On December 5, the U.S. Treasury reproposed the Section 871(m)
regulations with a new standard for determining which
dividend-related payments on equity derivative transactions with
non-U.S. counterparties are subject to U.S. withholding. The new
proposed regulations would apply a more objective approach than the
first regulations proposed in January 2012, the withdrawal of which
was announced by the Treasury in January 2013. The new regulations
would apply to some transactions not covered by the 2012 proposed
regulations and would apply to considerably more transactions than
were covered by Section 871(m) when it was enacted in 2010. The new
proposed regulations utilize a test based on the "delta"
or price change of an equity derivative relative to the underlying
stock. This is a major change from the list of seven types of
prohibited derivatives (the so-called "seven deadly
sins") that was the basis of the 2012 regulations. The new
regulations are proposed to be effective only for payments on
equity derivatives made on or after January 1, 2016, a substantial
Treasury concession since the earlier proposed rules would have
been effective January 1, 2014. There is, however, no
"grandfather" or other transition rule for transactions
entered into earlier; accordingly, all payments made on or after
January 1, 2016 would be covered.
Section 871(m) was added to the Internal Revenue Code by the 2010
Hiring Incentives to Restore Employment ("HIRE") Act to
deal with the perceived problem that payments related to dividends
on U.S. stock made to non-U.S. counterparties on equity derivatives
could be made free of U.S. withholding tax. This was contrasted to
the situation of the non-U.S. holder owning the underlying U.S.
stock directly, where withholding would be due on the dividends at
30 percent (or a lower treaty rate). Section 871(m) applies to
"dividend equivalents," which include dividend-related
payments on specified notional principal contracts (which include
many equity swaps), on repos and securities lending transactions,
and other payments determined to be "substantially
similar" by the Treasury.
The statute itself specifies four types of "specified
notional principal contracts," including equity swaps where
the long party transfers the underlying stock to the short party at
the commencement of the swap and where the short party either posts
the underlying stock as collateral or transfers the stock upon
termination of the swap. The earlier proposed regulations
supplemented this list with seven additional cases, which came to
be known as the "deadly sins." These were widely
criticized as overly broad and difficult to administer. For
example, many market participants objected to the prohibition on
the long party being "in the market" on the day or days
the contract was priced or terminated.
Like the 2012 regulations, the new regulations would impose
withholding on a broad range of equity derivative trades, including
many more than were covered by the statute as enacted in 2010. And
the approach of the new regulations is now one of economic
similarity between the contract and the underlying stock. Where an
equity notional principal contract (including most equity swap
transactions) at the time it is entered into has a
"delta" of 0.7 or greater with respect to the underlying
stock, the dividend-related payments become subject to withholding.
Where this delta is less than 1.0 but greater than 0.7 (measured at
the time of the dividend), the amount subject to withholding is
reduced on a pro rata basis. The withholding rate will be 30
percent, subject to reduction under any U.S. tax treaty that would
be applicable to the dividends. Where the contract references more
than one stock, withholding applies only with respect to the
dividend payments on the stock or stocks with respect to which the
swap has a delta of 0.7 or greater. Where the contract has a delta
with respect to the underlying stock that can be predicted to be
constant over the transaction term (e.g., always be exactly 0.5),
the dividend-related payments are, in effect, automatically subject
to withholding.
In a change from the earlier proposal, payments based on estimates
of dividends would be subject to withholding, even if the estimate
is not adjusted based on the actual dividend payment. The new
regulations contain an example of a "price only" swap
where a non-U.S. counterparty receives the appreciation on the
underlying shares at maturity, pays any depreciation at maturity,
and pays a LIBOR-based rate over the term of the contract that is
reduced to take into account expected annual dividends. The example
holds that, although the estimated dividend payments are not
specified in the contract, they are still subject to withholding
(generally in the amount of the actual dividends).
The rules on "equity-linked instruments" are expanded to
parallel the new rules on notional principal contracts (above). An
equity-linked instrument is defined as a futures contract, forward
contract, option, debt instrument, or other contractual arrangement
that references the value of one or more underlying stocks. Where
the equity-linked instrument has a delta with respect to the
underlying stock of 0.7 or greater, any dividend-related payments
are subject to the withholding rules. This 0.7 delta standard could
bring in transactions that most market participants did not think
were or should be subject to Section 871(m) withholding, like some
"out-of-the-money" options. Generally, the other rules
described above would also apply (such as where an equity-linked
instrument has a constant delta with respect to the stock or
relates to more than one stock). It also appears that equity-linked
instruments are subject to the rules above for estimated dividend
payments that are not specified in the contract—for example,
a single-stock future that is priced using estimated dividends
could be subject to withholding under this rule.
In addition, the new proposal provides an exception from
withholding for certain traded indices, derivatives in which are
not treated as subject to the rules (even if the delta tests are
met). To qualify, an index must reference 25 or more stocks (none
of which represents more than 10 percent of the weighting), must
not provide a dividend yield greater than 1.5 times the dividend
yield of the S&P 500 index, and must meet other requirements.
Other rules allow the IRS to combine transactions of one long party
(or related parties) in a single underlying stock, where the effect
is to make the combined transaction subject to withholding under
the rules. Under an "anti-abuse" rule, the IRS also has
the authority to subject an equity derivative to these rules where
it has been structured with "a principal purpose" to
avoid them.
As for determining the delta, it is the broker or dealer that must
calculate this number and report to the customer the amount of any
withholdable dividend equivalents. This imposes a large
responsibility for providing information and ensuring that
information is correct. It may also give rise to disputes with the
IRS.
Once again, the new rules would take effect only for payments on
or after January 1, 2016, allowing taxpayers a significant period
to comment on the proposed rules and then to plan their
implementation and adjust systems accordingly. As a result, the
current "interim" final regulations, effectively applying
Section 871(m) only to transactions described in the statute, are
extended until January 1, 2016. Comments on the new proposal are
due by March 5, 2014, with a hearing scheduled for April 11,
2014.
We will continue to monitor developments under Section 871(m) and
will apprise you of significant developments. In the interim,
please contact one of the Jones Day lawyers listed below with any
specific inquiries.
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.