As the U.S.'s current budget deficit indicates, a large number of U.S. Treasury obligations are held by foreign investors. Yields on these obligations have consistently remained attractive, due to the Federal Reserve's unwillingness to purchase Treasury debt for fear of inflationary pressures. The willingness (necessity?) of the Treasury to borrow, together with high real rates of return, unsurpassed safety of principal, and the availability of the portfolio interest withholding exemption to even non-treaty-country investors, have resulted in substantial holdings of U.S. obligations by foreign interests.

Borrowed Bonds

Yields on these investments can be further improved by entering into so-called "borrowed bonds transactions" with investment houses. These transactions are characterized by a foreign investor lender (the "lender") loaning a long-term Treasury bond to an investment house borrower (the "borrower") who is willing to pay a fee to the lender for the use of the security (for instance, to facilitate covering a short position). These transactions can take one of two forms:

* The receipt of cash lending fees, negotiated for each transaction, together with other U.S. Treasury bonds to collateralize the securities which are loaned.

* The receipt of cash collateral which is deposited in an interest bearing account. Upon the return of the loaned security to the foreign lender, the borrower is issued a rebate of a portion of the interest earned on the cash collateral, with the remaining portion being retained by the lender.

The apparently straight-forward nature of borrowed bonds transactions can result in unwelcome tax surprises if the transaction remains open past a coupon payment date. This seemingly innocuous technicality can result in the conversion of otherwise tax-exempt portfolio interest into "other income" which is subject to the statutory 30% withholding tax. Moreover, the 30% rate will likely apply even to treaty investors. The issues relevant to transactions which straddle a coupon payment date and those which do not are described in the following sections.

Transaction Closed Prior to

Coupon Payment Date

Lending Fees. Provided the lender is not deemed to be engaged in a U.S. trade or buiness and the transactions are consummated outside of the U.S., the lending fees should be classified as foreign source personal service income under Sec. 861(a)(3), rather than as a form of interest. Under these statutory principles, the source of the lending fee income willbe determined by the place in which the services are deemed rendered. Assuming that the facts and circumstances dictate that the lending transactions are effected outside of the U.S., then it appears that the receipt of lending fees will represent income from services performed by a foreign corporation or nonresident alien individual without the U.S. Accordingly, under such circumstances, the receipt of such fees by a foreign corporation would not be subject to U.S. income or withholding tax.

Interest Income. The U.S. Treasury bond interest should qualify as portfolio interest. Pursuant to Secs. 871, 881, 1441 and 1442, the receipt of portfolio interest from U.S. sources by a foreign corporation is free of U.S. income tax and, therefore, is not subject to the statutory withholding tax. This exemption from withholding can be claimed by the completion of Form W-8, Certificate of Foreign Status.

Transaction Open on Coupon

Payment Date

Lending Fees. The character of the fee income derived from the lending activities should not be affected by the determination of whether the transactions is open or cloed as of a coupon payment date. Therefore, the results described above for the receipt of lending fees is equally applicable to situations where the transaction remains open on the cpoupon payment date. As a result, the receipt of such fees should be exempt from U.S income tax and withholding provided they are derived from foreign sources. If the fees are deemed to be derived from U.S. sources under the applicable source of income rules, the foreign investor will not qualify for a business profits treaty exemption with respect to the lending fee income. This result occurs because the lending fee income will not be considered part of the active conduct of a trade or business. Rather, it will likely be treated as a passive investment activity.

Interest Income Becomes a Substitute Payment. The treatment of the receipt of Treasury bond interest income collected by the borrower which is paid over to the lending foreign corporation is far less clear. Where the transaction remains open past the coupon payment date, the lending transactions are likely to be viewed in a similar manner to stock which is on loan past a dividend payment date. These transactions derive what are known as substitute payments (sometimes referred to as "in lieu of" payments). Substitute payments have been held to convert the character of the original income for which the payment is substituted. Thus, payments in lieu of interest or dividends are not classified as interest or dividends but, rather, constitute a generic form of ordinary "other" income. IRS Publication 550, Investment Income and Expenses, guides taxpayers who maintain a long position in a short sale transaction. That publication indicates that, where a broker transfers a taxpayer's securities for use in a short sale and receives substitute payments for that taxpayer, the broker must report income on Form 1099-MISC as other income. The recipient taxpayer is specifically instructed to report the substitute payments received as "other" income, not as interest or dividends.

In applying Publication 550's comments to borrowed bonds transactions, it is important to note that it is written strictly in the context of U.S. resident taxpayers. The publication goes on to define substitute payments as payments which are known to be made in lieu of the following:

* Exempt-interest dividends;

* Capital gain dividends;

* Return of capital distributions; and

* Tax-exempt interest.

Each of these categories of income has a profound effect to resident taxpayers. For example, returns of capital distributions are not taxable under general principles but are taxed where they are deemed substitute payments. The absence of taxable interest from the list can be explained by the fact that the distinction between taxable interest and "other" ordinary income has no U.S. tax effect.

Applying this rationale to borrowed bonds transactions, the payment of the coupon interest receive by the borrower to the lending foreign corporation will, likely, be considered a substitute payment and not a payment of interest. As a result, it appears that the portfolio interest exemption will no longer apply--that exemption clearly requires that a payment constitute interest in order for the exception to apply. The receipt of the substitute payment would therefore be subject to tax under Secs. 871 or 881 since it would fall under the definition of an item of fixed or determinable annual or periodical income. The statutory 30% tax rate would apply.

As a result of the considerations described above, foreign investors who seek to increase their yields on U.S. obligations by engaging in borrowed bonds transactions should proceed with extreme caution. If doubt exists as to whether the transactions can be unwound by the coupon payment date, then it is advisable for the investor to let the opportunity pass. The handling fees which could be earned in the transaction would seemingly be far outweighed by the exporusre of the entire substitute coupon bond payment to a 30% withholding tax. Conversely, if the transaction were unwound by the interest payment date, then the U.S. tax results desired by the foreign investor should be achieved. Omega