The future of Section 871(m) of the Internal Revenue Code of 1986 (the "Code") continues to be a question mark for transaction planners after 2018. Section 871(m) generally treats "dividend equivalent" payments as U.S. source dividends potentially subject to 30% withholding. Final regulations under Section 871(m) were published in September 2015 and went into effect in 2017, but with a delayed effective date of January 1, 2018 for instruments that were not "delta one." The IRS subsequently extended the effective date for instruments that were not delta one to January 1, 2019. Whether the IRS will again delay the effective date for these types of instruments remains to be seen.


The basic effect of Section 871(m), which was enacted as part of the Hiring Incentives to Restore Employment Act of 2010, is that "dividend equivalent" payments are sourced in the United States for withholding tax purposes. Therefore, Section 871(m) directly overrides alternative sourcing rules that would source payments to the residence of the payee. As a result, payments to non-U.S. persons that are caught by Section 871(m) are generally subject to withholding tax at the 30 percent rate applicable to dividends (or lower rate if a treaty so provides).

Although the statutory provision of Section 871(m) applies to securities lending, sale-repurchase and certain notional principal contracts, the statute also empowers the Treasury Department to identify other transactions that may be within the scope of Section 871(m). In 2012, the Treasury Department issued proposed regulations that would have expanded the scope of Section 871(m) to notional principal contracts that met one of seven tests. The Treasury Department withdrew these regulations in 2013 and instead proposed a "delta" approach that would bring notional principal contracts and equity-linked instruments within scope if the "delta" of the instrument is high enough, indicating an economic equivalence to direct ownership of the underlying. These proposed regulations were finalized, with some modifications, in September 2015 and have been amended in part through additional regulations and IRS notices.


The critical question under Section 871(m) is whether a payment is a "dividend equivalent," in which case the payment is potentially subject to a 30% United States withholding tax. Under the regulations currently in effect, a dividend equivalent is any payment that references a dividend from a U.S. corporation pursuant to (1) a securities lending or sale-repurchase transaction, (2) a specified notional principal contract ("Specified NPC"), or (3) a specified equity-linked instrument ("Specified ELI"). Whether an NPC or ELI is a Specified NPC20 or Specified ELI is first determined by whether the contract is "simple" or "complex." A simple contract is generally one that references a fixed number of shares that is ascertainable when the contract is priced and that has a single maturity date. A complex contract is one that is not simple.

Simple ELIs or NPCs are Specified ELIs or Specified NPCs if they have a "delta" that is 0.8 or greater. The delta of an ELI or NPC is the ratio in the change of the fair market value of the ELI or NPC to a small change in the fair market value of the underlying security. The delta is generally determined when the contract is priced or issued (whichever is earlier), but if the contract is priced more than 14 days before it is issued, the delta is determined at issuance.

Complex ELIs or NPCs are Specified ELIs or Specified NPCs if they meet a "substantial equivalent test," which generally compares how sensitive the complex contract is to variations in the price of the underlying security to how sensitive a "simple contract benchmark" is to variations in the price of the underlying security.

NPCs or ELIs that reference a "qualified index" are not treated as referencing U.S. corporations and, thus, are generally not subject to Section 871(m). A qualified index is one that (i) references 25 or more component securities, (ii) references only long positions in component securities, (iii) references no component underlying security that represents more than 15 percent of the weighting of the component securities in the index, (iv) references no five or fewer component underlying securities that together represent more than 40 percent of the weighting of the component securities in the index, (v) is modified or rebalanced only according to publicly stated, predefined criteria, (vi) did not provide an annual dividend yield in the immediately preceding calendar year from component underlying securities that is greater than 1.5 times the annual dividend yield of the S&P 500 Index as reported for the immediately preceding calendar year, and (vii) is traded through futures contracts or option contracts on a national securities exchange or a foreign exchange or board of trade that is a "qualified board or exchange."


In December 2016, the IRS issued a notice that provided that transactions entered into in 2017 would not be Specified ELIs or Specified NPCs unless the contract had a delta of one. Then, in August 2017, the IRS further extended this treatment so that transactions entered into in 2018 would not be Specified ELIs or Specified NPCs unless they were delta-one. It is not clear whether the IRS will again push back the effective date for non-delta-one instruments or whether withholding on a broader range of ELIs and NPCs will come into effect January 1, 2019. In the meantime, practitioners may be left wondering and hoping for the best but planning for the worst.


20 NPCs issued before January 1, 2017, are Specified NPCs if either (i) in connection with entering into the contract, any long party to the contract transfers the underlying security to any short party to the contract; (ii) in connection with the termination of the contract, any short party to the contract transfers the underlying security to any long party to the contract; (iii) the underlying security is not readily tradable on an established securities market; or (iv) in connection with entering into the contract, the underlying security is posted as collateral by any short party to the contract with any long party to the contract.

Originally published in REVERSEinquiries: Volume 1, Issue 5.
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