United States: Final And Temporary Dividend Equivalent Regulations Issued – Some Good, Some Bad, And Some Ugly

On September 17, 2015, the Internal Revenue Service ("IRS") released final and temporary regulations under Section 871(m),1 the Internal Revenue Code provision that treats "dividend equivalents" paid under certain contracts as dividends from sources within the United States and therefore subject to U.S. withholding tax if paid to a non-U.S. person. The regulations finalize regulations proposed in 2013 (the "2013 Proposed Regulations"), with significant changes.

The new regulations generally adopt the "delta" approach introduced in the 2013 Proposed Regulations, which treat payments on notional principal contracts ("NPCs") and equity-linked instruments ("ELIs") as dividend equivalents if they have a delta above a threshold.2 However, the delta approach is limited to "simple" NPCs and ELIs and a new framework has been designed for "complex" NPCs and ELIs. We discuss this and other significant changes to the 2013 Proposed Regulations below.

The new regulations generally apply to NPCs and ELIs issued on or after January 1, 2017. NPCs and ELIs issued on or after January 1, 2016, and before January 1, 2017, are also subject to the new regulations, with a delayed effective date of January 1, 2018.

Important highlights of the regulations include:

  • Delta Threshold of 0.80. The delta threshold has been increased to 0.80 from 0.70. Generally, if an NPC or ELI has a delta of 0.80 or greater, the NPC or ELI is a Section 871 transaction and payments on the instrument that reference dividends paid on a U.S. corporation's stock are "dividend equivalents" treated as U.S.-source dividends subject to withholding. However, "complex" NPCs and ELIs are subject to different rules, as further described below.
  • Delta Determined Once. The delta of an instrument is determined when the instrument is issued.3 Delta is not re-tested when the instrument is acquired in the secondary market. This is a change from the 2013 Proposed Regulations, which required determining delta in the hands of each taxpayer on the relevant acquisition date.
  • Delta Determined Using Hedge. A taxpayer that issues an instrument that references a basket of 10 or more underlying securities and uses an exchange-traded security (e.g., an exchange-traded fund) that references substantially the same underlying securities to hedge the instrument at the time it is issued, may calculate the delta of the instrument by determining the ratio of the change in fair market value of the instrument to the change in the fair market value of the hedge (rather than of each underlying security in the basket). A similar approach (i.e., substituting the hedge for the basket securities) applies in the case of a complex NPC or ELI.
  • Estimated and Implicit Dividends Count. The new regulations retain the provisions of the 2013 Proposed Regulations that include estimated and implicit dividends as dividend equivalents. For example, a "price return" only instrument can give rise to dividend equivalent payments if the expected dividends on the underlying security are taken into account in pricing the instrument or setting its terms.
  • Qualified Index Exception. Similar to the 2013 Proposed Regulations, instruments linked to "qualified indices" are carved out from the dividend equivalent rules. However, the definition of a qualified index has been modified.4 Whether an index is a qualified index is determined on the first business day of each calendar year, and such determination applies for all relevant instruments issued during that year. In addition, an underlying security that tracks a qualified index (e.g., an exchange-traded fund) will be treated as a qualified index.
  • Limited Partnership Look-Through. For purposes of applying the Section 871(m) rules, an instrument that references a partnership interest is not treated as a potential Section 871(m) transaction, unless the partnership is a dealer or trader in securities for tax purposes, holds significant investments in securities,5 or directly or indirectly holds an interest in a lower-tier partnership that engages in those activities.
  • Combined Transactions. The regulations mostly retain the rules included in the 2013 Proposed Regulations that two or more transactions may be treated as a single transaction in determining whether Section 871(m) should apply. However, to address challenges that brokers acting as short parties may have in determining whether multiple transactions should be combined, the regulations provide that brokers may generally rely on two presumptions. They may presume that transactions are not entered into in connection with each other if the long party holds the transactions in separate accounts and they may presume that transactions entered into two or more business days apart are not entered into in connection with each other (unless the brokers have knowledge to the contrary).
  • Complex vs. Simple. Complex NPCs and ELIs6 are not subject to the "delta" test; instead, a complex NPC or ELI gives rise to dividend equivalents if it passes a "substantial equivalence" test. Generally, the substantial equivalence test calculates the difference between the change in value of the complex contract (determined at various "testing prices" of the underlying) and the change in value of a number of shares that fully hedges the complex contract, as determined on the issue date. The differences are then given a probability-weighted average over the various testing prices of the underlying (the "Complex Contract Calculation"). A similar process is repeated with a "simple contract benchmark"7 in place of the complex contract (the "Benchmark Calculation"). If the Complex Contract Calculation is less than or equal to the Benchmark Calculation, the complex contract is a Section 871 transaction. The IRS has requested comments regarding the administrability of the substantial equivalence test.

Select observations:

  • The regulations make a few notable improvements to the 2013 Proposed Regulations, in particular increasing the delta threshold to 0.80 and allowing for the delta of a particular instrument to be determined once.
  • Consistent with the 2013 Proposed Regulations, estimated and implicit dividends are not carved out and, since most price return only instruments take into account expected dividends on the underlyings, the regulations apply to price return only instruments.
  • Since the determination of whether an index is "qualified" is made on the first business day of a calendar year and applies for the entire year, a published list (updated annually) of all qualified indices for purposes of Section 871(m) would be helpful. Who will take that publication on?
  • The delta test or the substantial equivalence test, as applicable, needs to be conducted when the relevant instrument is issued. An instrument is issued at "inception" or upon "original issuance." Disclosure documents for instruments addressing the tax treatment are typically prepared on or immediately after the pricing date. Can the determination be made on the pricing date and included in the disclosure documents? The preamble to the regulations indicates that "an instrument is treated as "issued" when it is entered into, purchased, or otherwise acquired at its inception or original issuance."
  • Many structured products will be considered "complex." The rules for determining whether a complex NPC or ELI gives rise to a Section 871(m) transaction seem rather complex, and time will tell whether the framework is workable in practice. Those rules are part of the temporary regulations and the IRS has requested comments regarding the administrability before it will finalize them.


1. All section references are to the Internal Revenue Code of 1986, as amended (the "Code"), and the Treasury regulations promulgated thereunder.

2. For a summary of the 2013 Proposed Regulations, please see our client alert available at http://media.mofo.com/files/Uploads/Images/131212-IRS-Regulations.pdf

3. The regulations clarify that, in the case of a contingent debt instrument or convertible debt instrument, the delta of the embedded derivative or of the convertible feature is determined separately from the delta of the overall debt instrument.

4. Under the new regulations, a qualified index means an index that (i) references 25 or more component securities; (ii) references only long positions in component securities; (iii) references no component underlying security that represents more than 15% of the weighting of the component securities in the index; (iv) references no five or fewer component underlying securities that together represent more than 40% of the weighting of the component securities in the index; (v) is modified or rebalanced only according to publicly stated, predefined criteria, which may require interpretation by the index provider or a board or committee responsible for maintaining the index; (vi) did not provide an annual dividend yield in the immediately preceding calendar year from component underlying securities that is greater than 1.5 times the annual dividend yield of the S&P 500 Index as reported for the immediately preceding calendar year; and (vii) is traded through futures contracts or option contracts on a national securities exchange or certain foreign exchanges.

5. A partnership holds significant investment in securities if either (i) 25% or more of the value of the partnership's assets consist of securities that could give rise to U.S.-source dividends or that are potential Section 871(m) transactions, or (ii) the value of such securities or transactions equals or exceeds $25 million.

6. A complex NPC or ELI is any NPC or ELI that is not a simple contract; a simple contract is an NPC or ELI that has a fixed term and references a fixed number of underlying shares.

7. A simple contract benchmark is a "comparable simple contract" that has a delta of 0.8, references the same underlying security as the complex contract, and has the same maturity as the complex contract. Examples of simple contract benchmarks are put options, call options, or collars on a fixed number of shares.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Similar Articles
Relevancy Powered by MondaqAI
In association with
Related Topics
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions