||June 24, 1998
Trading Safe Harbors.
DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [REG-106031-98] RIN 1545-AW13
TITLE: Trading Safe Harbors.
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
SUMMARY: This document contains proposed rules for the treatment of
foreign taxpayers trading in derivative financial instruments for
their own account. These proposed rules provide that foreign
taxpayers who effect transactions in derivative financial
instruments for their own accounts are not thereby engaged in a
trade or business in the United States if they are not dealers in
stocks, securities, commodities or derivatives. These proposed rules
affect foreign persons that conduct such trading for their own
account either directly through U.S. offices or indirectly through
partnerships or other agents. This document also provides notice of
a public hearing on these proposed regulations.
DATES: Written comments must be received by September 10, 1998.
Outlines of oral comments to be discussed at the public hearing
scheduled for September 9, 1998, must be received by August 19,
ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-106031-98), room
5226, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered between the
hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-106031- 98),
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue
NW., Washington, DC. Alternatively, taxpayers may submit comments
electronically via the Internet by selecting the "Tax Regs" option
on the IRS Home Page, or by submitting comments directly to the IRS
Internet site at
http://www.irs.ustreas.gov/prod/tax_regs/comments.html. The public
hearing will be held in room 2615, Internal Revenue Building, 1111
Constitution Avenue NW., Washington, DC.
FOR FURTHER INFORMATION CONTACT: Milton Cahn of the Office of
Associate Chief Counsel (International), (202) 622-3870; concerning
submissions and the hearing, LaNita Van Dyke, (202) 622-7190 (not
Section 864(b) of the Code provides that the phrase "trade or
business within the United States" generally includes the
performance of personal services within the United States at any
time during the taxable year but, under certain circumstances, does
not include trading in stocks, securities, or commodities through an
independent agent or for a taxpayer's own account (the "trading safe
Regulations regarding certain aspects of the trading safe harbors
were promulgated in 1972. Since the promulgation of these
regulations, the use of derivative financial instruments has
increased significantly. This is due in large measure to the overall
expansion and growing sophistication of global capital markets.
Although guidance concerning the tax treatment of derivatives and
notional principal contracts has been issued under other provisions
of the Code (see, e.g., §§1.446-3, 1.863- 7(b)), the section 864(b)
regulations have not been modernized to take into account the manner
in which taxpayers customarily use derivative transactions.
Explanation of Provisions
1. In General
These proposed regulations provide that foreign taxpayers who are
not dealers with respect to any derivative transactions, who are not
otherwise dealers in stocks, securities, or commodities, and who
enter into derivative transactions for their own accounts are not
engaged in trade or business within the United States solely by
reason of those transactions. The term "derivative" is defined as an
interest rate, currency, equity or commodity notional principal
contract or an evidence of an interest in, or derivative financial
instrument in, any commodity, currency, or any of the items
described in Code section 475(c)(2)(A)-(D).
For purposes of these proposed regulations, the term "currency" is
limited to those currencies that are of a kind customarily dealt in
on an organized commodity exchange. No inference is intended,
however, as to whether currencies that are not traded on an
organized commodity exchange are "of a kind" customarily dealt in on
an organized commodity exchange.
Comments are solicited on this issue.
Under the statutory safe harbors, taxpayers who are dealers in
stocks and securities but not commodities may avail themselves of
the commodities trading safe harbor of section 864(b)(2)(B)(ii), and
likewise, dealers in commodities but not stocks and securities may
avail themselves of the stocks and securities trading safe harbor of
section 864(b)(2)(A)(ii). The proposed regulations, however, do not
specify into which statutory safe harbor any particular derivative
transaction falls. Accordingly, dealers in stocks, securities,
commodities, or derivatives may not avail themselves of the benefits
of these proposed regulations.
Treasury and the IRS are considering the appropriate application of
both the stocks and securities safe harbor of section 864(b)(2)(A)
(ii) and the commodities safe harbor of section 864(b)(2)(B)(ii)
with respect to a dealer in a derivative which arguably might be
classified as both a security and a commodity. Treasury and the IRS
are also considering the appropriate application of the section
864(b)(2)(A)(ii) and (B)(ii) safe harbors to dealers in either
stocks and securities or commodities who enter into a derivative
transaction which arguably might be classified within both sections.
Comments are solicited on these points including the classification
of specific derivatives for purposes of the safe harbors.
Comments are also solicited regarding whether the final regulations
should include derivative transactions in either the stocks and
securities, or commodities trading safe harbors under sections
864(b)(2)(A)(i) and (B)(i). In particular, the IRS solicits comments
as to whether certain dealers could inappropriately avoid the
limitations of section 864(b)(2)(C) with respect to derivative
transactions effected through independent agents in the United
2. Eligible Nondealer
Until Treasury and the IRS determine whether particular derivative
transactions should be classified under the stocks and securities or
commodities safe harbors, the proposed regulations provide that
derivative transactions (including hedging transactions) do not
constitute a U.S. trade or business if the taxpayer meets the newly
proposed definition of an "eligible nondealer."
An eligible nondealer is defined as a foreign resident taxpayer who
is not a dealer in stocks, securities, commodities or derivatives at
any time during the taxable year. Dealer status is determined on a
worldwide basis and disqualifies a taxpayer from the safe harbor of
the proposed regulations even if no dealing activities are conducted
in the United States. For example, if a taxpayer is a dealer in
commodities through its home country office and conducts no dealing
activities through its U.S. office, but enters into derivative
transactions for its own account through the U.S. office, the
taxpayer fails to be an eligible nondealer.
Under the proposed regulations, the definition of dealer in stocks
or securities refers to §1.864-2(c)(2)(iv) and the definition of
dealer in commodities refers to the use of that term in §1.864-2(d).
The definition of eligible nondealer contains language based on the
definition of dealer in securities in 475(c)(1)(B), including
regularly holding oneself out, in the ordinary course of one's trade
or business, as being willing and able to enter into either side of
a derivative transaction. See §1.475(c)-1(a)(2).
Treasury and the IRS are considering issuing additional guidance
with respect to the definition of a dealer for purposes of applying
the trading safe harbors generally. Comments are solicited regarding
the definition of a dealer, including the adequacy of the present
rules in §1.864-2(c)(2)(iv) and §1.864- 2(d), possible rules for
identifying derivative transactions entered into with customers in
the "ordinary course," and the appropriateness of adopting a
definition similar to that provided in section 475(c)(1).
3. Swaps on U.S. Equities
Treasury and the IRS are aware that in order to avoid the tax
imposed on U.S. source dividends under sections 871 and 881 and
Chapter 3 of the Code, some foreign investors use notional principal
contract transactions based on U.S. equities ("U.S. based equity
swaps"). Accordingly, Treasury and the IRS are considering whether
rules should be developed to preserve the withholding tax with
respect to such transactions. Specifically, Treasury and the IRS are
evaluating whether conduit (e.g., section 7701(l)) or other
principles should be invoked in regulations, to characterize
payments made with respect to U.S. based equity swaps as subject to
U.S. withholding tax.
Treasury and the IRS are considering whether or not finalization of
the proposed regulations as they relate to U.S.
based equity swaps should await guidance concerning the application
of the withholding rules to such transactions.
Broadening the section 864(b)(2)(A)(ii) and (B)(ii) safe harbors to
include derivatives could impair the ability of the United States to
tax U.S. source dividend payments.
Congress enacted the stocks and securities trading safe harbor in
1936 to provide certainty that foreign persons who merely trade
stocks and securities would not be subject to the net income tax
regime. Section 211(b), Revenue Act of 1936, Pub.
L. 74-740, 49 Stat. 1648, 1714-15 (1936); S. Rep. No. 2156, 74th
Cong., 2d Sess. 21 (1936). Congress' decision to include the safe
harbor was premised on the fundamental assumption that ordinary
income from U.S. stocks and securities would be appropriately
subject to U.S. taxation through the withholding tax on fixed and
determinable or annual and periodic income ("FDAP"), and that
activities beyond the scope of the safe harbor would remain subject
to net tax if the taxpayer was engaged in a trade or business or had
an office in the United States. Id.
The Foreign Investors Tax Act of 1966, which expanded the trading
safe harbors to include trading activities conducted by or on behalf
of a non-U.S. resident taxpayer through a U.S. office for the
foreign taxpayer's own account, built upon the same principles
reflected in the Revenue Act of 1936. See Section 102(d), Foreign
Investors Tax Act of 1966, Pub. L. 89-809, 80 Stat. 1539, 1544
(1966); S. Rep. No. 1701, 99th Cong., 2d Sess. 16-17, 22-23, 32-33
Treasury and the IRS request comments regarding the U.S.
taxation of non-U.S. persons investing in derivatives generally in
addition to the treatment of derivatives under the trading safe
harbors. Comments are also solicited concerning the appropriate
source of payments made pursuant to U.S. based equity swaps and
whether conduit or other principles should be invoked for purposes
of sections 871, 881 and Chapter 3 of the Code, including the
circumstances under which such payments between non-U.S. resident
counterparties (i.e., foreign-to-foreign payments) may be included
in such regulations. In addition, comments are also solicited
concerning the appropriate treatment of swaps or other derivative
transactions on property (other than stocks and securities) that
produce FDAP income, e.g., rents and royalties.
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in EO 12866.
Therefore, a regulatory impact analysis is not required. It also has
been determined that section 553(b) of the Administrative Procedure
Act (5 U.S.C. chapter 5) does not apply to these regulations, and
because the regulation does not impose a collection of information
on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter
6) does not apply. Therefore, a Regulatory Flexibility Analysis
under the Regulatory Flexibility Act (5 U.S.C. Chapter 6) is not
required. Pursuant to section 7805(f) of the Code, this notice of
proposed rulemaking will be submitted to the Chief Counsel for
Advocacy of the Small Business Administration for comment on their
impact on small business.
Comments and Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any written comments that are
submitted timely to the IRS (a signed original and eight (8)
copies). All comments will be available for public inspection and
A public hearing has been scheduled for September 9, 1998, at 10:00
A.M.,in room 2615, Internal Revenue Building, 1111 Constitution
Avenue NW, Washington, DC. Because of access restrictions, visitors
will not be admitted beyond the Internal Revenue Building lobby more
than 15 minutes before the hearing starts.
The rules of 26 CFR 601.601(a)(3) apply to the hearing.
Persons that wish to present oral comments at the hearing must
submit written comments by September 10, 1998, and submit an outline
of the topics to be discussed and the time to be devoted to each
topic by August 19, 1998.
A period of 10 minutes will be allotted to each person for making
An agenda showing the scheduling of the speakers will be prepared
after the deadline for receiving outlines has passed.
Copies of the agenda will be available free of charge at the
Proposed Effective Date
These regulations are proposed to be effective for taxable years
beginning 30 days after the date final regulations are published in
the Federal Register. Taxpayers may elect to apply the provisions of
the final regulations to taxable years beginning before the date
which is 30 days after these regulations are published as final in
the Federal Register. No inference is intended regarding the
treatment of derivative transactions under sections 864(b)(2)(A)(ii)
and (B)(ii) and the current regulations. For periods prior to the
effective date, taxpayers engaged in derivative transactions may
take any reasonable position with regard to the section 864(b)(2)(A)
(ii) and (B)(ii) safe harbors. Positions consistent with these
proposed regulations will be considered reasonable.
The principal author of these regulations is Milton Cahn of the
Office of Associate Chief Counsel (International). However, other
personnel from the IRS and Treasury Department participated in their
List of Subjects in 26 CFR Part 1 Income taxes, Reporting and
Proposed Amendments to the Regulations Accordingly, 26 CFR part 1 is
proposed to be amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.864(b)-1 is added to read as follows:
§1.864(b)-1 Trading in derivatives.
(a) Trading for taxpayer's own account. As used in part I (section
861 and following) and part II (section 871 and following),
subchapter N, chapter 1 of the Internal Revenue Code (Code), and
chapter 3 (section 1441 and following) of the Code, and the
regulations thereunder, if a taxpayer is an eligible nondealer, the
term engaged in trade or business within the United States does not
include effecting transactions in derivatives for the taxpayer's own
account, including hedging transactions within the meaning of
(b) Definitions--(1) Eligible nondealer. For purposes of this
section, an eligible nondealer is a person that is not a resident of
the United States and is not, at any place (domestic or foreign),
nor at any time during that person's taxable year, any of the
(i) A dealer in stocks or securities as defined in §1.864-2(c)(2)
(ii) A dealer in commodities as that term is used in §1.864-2(d); or
(iii) A person that regularly offers to enter into, assume, offset,
assign or otherwise terminate positions in derivatives with
customers in the ordinary course of a trade or business, including
regularly holding oneself out, in the ordinary course of one's trade
or business, as being willing and able to enter into either side of
a derivative transaction.
(2) Derivative. For purposes of this section, the term derivative
(i) An interest rate, currency (as defined in paragraph (b)(3) of
this section), equity, or commodity (as the term is used in section
864(b)(2)(B) and §1.864-2(d)) notional principal contract (as the
term is used in section 475(c)(2)); or (ii) An evidence of an
interest, or a derivative financial instrument (including any
option, forward contract, short position and any similar financial
instrument), in any--
(A) Commodity (as the term is used in section 864(b)(2)(B) and
(B) Currency (as defined in paragraph (b)(3) of this section);
(C) Share of stock (as the term is used in §1.864-2(c)(2));
(D) Partnership or beneficial ownership interest in a widely held or
publicly traded partnership or trust;
(E) Note, bond, debenture, or other evidence of indebtedness; or
(F) Notional principal contract described in paragraph (b)(2)(i) of
(3) Limitation. For purposes of this section, the term currency is
limited to currencies of a kind customarily dealt in on an organized
Michael P. Dolan
Deputy Commissioner of Internal Revenue
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