Section 871(m) Dividend Equivalent Guidance Including New Transition Relief Expected After Mid-November
The U.S. Internal Revenue Service (the “IRS”) plans to release a guidance package including final rules and transition relief for dividend equivalent transactions described in Section 871(m) of the U.S. Internal Revenue Code of 1986, as amended (the “Code”). According to one IRS official, the package should not be expected prior to mid-November.
Section 871(m) was added to the Code in 2010 as part of the Hiring Incentives to Restore Employment Act (the “HIRE Act”). Aimed at preventing non-U.S persons from skirting U.S. dividend withholding taxes, it subjects certain “dividend equivalent” payments to U.S. withholding tax by treating those payments as dividends from U.S. sources. Although generally effective for dividend equivalent payments made on or after September 14, 2010, Section 871 applies to U.S. equity-linked swap agreements in only limited circumstances through December 31, 2016. New rules released in September of 2015 that were to take effect on January 1, 2017, generally would apply to U.S. equity-linked swaps and other derivative instruments that have a “delta” (very generally, the ratio of a change in value of the derivative position to a change in value of the referenced equity security) of at least .8 at the time of issuance.
The forthcoming guidance package is expected to include a transition rule that maintains the January 1, 2017, effective date only for “delta-one” transactions, while providing a one-year delay until January 1, 2018, for all remaining 871(m) transactions. The guidance package is expected to clarify what is considered a delta-one transaction for purposes of the transition rule.
Combination Rule Application
The 871(m) rules originally scheduled to take effect on January 1, 2017, include a combination rule designed to capture dividend equivalent transactions entered into in connection with one another that, on a combined basis, are economically equivalent to a single transaction having a delta of at least .8. Short parties and the IRS (but not long parties) may rely upon certain presumption rules to determine whether separate transactions should be combined. In response to requests for more specific guidance as to the application of this combination rule, an IRS official replied that the rule intentionally lacked specificity to allow for greater flexibility in application, although another form of simplified guidance could be possible. Accordingly, the degree to which the new guidance package will modify the combination rule remains unclear.
Qualified Derivatives Dealer (“QDD”) Developments
It is expected that the guidance package will also address rules applicable to QDDs that receive dividend equivalent payments as dealers. Notice 2016-42, issued in July of 2016, announced proposed changes to the qualified intermediary (“QI”) regime permitting eligible QIs to act as QDDs if they agree to assume primary withholding responsibility. Withholding agents will not be required to withhold on dividend equivalent payments made to QDDs that properly certify their status. The QDD proposal has drawn industry commentary both from a technical standpoint as well as operationally, due to the challenges of implementing a regime that has yet to be finalized. Practitioners remain hopeful that the guidance package will address some of these concerns.