On January 19, 2017, the Internal Revenue Service (the "IRS") issued final, temporary, and proposed 1 regulations (the "Regulations") under section 871(m) of the Internal Revenue Code of 1986, as amended (the "Code"). Code section 871(m) imposes withholding tax on U.S. source "dividend equivalent" payments made on certain derivative financial products, including notional principal contracts ("NPCs"), equity linked instruments ("ELIs"), and sales-repurchase agreements. The Regulations serve to both clarify and codify much of the official and regulatory guidance issued under Code section 871(m) since 2012, the most recent of which was released on December 2, 2016 under Notice 2016-76 (the "Notice") (see prior client alert here). The Regulations are effective as of January 19, 2017; although there initially was uncertainty over whether the Regulations were currently in force due to an executive order issued by the Trump Administration on January 20, 2017, which imposes a moratorium on certain recently promulgated regulations. The position of the IRS, however, is that the Regulations are unaffected by the moratorium and that the Regulations are in force and effective as of January 19. To date, the Trump administration has not challenged this position.
The Regulations incorporate many, but not all, of the provisions in the Notice. However, the Notice itself remains in effect to the extent not inconsistent with the Regulations.
Most notably, the Regulations:
- Revise the definition of a dividend to include deemed dividends
- Revise the determination of a transaction as a "simple contract" in the case of certain corporate actions, such as a merger, stock split, or cash dividend
- Change the applicable date for determining a simple contract's "delta" or for performing the substantial equivalence test for a complex contract to be the earlier of the pricing date and the issuance date
- Clarify the determination date for dividend equivalent amounts to provide conformity between the initial determination of the dividend equivalent amount and the amount ultimately subject to withholding
- As in the Notice, postpone the implementation of the Code section 871(m) regulations with respect to non-delta one transactions until January 1, 2018
Implementation of Notice 2016-76
Certain aspects of Notice 2016-76 have been implemented in the Regulations, with a few modifications. These include the following:
Delayed Implementation for Non-Delta One and Complex Contracts
The Regulations adopt the Notice's "phased-in" approach with respect to non-delta one NPCs and ELIs, under which the Code section 871(m) regulations would not apply to payments made on such contracts until January 1, 2018. This approach reflects recognition that taxpayers may need additional time to implement the provisions of the Notice and to make systems operational.
Delayed Implementation for Certain Exchange Traded Notes
The Notice identified certain specific exchange-traded notes issued on or after January 1, 2017, the payments with respect to which would be exempt from Code section 871(m) until on or after January 1, 2020. The Regulations codify this exemption, and explicitly refer to the Notice for the list of applicable exchange-traded notes.
Net Delta Computation for QDD Section 871(m) Amount
The Regulations codify certain rules applying to qualified derivatives dealers ("QDD") as described in the Notice. The Notice had provided for use of a "net delta" approach designed to protect QDDs from what would amount to two levels of tax on the same dividend when, for example, a QDD hedges certain transactions through a U.S. branch in a back-to-back hedging transaction after having hedged the issuance of a structured note referencing an index (under which the QDD was holding individual components of the index). Under the Notice, pursuant to suggestions by the Securities Industry and Financial Markets Association ("SIFMA"), a QDD would remain liable for tax under Code section 881(a)(1), and subject to withholding, on the actual dividends it receives, and a qualified intermediary ("QI") agreement would provide that a QDD's section 871(m) amount is to be determined by calculating the net delta exposure (measured in number of shares) of the QDD on the applicable date, multiplied by the relevant dividend amount per share.
For these purposes, all payments (other than dividend equivalent payments) made to a QDD with respect to underlying securities will be subject to withholding tax and reporting obligations if those payments would be subject to the same when received by a foreign person.
A few key provisions are conspicuously absent from the Regulations. First, the Regulations do not mention simplified standards for the "combination rule" of Treasury Regulations section 1.871-15(n). The combination rule provides for aggregation of many transactions into one deemed transaction when (1) a long party (or related person) enters into multiple transactions that reference the same underlying security, (2) the combined potential section 871(m) transactions replicate the economics of a transaction that would be a section 871(m) transaction, and (3) the transactions were entered into in connection with each other. In response to the need to develop new and sophisticated systems for identifying related transactions for these purposes, the Notice indicated both that (1) there would be an exemption from the combination rule in 2017 for listed securities and (2) withholding agents would be allowed to use simplified standards for these purposes with respect to transactions entered into in 2017, under which aggregation would only be required for over-the-counter transactions that were priced, marketed, or sold in connection with each other.
Second, although not mentioned in the Notice, and perhaps of little surprise to taxpayers, the Regulations failed to provide much-needed guidance as to the application of recent Code section 871(m) developments to certain partnership entities – in particular, master limited partnerships ("MLPs"). MLPs are publicly traded partnerships that are often used to house businesses generating certain types of passive income and specified energy related income (including oil and gas). The MLP structure allows such companies access to public markets through a tax-favorable, flow-through entity structure. The default rule is that contracts referencing an interest in a partnership are not subject to Code section 871(m), except in three cases:
- The partnership carries on a trade or business of dealing or trading in securities;
- The partnership holds significant investments in securities (defined as either (1) an interest in underlying securities or potential section 871(m) transactions accounting for 25% or more of the value of the partnership's assets or (2) the value of the underlying securities or potential section 871(m) transactions is at least $25 million); or
- The partnership directly or indirectly holds an interest in a lower-tier partnership that satisfies one of the first two of the abovementioned tests
While it appears the Code section 871(m) rules referencing partnerships clearly intended to target derivatives on financial MLPs, many believe that such rules were not intended to impact MLPs engaged in businesses related to oil and gas and other natural resources, whose stock held in blocker corporations with a value in excess of $25 million would presumably constitute securities for purposes of these rules. Moreover, on a derivative referencing a partnership interest, such MLPs would likely find it difficult, if not impossible, to determine the proper amount of U.S. withholding tax under Code section 871(m) prior to the issuance of a Schedule K-1, which almost invariably would not occur until after the end of the tax year during which the relevant dividends are paid.
Other provisions addressed in Notice 2016-76 but not addressed in the Regulations include the following:
- Application of a "good faith" standard to taxpayers and withholding agents as to administration and enforcement (including penalties) of the Regulations in the context of both delta one and non-delta one transactions
- Application of a "good faith" standard for QDDs during 2017 for purposes of complying with applicable QDD provisions in a QI agreement
- Allowance for withholding agents to remit amounts withheld from dividend equivalent payments on a quarterly basis during 2017
- Allowance for prospective QDDs to apply for QDD status on or before March 31, 2017, and if accepted by the IRS, to be treated as having QDD status as of January 1, 2017
- Allowance for QDDs, prior to receiving a QI-EIN, to provide a statement on a Form W-8IMY that the QDD is "awaiting a QI-EIN," which may be relied upon by withholding agents
The Regulations introduce several new provisions as well, which will provide helpful clarification to taxpayers looking to make sense of the complexities of the existing regulatory provisions. The highlights of these new rules are as follows:
Change in Timing of Delta Determination
Formerly, the delta of a simple contract (i.e., the ratio of the change in the fair market value of an NPC or ELI to a small change in the fair market value of the number of shares of the equity security referenced by the derivative) was determined only at the time of a contract's issuance. However, in a substantial change under the Regulations, delta is now determined as of the "calculation time." For these purposes, the calculation time means the earlier of the date that the transaction is priced and the date when the transaction is issued. Importantly, if pricing occurs more than 14 days before the issue date, the issue date must be used for measuring delta. Analogous rules apply to complex contracts under the substantial equivalence test.
With respect to qualified indices, the Regulations address how the rules apply to an index in the first year it is created. For the first year, an index is tested on the first business day it is listed, and the dividend yield calculation is determined using the dividend yield that the index would have had in the immediately preceding year if it had the same components throughout the year that it had on the date it was created.
Under the prior regulations, an index could be a qualified index if U.S. stock components comprise 10% or less of the weighting of the component securities in the index. This permitted taxpayers to create customized index and avoid withholding so long as 10% or less of the index were U.S. securities. As revised under the Regulations, the index needs to be both widely traded and the index may not be formed or available of with a principal purpose of avoiding U.S. tax.
Determination of Responsible Party
In determining whether a potential section 871(m) transaction is in fact a section 871(m) transaction, confusion may arise when multiple parties are involved because under prior law, more than one party may have qualified as the responsible party. The Regulations resolve this duplication problem in four circumstances:
- Both the short party (i.e., the party paying the dividend equivalent amount) and an agent or intermediary of the short party are a broker or dealer;
- The short party is not a broker or dealer and more than one of the agents or intermediaries of the short party is a broker or dealer;
- The short party and its agents or intermediaries are not brokers or dealers, and more than one agent or intermediary acting on behalf of the long party is a broker or dealer; and
- Potential section 871(m) transactions are traded on an exchange and cleared by a clearing organization
The Regulations provide that the short party is the "responsible party" for these purposes, primarily because the IRS believes that the short party, unlike an agent or intermediary, should have the easiest access to the relevant data regarding the transaction. If the short party is not a broker or dealer, but more than one agent or intermediary acting on behalf of short party is a broker or dealer, the broker or dealer closest to short party in payment chain is the responsible party.
A similar rule applies when potential section 871(m) transactions are traded on an exchange and cleared by a clearing organization. The broker or dealer that has an ongoing customer relationship with foreign investor is the responsible party – which generally will be the clearing firm. Finally, the Regulations provide that the issuer will be the responsible party when a potential section 871(m) transaction is a structured note, contingent payment debt instrument ("CPDI"), convertible debt instrument, or warrant.
Determination of Dividend Equivalent Amount
Under the Regulations, the determination of the dividend equivalent amount is now made for a long party in the year the dividend payment is subject to withholding, and in the case of a QDD, when the payment of the applicable dividend on the underlying security is subject to withholding. This change was made so as to assist withholding agents in discharging their duties, as well as to prevent a large number of foreign holders from having to file a U.S. return and pay U.S. taxes notwithstanding what would otherwise be a lack of a meaningful presence in the United States. Also, for these purposes, the amount of a dividend equivalent subject to tax will not change because the tax is withheld at a later date. Moreover, a long party is only liable for tax on dividend equivalents that arise while the long party is a party to the transaction.
Other new provisions include:
- The Regulations expand the definition of "dividend" to include deemed dividends, such as dividends described in Code section 305(c)
- The Regulations implement new rules for determining the delta of an option listed on a regulated exchange (as discussed below). Although less accurate than determining delta on the issue date, Treasury adopted comments recommending that the delta for listed options should be based on the closing price from the prior trading day, rather than the day of issuance. The comments noted that the Options Clearing Corporation currently calculates the end-of-day delta for options listed on U.S. options exchanges; thus, using of the delta calculation from the prior day for listed options would substantially reduce the burden on taxpayers and make the rules more administrable. Thus, under the Regulations, delta is determined as of close of business on the business day before issuance. However, on the date an option contract is listed for the first time, delta is determined at the close of business on the date of issuance
- The Regulations provide a new definition of "regulated
exchange," so as to enable foreign exchange to qualify.
This definition is relevant for listed options, but is not
applicable to qualified indices. A regulated exchange is now
any exchange defined in Treasury Regulations
section 1.871-15(l)(3)(vii), or, under the temporary
regulations, a foreign exchange that meets all of the following
- There is regulation by a government agency in the jurisdiction of the exchange
- The exchange complies with certain standards designed to protect investors and prevent fraud/manipulation, including sufficient trading volume, listing, financial disclosure, surveillance, and other requirements
- The exchange has rules that effectively promote the active trading of listed options
- There is average daily volume on the exchange of $10 billion per day during the immediately preceding calendar year. For these purposes, if an exchange in a foreign country has more than one tier or market level on which options may be separately listed or traded, each tier or level constitutes a separate exchange
- Under the Regulations, an entity is no longer treated as a broker for Code section 871(m) purposes solely because it redeems its own shares (i.e., the definition under Code section 6045(c) no longer applies)
- The definition of "insurance company" is modified to eliminate the previous requirement of being predominantly engaged in the insurance business
- A bank holding company (and any subsidiary thereof) is now one of the types of "eligible entities" that can act as a QDD under a QI agreement for purposes of Treasury Regulations section 1.1441-1(e), since such entities are regulated financial institutions
- The Qualified Securities Lender ("QSL") regime is
being replaced by incorporating the QDD rules into the existing QI
framework, including the specific rules for pooled reporting on
Form 1042-S and the QI requirements for compliance review and
- For these purposes, the 2017 QSL Notice remains in effect through 2017 with the new regime beginning in 2018
- Treasury Regulations section 1.1441-2(e)(7) now provides that a payment of a dividend equivalent occurs when a section 871(m) transaction is transferred to an account not maintained by the withholding agent or upon a termination of the account relationship
- Withholding agents now have the flexibility to withhold either based on the "later of" rule of Treasury Regulations section 1.1441-2(e)(7) (i.e., withholding occurs on the later of the dividend equivalent determination date or the date of payment) or simply on the dividend payment date for the underlying security without regard to timing. If withholding agent acts as a QDD, it will be required to use the dividend payment date.
- The Regulations provide a simplified delta calculation for
certain simple contracts that reference 10 or more underlying
securities, provided the short party to the transaction uses an
exchange traded security that references substantially all of the
underlying securities to hedge the NPC or ELI at the time of
- For these purposes, the Regulations permit delta with respect to NPCs and ELIs to be calculated by determining the ratio of the change in fair market value of the simple contract to a small change in fair market value of an exchange traded security
- As an anti-abuse measure, for purposes of determining whether a simple contract is "closely comparable" to a complex contract when choosing a simple contract benchmark, the Regulations provide that the simple contract benchmark may be an actual or hypothetical simple contract that at the time the substantial equivalence test is applied to 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. Additionally, the simple contract benchmark must consistently apply reasonable inputs, including a reasonable time period for the contract (e.g., the reasonable time period for the contract must be consistently applied in determining standard deviation and other terms dependent on that time period).
- The Regulations make certain changes to the 2017 QI Agreement
- The definition of "eligible entities" now includes a bank holding company, as well as subsidiaries of a bank holding company
- The eligible entity test is applied at the home office or branch level, and each home office or branch is considered a separate QDD
The definition of eligible entity also now includes a foreign branch of a U.S. financial institution that would meet eligible entity criteria if the branch were a separate entity.
Confusion Surrounding the Effective Date of the Regulations
The executive order referenced above provides for (1) an immediate withdrawal of regulations for review and approval to the extent such regulations both (i) have been sent to the Office of the Federal Register ("OFR") and (ii) have not been published in the Federal Register, as well as (2) a temporary (60 day) postponement of regulations that have been published in the Federal Register but have not yet taken effect. At the time of the order, the Regulations would have fit into the first of these two categories, since the Regulations had been sent to the OFR but had not yet been published. However, arguably, this status changed on January 24, 2017, when the Regulations were published in the Federal Register notwithstanding the fact that the publication occurred after the date of President Trump's executive order. Moreover, since the Regulations have an effective date of January 19, 2017, which is one day prior to the date of the executive order, it would appear that the second of the two categories is also inapplicable. As a result, both the IRS and many practitioners are of the opinion that the Regulations are currently in effect. To date, the Trump administration has not challenged the position of the IRS on this issue.
1. The proposed regulations are identical to the temporary regulations.
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.