31 January 2025

United States | Proposed BEAT regulations would provide favorable guidance on qualified derivative payments in securities lending transactions

  • The proposed regulations would exclude mark-to-market gain or loss on a securities loan from "base erosion payments."
  • The proposed regulations provide an alternative method to determine the recipient of a substitute payment on a securities loan.
  • The QDP "good faith reporting period" has been extended to tax years beginning on or after 1 January 2027, consistent with Notice 2024-43.
 

In proposed regulations (REG-107895-24; the Proposed Regulations) released 10 January 2025, under IRC Section 59A, the IRS and Treasury Department outlined how to determine and report qualified derivative payments (QDPs) on securities lending transactions.

Background

In addition to any other income tax, an applicable taxpayer for purposes of the base erosion and anti-abuse tax (BEAT) must pay a "base erosion minimum tax amount" equal to the excess (if any) of 10% of its "modified taxable income" over an amount equal to its regular tax liability, with certain adjustments for the tax year. An applicable taxpayer's modified taxable income equals its taxable income for the year, determined without regard to, among other things, any deductions allowed (or certain reductions to gross receipts) (a base erosion tax benefit) with respect to a "base erosion payment." Generally, a base erosion payment is any amount paid or accrued by the taxpayer to a "foreign related party" and for which a deduction is allowed. The base erosion tax benefit is the deduction allowed for the tax year for the base erosion payment.

Payments made to a foreign related party on derivatives are base erosion payments for purposes of BEAT. However, QDPs are not treated as base erosion payments if they are properly reported to the IRS. IRC Section 59A(h)(2)(A) defines a QDP as any payment made by a taxpayer pursuant to a derivative on which the taxpayer:

  • Recognizes gain or loss as if the derivative were sold for its fair market value on the last business day of the tax year (and additional times as required under a statute or the taxpayer's method of accounting)
  • Treats any gain or loss recognized as ordinary
  • Treats the character of all items of income, deduction, gain, or loss with respect to a payment pursuant to the derivative as ordinary.

Under IRC Section 59A(h)(2)(B), a payment is not a QDP unless the taxpayer satisfies certain reporting requirements. Treas. Reg. Section 1.6038A-2(b)(7)(ix) requires a taxpayer subject to BEAT to report on Form 8991, Tax on Base Erosion Payments of Taxpayers With Substantial Gross Receipts, the aggregate amount of QDPs for the tax year, and represent that all payments satisfy the reporting requirements of Treas. Reg. Section 1.59A-6(b)(2). If a taxpayer fails to satisfy the reporting requirements for any payments, those payments are not eligible for the QDP exception and are generally treated as base erosion payments. However, until QDP reporting requirements apply, a taxpayer may report the aggregate amount of QDPs in good faith.

In a series of notices, including the most recent Notice 2024-43, 2024-25 IRB 1737, the IRS and Treasury Department announced their intention to defer the applicability date of the reporting requirements for QDPs under Treas. Reg. Section 1.6038A-2(b)(7)(ix) until tax years beginning on or after 1 January 2027.

Once Treas. Reg. Section 1.6038A-2(b)(7)(ix) becomes applicable, the reporting requirements for QDPs will no longer be satisfied by reporting the aggregate amount of QDPs in good faith. Instead, taxpayers must correctly report the aggregate amount of QDPs on Form 8991 to satisfy the reporting requirements and only those payments for which the reporting requirements have been satisfied will qualify for the QDP exception.

The definition of aggregate amount of QDPs under Treas. Reg. Section 1.59A-6(b)(2)(iii) and (b)(3) incorporates Treas. Reg. Section 1.59A-2(e)(3)(vi) (the BEAT Netting Rule). The BEAT Netting Rule requires taxpayers to determine their gain or loss for any position for which they applied a mark-to-market method of accounting for any tax year by combining all items of income, gain, loss or deduction arising with respect to the position during the tax year, such as from a payment, accrual, or mark. According to the Preamble to the 2019 final regulations, the BEAT Netting Rule was adopted to ensure that only a single deduction is claimed for each transaction that is marked to market and to prevent distortions in deductions from being included in the denominator of the base erosion percentage.

The Proposed Regulations

In a typical intercompany securities borrowing transaction a taxpayer borrows securities from a foreign related party and must return identical securities to the foreign related party at a later date. The taxpayer is generally required to pay amounts equivalent to all interest, dividends, and other distributions that the foreign related party would be entitled to receive during the term of the lending transaction if it had not loaned the securities (substitute payments). The securities borrower may be required to pay a separately stated borrow fee or provide cash collateral and receive interest (the cash amount of which may be reduced by an embedded borrow fee) on that collateral. A taxpayer may also lend securities to a foreign related party under similar terms. Under a taxpayer's method of accounting, intercompany securities lending transactions may be marked to market on the last business day of its taxable year.

Proposed Treas. Reg. Sections 1.59A-6(b)(3)(iii)(A) and 1.59A-3(b)(2)(iv)

The Proposed Regulations would not treat mark-to-market losses (and gains) on intercompany securities lending transactions as QDPs, so a base erosion payment would not arise (the Mark-to-Market Exclusion Rule). As a result, mark-to-market gains or losses with respect to a securities loan would be excluded from the QDP reporting requirement. Mark-to-market gains and losses on other derivative transactions would have to be included in QDP reporting. Further, substitute payments and other payments to foreign related parties would remain subject to QDP reporting. The Proposed Regulations would also clarify that mark-to-market losseson such intercompany securities loans are included in the denominator of the base erosion percentage.

Proposed Treas. Reg. Section1.59A-3(b)(2)(iv) provides a conforming amendment to the definition of a base erosion payment so that the BEAT Netting Rule under Treas. Reg. Section1.59A-2(e)(3)(vi) would not apply to net QDPs with mark-to-market gains and losses on securities lending transactions. Consequently, only amounts that are paid to a foreign related party under a securities lending transaction and do not qualify as a QDP would be taken into account for purposes of the numerator of the base erosion percentage, such as where a taxpayer lends securities and pays or accrues interest to a foreign related party with respect to the cash leg of a securities lending transaction.

The Proposed Regulations provide the following example illustrating how the special rule works:

Foreign Parent (FP) is a foreign corporation that owns all the stock of Domestic Corporation DC, a registered securities dealer and foreign related party under BEAT. During year 1, DC enters into a securities lending transaction with FP in which it borrows stock from FP, having a value of $100x. DC provides cash collateral for the loan and receives interest on that collateral from FP. Also during year 1, DC receives a dividend of $1x paid by the issuer of the stock at which time DC pays a substitute dividend of $1x to FP under the terms of the security loan. There are no other payments made or received during the year. At the end of the year, the stock has a value of $106x. DC is required to mark-to-market the securities leg of securities lending transaction for U.S. Federal income tax purposes.

Under these facts, DC has a deduction of $1x as a result of the substitute dividend it pays to FP. Assuming that the securities lending transaction otherwise meets the requirements of Treas. Reg. Section1.59A-2(e)(3) (including reporting the information required by Treas. Reg. Section 1.6038A-2(b)(7)(ix)), DC's QDP with respect to the securities lending transaction is $1x. Payments with respect to the cash collateral are not treated as part of the securities lending transaction. For the securities leg of the securities lending transaction, DC has a mark-to-market loss of ($6x), which is not included when determining the QDP. The ($6x) mark-to-market loss is also not taken into account in determining the base erosion tax benefit amount for purposes of the numerator of the base erosion percentage. The ($6x) loss is taken into account in the denominator of the base erosion percentage, while the $1x substitute dividend payment is not taken into account for that purpose because it is a QDP.

Proposed Treas. Reg. Section 1.59A-6(b)(3)(iv)

It is often challenging for a financial institution to determine whether it has borrowed a security from a foreign related party or an unrelated third-party customer. The Proposed Regulations would permit taxpayers to report the amount actually paid to foreign related parties for QDP reporting purposes if they could associate the substitute payment on securities borrowed and other payments made pursuant to a securities loan (such as borrow fees) with a specific recipient. The Proposed Regulations provide an alternative rule that would treat the substitute payments that a taxpayer pays with respect to borrowed securities as having been paid first to foreign related parties (but not those exceeding the payments received by the foreign related parties) (the Substitute Payment Stacking Rule).

Proposed Treas. Reg. Section 1.59A-10: Applicability dates

Proposed Treas. Reg. Sections1.59A-3(b)(2)(iv) and 1.59A-6(b)(3)(iii) and (iv) would apply to tax years beginning on or after the date that final regulations are filed with the Federal Register. Proposed Treas. Reg. Section1.6038A-2(b)(7)(ix), addressing the rules relating to QDP reporting, would apply to payments made in tax years beginning on or after 1 January 2027.

Implications

The Mark-to-Market Exclusion Rule better aligns the economic realities of a securities lending transactions with the ownership/disposition of a third-party security, the gains and losses on which are generally not treated as base erosion payments. Additionally, this rule reduces the information tracking and reporting requirements with which taxpayers would otherwise need to comply to substantiate a gain/loss under a securities lending transaction as a QDP.

The Substitute Payment Stacking Rule should generally be welcomed by taxpayers. Assuming a taxpayer cannot determine the amount of substitute payments that it paid to a foreign related party, such a rule limits the substitute payment made by a taxpayer to foreign related parties to the substitute payments and other payments (as described in Prop. Treas. Reg. Section 1.59A-6(b)(3)(iii)) that the taxpayer received annually from all its foreign related parties. This alternative rule should generally reduce the burden of developing financial systems for tracking the ultimate recipient of a substitute payment made by a taxpayer. Such tracking could be costly and overly burdensome to do in an integrated global dealing business where a taxpayer's customers may have a global business relationship with the taxpayer through foreign affiliates and the taxpayer enters into actual or deemed intercompany transactions with those foreign affiliates.

It is uncertain how much reporting will be required and what form that reporting will take (i.e., whether the IRS will create a separate form for reporting additional information on payments that qualify as QDPs or if the existing Form 8991 will be utilized). However, if the Proposed Regulations are finalized in current form, any such additional reporting should be limited to substitute payments or other payments associated with the "cash leg" of a securities lending transaction (e.g., interest payments on collateral).

Similarly, it is unclear how much the alternative method of satisfying the QDP reporting requirements for substitute payments will benefit taxpayers in practice, given the alternative method first treats any substitute payment made by a taxpayer as being made to a foreign related party, up to the total of substitute payments and certain other payments received by all the taxpayer's foreign related parties.

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Contact Information

For additional information concerning this Alert, please contact:

International Tax Services

International Tax Services - Capital Markets

International Tax Services — Financial Services

Published by NTD’s Tax Technical Knowledge Services group; Chris DeZinno, legal editor

Document ID: 2025-0378