclear, they must either refuse certain types of lending transactions or withhold tax from transactions by applying the most unfavorable potential interpretations of the law. Unclear tax rules cause inefficiencies in the securities lending market, and discourage lending activities within particular jurisdictions. It is far preferable if each tax administration states its guidelines clearly, even if defining such positions requires balancing and choosing between conflicting policy objectives.

2. LEAVE LENDER IN THE SAME ECONOMIC AFTER-TAX POSITION

[8] To the extent possible, the lender should remain in the same after-tax position as if the securities had been retained in its possession. If the transaction increases the lender's return, the issue of which jurisdiction should have primary jurisdiction to tax that amount of additional income is presented. But the lending activity should not subject the lender or borrower to significantly different tax results with respect to the returns on the securities and collateral they hold prior to and following the loan. Such disparity encourages abusive transactions to reduce current tax and penalizes legitimate loans.

3. ADOPTION OF WORLDWIDE RULES THAT PRODUCE COMPATIBLE TAX RESULTS

[9] The primary objective of certainty requires clear tax rules in each of the jurisdictions involved in a securities lending transaction. Uniformity among such tax regimes reduces the risks of double taxation and of cross-border tax avoidance. Thus it is highly desirable for domestic tax regimes to be compatible with the rules of other jurisdictions.

B. APPLICATION OF ABOVE PRINCIPLES TO U.S. REGULATIONS

1. NEED FOR OBJECTIVE COMPREHENSIVE GUIDANCE

[10] The Northern Trust Company urges that the final regulations provide guidance on the issues discussed in detail in a letter dated February 12, 1996 from the committee on Securities Lending of the Robert Morris Associates. These issues were left unanswered in the Proposed Regulations. Even if the specific recommendations in this comment are not adopted, a clear answer to the issues raised in the form of administrable rules would in most cases be preferable to no rule at all.

2. POLICY OF NEUTRALITY TO LENDERS

[11] Tax neutral treatment of securities lenders not only removes tax impediments to the cross-border flow of capital, but it also promotes a Congressional policy of improving the liquidity of the securities lending market. This principle is reflected in the Proposed Regulations' rules for substitute payments. We believe this policy should be extended to other payments made in securities lending transactions.

[12] Tax neutrality is consistent with the clear Congressional intent expressed in the legislative history to the enactment of Code sections 1058 and 512(a)(5). Congress did not believe that tax rules should create barriers to legitimate securities lending transactions. The IRS has also followed this policy in subsequent rulings addressing domestic securities loans issues.

3. EQUIVALENT TREATMENT OF SIMILAR TRANSACTIONS

[13] Equivalent worldwide tax treatment of economically similar transactions discourages artificial manipulation of transactions for tax purposes. The U.S. securities lending regulations should therefore reflect policies that can be adapted to foreign tax systems and will contribute to uniform principles of taxation. We recommend that the IRS adopt securities lending rules that can be applied to securities loans by and to U.S. residents, and that the Administration encourage its major trading partners, through the Organization for Economic Cooperation and Development (the "O.E.C.D.") and bilateral treaty negotiation, to adopt consistent rules.

[14] As previously stated, risk adverse lending agents find that they must refuse lending on behalf of non U.S. lenders to U.S. broker dealers due to the current risk of withholding tax on the substitute payment. A requirement that the borrower "gross-up" the payment to allow for withholding tax renders non U.S. lending portfolios undesirable to U.S. borrowers. As a consequence, U.S. lending agents are finding that securities lending income is being diverted from the U.S., and the European and Japanese lending markets are growing as a result. The present lack of certainty places Northern Trust and other U.S. agent lenders at an economic disadvantage relative to our U.K. and Japanese counterparts.

[15] The clear outcome of this issue is extremely important for the continued viability of U.S. providers of securities lending services. I would be pleased to discuss this further with you at any time. Thank you for your attention to this important matter.

Sincerely,

Terence J. Toth

 

Senior Vice President

 

Northern Trust

 

Chicago, Illinois
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