United States: New 871(M) Regulations Finalize Dividend Equivalent Payment Withholding Rules For Equity Derivatives

Introduction

On September 17, 2015, the IRS and the Treasury Department issued final, temporary, and proposed regulations under section 871(m) of the Internal Revenue Code (collectively, the "new regulations") that provide the rules for withholding on "dividend equivalent payments" on derivatives that reference U.S. equity securities.¹ In general, the rules narrow the class of derivatives that would have been subject to withholding under the proposed regulations issued in 2013 (the "2013 proposed regulations").²  For example, under the new regulations, a "simple contract" is not subject to withholding unless its delta is 0.80 or more whereas, under the 2013 proposed regulations, withholding would have been imposed if the delta was at least 0.70.³ However, the new regulations still require withholding on "price return only" derivatives that do not provide for payments that reference dividends.⁴

In addition, the new regulations delay the effective date that would have applied under the 2013 proposed regulations. Under the new regulations, withholding is imposed on equity derivatives issued after 2015 that are still outstanding in 2018, and on all equity derivatives issued after 2016.⁵ The 2013 proposed regulations generally would have applied to all payments made on an equity derivative after 2015, regardless of when the derivative was entered into.

Some of the most important aspects of the new regulations are:

• Higher delta threshold of 0.80.  As mentioned above, the new regulations increase the delta threshold for a "simple" contract to determine whether an equity derivative is subject to withholding to 0.80, from 0.70 in the 2013 proposed regulations.⁶ A simple contract is a derivative for which payments are calculated by reference to a single, fixed number of shares that can be ascertained when the derivative is issued, and that has a single maturity or exercise date with respect to which all amounts (other than any upfront payment or any periodic prepayments) are required to be calculated with respect to the underlying security.⁷
• Special rules for complex contracts.  The new regulations do not apply the 0.80 delta test to "complex contract" (i.e., all derivatives other than simple contracts).  Instead, the new regulations adopt a "substantial equivalence" test that compares the change in value of a complex contract with the change in value of the shares of the equity security that would be held to hedge the derivative over an increase or decrease in the price of the equity security by one standard deviation.⁸ If the proportionate difference between (1) the change in value of the complex contract and the change in value of its hedge is no greater than (2) the change in value of a benchmark simple contract with respect to the same shares with a delta of 0.80 and the change in value of its hedge, then the complex contract is substantially equivalent to the underlying security and dividend equivalent payments with respect to it are subject to withholding.⁹
• Day-one delta test.  The new regulations test a derivative's delta (or substantial equivalence) at initial issuance.¹⁰ By contrast, the 2013 proposed regulations generally tested a derivative's delta each time a foreigner acquired the derivative and each time a dividend was paid or (in the case of short-term derivatives) the derivative was disposed of.  The day-one delta test makes it much easier for taxpayers to identify derivatives subject to withholding.
• Convertible debt instruments.  Although the new regulations apply to convertible debt instruments (as did the 2013 proposed regulations), the combination of the increased 0.80 delta threshold and the day-one delta test will have the effect of exempting most traditional convertible debt instruments because they generally have deltas lower than 0.80 upon issuance.
• Withholding on price return only derivatives.  As mentioned above, the new regulations retain the rule in the 2013 proposed regulations that requires withholding on an equity derivative that satisfies the 0.80 delta test or the substantial equivalence test even if the derivative does not provide for payments based on dividends, on the theory that dividend payments are implicit even in a contract that does not provide for them. ¹¹ As discussed below, we believe that this rule continues to present statutory authority and tax treaty issues.
• Simplified rules for determining the amount of a dividend equivalent payment subject to withholding.   Under the 2013 proposed regulations, the amount of the dividend equivalent payment subject to withholding was equal to the per share dividend amount with respect to the underlying security, multiplied by the number of shares of the underlying security referenced in the contract, multiplied by the delta at the time the dividend equivalent was determined.  Determining the delta each time the dividend equivalent is determined would have been particularly difficult as an administrative matter.  The new regulations require delta to be determined only at the time a derivative is issued.¹²
• Withholding on short-term options.  The new regulations impose withholding on an equity option with a delta of 0.80 or more, even if the option has a term of one year or less and is not exercised.  The 2013 proposed regulations did not require withholding on lapsed short-term options.
• Presumptions for combined transactions.  The 2013 proposed regulations required a withholding agent to withhold on an equity derivative that failed the delta test if, after using "reasonable diligence," the withholding agent concluded that the derivative had been entered into "in connection with" another derivative and, when combined, the derivatives satisfied the delta test.  The new regulations retain this rule, ¹³ but add two helpful presumptions for short-party brokers.  First, a short-party broker may presume that transactions are not entered into in connection with each other if the long party holds the transactions in separate accounts, so long as the broker does not have actual knowledge that the long party used the separate accounts to avoid section 871(m) or that the transactions were entered into in connection with each other. ¹⁴ Second, a short-party broker may presume that transactions are not entered into in connection with each other if they are entered into at least two business days apart, so long as the broker does not have actual knowledge that the transactions were entered into in connection with each other.¹⁵ These presumptions do not apply to long parties;¹⁶ thus, all transactions that are entered into in connection with each other are combined for purposes of determining whether a long party is subject to tax under section 871(m), but, if the short party benefits from a presumption, this tax may not be collected through withholding.
• Qualified indices.  Derivatives that reference a "qualified index" are not subject to withholding under section 871(m).¹⁷ The new regulations test whether an index is a qualified index on the first business day of the calendar year in which a derivative is issued, whereas the 2013 proposed regulations generally required testing each time a foreigner acquired the derivative.¹⁸ The new regulations generally retain the definition of "qualified index."  However, the new regulations remove the requirement in the 2013 proposed regulations that any rebalancings of the index to be based on objective rules, thereby permitting the S&P 500 Index and other major stock indices that rebalance based on subjective criteria to qualify as qualified indices.¹⁹ The new regulations also allow indices to qualify as qualified indices if they are referenced by futures or option contracts that trade on certain foreign exchanges or boards of trade if U.S. stock comprises less than 50% of their weighting.²⁰ The 2013 proposed regulations required an index to be referenced by futures or options contracts that trade on a domestic securities exchange or board of trade.
• No withholding until payment or settlement.  The new regulations do not require a short party to withhold on a foreign long party until a payment is made under the derivative or there is a final settlement of the derivative.²¹ This rule is less burdensome than the analogous rule in the 2013 proposed regulations, which would have required brokers to withhold and remit tax on dividend equivalent payments during the term of the derivative, even if no payments were made.  However, the new regulations (like the 2013 proposed regulations) require withholding on a final settlement (including a lapse of an option) even if the withholding agent is not required to make a payment to the foreign counterparty. ²²
• No constant delta rule.  The new regulations eliminate the rule under the 2013 proposed regulations under which a derivative that was expected to have a constant delta was treated as having a delta of 1.0 with respect to an adjusted number of shares.  Thus, for example, dividend equivalent payments on a swap that references 100 shares of IBM and has a constant delta of 0.50 generally will not be subject to withholding under the new regulations, whereas the 2013 proposed regulations would have treated this swap as referencing 50 shares of IBM and having a delta of 1.0.
• No withholding on qualified derivatives dealers.  To reduce the potential for multiple withholdings on a single stream of dividends, the new regulations allow foreign securities dealers and foreign banks to avoid being subject to withholding on dividends and dividend equivalent payments by agreeing to assume primary withholding and reporting responsibility when they pass those amounts through to customers.²³
• Delayed effective date.  As mentioned above, under the new regulations, withholding is required on equity derivatives issued after 2015 that are still outstanding in 2018, and on all equity derivatives issued after 2016.²⁴ The 2013 proposed regulations generally would have applied to all payments made on an equity derivative after 2015 regardless of when the derivative was entered into.

Part II of this memorandum discusses the history and purpose of section 871(m).  Part III discusses the new regulations.

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Footnotes

1 Treasury Decision 9734 (September 17, 2015).

All references to section numbers are to the Internal Revenue Code of 1986, as amended (the “Code”), or to Treasury regulations promulgated thereunder.

2 We discussed the 2013 proposed regulations in a previous Clients and Friends Memo, which is available at http://www.cadwalader.com/resources/clients-friends-memos/final-and-proposed-regulations-address-us-witholding-tax-on-dividend-equivalent-payments.

3 Treasury regulations section 1.871-15(e)(1).

4 Treasury regulations section 1.871-15(i)(2)(ii).

5 Treasury regulations section 1.871-15(r)(3).

6 Treasury regulations sections 1.871-15(d)(2)(i), (e)(1).

7 Treasury regulations section 1.871-15(a)(14)(i).

8 Temporary Treasury regulations section 1.871-15T(h).

9 Temporary Treasury regulations section 1.871-15T(h)(1).

10 Treasury regulations section 1.871-15(g)(2) (delta); Temporary Treasury regulations section 1.871-15T(h)(1) (substantial equivalence).

11 Treasury regulations section 1.871-15(i)(2)(ii).

12 Treasury regulations section 1.871-15(g)(2).

13 Treasury regulations section 1.871-15(n)(1).

14 Treasury regulations section 1.871-15(n)(3)(i).

15 Treasury regulations section 1.871-15(n)(3)(ii).

16 Treasury regulations section 1.871-15(n)(5)(ii).

17 Treasury regulations section 1.871-15(l)(2).

18 Treasury regulations section 1.871-15(l)(2).

19 Treasury regulations section 1.871-15(l)(3)(v).

20 Treasury regulations section 1.871-15(l)(3)(vii)(B).

21 Treasury regulations section 1.1441-2(e)(8).

22 Treasury regulations section 1.1441-2(e)(8)(ii)(C).

23 Temporary Treasury regulations section 1.871-15T(q).

24 Treasury regulations section 1.871-15(r)(3).

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