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IRS regulations regarding withholding on US-source 'dividend equivalents' and the formalization of a 'delta' based approach for certain dividend equivalent payments made on or after 1/1/17.  hedge fund.

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

On September 18, 2015, the IRS issued final, and temporary and proposed, regulations with respect to withholding on United States-source “dividend equivalents.”  These regulations replace and expand upon final and proposed regulations previously issued in December, 2013.  (See the EisnerAmper Alert, dated January 10, 2014, entitled “IRS Issues Final and Proposed Regulations on “Dividend Equivalent” Payment Withholding.”) Of particular significance is the formalization of a “delta” based approach for certain dividend equivalent payments made on or after January 1, 2017 and the introduction, in temporary and proposed form, of a methodology to address dividend equivalent payments in the case of so-called “complex contracts.” 
 
Background and Final Regulations

Under Internal Revenue Code (“IRC”) Section 871(m) and the final regulations, a dividend equivalent is treated as a dividend from sources within the United States for purposes of taxing and withholding at source on nonresident alien individuals, foreign corporations and foreign organizations.  A dividend equivalent is treated as a dividend also for purposes of any provision regarding dividends in an income tax treaty.  Specifically, the final regulations define a “dividend equivalent” as (1) any payment that references a U.S. dividend from an “underlying security” pursuant to a securities lending or sale-repurchase transaction, (2) any payment that references a U.S. dividend from an underlying security pursuant to a “specified notional principal contract” (“specified NPC”), (3) any payment that references a U.S. dividend from an underlying security pursuant to a “specified equity linked instrument” (“specified ELI”), or (4) any other substantially similar payment.  Such a securities lending or repurchase transaction, specified NPC or specified ELI is referred to as a “Section 871(m) transaction” or a “potential Section 871(m) transaction.”  An “underlying security” is an interest in an entity if a payment with respect to that interest could give rise to a U.S. source dividend. 

A “payment” includes any gross amount that references a U.S. source dividend, whether actual or estimated, explicit or implicit, and that is used to compute any net amount transferred to or from the “long party” (i.e., the party that would receive the dividend equivalent payment), even if the long party makes a net payment to the “short party” (i.e., the party that would be obligated to make a dividend equivalent payment) or no amount is paid because the net amount is zero.  A payment references a U.S. source dividend if the payment is directly or indirectly contingent upon a U.S. source dividend or is determined by reference to such a dividend.
 
With respect to NPCs entered into before January 1, 2017, for payments made before January 1, 2017, a specified NPC is any NPC (e.g., a swap) if:

  • In connection with entering into an NPC, a long party (non-U.S.) 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 (non-U.S.);
  • 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 to the non-U.S. person.

An NPC that is treated as a specified NPC under the above criteria remains a specified NPC on or after January 1, 2017.

Delta

Beginning with payments made on or after January 1, 2017 with respect to any transactions issued on or after January 1, 2017 (and for payments made on or after January 1, 2018 with respect to transactions issued on or after January 1, 2016 not covered by the specified NPC rule above and before January 1, 2017), a derivative’s “delta” will be used to determine whether a contract is subject to tax under IRC Section 871(m).  The final regulations cover “equity linked instruments” (“ELIs”) as well as NPCs.  The term “ELI” includes a futures contract, forward contract, option, debt instrument or other contractual arrangement that references the value of one or more underlying securities.  Delta is the ratio of the change in the fair market value of an NPC or ELI to a small change in the fair market value of the number of shares of the underlying security referenced by the NPC or ELI.  Typically, a small change is a change of less than 1%.  If an NPC or ELI references more than one underlying security or other property, the delta with respect to each underlying security must be taken into account without taking into account any other security or property.  Delta is to be determined in a commercially reasonable manner; if a taxpayer calculates delta for non-tax business purposes, the final regulations say that delta ordinarily is the delta to be used.
 
The delta is determined only when the instrument is “issued;” it is not re-tested when the instrument is subsequently purchased or otherwise acquired in the secondary market.  However, where an instrument is deemed re-issued as a result of a significant modification of the instrument, testing is required on the date of re-issuance. Only an NPC or ELI that has a delta of 0.80 or greater at the time it is issued (or re-issued as here noted) is a specified NPC or specified ELI.  The regulations proposed in 2013 had established a 0.70 delta threshold, which had been viewed by most commentators as too low a threshold and therefore would result in contracts not sufficiently resembling the underlying securities being caught within the scope of the dividend equivalent rules. 

Simple and Complex Contracts

To deal with situations where the delta is indeterminate – e.g., the number of shares of the underlying security that determine the payout of the derivative cannot be shown – the final regulations distinguish between a “simple contract” and a “complex contract.”  A simple contract is a contract that references a single fixed number of shares of one or more issuers to determine the payout.  The number of shares must be known when the contract is issued, and the contract must have a single maturity or exercise date on which all amounts (other than any upfront payment or any periodic payments) are required to be calculated with respect to the underlying security.  The fact that a contract has more than one expiration date, or a continuous expiry, does not preclude the contract from being a simple contract.  Thus, according to the preamble to the final and temporary regulations, an American-style option is treated as a simple contract even though the option may be exercised by the holder at any time on or before the expiration of the option if amounts due under the contract are determined by reference to a single, fixed number of shares on the exercise date.  The final regulations provide a simplified delta calculation for certain simple contracts that reference 10 or more underlying securities.   The IRS expects that most NPCs and ELIs will be simple contracts and will be subject to the delta test.
 
A “complex contract” is any contract that is not a simple contract.  Contracts with indeterminate deltas are classified as complex contracts and, in lieu of the delta test described above, are subject to a new “substantial equivalence” test included in the temporary and proposed regulations (discussed below). Thus, the delta test in the final regulations applies only to simple contracts. Examples of a complex contract include: a contract with asymmetrical or binary payouts that reference a different number of shares of an underlying security at different payout points and a contract (“digital option”) that provides for a payment that does not vary with the price of the shares. These have an indeterminate delta because the number of shares that determine the payout of the derivative cannot be known when the contract is entered into.  Path-dependent contracts generally are also complex contracts.

Exceptions from Definition of Dividend Equivalent or Section 871(m) Transactions

The final regulations provide a number of exceptions from the definition of dividend equivalent or Section 871(m) transactions.  For example:

  • A payment referencing a distribution on an underlying security is not a dividend equivalent to the extent the distribution would not be subject to tax (under the provisions dealing with nonresident alien individuals and income of corporations not effectively connected with a U.S. trade or business) if the long party owned the underlying security directly.  For example, if an NPC references stock in a regulated investment company (“RIC”) which pays a dividend that includes a capital gains dividend that would not be subject to tax if paid to a non-U.S. long party, then an NPC payment is not a dividend equivalent to the extent that it is determined by reference to the capital gains dividend.
  • A dividend equivalent is reduced by any amount treated under IRC Section 305(b) and (c) [“Distribution of Stock and Stock Rights”] as a dividend with respect to the referenced underlying security.  For example, if a change in conversion ratio of a convertible security is treated as a Section 305 dividend paid to the holder of the convertible security, a dividend equivalent is reduced by the amount of the section 305 dividend arising from such change.
  • A dividend equivalent does not include a payment made pursuant to a “due bill” that arises from the actions of a securities exchange that apply to all transactions in the stock and when the relevant exchange has set an ex-dividend date that occurs after the record date.  
  • IRC Section 871(m) does not apply to employee compensation that is generally subject to withholding or is entitled to a specific exception.  For example, a dividend equivalent does not include the portion of equity-based compensation for personal services of a nonresident alien individual that is subject to wage withholding, excluded from the definition of wages or otherwise exempt from withholding.  For example, when a restricted stock unit is paid as compensation and tax is collected by the employer at the time of payment through withholding, the payment is not a dividend equivalent.  However, if the restricted stock unit results in the receipt of stock, then dividends subsequently paid on that stock would be subject to withholding under these rules.  
  • A transaction is not covered by IRC Section 871(m) when a taxpayer enters into a transaction as part of a plan pursuant to which one or more persons are obligated to acquire more than 50% of the entity issuing the underlying securities. 
  • A transaction referencing a “qualified index” is not treated as a specified NPC or specified ELI.  This exception is not intended to apply to any index that is customized or reflects a trading strategy, is unavailable to other investors, or targets special dividends.

IRC Section 871(m) applies to derivatives that reference a partnership interest only when the partnership is either a dealer or trader in securities, has “significant investments in securities,” or holds an interest in a lower-tier partnership that engages in those activities.  A partnership holds significant investments in securities if either 25% or more of the partnership’s assets consist of underlying securities or potential Section 871(m) transactions, or the value of such securities or transactions exceeds $25 million.
 
The final regulations also address when and how multiple transactions are combined and treated as a single transaction for purposes of determining if the transactions trigger the application of these dividend equivalent rules. 

Amount of Dividend Equivalent

For a securities lending or sale-repurchase transaction, the amount of the dividend equivalent for each underlying security is the amount of the actual per-share dividend paid on the underlying security multiplied by the number of shares of the underlying security.
 
For a simple contract, the amount of the dividend equivalent for each underlying security is the amount of the per-share dividend, multiplied by the number of shares referenced in the contract, multiplied by the applicable delta.  Special rules apply to dividend equivalents with respect to baskets of more than 25 securities and to situations where the Section 871(m) transaction references a security index for which there is a publicly available quarterly dividend yield.
 
For a complex contract, the amount of the dividend equivalent for each underlying security is the amount of the per-share dividend multiplied by the number of shares that constitute the initial hedge for the underlying security.  See discussion under “Temporary and Proposed Regulations,” below.

Specified NPCs and Specified ELIs with a Term of One Year or Less

The regulations proposed in 2013 effectively exempted specified NPCs and specified ELIs with terms of one year or less where there was no actual payment.  Thus, for example, a long party that acquired an option with a term of one year or less that was a specified ELI would not be subject to withholding tax if the option lapsed under those proposed regulations. This provision was not included in the final regulations.   Accordingly, a dividend equivalent amount must be determined for any option, including a short-term option, that is treated as a specified ELI.
 
Withholding

A withholding agent is not obligated to withhold on a dividend equivalent until the later of when a payment is made with respect to a Section 871(m) transaction or when the amount of a dividend equivalent is determined.  Such payment generally occurs when the long party receives or makes a payment, when there is a final settlement of the Section 871(m) transaction (including, in the case of an option, a lapse), or when the long party sells or otherwise disposes of the Section 871(m) transaction.  In the case of options or other contracts that may require an upfront payment, premium or other upfront payment is not treated as “payment” for withholding purposes. The preamble to the final and temporary regulations notes that the parties may need to modify contractual arrangements to ensure that there are sufficient funds available to satisfy withholding obligations. 

Contingent Interest and Convertible Debt

Contingent interest does not qualify for the portfolio interest exception from the 30%  (or lower treaty rate) withholding tax on interest paid to nonresident alien individuals and foreign corporations to the extent that the contingent interest is a dividend equivalent, effective September 18, 2015. Also, convertible debt instruments are not excluded from the definition of an ELI.  Accordingly, a convertible debt is a specified ELI if the delta of the embedded option at the time the convertible debt is issued is 0.80 or higher.  The delta of the convertible feature is tested separately from the delta of the debt instrument in making Section 871(m) calculations.  The preamble to the final and temporary regulations notes that the fact that convertible debt ordinarily has been issued with a delta on the embedded option of less than 0.80 is expected to significantly reduce the effect of these regulations on the convertible debt market.

Anti-Abuse Rule

Pursuant to the final regulations, the IRS may treat any payment made with respect to a transaction as a dividend equivalent if the taxpayer (directly or through the use of a related party) acquires the transaction with “a principal purpose” of avoiding the application of IRC Section 871(m). A purpose may be “a principal purpose” even though it is outweighed by other purposes (taken together or separately).  The preamble to the final and temporary regulations notes that nothing in IRC Section 871(m) precludes the IRS from asserting that a contract labeled as an NPC or other equity derivative is in fact an ownership interest in an underlying security referenced in the contract.

Reporting

The final regulations also provide reporting requirements.  In general, if a broker or dealer is a party to a potential Section 871(m) transaction with a counterparty or customer that is not a broker or dealer, the broker or dealer is required to determine whether the potential Section 871(m) transaction is in fact a Section 871(m) transaction.  If both parties are brokers or dealers, or neither party is a broker or dealer, the short party must make the determination whether there is a Section 871(m) transaction.  Whoever is required to make that determination must also determine and report to the counterparty or customer, in general, the timing and amount of any dividend equivalent.  These determinations are binding on the parties to the Section 871(m) transaction and on any applicable withholding agent, absent knowledge that the information is incorrect, but they are not binding on the IRS.  The party required to report the information must also provide to any party to the transaction, upon request, within 10 business days the amount of each dividend equivalent, the delta of the potential Section 871(m) transaction, the amount of any tax withheld and deposited, any estimated dividend amount (under specified circumstances), the identity of any transactions combined, and any other information necessary to apply the dividend equivalent rules.
 
Recordkeeping

In order to ensure that the IRS has access to sufficient information to audit taxpayers and withholding agents that are parties to Section 871(m) transactions, the final regulations provide that any person required to retain records must keep sufficient information to establish whether a transaction is a Section 871(m) transaction and the amount of a dividend equivalent.  In this regard, a taxpayer must retain documentation and work papers supporting a delta calculation or substantial equivalence (including the number of shares of the initial hedge) [see discussion below] and the amount of written estimated dividends, if any.  The records and documentation must be created substantially contemporaneously with the time the potential Section 871(m) transaction is issued.

Temporary and Proposed Regulations

Temporary regulations (simultaneously issued also as proposed regulations) address, in part, contracts with indeterminate deltas – for example, in the case of structured notes – which constitute “complex contracts.”  To test whether a complex contract is a Section 871(m) transaction, a “substantial equivalence” test has been adopted.  Generally, the substantial equivalence test measures the change in value of a complex contract when the price of the underlying security referenced by that contract is hypothetically increased or decreased by one standard deviation (each, a “testing price”) and compares that change to the change in value of the shares of the underlying security that would be held to hedge the complex contract at the time the contract is issued (the “initial hedge”) at each testing price.  The smaller the proportionate difference between the change in value of the complex contract and the change in value of its initial hedge at multiple testing prices, the more equivalence there is between the contract and the referenced underlying security.  When this difference is equal or less than the difference for a “simple contract benchmark” with a delta of 0.80 and its initial hedge, the complex contract is treated as substantially equivalent to the underlying security.
 
Under the temporary regulations, the “simple contract benchmark” is a closely comparable simple contract that, at the time the complex contract is issued, has a delta of 0.80, references the applicable security referenced by the complex contract, and has the same maturity as the complex contract with respect to the applicable underlying security.  Depending on the complex contract, the simple contract benchmark might be, for example, a call or put option, or a collar.

The temporary regulations also provide that there is no dividend equivalent associated with the payment that a foreign person receives under the terms of an annuity, endowment or life insurance contract issued by a domestic insurance company (including the foreign or U.S. possessions branch of the domestic company) if the payment is otherwise subject to withholding tax.  Further, payments made pursuant to such insurance contracts do not include a dividend equivalent when issued by a foreign insurance company. Payments made pursuant to a policy of insurance (including a policy of reinsurance) do not include a dividend equivalent if made to a foreign insurance company.
 
Effective Date

Except as otherwise provided in this alert – notably as applied to specified NPCs and specified ELIs – the final and temporary regulations are generally effective as of September 18, 2015.

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