United States: Final Regulations Under Section 871(m) Clarify Withholding Tax Rules For Equity-Linked Derivatives, Yet Many Challenges Remain

On September 17, 2015, the Treasury Department and the Internal Revenue Service (the "IRS") issued new temporary and final regulations under section 871(m) of the Internal Revenue Code regarding the imposition of US federal withholding tax on certain equity-linked instruments. Under the final regulations, the general framework set forth in regulations proposed in 2013 was retained, including the delta standard for determining whether "simple" contracts relating to US equity securities are subject to US federal withholding tax. The final regulations, however, increased the delta standard from 0.70 to 0.80, requiring a stronger economic correlation between the contract and the underlying securities in order for the contract to be subject to withholding. The final regulations require that a contract's delta be tested only at the contract's issuance, which effectively excludes most convertible debt from being treated as section 871(m) transactions. For "complex" contracts (e.g., those that reference a number of securities that may change over time), the temporary regulations set forth a "substantial equivalence" test for determining whether US federal withholding tax will apply. The final and temporary regulations make a number of other important changes, which are discussed in detail below.


US withholding tax generally is imposed on certain types of US source income, including dividends from a domestic corporation, paid to foreign persons at a 30 percent rate (subject to reduction or elimination pursuant to an applicable income tax treaty).1 In general, swap payments are not subject to US withholding tax because payments made to a foreign person under a notional principal contract ("NPC") are treated as foreign source income.2  Prior to the enactment of section 871(m), the treatment of swap payments made to a foreign person as foreign source income applied even where the swap payments were based on US source dividends.

Section 871(m)

Section 871(m) was enacted on March 18, 2010 as part of the Hiring Incentives to Restore Employment ("HIRE") Act.3

Under section 871(m), "dividend equivalent" payments are treated as US source income. The term "dividend equivalent" is defined to include payments made on a "specified notional principal contract" (a "specified NPC") on or after September 14, 2010 that are contingent upon, or determined by reference to, the payment of dividends on US securities.4  Accordingly, such payments when made to a foreign person are generally subject to US withholding tax at a 30 percent rate (subject to reduction or elimination pursuant to an applicable income tax treaty). Pursuant to section 871(m)(3)(A) and Treasury regulations that have been in effect since 2012, an NPC is considered a specified NPC if:

  • in connection with entering into the contract, any "long party" to the contract transfers the underlying security to any "short party" (i.e., there is a "crossing-in");
  • in connection with the termination of the contract, any short party to the contract transfers the underlying security to any long party (i.e., there is a "crossing-out");
  • the underlying security is not "readily tradable on an established securities market"; or
  • in connection with entering into the contract, the underlying security is posted as collateral by any short party to the contract with any long party to the contract.5

While the categories of specified NPCs enumerated in the statute are relatively narrow, section 871(m) provided for the statutory categories to be temporary measures until the Treasury Department and the IRS determined which transactions lacked tax avoidance potential and thus deserved not to be classified as specified NPCs. The Treasury Department and the IRS worked to establish a more comprehensive method of clarifying transactions as specified NPCs and, on January 19, 2012, issued the first set of proposed regulations under section 871(m). The proposed regulations provided that an NPC would be considered a specified NPC if it fell into one of seven enumerated categories. Temporary regulations, which were issued at the same time and subsequently amended, provided that the statutory definition of a specified NPC under section 871(m)(3)(A) would apply to payments made on or before December 31, 2013.6

After numerous commentators expressed concerns that the seven categories in the 2012 proposed regulations were too difficult to implement in practice, the Treasury Department and the IRS withdrew the 2012 proposed regulations and released revised proposed regulations on December 4, 2013 (the "Proposed Regulations").7

The Proposed Regulations

The Proposed Regulations made several important changes and clarifications to the existing statutory regime, including:

  • broadening the definition of specified NPC to include any NPC8 with a fair market value correlation (i.e., a "delta") of 0.70 or greater with respect to an underlying security at the time the long party acquired the NPC;
  • expanding section 871(m) to apply to payments under certain equity-linked instruments ("ELIs," such as futures, forwards and options, referred to as "specified ELIs") to the extent that such derivatives had a delta of 0.70 or greater with respect to an underlying security at the time the long party acquired the ELI;
  • providing certain exceptions for transactions that had limited potential for tax avoidance, such as when the long party is a dealer; and
  • extending the application of section 871(m) to instruments that take into account estimated or implicit (rather than actual) dividends on the underlying security.

Final and Temporary Regulations

On September 17, 2015, the much anticipated new final regulations (the "Final Regulations") and temporary regulations (the "Temporary Regulations") under section 871(m) were issued. The Final Regulations generally preserve the delta standard and overall framework set forth in the Proposed Regulations, while increasing the delta threshold (as discussed below). The new regulations retain the delta test only for simple contracts, and instead use a "substantial equivalence" test (rather than a delta test) for complex contracts.

Simple Contracts

Like the Proposed Regulations, the Final Regulations define the term "dividend equivalent" to include any payment pursuant to a specified NPC or a specified ELI that references the payment of a dividend from an underlying security (i.e., security payments which may be considered US-source income).9 Unlike the Proposed Regulations, the Final Regulations divide NPCs and ELIs into "simple" and "complex" instruments and provide different texts for determining whether each type of instrument is a specified NPC or a specified ELI.

In response to concerns from commentators that delta was difficult or impossible to discern with respect to certain complicated derivative contracts (which are referred to as "complex contracts"), the Treasury Department and the IRS, based upon suggestions from certain financial institutions, developed a standard for determining when such complex contracts are subject to section 871(m).

As an initial matter, the Treasury Department and the IRS defined a "simple contract" (to which the delta standard applies) as an NPC or ELI that references a single, fixed number of shares of the underlying security and has a single maturity or exercise date when amounts due under the contract are required to be calculated.10 A "complex contract" (to which the delta standard does not apply) is defined as any NPC or ELI that is not a simple contract.11 Complex contracts are subject to the "substantial equivalence" test, discussed in detail below, rather than the delta test.

A simple contract that has a delta of 0.80 or greater with respect to an underlying security when the NPC is issued is a specified NPC or specified ELI.12

It is important to note that the definition of specified NPC and specified ELI described above apply only with respect to transactions and payments that occur after the dates specified in the detailed effective date provision of the Final Regulations or Temporary Regulations (which are described below). All other instruments are subject to the existing statutory framework under section 871(m).

Calculation of Delta

The Final Regulations, like the Proposed Regulations, define the delta of a contract generally as 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 by the contract.13

The Final Regulations clarify, however, that the delta ratio is intended to measure the change in the fair market value of the contract to a small change in the fair market value of the underlying property referenced by the contract,14 and the preamble to the Final Regulations (the "Preamble") explains that a small change is typically a change of less than 1 percent.15

Delta Threshold

As noted above, the Final Regulations increase the delta threshold for specified NPC or specified ELI treatment to 0.80 from 0.70, thereby requiring closer economic correlation between the contract and the underlying securities than the Proposed Regulations.16 The Preamble explains that the Treasury Department and the IRS recognized that a delta threshold of 0.70 could cause section 871(m) to apply to contracts that are not economically similar enough to the underlying security.17 Although some commentators had suggested a delta threshold of 0.90, the Treasury Department and the IRS believed that such a high delta threshold would allow certain contracts that are "surrogates" for owning the underlying security, such as deep-in-the-money options, to escape withholding tax under section 871(m).18

Time for Testing Delta

Unlike the Proposed Regulations (which would have tested delta each time an instrument was acquired and each time a dividend on an underlying security was paid), the Final Regulations provide that the delta of a contract is tested only at the issuance of the contract.19 This change responded to comments on the difficulty associated with determining a contract's delta every time the contract is purchased or otherwise acquired in the secondary market.20 A contract is considered "issued" at inception, original issuance or at the time of an issuance pursuant to a section 1001 deemed exchange.21

While this change is a welcome simplification, we note that given the manner in which listed options are traded, each acquisition of a listed option appears to be considered a separate "issuance" for this purpose, such that the delta for a listed option may need to be calculated each time the option is acquired. It is unclear whether the disparate treatment of listed options and other types of derivatives was intended.

One issue that arises with respect to the issuance date rule is how to apply the issuance date rule to a basket contract that is issued prior to January 1, 2016, but provides the holder of the contract the right to change the components of the basket during its term. While not entirely clear, there is some risk that a deemed exchange of such contract for a new contract will be deemed to occur each time the holder changes one or more assets in the basket. If a deemed exchange were to occur, the contract would be treated as reissued for purposes of determining the delta of the contract. Any such deemed exchange would also be relevant for purposes of determining how the effective date rule applies.

A similar issue may arise in the context of certain issuances of structured notes. For example, assume that an issuer creates a class of structured notes, but issues less than all of the notes and retains the rest of such class. If the issuer later issues more notes from such class, the delta of such notes (or, if such notes are complex contracts, the application of the substantial equivalence test to the notes) would presumably need to be re-tested. Further, if subsequently issued notes had different consequences under section 871(m) than the originally issued notes, then the subsequently issued notes would likely need to be given a different CUSIP or identifying number.

Shorthand Method for Testing Delta

In response to comments requesting a simplified method for determining delta in certain circumstances, the Final Regulations provide that if:

  • a short party issues a simple contract that references a basket of ten or more securities,
  • the short party uses an exchange-traded security (such as the stock of an exchange-traded fund) to hedge its exposure under the contract, and
  • the exchange-traded security references substantially the same securities that are referenced in the contract,  then the short party may determine the contract's delta using the exchange-traded security.22

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1 I.R.C. §§ 871 and 881.

2  Treas. Reg. § 1.863-7(b)(1). This sourcing rule has been in effect since 1991.

3  The relevant provision was enacted as section 871(l), but was subsequently redesignated as section 871(m) pursuant to P.L. 111-226, § 217(b)(2).

4  I.R.C. § 871(m)(2)(B). Section 871(m) also applies to substitute dividend payments made under certain securities lending and sale-repurchase transactions. I.R.C. § 871(m)(2)(A).

5  Treas. Reg. § 1.871-15(d)(1).

6  T.D. 9572, 26 C.F.R. Part 1; REG-120282-10. See our prior client publication dated January 23, 2012 entitled "Temporary and Proposed Regulations Regarding US Withholding Tax on Certain Equity Swap Payments" available at www.shearman.com in the Tax practice area.

7 In addition, the Treasury Department and the IRS released final regulations that continued the existing regime of section 871(m)(3)(A) for any payments made on or prior to December 31, 2015. T.D. 9648, 26 C.F.R. Part 1; REG-120282-10, 26 C.F.R. Part 1. See our prior client publication dated December 6, 2013 entitled "New Proposed Regulations Under Section 871(m) Adopt a Single Factor Test but Delay Effective Date Until 2016" available at www.shearman.com in the Tax practice area.

8 For purposes of section 871(m), an NPC is defined as set forth in Treas. Reg. § 1.446-3(c).

9 Treas. Reg. § 1.871-15(c)(1).

10 Treas. Reg. § 1.871-15(a)(14)(i).

11 Treas. Reg. § 1.871-15(a)(14)(ii)(A).

12 Treas. Reg. § 1.871-15(d)(1); -15(e)(1).

13 Prop. Reg. § 1.871-15(g)(1). If an NPC or ELI contained more than one reference to a single underlying security, all references to that underlying security would be taken into account in determining the instrument's delta.

14 Treas. Reg. § 1.871-15(g)(1).

15 Preamble at 9.

16 Treas. Reg. §§ 1.871-15(d)(2)(i), (e)(1).

17 Preamble at 8.

18 Preamble at 8-9.

19 Treas. Reg. § 1.871-15(g)(2).

20 Preamble at 10.

21 Treas. Reg. § 1.871-15(a)(6).

22 Treas. Reg. § 1.871-15(g)(3).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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