On March 18, 2010, President Obama signed into law the Hiring Incentives to Restore Employment Act (the “Hire Act”).1 The Hire Act, by enacting Section 871(m),2 imposes a withholding tax on “dividend equivalents” paid under equity swaps by treating such amounts as U.S. source dividends.3 On January 19, 2012, Treasury released temporary and proposed regulations addressing dividend equivalents.
Pursuant to Section 871(m), a dividend equivalent is (i) any substitute dividend (made pursuant to a securities-lending or “repo” transaction), (ii) any amount paid pursuant to a “specified notional principal contract,” and that is contingent on, or determined by reference to, the payment of a U.S.-source dividend, and (iii) any amount that the Treasury determines is substantially similar to a payment described in (i) and (ii) (i.e., substantially similar to dividend equivalents).
A specified notional principal contract is any notional principal contract if (i) in connection with entering into the contract, any long party (i.e., the party entitled to receive the dividend related payment) transfers the underlying security, (ii) in connection with the termination of the contract, any short party (i.e., any party that is not a long party) transfers the underlying securities to any long party, (iii) the underlying security is not readily tradable on an established securities market, (iv) in connection with entering into the contract, any short party to the contract posts the underlying security as collateral, or (v) the Treasury identifies the contract as a specified notional principal contact. In addition, unless the Treasury determines that a notional principal contract is of a type that does not have the potential for tax avoidance, any notional principal contract pursuant to which payments are made after March 18, 2012, will be a specified notional principal contract.
The temporary regulations apply to payments made after March 18, 2012 and before December 31, 2012. Under the temporary regulations, the current definition of “specified notional principal contracts” is extended through December 31, 2012.
As indicated in the preamble to the regulations, Treasury and the IRS believe that an extension of this definition is necessary to allow taxpayers and withholding agents to modify their systems and other operating procedures to comply with these rules.
The proposed regulations broaden and expand the circumstances under which a notional contract would be considered a “specified notional principal contract” and will be effective for payments as of January 1, 2013, once finalized.
Specifically, a notional principal contract is a specified notional principal contract if (i) the long party is in the market on the same day that the notional principal contract is priced or terminates;4 (ii) the underlying security is not regularly traded on a qualified exchange; (iii) the short party posts the underlying security as collateral and the underlying security represents more than 10% of the total fair market value of all collateral; (iv) its actual term is less than 90 days (regardless of its contractual term); (v) the long party controls the short party’s hedge;5 (vi) the notional principal amount is greater than either 5% of the total public float of the underlying security or 20% of the 30-day daily average trading volume; or (vii) the notional principal contract is entered into on or after the announcement of a special dividend and prior to the ex-dividend date.6
The proposed regulations also expand the definition of dividend equivalents ot include the following: (i) any payment of a beneficial owner’s tax liability with respect to a dividend equivalent (e.g., a tax gross-up) and (ii) any payment (including the payment of the purchase price or an adjustment thereto) with respect to an equity-linked instrument7 that is determined by reference to a U.S. source dividend.
The proposed regulations state that payments determined by reference to an estimate of an expected dividend, without reference to or adjustment for the amount of any actual dividend, are not treated as dividend equivalents.
If a notional principal contract is linked to more than one underlying security or to a “customized index,”8 each security or component of such index is treated s an underlying security in a separate notional principal contract for purposes of applying the dividend equivalent provisions.
Further, a dividend equivalent is treated as a dividend for treaty purposes and for purposes of the special Code provision exemption foreign governments and international organizations from U.S. federal income tax.
This issuance of these regulations is likely to be followed by additional FATCArelated regulations. For all FATCA updates, including drafts of these temporary and proposed regulations, see our FATCA website at KNOWFatca.com.