Revised Guidance on Dividend-Equivalent Payments

1 Feb

In the last hours before Christmas Eve, the Internal Revenue Service issued a titillating 16-page regulation project, providing revised guidance to nonresidents and foreign corporations that hold financial products with payments contingent upon U.S.-source dividend payments. Internal Revenue Code, sec. 871(m). The preceding January 2012 regulation project (77 FR 3202) is withdrawn.

The 2013 proposed regulations better identify (1) when a notional principal contract (NPC) “is of a type which does not have the potential for tax avoidance”, and (2) other payments that are dividend equivalents, because they are substantially similar to specified NPC payments and substitute dividend payments.

Congress enacted Code section 871(m) in 2010, in the Hiring Incentives to Restore Employment Act (HIRE Act). Section 871(m) treats a dividend equivalent as a dividend from sources within the United States for withholding tax and other purposes. Payments for this purpose include any gross amount that is used in computing any net payment transferred to or from the taxpayer.

A dividend equivalent is

(1) any substitute dividend made pursuant to a securities lending or a sale-repurchase transaction that (directly or indirectly) is contingent upon or determined by reference to the payment of a U.S.-source dividend,

(2) any payment made pursuant to a specified NPC that is contingent upon or determined by reference to such payments, or

(3) any other payment that the Treasury determines is “substantially similar” to a specified NPC payment or substitute dividend payment.

The 2012 proposed regulations provided that a dividend equivalent included any gross amount used to compute any net amount transferred to or from the taxpayer, even if the taxpayer made a net payment or no payment was made because the net amount was zero. A dividend equivalent, however, did not include any amount determined by reference to an estimate of an expected (but not yet announced) dividend. This exception did not apply if the estimate adjusted to reflect the amount of the actual dividend.

For payments before March 18, 2012, a specified NPC was any NPC if (1) the long party transferred the underlying security to the short party in connection with entering into the NPC, (2) the short party transferred the underlying security to the long party in connection with the termination of the NPC, (3) the underlying security is not readily tradable on an established securities market, (4) the short party posted the underlying security as collateral with the long party, or (5) the NPC is identified by Treasury as a specified NPC. The long party is the counterparty that holds a long position with respect to an underlying security, such as the purchaser of a call option or the writer of a put option.

For payments made after March 18, 2012, any NPC is (much more drastically) a specified NPC, unless the Service determines that the NPC is of a type that does not have the potential for tax avoidance.

For payments made prior to January 1, 2014, the 2012 regulations defined a specified NPC using substantially the same definition as provided in the Code. For payments made on or after January 1, 2014, the 2012 proposed regulations defined a specified NPC as an NPC that meets one or more of the following factors: (1) the long party is “in the market” on the same day that the parties priced or terminated the NPC; (2) the underlying security is not regularly traded on a qualified exchange; (3) the short party posts the underlying security as collateral and the underlying security represents more than ten percent of the collateral posted by the short party; (4) the actual term of the NPC is fewer than 90 days; (5) the long party controls the short party’s hedge; (6) the notional principal amount is greater than five percent of the total public float of the underlying security or greater than 20 percent of the 30-day daily average trading volume; or (7) the NPC is entered into on or after the announcement of a special dividend and prior to the ex-dividend date.

The 2012 proposed regulations described payments that are substantially similar to substitute dividends made pursuant to securities lending and sale-repurchase transactions and to payments made pursuant to specified NPCs. A substantially similar payment was any (1) gross-up amount paid by a short party in satisfaction of the long party’s tax liability with respect to a dividend equivalent, or (2) payment made pursuant to an equity-linked instrument (ELI) that was calculated by reference to a U.S-source dividend if the ELI satisfied one or more of the specified NPC factors.

The 2012 proposed regulations provided that certain indices referenced by an NPC or ELI would not be underlying securities, and therefore, would not be subject to section 871(m). Each component security of a customized index would be treated as an underlying security in a separate NPC. A customized index was defined as (1) a “narrow-based index,” generally based on a definition in the Securities Exchange Act of 1934, or (2) any other index, unless futures contracts or options contracts referencing the index trade on a qualified board or exchange.

The 2012 regulations also provided rules to require a withholding agent to withhold tax owed with respect to a dividend equivalent, and explained the procedures when an NPC became a specified NPC after the date that the parties entered into the NPC. The proposed regulations provided that the term dividend equivalent included any payment that was made prior to the date the NPC became a specified NPC and that was (directly or indirectly) contingent upon or determined by reference to the payment of a U.S.-source dividend.

Several comments on the 2012 proposed regulations stated that the seven-factor approach to defining a specified NPC would not accurately identify tax avoidance transactions. The factors could treat a contract as a specified NPC even when the contract was not entered into primarily to avoid withholding. Similarly, some tax-motivated transactions would not be subject to tax under section 871(m), because the transaction would not meet any of the seven factors.

Comments on the 2012 proposed regulations also stated that the term of a contract does not indicate the potential for tax avoidance, and the term rule could result in retroactive withholding obligations. 90 days was not the appropriate threshold for a minimum term. Another comment acknowledged that the length of the term may indicate that a contract has a tax avoidance motive, but recommended adding an exception for termination events that are beyond the parties’ control. Withholding agents and taxpayers would have difficulty applying the “in the market” factor. A long party should be treated as being “in the market” only when the long party sold or purchased the underlying security “in connection with” entering into or terminating an NPC.

Comments also stated that the definition of a specified ELI was overly broad, because numerous types of ELIs do not give rise to the policy concerns underlying section 871(m). The comments requested that the final regulations limit the scope of the term ELI to contracts that provide delta-one or near delta-one exposure to the underlying equity. The delta of an instrument reflects the change in the value of the instrument relative to a change in the value of the underlying security. Non-delta-one derivatives do not provide investors with a substitute for physical ownership of the underlying security. One comment disagreed, stating that a delta-based standard would provide non-delta-one financial instruments with a competitive advantage over delta-one products because non-delta-one financial instruments would be subject to more favorable tax treatment.

Another comment suggested that the term ELI not include single stock futures contracts (SSFs) unless the SSF is an “exchange future for physical” (EFP). EFP is a transaction in which an investor (1) sold stock and purchased an SSF for future delivery of the same stock or (2) purchased stock and sold an SSF to deliver the same stock in the future. An SSF, other than an EFP, should not be treated as an ELI because SSFs trade on a regulated exchange, unlike bilateral over-the-counter contracts. An adjustment to the settlement price of an SSF is not a payment upon which withholding may be applied.

Several comments also recommended an exception to the term ELI for exchange-traded options, because many of these options do not provide close economic substitutes for owning stock. Two of the seven specified NPC factors will apply to many standard exchange-traded options, i.e., initial term of less than 90 days, and, when an investor exercises an exchange-traded call option, the investor acquires the underlying securities. The final regulations should account for the differences between over-the-counter and exchange-traded options.

Comments requested clarification on how the 2012 proposed regulations would interact with the regular withholding rules. The 2012 regulations did not clearly address whether intermediaries, custodians, clearing organizations, and members of clearing organizations are withholding agents. Due to the large volume of transactions cleared by exchanges on a daily basis, it would be impractical to treat an exchange as a withholding agent. The 2012 regulations would impose an undue burden on broker-dealers with non-U.S. customers, because the broker-dealers would have to develop complicated systems to determine whether an instrument is an ELI and the amount of any dividend equivalent. Other comments stated that a withholding agent should not be liable for U.S. tax when the withholding agent lacks the information necessary to determine whether a transaction constitutes a specified NPC.

Comments also questioned the proposed rule treating all payments as dividend equivalents if a contract became a specified NPC only as a result of the long party acquiring physical shares upon termination (“crossing out”). The 2012 regulations unfairly would have required a withholding agent to withhold for U.S. tax on all payments made pursuant to a contract that would be treated as dividend equivalents when the contract only became a specified NPC because of a “cross out”. Other comments recommended that this rule should apply only to NPCs that are specified NPCs because they meet the “in the market” or the 90-day factor.

Several comments stated that a chain of equity derivatives could result in the collection of cascading U.S. tax, and recommended that the final regulations incorporate specified NPCs into the qualified securities lender and credit-forward regimes described in Notice 2010–46, 2010–24 I.R.B. 757, which limits U.S. tax withheld in a chain of securities lending or sale-repurchase transactions.

Other comments recommended that certain transactions be exempt from section 871(m), such as transactions entered into by a non-U.S. dealer as a long party in the ordinary course of business. The non-U.S. dealer does not enter into the transaction to avoid U.S. tax, and U.S. tax would be paid on any dividend equivalent paid to the customers of the non-U.S. dealer.

One comment questioned the definition of narrow-based index, and suggested that the final regulations incorporate the exceptions provided in the Securities Exchange Act. Comments suggested that the term customized index be revised to apply only to a narrow-based index or any index offered by a publisher that is not a “recognized independent index publisher.” The definition of a customized index should exclude an index if an exchange-traded derivative tracked that index. A customized index should not include any index with respect to which U.S. equity securities comprise less than 20 percent of the notional value. The definition of customized index should be broadened, because the 2012 definition may have permitted certain transactions designed to avoid U.S. tax.

The 2012 proposed regulations provided that the rules would apply to payments made on or after the date the rules are adopted. Comments expressed concern about the potentially retroactive effect of the regulations. With respect to ELIs, the final regulations should apply only to those transactions entered into after the effective date, because taxpayers and withholding agents did not foresee that these contracts would be subject to U.S. tax. The effective date of the final regulations should be delayed, because market participants will be required to make systems modifications and operational adjustments.

Treasury and the Service agree that the proposed seven-factor approach to identify a specified NPC does not provide the best framework for evaluating whether an NPC “is of a type which does not have the potential for tax avoidance” and that the seven-factor approach would be difficult to administer. Accordingly, the new regulations are based on the objective measurement of a derivative’s delta. A transaction has the “potential for tax avoidance” if it approximates the economics of owning an underlying security without incurring the tax liability associated with owning that security. For both equity swaps and other equity derivatives, the determination of whether a transaction may give rise to a dividend equivalent will generally depend only on the determination of a single objective measurement at the time the transaction is acquired. Treasury’s proposal should not be used as a basis for applying the delta standard to interpret other Code sections.

The 2013 proposed regulations define a section 871(m) transaction as any securities lending or sale-repurchase transaction, specified NPC, or specified ELI. With respect to payments made on or after January 1, 2016, a specified NPC is any NPC that has a delta of 0.70 or greater when the long party acquires the transaction. A specified ELI is any ELI that has a delta of 0.70 or greater when the long party acquires the transaction.

If a transaction references more than one underlying security, the taxpayer must determine whether the transaction is a section 871(m) transaction with respect to each underlying security.

The delta of an NPC or an ELI is the ratio of the change in the fair market value of the NPC or ELI to the change in the fair market value of the property referenced. The delta of a transaction must be determined in a commercially reasonable manner. If the delta of an NPC or ELI is not reasonably expected to vary during the term of the transaction, the NPC or ELI has a constant delta and the delta is treated as 1.0. If a transaction would not have a delta of 1.0 but for this rule, the number of shares of the underlying security is adjusted to reflect the constant delta of 1.0. This prevents taxpayers from avoiding the 2013 proposed regulations by using transactions that reduce delta while retaining the economics of owning a set amount of shares.

The 2013 proposed regulations also treat multiple transactions as a single transaction for purposes of determining if the transactions are a section 871(m) transaction, when a long party (or a related person) enters into two or more transactions that reference the same underlying security and the transactions were entered into in connection with each other. These rules do not combine transactions when a taxpayer is the long party with respect to an underlying security in one transaction and the short party with respect to the same underlying security in another transaction.

Transactions that are combined in this manner are treated as separate transactions for all other purposes. A withholding agent is not required to withhold on a dividend equivalent paid pursuant to a transaction that has been combined with other transactions unless the agent knows that the long party (or a related person) entered into the potential section 871(m) transactions in connection with each other.

Treasury requests comments regarding whether (and, if applicable, how) the rules for combining separate transactions should apply in other situations, such as when a taxpayer holds both long and short positions with respect to the same underlying security.

The 2013 proposed regulations provide that a dividend equivalent is (1) any payment of a substitute dividend made pursuant to a securities lending or sale-repurchase transaction that references a U.S. source dividend payment, (2) any payment made pursuant to a specified NPC that references a U.S. source dividend payment, (3) any payment made pursuant to a specified ELI that references a U.S. source dividend payment, or (4) any other substantially similar payment. A payment references a U.S. source dividend payment, if the payment is directly or indirectly contingent upon or determined by reference to the payment of a U.S.-source dividend.

Certain transactions typically provide for dividend equivalents to be paid at the time a dividend is paid on a referenced stock, e.g., stock loans, equity sale-repurchase transactions, and total return swaps. Treasury believes that an ELI that has economic terms substantially similar to a securities lending or sale-repurchase transaction, or a specified NPC, creates the same potential for avoidance of U.S. withholding tax. An ELI is any financial transaction (other than a securities lending or sale-repurchase transaction or an NPC) that references the value of one or more underlying securities, e.g., forward contracts, futures contracts, options, debt instruments convertible into underlying securities, and debt instruments with payments linked to underlying securities. The 2013 proposed regulations provide that another substantially similar payment is a gross-up amount paid by a short party in satisfaction of the long party’s tax liability with respect to a dividend equivalent. Treasury requests comments regarding whether other payments should be treated as substantially similar payments, such as a payment made by a seller of stock to the purchaser pursuant to an agreement to deliver a pending U.S. source dividend after the record date (for example, a due bill).

The definition of an underlying security has also been revised, as any interest in an entity taxable as a corporation for Federal tax purposes if a payment with respect to that interest may give rise to a U.S. source dividend. If a transaction references more than one such entity (including a reference to an index that is not a qualified index), each interest is treated as a separate underlying security. If a transaction references a qualified index, the qualified index is treated as a single security that is not an underlying security.

The 2013 proposed regulations also revise the rules pertaining to indices. In general, a qualified index is any index that (1) references 25 or more underlying securities; (2) references only long positions in underlying securities; (3) contains no underlying security that represents more than 10 percent of the index’s weighting; (4) rebalances based on objective rules at set intervals; (5) does not provide for a high dividend yield; and (6) is referenced by futures or option contracts that trade on a national securities exchange or a domestic board of trade.

The 2013 proposed regulations provide rules for identifying a payment of a dividend equivalent. A payment includes any gross amount that references a U.S. source dividend and that is used to compute any net amount transferred to or from the long party, even if the long party makes a net payment to the short party or the net payment is zero. A payment is treated as made on the date the amount of the dividend equivalent is fixed, even if it is paid or otherwise taken into account on a later date.

The 2013 proposed regulations eliminate an earlier exception, and explicitly treat estimated dividend payments as dividend equivalents, because the economic benefit of a dividend is present.

A dividend equivalent also includes any amount that references the payment of a U.S. source dividend, and any contractual term of a potential section 871(m) transaction that is calculated based on an actual or estimated dividend. For example, when a long party enters into an NPC that provides for payments based on the appreciation in the value of an underlying security but does not explicitly entitle the long party to receive payments based on regular dividends (a price return swap), the 2013 proposed regulations treat the price return swap as a transaction that provides for the payment of a dividend equivalent, because the anticipated dividend payments are presumed to be taken into account in determining other terms of the NPC, such as in the payments that the long party is required to make to the short party or in setting the price of the underlying securities.

The 2013 proposed regulations also provide rules for calculating the amount of a dividend equivalent. For a securities lending or sale-repurchase transaction, the amount of a dividend equivalent for each underlying security equals the actual per share dividend amount paid on the underlying security, multiplied by the number of shares of the underlying security transferred. For a specified NPC or specified ELI, the amount of a dividend equivalent equals the per share dividend amount with respect to the underlying security multiplied by the number of shares of the underlying security (subject to adjustment), multiplied by the delta with respect to the underlying security at the time that the dividend equivalent is determined. If a transaction provides for a payment based on an estimated dividend, the 2013 proposed regulations require that the actual amount of the dividend payment is used to calculate the amount of the dividend equivalent, unless the short party identifies a reasonable estimated dividend amount in writing at the inception of the transaction. Then the per share dividend amount used to compute the amount of a dividend equivalent is the lesser of the amount of the estimated dividend and the amount of the actual dividend paid.

The delta of a transaction at the time the long party acquires a potential section 871(m) transaction is used to determine whether the transaction is a section 871(m) transaction. The delta of the section 871(m) transaction at the time that the amount of the dividend equivalent is determined is used to calculate the amount of the dividend equivalent. Because the delta of a transaction may vary over time, the delta used to calculate the amount of a dividend equivalent is not used to re-test whether a transaction is a section 871(m) transaction. A long party’s section 871(m) transaction continues to be subject to tax, even if the delta of the section 871(m) transaction is below 0.70 at the time the dividend equivalent is determined. Similarly, a long party that acquires a potential section 871(m) transaction that has a delta below 0.70 at the time of acquisition, will not have a section 871(m) transaction even if the delta increases above 0.70 during the time the long party holds the transaction.

The amount of the dividend equivalent generally is determined on the earlier of the ex-dividend date or the record date for the dividend. However, if a section 871(m) transaction has a term of one year or less, the amount of the dividend equivalent is determined when the long party disposes of the transaction. Therefore, a long party that acquires an option with a term of one year or less that is a specified ELI will not incur a withholding tax if the option lapses.

The 2013 proposed regulations provide exceptions to the definition of a section 871(m) transaction for two transactions that have little potential for tax avoidance. The first exception applies when a qualified dealer (i.e., subject to regulatory supervision) enters into a transaction as the long party in its capacity as a dealer. The dealer must certify that it is a qualified dealer, and withhold and deposit any tax imposed by section 871(m). The second exception applies when a taxpayer enters into a transaction as part of a plan pursuant to which one or more persons are obligated to acquire 50 percent or more of the entity issuing the underlying securities.

An NPC may reference a partnership interest, and the partnership could be formed to hold a basket of U.S. equity securities. A comment recommended that regulations treat an NPC that references a partnership interest as a separate NPC with respect to each underlying security held by the partnership. The 2013 proposed regulations treat a transaction that references an interest in an entity that is not a C corporation as referencing the allocable portion of any underlying securities and potential section 871(m) contracts held directly or indirectly by that entity. There is an exception if underlying securities and potential section 871(m) transactions represent 10 percent or less of the value of the interest in the referenced entity at the time the transaction is entered into.

The Service may also treat any payment made with respect to a transaction as a dividend equivalent, if the taxpayer acquires a transaction with a principal purpose of avoiding the application of these rules. The Service will continue to closely scrutinize other transactions that are not covered by section 871(m), and that may be used to avoid U.S. taxation. In addition, the IRS may challenge the U.S. tax results using all available statutory provisions and judicial doctrines (e.g., substance over form doctrine, the economic substance doctrine, etc.) as appropriate.

When a broker or dealer is a party to a potential section 871(m) transaction, the broker or dealer is required to determine whether the transaction is a section 871(m) transaction, and if so, the amounts of the dividend equivalents. If a broker or dealer is not a party to the transaction or both parties are brokers or dealers, the short party must make these determinations.

The 2013 proposed regulations also describe the exception to withholding where no money or property is paid. A withholding agent is not obligated to withhold on a dividend equivalent until the later of: (1) the time that the amount of the dividend equivalent is determined and (2) the time at which any of the following has occurred: (a) money or other property is paid pursuant to a section 871(m) transaction, (b) the withholding agent has custody or control of money or other property of the long party after the amount of the dividend equivalent is determined, or (c) there is an upfront payment or a prepayment of the purchase price. A withholding agent is relieved of liability when the agent does not have control of money or other property of the long party, but the long party remains liable for U.S. tax on the dividend equivalent.

U.S. source portfolio interest received by a nonresident alien individual is not subject to withholding tax. Certain contingent interest payments are excluded from the definition of portfolio interest. Treasury has authority to impose tax on contingent interest when necessary to prevent tax avoidance. Most contingent debt instruments are either referenced to a qualified index, have an embedded option with a delta below 0.70, or both. A debt obligation that is a specified ELI and provides for a contingent interest payment determined by reference to a U.S. source dividend payment has the potential to be used by a nonresident alien individual or foreign corporation to avoid section 871(m). Therefore, any contingent interest will not qualify for the portfolio interest exemption to the extent that the contingent interest payment is a dividend equivalent.

The 2013 proposed regulations generally will apply to payments made on or after the date of publication of the Treasury decision adopting final regulations. Certain provisions in the 2013 proposed regulations apply at different dates. Consideration will be given to any written comments, and a public hearing has been scheduled for April 11, 2014.

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