SIFMA Suggests Guidance on Treatment of Negative Rate Payments

July 9, 2020

Mr. Chip Harter
Deputy Assistant Secretary, International Tax Affairs
U.S. Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Ms. Erika Nijenhuis
Senior Counsel, Office of Tax Policy
U.S. Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Mr. Brett York
Deputy Tax Legislative Counsel, Office of Tax Legislative Counsel
U.S. Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Re: Treatment of Negative Rate Payments for U.S. Tax Information Reporting and Withholding Purposes

Dear Mr. Harter and Ms. Nijenhuis and Mr. York:

The Securities Industry and Financial Markets Association (“SIFMA”)¹ would like the opportunity to raise the issue of negative rate payments — colloquially known as “negative interest” — and present our recommendations for guidance on the tax treatment of such payments.²

As you are aware, in mid-2014, central banks in Europe and Japan began making negative rate payments, a trend that has sustained for several years and does not appear to be reversing. The practice has raised questions on its tax treatment since the inception of the idea. We discussed the reasoning and trend toward negative interest in the December 2014 SIFMA letter³, and in the current market environment some analysts have considered whether the U.S. Federal Reserve would drop rates below zero as well.

This letter focuses on cross-border transactions.

SIFMA members increasingly engage in cross-border transactions that involve negative rate payments or charges, but the U.S. tax rules do not currently provide specific guidance on either the characterization or sourcing of these payments. Final Regulations issued in January 2014 amended Treasury Regulation section 1.171-2 to provide rules applicable to premiums paid on bonds, and these regulations appear to encompass bonds with negative yield that may be attributable to negative interest rates, but there are no other direct tax precedents.⁴ Withholding agents need guidance from the government to ensure correct and consistent treatment across the industry.

Below are a few scenarios highlighting situations in which negative rate payments might arise:

• Cash Deposits: In this scenario, a U.S. financial institution has a deposit account with a non-U.S. bank. Typically, the non-U.S. bank would pay interest on the amount deposited. In a negative rate environment, the U.S. financial institution would make a negative rate payment to the non-U.S. bank with respect to the funds held in the deposit account.

• Margin Loan: A non-U.S. client borrows cash from a U.S. broker to purchase U.S. securities. Typically, the non-U.S. client would pay interest to the U.S. broker on the borrowed funds and the securities are used as collateral. In a negative rate environment, the U.S. broker would pay the non-U.S. client an amount based on the negative rate.

• Derivatives: Cash collateral is pledged by a U.S. financial institution to a non-U.S. counterparty. Usually, the non-U.S. counterparty would pay interest on the cash collateral. In a negative rate environment, the U.S. financial institution would make a negative rate payment to the non-U.S. counterparty with respect to the funds held as collateral.

• Sale-and-repurchase transactions (“repos”): A non-U.S. client that owns U.S. Treasury securities (repo seller) sells them to a U.S. counterparty (repo buyer) for cash. The repo buyer agrees to resell the securities at a later date to the repo seller at the original price plus an amount determined by reference to an interest rate. The incremental amount is termed “Price Differential.” When positive, the Price Differential is generally treated as interest when paid by the repo seller. In low interest rate environments, the Price Differential may be negative and there would be a negative rate payment. Additionally, if the repo buyer fails to deliver the repoed securities to the repo seller at repurchase, the U.S. repo buyer might be obligated to pay a “fails charge” to the repo seller. If paid, the fails charge would further lower the yield to the repo buyer. The fails charge is, in effect, a surrogate for a negative repo rate.⁵

In each of these scenarios, the question arises as to how to characterize and source the negative rate payment. In the repo example, it seems clear the negative rate payment is economically comparable to a “fails charge” and should be sourced based on existing guidance to the residence of the recipient.⁶ In other examples, discussions among industry members have suggested that the character and source of this type of payment could be treated similar to interest (or “interest-like”), fees, or another type of payment not subject to withholding (e.g., premium or an additional amount lent).

SIFMA recommends these payments, to the extent characterized as a payment of income, be sourced on a prospective basis to the recipient or payee. This directly follows guidance from Treasury and IRS relating to “qualified fails” charges. This also follows rules applicable to fees or services income, where the recipient of a negative rate payment is effectively receiving a payment similar to a custodial fee for holding and safeguarding the payee's cash. When the recipient or payee is outside the United States, the payment should be sourced outside the United States and not subject to U.S. withholding. Moreover, as a policy matter, this would put U.S. and foreign payors on equal footing. Such treatment would also be consistent with and analogous to the U.S. tax treatment of: Notional Principal Contracts, and premiums paid with respect to a negative yield bond, deposit/CD or loan.

Generally, this approach would create a practical and administrable solution for withholding agents by eliminating U.S. withholding tax on payments made to non-U.S. persons, and treating payments of income to U.S. persons as U.S. source income.

The alternative conclusion that the payment be sourced to the residence of the payor would be extremely disruptive. As mentioned in the 2014 SIFMA letter, application of the 30% withholding tax on amounts received from sources within the U.S. by foreign businesses and individuals could cause market participants to withdraw from the markets to avoid significant liability. This gross-basis tax often far exceeds the income earned on particular transactions, and both intermediaries and principals are liable for the tax.

Finally, because banks and financial institutions have been operating in this uncertain environment without guidance regarding the proper tax characterization of negative rate payments, SIFMA requests that firms not be challenged on audit if the prior tax treatment of these payments is inconsistent with the position the government ultimately dictates.

We appreciate your consideration of our members' concerns and our recommendations. Please don't hesitate to contact me at JSok@sifma.org or (202) 962-7399, or Jillian Enoch at JEnoch@sifma.org or (202) 962-7339.

Respectfully submitted,

Justin Sok
Managing Director, Tax
Securities Industry and Financial Markets Association
Washington, DC

Enclosures