Substitute interest qualified for a RIC's interest-related dividends

Plain-English summary

A sponsor asked whether substitute interest received by its exchange-traded regulated investment companies in securities lending and sale-repurchase transactions would count as qualified interest income. The transactions involved registered U.S. debt instruments, including Treasury securities and corporate bonds, and the funds would separately track actual and substitute interest. The IRS ruled that qualifying substitute payments are treated as interest when computing qualified interest income under section 871(k)(1)(E). This treatment supports the exemption for interest-related dividends paid by a regulated investment company to foreign shareholders because the payments would retain their interest character if received directly by those shareholders. The ruling applies only when the substitute payments otherwise satisfy the statutory requirements for qualified interest income.

Ruling snapshot

• Question: Do substitute interest payments from securities lending and sale-repurchase transactions involving registered U.S. debt instruments count as qualified interest income for the funds?
• Outcome: Approved, limited to payments that otherwise meet section 871(k)(1)(E)
• Key authorities: IRC §§ 871(k), 881(e), and 1058; Treas. Reg. §§ 1.861-2(a)(7), 1.871-7(b)(2), and 1.881-2(b)(2)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202340003 Third Party Communication: None
Release Date: 10/6/2023 Date of Communication: Not Applicable
Index Number: 871.02-13
Person To Contact:
------------------- -----------------------, ID No. -----------------
--------------------- Telephone Number:
---------------------------------- ---------------------
--------------------------------------- Refer Reply To:
In Re: CC:INTL:B01
PLR-100588-23
Date:
July 07, 2023

Legend

Company = ----------------------------------------------------------------------------------------------
------------------------
Funds = -------------------

Dear -------------:

This responds to the request dated December 28, 2022, submitted on your behalf by
your authorized representative, in which you request that the Internal Revenue Service
rule that certain income arising from the securities lending and sale-repurchase
transactions described in this letter will constitute qualified interest income to Funds as
defined in section 871(k)(1)(E) of the Internal Revenue Code of 1986, as amended (the
Code).

The rulings contained in this letter are based upon facts and representations submitted
by Company and accompanied by a penalty of perjury statement executed by an
appropriate party. This office has not verified any of the material submitted in support of
the request for a ruling. Verification of the factual information, representations, and other
data may be required as a part of the audit process.

                                            FACTS

Company is the sponsor and investment manager of Funds, a collection of exchange-
traded funds. Each Fund qualifies as a regulated investment company (RIC) under
Subchapter M, Part I of the Code. The Funds are formed as series of legal entities
structured as series trusts and are each required to be registered with the U.S.
Securities and Exchange Commission.
PLR-100588-23 2

The Funds’ investments include debt instruments that are issued by U.S. issuers in
registered form. These debt instruments include U.S. Treasury securities and U.S.
corporate bonds.

Certain Funds intend to enter into securities lending transactions in which a Fund lends
a U.S. debt instrument to a counterparty in exchange for an obligation to return an
identical debt instrument and payments for the use of the debt instrument. The transfer
of the debt instrument will be made pursuant to a securities lending agreement that
meets the requirements of section 1058(b). Accordingly, the transfer of the debt
instrument and its return will not result in the recognition of gain or loss to the Fund.
Additionally, certain Funds intend to enter into sale-repurchase transactions in which a
Fund sells a particular U.S. debt instrument to a counterparty and agrees to purchase
an identical debt instrument from the counterparty on a fixed date for a fixed price in the
future. The counterparty will not be restricted from rehypothecating the debt instrument,
subject to the terms and conditions of a lending agreement that meets the requirements
of section 1058(b). During the term of the securities lending transaction or the sale-
repurchase transaction, the Fund may receive substitute payments of amounts
equivalent to any interest payments made on the debt instrument.

Company, on behalf of the Funds, will separately track the amounts of interest and
substitute interest received by each Fund. Because the Funds are exchange-traded
funds, Company and its affiliates, as managers of the Funds, are required to provide
certain information to brokers on an annual basis to facilitate reporting to the Funds’
shareholders on Forms 1099, 1042, and 1042-S. Company will report to brokers the
percentage of each distribution that qualifies as an interest-related dividend under
section 871(k)(1) or section 881(e)(1).

                              LAW AND ANALYSIS

Section 851(a) defines a RIC as any domestic corporation: (1) which, at all times during
the taxable year, is registered under the Investment Company Act of 1940 (15 U.S.C.
§§ 80a-1 to 80b-2), either as a management company or as a unit investment trust, or
has in effect an election under such Act to be treated as a business development
company, or (2) which is a common trust fund or similar fund excluded by section
3(c)(3) of such Act (15 U.S.C. § 80a-3(c)) from the definition of “investment company”
and is not included in the definition of “common trust fund” by section 584(a). Section
851(b) provides additional requirements for qualifying as RIC. A RIC that meets the
requirements of section 852(a), including certain distribution requirements, generally is
taxed in accordance with Subchapter M, Part I of the Code.

A foreign shareholder generally treats a dividend received from a RIC as U.S. source
fixed or determinable annual or periodical income subject to gross basis taxation under
section 871(a) or section 881(a). A RIC is obligated to withhold tax from the dividend
under section 1441 or section 1442, unless an exception to withholding applies.
PLR-100588-23 3

Sections 871(k) and 881(e) provide that no tax is imposed under sections 871(a) and
881(a) on any interest-related dividend (as defined in section 871(k)(1)) received from a
RIC that meets the requirements of section 852(a) for the taxable year in which the
dividend is paid. The exemption under section 871(k) or section 881(e) does not apply
to an interest-related dividend if any of the exceptions in section 871(k)(1)(B) or section
881(e)(1)(B) apply. These exceptions generally impose requirements with respect to
interest earned by the RIC for the interest to qualify for the portfolio interest exemption
under section 871(h) or section 881(c) had it been paid directly to the foreign
shareholder. Sections 1441(c)(12) and 1442(a) provide that a RIC is not required to
withhold tax from any amount exempt from the tax imposed by section 871(a) or section
881(a) by reason of section 871(k) or section 881(e).

Section 871(k)(1)(C)(i) provides that an interest-related dividend is any dividend, or part
thereof, which is reported by the company as an interest-related dividend in written
statements furnished to its shareholders. Section 871(k)(1)(C)(ii) limits the amount a
RIC may designate as an interest-related dividend to the RIC's qualified net interest
income for the taxable year.

Section 871(k)(1)(D) defines qualified net interest income as a RIC's qualified interest
income reduced by the deductions properly allocable to such income.

Section 871(k)(1)(E) defines qualified interest income as the sum of the following
amounts derived by a RIC from sources within the United States and includible in its
gross income: (i) original issue discount on an obligation payable 183 days or less from
the date of original issue; (ii) any interest (including amounts recognized as ordinary
income in respect of original issue discount, market discount, or acquisition discount
under section 1271 et seq. and such other amounts as regulations may provide) on an
obligation in registered form, except interest on an obligation issued by a corporation or
partnership in which the RIC is a 10-percent shareholder or contingent interest not
treated as portfolio interest under the rules of section 871(h)(4); (iii) certain interest on
deposits; and (iv) interest-related dividends from other RICs.

Treas. Reg. § 1.861-2(a)(7) (the “sourcing rule”) provides that a substitute interest
payment made with respect to a securities lending transaction or a sale-repurchase
transaction is sourced in the same manner as the interest that accrues on the
transferred securities for purposes of Treas. Reg. §§ 1.861-2 and 1.862-1.1 A substitute
interest payment is defined as a payment made to the transferor of a security in a
securities lending transaction or a sale-repurchase transaction of an amount equivalent
to an interest payment that the owner of the transferred security is entitled to receive
during the term of the transaction. A securities lending transaction is defined as a
transfer of one or more securities that is described in section 1058(a) or a substantially
similar transaction, and a sale-repurchase transaction is defined as an agreement under
1
Treas. Reg. §§ 1.861-2 and 1.862-1 provide the general rules for sourcing interest for purposes of
sections 861 and 862.
PLR-100588-23 4

which a person transfers a security in exchange for cash and simultaneously agrees to
receive substantially identical securities from the transferee in the future in exchange for
cash.

Treas. Reg. §§ 1.871-7(b)(2) and 1.881-2(b)(2) (the “character rules”) provide that a
substitute interest payment (as defined in Treas. Reg. § 1.861-2(a)(7)) received by a
foreign person pursuant to a securities lending transaction or a sale-repurchase
transaction has the same character as interest income paid or accrued with respect to
the terms of the transferred security for purposes of Treas. Reg. §§ 1.871-7 and
1.881-2.2 A substitute interest payment made with respect to a debt instrument in
registered form, the interest on which would qualify as portfolio interest under section
871(h) or section 881(c) in the hands of the lender, is treated as portfolio interest if the
lender satisfies the documentation requirements under those sections.
Sections 871(k) and 881(e) were enacted to eliminate disparate tax treatment between
a foreign person who invests directly in certain interest-bearing and other securities and
a foreign person who invests in such securities indirectly through U.S. mutual funds,
and to encourage U.S. financial institutions to form and operate their mutual funds
within the United States. As stated in the legislative history to those sections: “[T]he
Committee believes that, to the extent a RIC distributes to a foreign person a dividend
attributable to amounts that would have been exempt from U.S. withholding tax had the
foreign person received it directly (such as portfolio interest and capital gains, including
short-term capital gains), such dividend similarly should be exempt from the U.S. gross-
basis withholding tax.” H.R. Rep. No. 108-548, Part I, at 163-164 (2004). Thus,
Congress intended to provide to investors in U.S. mutual funds the same exemptions
from withholding tax with respect to certain types of income, including interest, available
to foreign persons who directly invest in the same securities.

The preamble to Treasury Decision 8735, 62 Fed. Reg. 53498 (Oct. 14, 1997), states
that the rules in Treas. Reg. §§ 1.861-2(a)(7), 1.871-7(b)(2), and 1.881-2(b)(2) are
intended to source substitute interest payments using the general rules governing the
source of interest under sections 861 and 862, and characterize such payments as
interest for purposes of sections 864(c)(4)(B), 871, 881, 894, and 4948(a), and chapter
3 of the Code. The preamble explains that while the sourcing rule applies for all
purposes of the Code, the character rules only apply with respect to “foreign taxpayers
and only for limited purposes” so that they do not affect existing guidance applicable to
both U.S. and foreign taxpayers concerning the characterization of substitute payments
for purposes of other sections. Thus, while the character rules were intentionally limited
in scope, they are intended to apply when a substitute interest payment is made to a
foreign person subject to tax under section 871(a) or section 881(a), including for

2
Treas. Reg. §§ 1.871-7 and 1.881-2 provide the general rules imposing gross basis taxation under
sections 871(a) and 881(a) on a foreign person that receives U.S. source fixed or determinable annual or
periodical income. Because the character rules apply for purposes of these operative rules, it is
appropriate to also apply the character rules for purposes of any applicable exception to those rules, such
as section 871(k) or section 881(e).
PLR-100588-23 5

purposes of applying the portfolio interest exemption under section 871(h) or section
881(c).

In this case, the substitute interest payments will be made to the Funds, which are
domestic corporations for purposes of the Code. However, if the substitute payments
were made directly to the foreign shareholders of the Fund, they would retain their
character as interest under Treas. Reg. §§ 1.871-7(b)(2) and 1.881-2(b)(2) and would
qualify as portfolio interest under section 871(h) or section 881(c). Because sections
871(k) and 881(e) are intended to provide the foreign shareholders of a RIC with the
same exemptions from tax that would have applied had they received the interest
directly, it is appropriate to treat the substitute interest payments as interest for
purposes of computing each Fund’s qualified interest income under section
871(k)(1)(E).

                                   CONCLUSION

Based on the facts as represented, it is concluded that substitute interest payments
received by the Funds in connection with the securities lending and sale-repurchase
transactions described in this letter involving U.S. debt instruments in registered form
constitute qualified interest income as defined in section 871(k)(1)(E). This ruling only
applies to substitute interest payments that, if treated as interest, would otherwise meet
the requirements to be qualified interest income under section 871(k)(1)(E). The
substitute interest payments are treated as interest solely for the purpose of computing
a Fund’s qualified interest income under section 871(k)(1)(E).

This ruling is directed only to the taxpayer(s) requesting it. Section 6110(k)(3) of the
Code provides that it may not be used or cited as precedent.

A copy of this letter must be attached to any income tax return to which it is relevant.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representatives.

                                         Sincerely,


                                         _______________________________
                                         Subin Seth
                                         Senior Counsel, Branch 1
                                         Associate Chief Counsel (International)

PLR-100588-23 6

Enclosure:
Copy for 6110 Purposes

cc:

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