United States: An Overview Of The Substantial Equivalence Test Under Internal Revenue Code Section 871(M)

Last Updated: February 9 2017
Article by Derivatives In Review

Internal Revenue Code Section 871(m) and the regulations thereunder treat "dividend equivalent payments" on certain equity derivatives as dividends from sources within the United States.1, 2 That is, federal withholding tax applies to such payments made to non-U.S. parties.3

More specifically, the 871(m) regulations generally impose U.S. withholding tax on equity derivatives that reference one or more U.S. equities and that (i) have a delta greater than or equal to 0.8 (if the derivative is a "simple contract," as explained below) or (ii) fail a "substantial equivalence test" (if the derivative is a "complex contract," as explained below).4

A simple contract is, essentially, an equity derivative that has (i) a single, fixed number of shares of the underlying asset and (ii) a single exercise or maturity date.5 A complex contract is, essentially, an equity derivative that is not a simple contract and, therefore, for which computing delta would be conceptually problematic, thus requiring application of the substantial equivalent test ("SET").

Regarding the SET, the preamble to 2017 Release provides the following very high-level description:

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 by one standard deviation 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 when 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 to 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. When the steps of the substantial equivalence test cannot be applied to a particular complex contract, a taxpayer must use the principles of the substantial equivalence test to reasonably determine whether the complex contract is a section 871(m) transaction with respect to each underlying security.6

The SET is described in greater detail below. The SET is considerably more elaborate than the 0.8 delta test and involves a degree of mathematical and statistical complexity uncharacteristic of the tax laws. This article attempts to provide a brief, but comprehensible overview of the SET.

Simple Contracts and Measuring Delta

Before turning to the SET, a brief discussion of measuring delta for simple contracts is in order. As an example of a simple contract, the graph below depicts a vanilla call option. The black line represents payoff at maturity and the green line represents the fair market value of the call option at issuance. As reflected in the graph, the green line becomes increasingly steep as the spot price increases. At very low spot prices, the slope of the green line is nearly 0; at such levels, a small increase in the spot price of, for example, $1 results in a change in the payoff of little more than $0. Accordingly, the delta in such a case is approximately $0 / $1 = 0. By contrast, at very high spot prices, the slope of the green line is nearly 1; an increase in the spot price of $1 results in an increase in the payoff of a little less than $1. Accordingly, the delta in such a case is approximately $1 / $1 = 1. Between those two extremes, at a spot price of $100 (the "at-the-money" spot price), the delta is approximately $0.50 / $1 = 0.5.

Complex Contracts and Applying the SET

The applicable regulations generally define "complex contract" as any derivative that references one or more U.S. equities but that is not a simple contract.7 Depending on the type of complex contract, various conceptual problems may preclude application of the 0.8 delta test. For example, holding a structured note that provides a 200% possible upside return and a 100% possible downside return is economically equivalent to being long two call options and short one put option. In calculating the delta for such a structured note, it is unclear whether the denominator component of the delta ratio should equal a small change in one share of the underlying asset or a small change in two shares of the underlying asset. The component of the structured note consisting of two long call options implies that two is the appropriate number, whereas the component consisting of one short put option implies that one is the appropriate number. Other types of complex contracts, including digital options or structured notes with knock-in or knock-out features, present similar problems for measuring delta.

To understand the rationale for the SET, assume that a non-U.S. investor wishes to purchase and receive dividends on a U.S. equity security. To do so, the investor could directly purchase the desired amount of the U.S. equity security ("strategy A"). Alternatively, the investor could enter into a derivative that was economically comparable to strategy A ("strategy B").

For small changes in the price of the U.S. equity security, the payoff of strategy A would be essentially the same as the payoff of strategy B. However, for larger changes in price of the U.S. equity security, the two payoffs could differ substantially, in which case the investor would be more likely to conclude that strategy B is not an acceptable alternative to strategy A.

As illustrated in the graph below, the SET examines the difference between strategy A and strategy B given probable changes in the price of the underlying asset. The graph depicts a structured note that is equivalent to being long an "up-and-out" call option (i.e., a call option ceases to exist if the price of the underlying asset increases beyond a specified price) and short a "down-and-in" put option (i.e., a put option that exists only if the price of the underlying asset decreases beyond a specified price). The solid black line represents the payoff of the complex contract at maturity. The green line represents the payoff of the complex contract at issuance. The dashed line represents the payoff of the initial hedge of the complex contract.8 Because of its hedging function, the initial hedge should resemble Strategy A and involve the same number of shares that would be purchased in Strategy A.

The difference between the value of the complex contract at issuance and the value of the initial hedge is represented by the two red lines. The red lines are placed one standard deviation below and one standard deviation above the spot price of the underlying equity security at issuance of the complex contract.9 Because the dashed lined indicates the values of strategy A and the green line indicates the values of strategy B, shorter red lines imply greater equivalence between the two strategies.

The lengths of the red lines are then multiplied by the probabilities that the price will increase or decrease, as applicable, from the spot price at issuance. Those numbers are then added together and divided by the number of shares of the underlying asset used in the initial hedge. These adjustments produce a single number that will be appropriately scaled to be compared against the corresponding number for the benchmark instrument, as described below.

The SET then similarly examines a "benchmark instrument," defined as:

. . . an actual or hypothetical simple contract that, at the calculation time for the complex contract, has a delta of 0.8, references the applicable underlying security referenced by the complex contract, and has terms that are consistent with all the material terms of the complex contract, including the maturity date. If an actual simple contract does not exist, the taxpayer must create a hypothetical simple contract. Depending on the complex contract, the simple contract benchmark might be, for example, a call option, a put option, or a collar.10

Given the terms of the complex contract in this case, a call option is the appropriate benchmark instrument. In the graph below, the solid black line represents the payoff of the call option at maturity, the green line represents the payoff of the call option at issuance, and the dashed line represents the payoff of the initial hedge of the call option.

The SET compares the payoff of the call option at issuance to the payoff of the initial hedge, in the same manner as for the complex contract and its initial hedge, as described above. Again, the lengths of the red arrows are multiplied by the relevant probabilities, and then added together, and then divided by the number of shares of the underlying asset used in the initial hedge.

Because the benchmark instrument has a delta of 0.8, this final number for the benchmark instrument can be understood as a threshold that is derived from the 0.8 delta test for simple contracts. Accordingly, if the final number for the complex contract exceeds the final number for the benchmark instrument, the complex contract "passes" the SET and is not treated as an 871(m) transaction.

The regulations under 871(m) provide a detailed numerical example the SET, which is provided in the box below in full.11 The example presents a SET analysis for a complex contract that fails the SET. In the example, the absolute values of the differences between the change in value of the initial hedge and the complex contract at the two testing prices (i.e., one standard deviation up and one standard deviation down) are $720 and $244. In the graphical approach taken above, these amounts would be represented by the red arrows in the graph relating to the complex contract and its initial hedge. After multiplying those amounts by the relevant probabilities, and then summing the amounts together and dividing by the number of shares that constitute the initial hedge, the ultimate calculation is 7.68. The equivalent calculation for the benchmark instrument is 4.473. Because 7.68 exceeds 4.473, the complex contract fails the SET and will not be subject to the 871(m) withholding requirements. The numerical example can be read in light of the conceptual background provided in this article.



Footnotes

1 The graphical approach taken in this article is based on a presentation by Richard Maile at the International Fiscal Association USA New York Region Fall Seminar on December 7, 2015. Section 871(m) regulations have been discussed in previous Derivatives in Review postings (available here, here, and here).

2 The Section 871(m) regulations apply to delta-one transactions issued on or after January 1, 2017 and will apply to non-delta-one transactions issued on or after January 1, 2018. See Dividend Equivalents from Sources Within the United States, 82 Fed. Reg. 8,144, 8,154-55 (January 24, 2017) (the "2017 Release").

3 For some time, parties to ISDA Master Agreements and other derivatives trading agreements have included a provision incorporating the ISDA 2015 Section 871(m) Protocol. By incorporating this Protocol, the parties agree to allocate the risk of withholding tax under Section 871(m) to the long party to any transaction entered into on or after January 1, 2016.

4 Generally, delta is the ratio of the change in the fair market value of the derivative to a small change in the fair market value of the number of shares of the underlying security.

5 § 1.871–15(a)(14)(i).

6 2017 Release at 8,147.

7 § 1.871–15(a)(14)(ii).

8 An initial hedge is the number of shares of the underlying security that a short party would need to fully hedge the derivative at issuance (even if the short party does not in fact fully hedge the derivative). More intuitively, the number of shares in the initial hedge determines the slope of the dashed line in the graph above (with more shares causing a steeper dashed line). The appropriate initial hedge will create a dashed line that approximates the slope of the fair market value of the derivative (i.e., the green line) at and around the spot price at issuance (which, in this example, is $10).

9 Standard deviation measures the variation of the price of the underlying asset based on its past behavior. A one standard deviation increase or decrease in the spot price constitutes a significant but not improbably large change, based on past prices of the underlying asset.

10 § 1.871–15(h)(2).

11 § 1.871–15(h)(7).

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.

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.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
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
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). 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 & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd 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 or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.