The United States imposes a 30 percent withholding tax on U.S. source dividends, which are generally dividends paid by corporations incorporated in the United States ("U.S. Equities"). Traditionally, financial derivatives such as securities lending transactions and notional principal contracts entered into by non-U.S. residents that include "substitute" dividend payments that are determined by reference to the amount of dividends paid on U.S. Equities have been sourced outside of the United States and are therefore not subject to this withholding tax.
Amid concerns that these financial derivatives provide a way to avoid the U.S withholding tax on U.S. Equities, the Hiring Incentives to Restore Employment Act (the "HIRE Act"), enacted in 2010, added Section 871(m) to the U.S. Internal Revenue Code (the "Code") to treat certain "dividend equivalent" payments that are considered to be economically equivalent to dividends paid on U.S Equities as being from U.S. sources for withholding tax purposes. Dividend equivalent payments include payments made in connection with securities lending transactions and certain notional principal contracts that reference U.S. Equities where the payments are contingent upon or determined by reference to the payment of a dividend on a U.S. Equity.
For notional principal contracts, dividend equivalent payments paid before March 18, 2012, are covered by Section 871(m) if one of four criteria are met: (i) in connection with entering the notional principal contract, the long party transfers the underlying U.S. Equity security to the short party to the contract, (ii) in connection with closing the contract, the short party transfers the security to the long party, (iii) the underlying security is not readily tradable on an established security market, or (iv) the underlying security is posted as collateral by the short party to the contract.
The U.S. Treasury Department and the U.S. Internal Revenue Service have recently issued temporary and proposed regulations that provide that the existing rules will be extended to payments made with respect to notional principal contracts until the end of 2012. For notional principal contract payments made in 2013 and thereafter (even if the NPC was entered into before that date), the categories of notional principal contracts that will be covered by Section 871(m) will be expanded to include contracts where (i) the long party is considered to be "in the market" with respect to the relevant U.S. Equity on the day the contract is priced or terminated, (ii) the underlying U.S. Equity is not publicly traded, (iii) the underlying security is posted as collateral by the short party and this collateral represents more than 10 percent of the collateral posted by the short party, (iv) the contract has a term of less than 90 days, (v) the long party contractually or by conduct controls the short party's hedge, (vi) the notional principal amount of the underlying U.S. Equity represents more than 5 percent of the total public float or 20 percent of the 30-day average trading volume of the U.S. Equity, or (vii) the contract is entered into on or after the announcement of a special dividend and prior to the ex-dividend date of the special dividend. Detailed rules expand the precise contours of these categories. Other specific rules treat a notional principal contract that references multiple issuers or a customized index as consisting of separable contracts, each of which is potentially subject to 871(m). In addition, payments made beginning in 2013 on an equity-linked financial instrument, such as a forward or futures contract or an option, that are contingent upon or determined by reference to a dividend paid on a U.S. Equity will be treated as dividend equivalent payments subject to Code Section 871(m). The proposed rules will likely be the subject of a variety of comments that may be incorporated into the regulations before they are finalized.
The 30 percent withholding tax on dividends paid on U.S. Equities can be reduced by treaty and eliminated for certain types of investors, such as foreign governmental investors entitled to the benefits of Section 892 of the Code. In a helpful development for foreign governmental investors, the proposed regulations also provide that payments treated as dividend equivalent payments subject to Code Section 871(m) will be treated as dividends eligible for the exemption provided by Section 892 of the Code, and permits taxpayers to rely on this rule immediately. In addition, the dividend equivalent amount will be treated as a dividend for purposes of U.S. tax treaties, although no explicit permission is given to rely on this rule until the proposed regulations are finalized.
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