On December 16, 2019, the Internal Revenue Service (the "IRS") released Notice 2020-2 (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 U.S. source dividends that are subject to withholding tax if paid to a non-U.S. 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 (the "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;
- IRS Notice 2017-42 providing a similar phase-in of the Regulations and related provisions, published in August 2017; and
- IRS Notice 2018-72 also providing a similar phase-in of the Regulations and related provisions, published in October 2018. 5
The Notice is a near mirror image of Notice 2018-72, again providing 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 derivative dealer ("QDD") reporting, 6 and (4) the transition out of the qualified securities lender (the "QSL") regime. Each of these extensions is discussed in more detail below.
In addition to the Notice, the IRS also released a small set of regulations finalizing some temporary regulations under Section 871(m). 7 Those final regulations do not make significant changes.
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) transactions8 that were not delta-one and that were entered into before January 1, 2021. The Notice extends this relief for non-delta-one transactions to cover transactions entered into before January 1, 2023. 9 This additional two-year extension is welcome to 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 2017-2020 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 effort10 to comply with the Regulations when enforcing the same. Prior guidance also provided that through 2020 non-delta-one transactions would be reviewed on this good faith standard. The Notice extends this more lenient enforcement standard through 2022 for delta-one transactions and provides that examinations of non-delta-one transactions will use the good faith standard through 2022. Additionally, previous IRS guidance provided that the IRS would take into account the extent to which a qualified derivatives dealer (a "QDD") made a good faith effort to comply with the Regulations and the relevant provisions of the 2017 QI Agreement through 2020. The Notice extends this similar good faith enforcement standard through 2022.
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 2017-2020. The Notice extends application of the simplified standard through 2022.
Extension of Phase-ins for QDDs
The Notice extends the same three QDD phase-ins that were pushed until 2021 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 2021;
- will be required to compute its Section 871(m) tax liability using a net delta approach beginning January 1, 2021; and
- pursuant to the 2017 QI Agreement must perform certain periodic reviews with respect to its QDD activities, but only beginning in 2021.
The Notice pushes each of these dates back to begin in 2023.
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 through 2020. The Notice provides that withholding agents can use the QSL rules for payments made in 2021 and 2022 as well.
What will ultimately become of Section 871(m) and its regulations? The tax community has wondered whether non-delta-one transactions might one day become exempt from the Regulations completely. However, with extensions until 2023, Section 871(m) and its regulations may go back 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 2020-2 is available at http://bit.ly/2YRdrXa.
2 All section references are to the Internal Revenue Code of 1986, as amended (the "Code"), and the Treasury regulations promulgated thereunder.
3 For a more detailed discussion of the 2015 final regulations, see http://bit.ly/2ZPqIA6.
4 For a more detailed discussion of Notice 2016-76, see http://bit.ly/2SKXwbJ.
5 For a more detailed discussion of Notice 2018-72, see http://bit.ly/39wBSxW.
6 For a more detailed discussion of the QDD rules, see http://bit.ly/2tnBu4f.
7 Those final regulations are available at http://bit.ly/2FcslhC.
8 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.
9 The Notice and thus the grandfather for non-delta-one instruments does not apply to a "specified NPC," as described in Treas. Reg. section 1.871-15(d)(1).
10 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.
Originally published in REVERSEinquiries: Volume 3, Issue
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