United States: Dividend Equivalent Payments — Final And Temporary Regulations Issued

Last Updated: October 5 2015
Article by Barry Herzog and Jason Tomitz

On Sept. 18, 2015, the IRS issued final regulations governing "dividend equivalent" payments made to foreign persons. The regulations retain the basic framework set forth in the regulations proposed on Dec. 5, 2013 (the "proposed regulations"), but incorporate several public comments made in response thereto.

Internal Revenue Code Section 871(m), which was enacted in 2010 to prevent dividend equivalent payments and substitute dividend payments that are based on U.S. corporate dividends from escaping U.S. federal income taxation, treats a dividend equivalent payment as U.S. source income and thus generally subject to a 30% U.S. federal tax (unless such payment is effectively connected with the payee's U.S. trade or business, or the rate is eliminated or reduced by treaty). Under the final regulations, a dividend equivalent payment is generally any payment that references the payment of a U.S. source dividend made pursuant to (i) a securities lending transaction or sale-repurchase transaction; (ii) a specified notional principal contract ("NPC"); (iii) a specified equity-linked instrument ("ELI"); or (iv) any other substantially similar payment (each of (i) - (iii), a "Section 871(m) transaction"). As a result, dividend equivalent payments made exclusively between foreign persons could be subject to U.S. tax.

Under existing law, a specified NPC is an NPC that has any one of the following characteristics: (i) in connection with entering into the NPC, any long party to the NPC transfers the underlying security to any short party to the NPC; (ii) in connection with the termination of the NPC, any short party to the NPC transfers the underlying security to any long party to the NPC; (iii) the underlying security is not readily tradable on an established securities market; or (iv) in connection with entering into the NPC, the underlying security is posted as collateral by any short party to the NPC with any long party to the NPC (the "factor test"). Specified ELIs are not expressly subject to Section 871(m) under current law.

To determine whether an NPC or ELI is a specified NPC or specified ELI, the proposed regulations replaced the factor test with a delta test. Delta is the degree of correlation between a change in the fair market value of the underlying security and the corresponding change in the fair market value of the NPC or ELI. The proposed regulations provided that an NPC or ELI with a delta of 0.7 or greater would be a specified NPC or specified ELI and thus subject to Section 871(m). The final regulations retain the delta test but, in response to taxpayers, increased the delta threshold to 0.8. By adopting a 0.8 delta test, the IRS tried to cover financial instruments that provide an economic return that is substantially similar to owning the underlying stock itself. The IRS believes that the 0.8 threshold "strikes a balance between the potential over-inclusiveness of the 0.7 delta threshold and the likelihood that a 0.9 (or higher) threshold would exclude transactions with economic returns that closely resemble an underlying security." For certain complex contracts (e.g., contracts with indeterminate deltas), temporary regulations issued in conjunction with the final regulations set forth a new "substantial equivalence test" for purposes of determining whether a complex NPC or ELI is a specified NPC or specified ELI. In a significant concession to taxpayers and to ease administrative compliance, the final regulations also provide that delta is tested only once upon the issuance of an NPC or ELI (rather than every time an NPC or ELI is acquired, as was provided in the proposed regulations).

Dividend equivalent payments are determined on a gross basis and include amounts that expressly reference an actual or estimated dividend payment as well as amounts that are not expressly referenced but are implicitly taken into account in computing one or more terms in the transaction. One example of this is a price return swap (which provides for payments based only on the appreciation of the underlying stock but does not entitle the long party to payments based on dividends) because the pricing of the swap (or other swap terms) is presumed to reflect the estimated dividend payments.

In general, the dividend equivalent payment amount for most Section 871(m) transactions will equal the per-share dividend amount paid on the underlying referenced stock multiplied by the number of shares referenced in the Section 871(m) transaction multiplied by the delta that was determined upon issuance (rather than the delta as of the date the dividend equivalent payment amount is determined, as was provided in the proposed regulations). The dividend equivalent payment amount for complex contracts is subject to a different calculation set forth in the temporary regulations.

In another significant change in response to taxpayer comments, withholding on dividend equivalent payments generally will be required only when an actual payment is made or there is a final settlement of the Section 871(m) transaction. The proposed regulations, in contrast, provided for withholding on certain upfront payments and prepayments of purchase price and even if there was no actual payment made due to netting provisions or otherwise.

The final regulations also adopted rules with respect to several other issues that were addressed in the proposed regulations, including certain exceptions to dividend equivalency and rules relating to qualified indices, combined transactions, derivatives referencing partnership interests, reporting obligations, and contingent and convertible debt instruments.

The final and temporary regulations are generally effective Sept. 18, 2015. However, to ensure that brokers have adequate time to develop systems needed for implementation, the final and temporary regulations will generally apply to (i) Section 871(m) transactions that are issued on or after Jan. 1, 2017, and (ii) dividend equivalent payments made on or after Jan. 1, 2018, with respect to Section 871(m) transactions issued on or after Jan. 1, 2016, and before Jan. 1, 2017. The current rules based on the factor test will remain in effect for Section 871(m) transactions that are issued before Jan. 1, 2016.

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.

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