The Internal Revenue Service plans to issue guidance on the taxation of “fails charges” for failed deliveries of U.S. Treasuries.

In response to persistent delivery failures in the pay-for-delivery market for U.S. Treasury securities during the fall of 2008, a new trading practice governing failed deliveries of U.S. Treasuries has been voluntarily adopted by many market participants, including the Federal Reserve Bank of New York and most dealers, custodians and asset managers of U.S. Treasuries. 

Under the new practice, if one party fails to deliver U.S. Treasuries to another party by the date previously agreed to, the failing party will pay an amount known as a “fails charge” to the non-failing party. The fails charge accrues daily and, if properly claimed by the non-failing party, is due and payable in the month following the month in which the failing party actually delivers the promised U.S. Treasury.

The new fails charge practice was adopted by market participants to preserve and enhance the efficiency of the secondary market for U.S. Treasuries by reducing the incidence of delivery failures, especially in low interest rate environments, where the economic incentive to deliver timely is reduced.

Many market participants have indicated that there is a lack of clarity regarding the treatment of these fails charges for purposes of Sections 871, 881, 1441 and 1442 of the Tax Code, which relate to gross-basis taxation of foreign persons not otherwise subject to U.S. net-basis taxation. As a result, these market participants suggest that unless guidance is provided, there may be disruptions in the secondary market for U.S. Treasuries as various withholding agents take different positions with respect to the proper characterization of fails charges for those purposes.

In response, the IRS published Notice 2009-61 this week announcing that the Treasury Department and the IRS are considering issuing guidance regarding the circumstances, if any, in which fails charges are subject to U.S. gross-basis taxation. Any such guidance regarding the treatment of a fails charge under Sections 871, 881, 1441 and 1442 of the Tax Code will be prospective in effect.

In light of the complexity of the issues raised by the proper treatment of fails charges for U.S. federal tax purposes and the need for guidance, the IRS said it would not challenge a position taken by a taxpayer or a withholding agent that a fails charge that is paid on or before Dec. 31, 2010, is not subject to U.S. gross-basis taxation unless contrary guidance has been issued effective before that date.

Notice 2009-61 will appear in IRB 2009-32 dated August 10, 2009.

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