On September 20, 2018, the US Internal Revenue Service ("IRS") released Notice 2018-72 (the "Notice"),1 which further extends the phase-in of regulations under Section 871(m) of the Code2 (the "Regulations")3 and related provisions. Section 871(m) and its regulations generally treat "dividend equivalents" paid (or deemed paid) under certain contracts as US source dividends that are subject to withholding tax if paid to a non-US person.
Prior to the release of the Notice, the IRS had issued the following guidance on the Regulations:
- Notice 2010-46 containing the qualified securities lender ("QSL") regime, published in June 2010;
- Notice 2016-76 delaying the effective date of the Regulations, among other things, published in December 2016 and its corresponding final and temporary regulations published in January 2017;4
- Revenue Procedure 2017-15 containing the final Qualified Intermediary Agreement (the "2017 QI Agreement"), published in January 2017; and
- IRS Notice 2017-42 providing a similar phase-in of the Regulations and related provisions, published in August 2017.
The Notice provides for extensions to four areas related to Section 871(m): (1) the phase-in for non-delta-one transactions, (2) the simplified standard for determining whether transactions are "combined transactions" within the meaning of the Regulations, (3) relief for qualified derivatives dealer ("QDD") reporting5 and (4) the transition out of the qualified securities lender (the "QSL") regime. Each of these extensions is discussed in more detail below.
Extension of Phase-In for Delta-One and Non-Delta-One Transactions
Under previous IRS guidance, the Regulations would not apply to potential Section 871(m) transactions6 that were not delta-one and that were entered into before January 1, 2019. The Notice extends this relief for non-delta-one transactions to cover transactions entered into before January 1, 2021.7 This two-year extension is welcomed by the structured products market since a majority of structured products are non-delta-one transactions.
The Regulations still apply to any potential Section 871(m) transaction that has a delta of one entered into on or after January 1, 2017.
Previous IRS guidance provided that 2017 and 2018 would be phase-in years for delta-one transactions, meaning that the IRS would take into account a taxpayer's or withholding agent's good faith effort8 to comply with the Regulations when enforcing the same. Prior guidance also provided that in 2019 non-delta-one transactions would be reviewed on this good faith standard. The Notice extends this more lenient enforcement standard through 2020 for delta-one transactions and provides that examinations of non-delta-one transactions will use the good faith standard through 2021. Additionally, previous IRS guidance provided that the IRS would take into account the extent to which a qualified derivatives dealer made a good faith effort to comply with the Regulations and the relevant provisions of the 2017 QI Agreement through 2018. The Notice extends this similar good faith enforcement standard through 2020.
Extension of the Simplified Standard for Determining Whether Transactions Are Combined Transactions
IRS guidance provides for a simplified standard for withholding agents to apply in determining whether two or more transactions should be combined in order to determine whether the transactions are subject to Section 871(m), namely that a broker may presume that transactions should not be combined for Section 871(m) purposes unless they are over-the-counter transactions that are priced, marketed or sold in connection with each other. Under the general rule in the Regulations, a short party could have presumed that transactions that together generate the required dividend equivalent payments are not entered into in connection with each other if either (i) the long party holds the transaction in separate accounts and the short party does not have actual knowledge that the accounts were created separately to avoid Section 871(m), or (ii) the transactions were entered into two or more business days apart. IRS guidance provided a simplified standard for 2017 and 2018. The Notice extends application of the simplified standard to 2020.
Extension of Phase-Ins for QDDs
The Notice extends the same three QDD phase-ins that were pushed until 2019 by prior IRS guidance. Previous IRS guidance provided that a QDD:
- Will not be subject to tax on dividends and dividend equivalents received in the QDD's equity derivatives dealer capacity until 2019;
- Will be required to compute its Section 871(m) tax liability using a net delta approach beginning January 1, 2019; and
- Pursuant to the 2017 QI Agreement, must perform certain periodic reviews with respect to its QDD activities but only beginning in 2019.
The Notice pushes each of these dates back to begin in 2021.
Extension of QSL Transition Rules
Notice 2010-46 contained an early IRS solution to potential overwithholding on a chain of dividends and dividend equivalents (i.e., where an intermediary is withheld upon and subsequently withholds on the same payment stream). The QSL regime provides for (1) an exception to withholding for payments to a QSL and (2) a framework to credit forward prior withholding on a chain of dividends and dividend equivalents. The QDD rules were meant to replace the QSL regime; however, IRS guidance provided that withholding agents may use the QSL rules for payments made in 2018 and 2019. The Notice provides that withholding agents can use the QSL rules for payments made in 2020 as well.
Whispers have been in the wind for much of 2018 about a potential extension of the phase-in for the Section 871(m) regulations. Some in the tax community wondered whether non-delta-one transactions could become exempt from the Regulations completely. With extensions to 2021 across the board, and Treasury focused on implementing tax reform, Section 871(m) and its regulations may go on the back burner for the immediate future. The Notice states that taxpayers are permitted to rely on it until the Regulations and the 2017 QI Agreement are amended to reflect the extensions contained in the Notice.
1 Notice 2018-72 is available at https://www.irs.gov/pub/irs-drop/n-18-72.pdf.
3 For a more detailed discussion of the 2015 final regulations, see " IRS Releases Final & Temporary HIRE Act Regulations Addressing Section 871(m) Dividend Equivalents."
4 For a more detailed discussion of Notice 2016-76, see "Stress Relief: IRS Notice 2016-76 Eases the Implementation Rules for Cross-Border Dividend Equivalent Withholding."
5 For a more detailed discussion of the QDD rules, see "I Have Always Been Afraid of Banks: the IRS Revamps Cross-Border Dividend Equivalent Rules on President Obama's Last Day in Office."
6 See Treas. Reg. Section 1.871-15(a)(12). A "potential Section 871(m) transaction" is any securities-lending or sale-repurchase transaction, NPC or ELI that references one or more underlying securities.
8 Relevant considerations for the determination of good faith include whether a taxpayer or withholding agent made a good faith effort to (i) build or update its documentation and withholding systems to comply with the Section 871(m) regulations, (ii) determine whether transactions are combined, (iii) report information required under the Section 871(m) regulations and (iv) implement the substantial equivalence test. See Notice 2016-76.
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