Temporary and Proposed Regulations Issued Affecting Withholding on Dividend Equivalents
The Internal Revenue Service (“IRS”) and the Treasury Department (“Treasury”) recently issued Temporary Regulations, in tandem with Proposed Regulations, which affect the taxation of U.S. equity derivatives, pursuant to Internal Revenue Code (“IRC”) Section 871(m). The temporary regulations extend the current tax treatment, which was scheduled to expire on March 18, 2012, to December 31, 2012. The proposed regulations clarify the changes that will now take place beginning January 1, 2013.
Dividends paid by U.S. Corporations (“U.S. Dividends”) to foreign persons are subject to withholding at a rate of 30% (or lower applicable treaty rate). Prior to the enactment of IRC Section 871(m), which was included as part of the HIRE Act in March 2010, withholding on U.S. dividends could be avoided by use of a swap, which would give the economic equivalent of a dividend without the corresponding withholding treatment.
This strategy was eliminated, for the most part, with the enactment of IRC §871(m), which treats a “Dividend Equivalent” as a dividend and therefore requires the same withholding obligation as the actual payment of a dividend.
IRC §871(m)(2) defines a Dividend Equivalent as:
- Any substitute dividend made pursuant to a securities lending transaction, a sale-repurchase transaction, or a substantially similar transaction that is contingent upon or determined by reference to the payment of a U.S. sourced dividend,
- Any payment made pursuant to a Specified Notional Principal Contract (“Specified NPC”), that is contingent upon or determined by reference to the payment of a U.S. sourced dividend, or
- Any payment substantially similar to the above.
IRC §871(m)(3)(A) defines a Specified NPC, referenced in §871(m)(2)(B) above, as any notional principal contract if—
- in connection with entering into such contract, any long party to the contract transfers the underlying security to any short party to the contract,
- in connection with the termination of such contract, any short party to the contract transfers the underlying security to any long party to the contract,
- the underlying security is not readily tradable on an established securities market,
- in connection with entering into such contract, the underlying security is posted as collateral by any short party to the contract with any long party to the contract, or
- such contract is identified by the Secretary as a specified notional principal contract.
In addition, IRC §871(m)(3)(B) states that absent any regulation to the contrary, payments made on or after March 19, 2012 on any notional principal contract were deemed to be Specified NPC’s, unless the Secretary determined that the contract was of a type that did not have the potential for tax avoidance.
Temporary Regulation §1.871-16T
In order to give clarity to the definition of Specified NPCs and to give taxpayers additional time to establish compliance procedures (as well as to give the IRS additional time to create enforcement procedures), Temporary Regulation §1.871-16T was issued. This temporary regulation precludes Specified NPC treatment (and the corresponding withholding obligation) on payments made prior to January 1, 2013 with respect to notional principal contracts other than those enumerated under IRC §871(m)(3)(A)(i) through (iv) above.
Proposed Regulation §1.871-15 – Treatment of Dividend Equivalents
In addition to restating the definition of Dividend Equivalent that is stated in IRC §871(m)(2) with the appropriate references to Proposed Regulation §1.871-16 inserted, Proposed Regulation §1.871-15, Treatment of Dividend Equivalents, states that the definition of substantially similar payments (which are subject to withholding) includes any payment of a beneficial owner's tax liability with respect to a dividend equivalent made by a withholding agent.
In addition, and perhaps more significantly, the definition of dividend equivalent under Proposed Regulation §1.871-15 also includes any payment made pursuant to an equity-linked instrument, that is contingent upon or determined by reference to a U.S. sourced dividend. The proposed regulation further states that the definition of an equity-linked instrument includes futures contracts, forward contracts, options or any other contractual arrangement where the value of the instrument is determined by reference to one or more underlying securities. Further, the proposed regulation states that equity linked instruments are deemed to be NPCs for purposes of the definition of Specified NPCs under IRC §871(m)(3) and Proposed Regulation §1.871-16.
Proposed Regulation 1.871-16 – Specified Notional Principal Contracts
The main focus of the proposed regulations (and of this article) is the new definition of Specified Notional Principal Contracts, pursuant to Proposed Regulation §1.871-16. If finalized in its current form, this Proposed Regulation would specify which types of transactions are deemed to be Specified NPCs, subject to withholding. It is important to note that the Proposed Regulations would apply to payments made on or after January 1, 2013, even if the instrument giving rise to the payment was executed prior to 2013.
There are seven categories of Specified NPCs, as enumerated in Proposed Regulation §1.871-16(c):
- Contemporaneous transfers of the underlying securities — the long party to the NPC is "in the market" with respect to the underlying security on the same day or days that the parties price the NPC or on the same day or days that the NPC terminates. A long party is “in the market” with respect to the underlying security if the long party:
- A. sells or otherwise disposes of the underlying security on the same day or days that the parties price the NPC,
- purchases or otherwise acquires the underlying security on the same day or days that the NPC terminates, or
- either purchases or disposes of the underlying security at a price that is set or calculated in such a way as to be substantially identical to or determined by reference to an amount used to price or terminate the NPC;
- The underlying security is not regularly traded;
- The underlying security is posted as collateral — the short party to the NPC posts the underlying security with the long party as collateral and the underlying security posted as collateral represents more than ten percent of the total fair market value of all the collateral posted by the short party on any date that the NPC is outstanding;
- The NPC has a term of fewer than 90 days;
- The long party controls (contractually or by conduct) the short party's hedge of the short position or the long party enters into an NPC using an underlying equity control program;
- The notional principal amount of the underlying security in the NPC represents a significant percentage of trading volume (it exceeds five percent of the total public float of that class of security or it exceeds twenty percent of the 30-day average daily trading volume determined as of the close of the business day immediately preceding the first day in the term of an NPC); or
- The NPC provides for the payment of a special dividend.
As an additional concern, the proposed regulations would likely create substantial hardships as it would be difficult or impossible for large financial institutions and funds to be aware of all counterparties to all swap transactions and be able to determine if the NPC qualifies as a Specified NPC. These situations would create particular difficulty for withholding agents, as circumstances could arise whereby the withholding agent would not be able to determine whether or not an NPC is a Specified NPC, and would be deemed liable for failure to withhold tax. Certainly, it would be helpful for the IRS to modify or clarify this proposed regulation to, at a minimum, provide relief to withholding agents who, based upon representations received, conclude that withholding is not mandated in a particular transaction.
We will be watching this and other developments related to Dividend Equivalents and Specified Notional Principal Contracts and will issue further alerts as appropriate.
This publication is intended to provide general information to our friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.