|December 13, 2013|
Previously published on December 2013
On December 5, the U.S. Treasury reproposed the Section 871(m) regulations with a new standard for determining which dividend-related payments on equity derivative transactions with non-U.S. counterparties are subject to U.S. withholding. The new proposed regulations would apply a more objective approach than the first regulations proposed in January 2012, the withdrawal of which was announced by the Treasury in January 2013. The new regulations would apply to some transactions not covered by the 2012 proposed regulations and would apply to considerably more transactions than were covered by Section 871(m) when it was enacted in 2010. The new proposed regulations utilize a test based on the "delta" or price change of an equity derivative relative to the underlying stock. This is a major change from the list of seven types of prohibited derivatives (the so-called "seven deadly sins") that was the basis of the 2012 regulations. The new regulations are proposed to be effective only for payments on equity derivatives made on or after January 1, 2016, a substantial Treasury concession since the earlier proposed rules would have been effective January 1, 2014. There is, however, no "grandfather" or other transition rule for transactions entered into earlier; accordingly, all payments made on or after January 1, 2016 would be covered.
Section 871(m) was added to the Internal Revenue Code by the 2010 Hiring Incentives to Restore Employment ("HIRE") Act to deal with the perceived problem that payments related to dividends on U.S. stock made to non-U.S. counterparties on equity derivatives could be made free of U.S. withholding tax. This was contrasted to the situation of the non-U.S. holder owning the underlying U.S. stock directly, where withholding would be due on the dividends at 30 percent (or a lower treaty rate). Section 871(m) applies to "dividend equivalents," which include dividend-related payments on specified notional principal contracts (which include many equity swaps), on repos and securities lending transactions, and other payments determined to be "substantially similar" by the Treasury.
The statute itself specifies four types of "specified notional principal contracts," including equity swaps where the long party transfers the underlying stock to the short party at the commencement of the swap and where the short party either posts the underlying stock as collateral or transfers the stock upon termination of the swap. The earlier proposed regulations supplemented this list with seven additional cases, which came to be known as the "deadly sins." These were widely criticized as overly broad and difficult to administer. For example, many market participants objected to the prohibition on the long party being "in the market" on the day or days the contract was priced or terminated.
Like the 2012 regulations, the new regulations would impose withholding on a broad range of equity derivative trades, including many more than were covered by the statute as enacted in 2010. And the approach of the new regulations is now one of economic similarity between the contract and the underlying stock. Where an equity notional principal contract (including most equity swap transactions) at the time it is entered into has a "delta" of 0.7 or greater with respect to the underlying stock, the dividend-related payments become subject to withholding. Where this delta is less than 1.0 but greater than 0.7 (measured at the time of the dividend), the amount subject to withholding is reduced on a pro rata basis. The withholding rate will be 30 percent, subject to reduction under any U.S. tax treaty that would be applicable to the dividends. Where the contract references more than one stock, withholding applies only with respect to the dividend payments on the stock or stocks with respect to which the swap has a delta of 0.7 or greater. Where the contract has a delta with respect to the underlying stock that can be predicted to be constant over the transaction term (e.g., always be exactly 0.5), the dividend-related payments are, in effect, automatically subject to withholding.
In a change from the earlier proposal, payments based on estimates of dividends would be subject to withholding, even if the estimate is not adjusted based on the actual dividend payment. The new regulations contain an example of a "price only" swap where a non-U.S. counterparty receives the appreciation on the underlying shares at maturity, pays any depreciation at maturity, and pays a LIBOR-based rate over the term of the contract that is reduced to take into account expected annual dividends. The example holds that, although the estimated dividend payments are not specified in the contract, they are still subject to withholding (generally in the amount of the actual dividends).
The rules on "equity-linked instruments" are expanded to parallel the new rules on notional principal contracts (above). An equity-linked instrument is defined as a futures contract, forward contract, option, debt instrument, or other contractual arrangement that references the value of one or more underlying stocks. Where the equity-linked instrument has a delta with respect to the underlying stock of 0.7 or greater, any dividend-related payments are subject to the withholding rules. This 0.7 delta standard could bring in transactions that most market participants did not think were or should be subject to Section 871(m) withholding, like some "out-of-the-money" options. Generally, the other rules described above would also apply (such as where an equity-linked instrument has a constant delta with respect to the stock or relates to more than one stock). It also appears that equity-linked instruments are subject to the rules above for estimated dividend payments that are not specified in the contract—for example, a single-stock future that is priced using estimated dividends could be subject to withholding under this rule.
In addition, the new proposal provides an exception from withholding for certain traded indices, derivatives in which are not treated as subject to the rules (even if the delta tests are met). To qualify, an index must reference 25 or more stocks (none of which represents more than 10 percent of the weighting), must not provide a dividend yield greater than 1.5 times the dividend yield of the S&P 500 index, and must meet other requirements. Other rules allow the IRS to combine transactions of one long party (or related parties) in a single underlying stock, where the effect is to make the combined transaction subject to withholding under the rules. Under an "anti-abuse" rule, the IRS also has the authority to subject an equity derivative to these rules where it has been structured with "a principal purpose" to avoid them.
As for determining the delta, it is the broker or dealer that must calculate this number and report to the customer the amount of any withholdable dividend equivalents. This imposes a large responsibility for providing information and ensuring that information is correct. It may also give rise to disputes with the IRS.
Once again, the new rules would take effect only for payments on or after January 1, 2016, allowing taxpayers a significant period to comment on the proposed rules and then to plan their implementation and adjust systems accordingly. As a result, the current "interim" final regulations, effectively applying Section 871(m) only to transactions described in the statute, are extended until January 1, 2016. Comments on the new proposal are due by March 5, 2014, with a hearing scheduled for April 11, 2014.