The Recharacterization of Cross-Border Interest Rate Swaps: Tax Consequences and Beyond

Abstract

The interaction of domestic tax policies and double taxation treaties has created unintended and potentially serious impediments to the fair and efficient functioning of international financial markets, with particularly significant consequences for cross-border interest rate swaps. The importance of interest rate swaps is well-documented: They reduce and transfer interest rate risk, and they contribute substantially to the liquidity of the world's capital markets. Accordingly, any tax-related interference with interest rate swap markets may have materially negative and unforeseen consequences on many types of domestic and international capital transactions.
An apparently inadvertent example of tax-related interference arises from the U.S. Treasury regulations on notional principal contracts, promulgated in 1993, under which an off-market interest rate swap with a "large" nonperiodic payment is recharacterized as a package consisting of a swap and an embedded loan bearing interest. The resulting conversion of swap income into interest income (for all U.S. tax purposes) creates a variety of tax issues under domestic law and has especially significant and complex ramifications in cross-border cases. In these cases, a withholding tax may be imposed on the interest, and double taxation of the interest is a possibility even in the presence of a tax treaty. The withholding tax on U.S. source interest paid to a non-U.S. entity is not necessarily eliminated by the portfolio interest exemption, as may generally be thought, because the exemption does not apply to interest paid to banks, which make up a large portion of swap participants.