Which sovereign jurisdiction can tax an item of income?

This eternal question arises whenever Wall Street creates a new financial product involving multinational parties.

For “fails charges,” the Service just issued a new batch of rules (found at Regulation Sec. 1.863-10) to determine whether these fees should be treated as US or foreign income.

So, uh, what’s a “fails charge?”

These payments developed in the world of high-stakes bond trading as a response to persistent failures to deliver Treasury securities in 2008.  Under certain arrangements, if one party fails to deliver Treasury securities to another by an agreed-upon date, the failing party pays an amount (the “fails charge”) to the other party. For US taxpayers, the treatment of these fees are relatively straightforward.

However, until this week, the general income-sourcing rules provided little guidance for foreign traders who become entitled to such fees.

Now, the final IRS regulations provide that the source of income from a qualified fails charge is generally determined by reference to the residence of the recipient.

With two exceptions.

First, qualified fails charge income earned by a qualified business unit of a taxpayer will be sourced to the country in which the qualified business unit is engaged in a trade or business.  Second, qualified fails charge income arising from a transaction effectively connected to a U.S. trade or business will be sourced to the United States.

Oddly, the final IRS regulations do not address the proper sourcing of a non-qualified fails charge, which begs the question of the “qualified” designation’s relevance.

Er, slight “regulation fail?”

Photo provided by Chris Griffith.