On September 17, 2015, the U.S. Internal Revenue Service (the IRS) issued final regulations under Section 871(m) of the U.S. Internal Revenue Code of 1986 (the Code) clarifying the requirement to withhold on certain payments that are linked to the payment of U.S.-source dividends (the Final Regulations). The Final Regulations address a number of industry concerns that were raised in response to the proposed regulations issued on December 4, 2013 (the 2013 Proposed Regulations) including by, inter alia, raising the delta threshold of an instrument that triggers withholding under Section 871(m) to 0.80 (from 0.70), providing that the delta of an instrument is measured at the time the instrument is issued (rather than re-tested when an instrument is acquired in the secondary market), providing alternative methods for determining the treatment of instruments where the delta is either indeterminate or inaccessible to the withholding agent and providing presumption rules for determining whether separate transactions should be combined for purposes of determining the applicability of Section 871(m).
The Final Regulations provide for phased implementation and do not apply to transactions issued before January 1, 2016. For transactions issued on or after January 1, 2016 and before January 1, 2017, the Final Regulations will apply to any payment of a dividend equivalent made on or after January 1, 2018. The Final Regulations are generally applicable to all payments in respect of transactions issued on or after January 1, 2017. Please note, however, that the phased implementation does not apply to transactions already treated as specified notional principal contracts (SNPCs) under the statutory definition of SNPC.
Section 871(m) of the Code imposes U.S. withholding tax on dividend equivalent payments (DEPs) received by non-U.S. persons. Under the statute, DEPs are generally defined as payments under securities loans, sales-repurchase transactions, SNPCs, or similar transactions that are contingent upon or determined by reference to the payment of a U.S.-source dividend. Section 871(m) lists four categories of notional principal contracts (NPCs) that will be considered SNPCs. This statutory definition applies until the definition of SNPC under the Final Regulations comes into effect on January 1, 2017.
On January 19, 2012, the IRS proposed regulations under Section 871(m) (the 2012 Proposed Regulations), which provided a complex seven-factor approach to defining an SNPC. The 2012 Proposed Regulations also treated equity-linked instruments (ELIs) that provide for a payment that is "substantially similar" to a DEP as NPCs. The 2013 Proposed Regulations replaced this seven-factor test with a single test based solely on the objective measurement of an NPC or ELI’s "delta" to determine whether an instrument may be subject to tax under Section 871(m). The 2013 Proposed Regulations provided that an NPC that has a delta of 0.70 or greater when the long party enters into the transaction will be treated as an SNPC subject to Section 871(m) withholding on any DEPs. Similarly, the 2013 Proposed Regulations provided that ELIs that have a delta of 0.70 or greater when the long party acquires the instruments will be treated as specified ELIs (SELIs) subject to Section 871(m) withholding on any DEPs. For these purposes, the delta of an NPC or ELI would be the ratio of the change in the fair market value of the NPC or ELI to the change in the fair market value of the underlying security or index. If an NPC or ELI has a delta that is not reasonably expected to vary during the term of the transaction, such NPC or ELI would generally be treated as having a delta of 1.0.
Under the 2013 Proposed Regulations, if a transaction referenced more than one underlying security, the taxpayer would determine whether the transaction is a Section 871(m) transaction with respect to each underlying security. A single transaction, therefore, could be a Section 871(m) transaction with respect to one or more underlying securities referenced in the transaction, but may not be treated as a Section 871(m) transaction with respect to other underlying securities referenced by that same transaction. In addition, two or more transactions that reference the same underlying security may be aggregated into a single transaction for these purposes if such transactions are entered into "in connection" with each other, with the combined transaction’s delta measured at the time of such aggregation.
THE FINAL REGULATIONS
The Final Regulations generally implement the 2013 Proposed Regulations, subject to certain revisions intended to clarify the application of the regulations and, in certain cases, provide relief. Notable developments include the following:
The Final Regulations implement the delta test from the 2013 Proposed Regulations for determining whether an instrument is an SNPC or SELI. In response to industry concerns that using a delta threshold of 0.70 could cause contracts that do not sufficiently resemble the underlying security to be treated as SNPCs or SELIs, the Final Regulations raise the delta threshold to 0.80.
Time for Testing Delta
The Final Regulations clarify that the delta of an NPC or ELI is determined only when the instrument is issued and the delta is not re-tested if the instrument is purchased or otherwise acquired in the secondary market. An instrument is "issued" for these purposes when it is entered into, purchased or otherwise acquired at its inception or original issuance. An instrument may also be treated as "issued" pursuant to a deemed exchange under Section 1001 of the Code. This change also eliminates a narrow exception under the 2013 Proposed Regulations that applied to short-term options that lapse.
In response to industry concerns that the delta test would be difficult to apply in the context of more exotic equity derivatives or structured notes, the Final Regulations introduce the concepts of "Simple Contracts" and "Complex Contracts." Generally, a Simple Contract is a contract that (i) references a single, fixed number of shares of one or more issuers to determine the payout and (ii) has a single maturity or exercise date with respect to which all amounts (other than any upfront payment or periodic payments) are required to be calculated with respect to the underlying security. A contract will be treated as having a single exercise date even if it may be exercised by the holder at any time before the expiration of the contract (e.g., American-style options). The IRS anticipates that most NPCs and ELIs will be treated as Simple Contracts. NPCs and ELIs that are treated as Simple Contracts are subject to the delta test described above.
A Complex Contract, on the other hand, is any contract that is not a Simple Contract. The Final Regulations introduce the "Substantial Equivalence Test" to determine whether any Complex Contracts should be treated as SNPCs or SELIs, as applicable. Generally, the Substantial Equivalence Test compares the change in value of a Complex Contract against the value of the shares of the underlying security used to hedge the Complex Contract at the time the contract is issued when the price of the underlying security is hypothetically increased or decreased by one standard deviation. If the difference between the change in value of the Complex Contract and the initial hedge is equal to or less than the difference for a benchmark Simple Contract and its initial hedge, the Complex Contract will be treated as an SNPC or SELI, as applicable. If the Substantial Equivalence Test cannot be applied to a Complex Contract, the principles of the Substantial Equivalence Test should be applied to reasonably determine whether the Complex Contract will be treated as an SNPC or SELI.
Calculations of Dividend Equivalent Amounts
Under the 2013 Proposed Regulations, the amount of a DEP would be calculated by multiplying the per-share dividend amount with respect to the underlying security by the number of shares of the underlying security referenced in the instrument multiplied by the delta at the time the amount of the DEP is determined. The Final Regulations generally implement the approach from the 2013 Proposed Regulations with respect to Simple Contracts, subject to certain simplifying changes. In particular, the Final Regulations provide that taxpayers may use the delta for the instrument as of the time the instrument was issued to calculate the amount of the DEP (rather than the delta at the time of the calculation). This change appears to be in response to comments indicating that recalculating the delta for each calculation of the amount of a DEP would unnecessarily introduce administrative complexity. For Complex Contracts, the Final Regulations provide that the amount of a DEP equals the amount of the per-share dividend with respect to the underlying security multiplied by the number of shares that constitute the initial hedge of the Complex Contract.
The 2013 Proposed Regulations included an exception for transactions that reference certain broad-based indices, even if such indices include U.S. securities (such indices, "Qualified Indices"). The Final Regulations generally expand the scope of the Qualified Indices exception by, inter alia, permitting additional criteria to be considered when rebalancing indices and considering indices referenced by futures or option contracts that trade on certain foreign exchanges (rather than just certain domestic exchanges, as was the case under the 2013 Proposed Regulations). Whether an index should be treated as a Qualified Index requires fact-intensive analysis that considers, inter alia, the number of component securities, the relative weight of component securities that could make U.S.-source payments, the process for determining whether the index is rebalanced and whether the index is referenced by futures or option contracts that trade on certain exchanges.
Under the 2013 Proposed Regulations, multiple transactions may be aggregated into a single transaction for purposes of determining whether the transactions are SNPCs or SELIs when a long party enters into two or more transactions that reference the same underlying security "in connection" with each other. To address concerns that identifying transactions to be combined could present significant challenges to short parties, the Final Regulations permit short parties acting as brokers to apply presumption rules to determine whether transactions are entered into in connection with each other. Specifically, if transactions are held in or reflected in separate accounts or separated by at least two business days, a short party acting as a broker may presume that such transactions are not entered into in connection with each other unless such party has actual knowledge to the contrary. While the presumption rules alleviate some of the concern for short parties acting as brokers, the combined transaction rules may still present significant challenges for short parties acting in other capacities. Further, short parties to whom the presumption rules are available may wish to take additional steps to ensure that they do not have actual knowledge that transactions should be aggregated. Accordingly, from a documentation perspective, it may be helpful for a long counterparty to provide a representation that it is not entering into, and will not enter into, any other transactions in connection with a specific transaction for purposes of Section 871(m).
Timing for Withholding Obligation
The Final Regulations provide that a withholding agent is not required to withhold in respect of DEPs until the later of (i) when a payment is made with respect to an SNPC or SELI or (ii) when the amount of the dividend equivalent is determined. In contrast to the 2013 Proposed Regulations, the Final Regulations do not treat premiums and upfront payments paid to the short party at the time the instrument is issued as payments that would trigger withholding.
The International Swaps and Derivatives Association (ISDA) is considering a protocol to address Section 871(m) in light of the Final Regulations. The staggered effective dates in the Final Regulations, as well as the combined transaction rule, present technical challenges, and balancing the interests of long and short parties will be a key concern that will need to be addressed to ensure buy-in from market participants. ISDA is currently in the process of soliciting input from market participants, and has begun the process of educating such market participants, in an effort to make the protocol acceptable to the widest possible range of parties. ISDA is optimistic that the protocol will be available within the next month.