IRS Issues Final and Proposed Regulations on “Dividend Equivalent” Payment Withholding

On December 4, the IRS issued final and proposed regulations with respect to withholding on United States-source “dividend equivalents.” These regulations replace temporary and proposed regulations previously issued in January, 2012.  Of particular significance is the introduction in the 2013 proposed regulations of a “delta”-based approach for certain dividend equivalent payments made on or after January 1, 2016. 

Background and 2013 Final Regulations

As a consequence of the 2010 Hiring Incentives to Restore Employment Act (HIRE Act), a dividend equivalent payment is now treated as a dividend from sources within the U.S. for purposes of taxing and withholding at source on nonresident aliens, foreign corporations and foreign organizations. 

Under Internal Revenue Code Sec. 871(m), a “dividend equivalent” is any payment or substitute dividend that (directly or indirectly) is contingent upon or determined by reference to the payment of a U.S. source dividend, but only if such payment or substitute payment is made pursuant to a securities lending transaction, a sale-repurchase transaction, or a “specified notional principal contract” (“specified NPC”).  A dividend equivalent is also any other payment that is determined to be substantially similar to these payments.

Under the 2013 Final Regulations, which effectively extend the applicability of the 2012 temporary regulations to payments made before January  1, 2016 (and after March 18, 2012), a specified NPC is any NPC with respect to which:

• In connection with entering into an NPC, a long party transfers the underlying security to a short party;
• In connection with terminating an NPC, a short party transfers the underlying security to a long party;
• The underlying security is not readily tradable on an established securities market; or
• In connection with entering into an NPC, the underlying security is posted as collateral by the short party.

The 2013 Final Regulations also provide:

• Dividend equivalent payments made to a foreign government may be exempt from withholding.
• Provisions of an income tax treaty relating to dividends apply to the payment of a dividend equivalent.
• The amount of a dividend equivalent includes any gross amount that is used in computing any net payment amount.
• A withholding agent that makes a payment attributable to a specified NPC not treated as effectively connected with a U.S. trade or business is obligated to withhold on the amount of the dividend equivalent payment.

2013 Proposed Regulations

The previously proposed regulations have been replaced with the new 2013 proposed regulations based on a derivative’s delta to determine whether a contract is subject to tax under IRC Sec. 871(m).  As was the case with the prior proposed regulations, the 2013 proposed regulations cover “equity-linked instruments” (ELI) as well as NPCs.  The term “ELI” includes instruments such as forward contracts, futures contracts, options, convertible debt and debt instruments with payments linked to underlying securities.   Delta is the ratio of the change in the fair market value of the contract to the change in the fair market value of the property referenced in the contract.  The Treasury and the IRS believe that the use of a delta-based standard will prevent taxpayers from avoiding withholding by electing derivative exposure to U.S. equities rather than physical ownership.

Similar to the 2013 final regulations just described, the 2013 proposed regulations provide that a dividend equivalent is any substitute dividend made pursuant to a securities lending or sale-repurchase transaction that references a U.S.-source dividend payment, a payment made pursuant to a specified NPC or a “specified ELI” that references a U.S. source dividend payment or any other “substantially similar” payment.  An example of a 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.

Under the 2013 proposed regulations, a “specified NPC” is any NPC that has a delta of 0.70 or greater when the long party acquires the NPC; similarly, a specified ELI has a delta of 0.70 or greater.  If a long party enters multiple transactions referencing the same underlying security, the transactions are treated as a single transaction.  So, for example, if a taxpayer purchases a call option and sells a put option referencing the same underlying security that each have a delta below 0.70 but together have a delta that exceeds 0.70, the threshold for a specified ELI would be met.   If a transaction references more than one underlying security, it needs to be tested for each underlying security independently.  The delta of a transaction must be determined in a commercially reasonable manner; if a taxpayer calculates delta for non-tax business purposes, that delta ordinarily will be treated as the delta for this purpose. If the delta of an NPC or ELI is not reasonably expected to vary during the term of the transaction, the NPC or ELI is treated as having a constant delta of 1.0.

A payment of a dividend equivalent includes any gross amount that references a U.S. source dividend and is used to compute any net income 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.  Payment includes any amount that references an actual or estimated payment of dividends, whether the reference is explicit or implicit.

Special note should also be made of other provisions contained in the 2013 proposed regulations:

• The IRS may treat any payment made as a dividend equivalent if the taxpayer acquires  a transaction with a principal purpose of avoiding application of the dividend equivalent rules.
• A transaction referencing a “qualified index” will not be treated as a specified NPC or ELI.
• Transactions excepted from the dividend equivalent payment rules include when (1) a qualified dealer enters into a transaction as the long party in its capacity as a dealer in securities and (2) a taxpayer enters into a transaction as part of a plan pursuant to which one or more persons are obligated to acquire 50% or more of the entity issuing the underlying securities.
• Contingent interest will not qualify for the portfolio interest exception to the extent the contingent interest is a dividend equivalent.