Overview of New Guidance
On Dec. 16, the Internal Revenue Service (IRS) issued final regulations (the new regulations) governing a narrow aspect of rules applicable to withholding on “dividend equivalent payments” made to foreign persons. The new regulations finalize 2017 proposed regulations (which were issued together with identical temporary regulations) without any substantive change. The new regulations are effective on the date of their publication in the Federal Register.
The new regulations are limited to two components:
- The new regulations provide guidance identifying which party to a potential “Section 871(m) transaction” (described below) is responsible for determining whether a transaction is in fact a Section 871(m) transaction when multiple brokers or dealers are involved in the transaction, and they clarify the meaning of the term “broker” for these purposes.
- The new regulations provide guidance relating to when the delta of an option that is listed on a foreign regulated exchange should be calculated based on the delta of that option at the close of business on the business day before the date of issuance.
Concurrently with issuance of the new regulations, the IRS released Notice 2020-02 (the Notice), which provides taxpayers additional guidance for complying with the Section 871(m) final and temporary regulations and further extends transition relief provided in previous notices.
Section 871(m) of the Internal Revenue Code, which was enacted in 2010, generally subjects a dividend equivalent payment received by a foreign person to a 30 percent U.S. withholding tax (unless reduced or eliminated by treaty or effectively connected with a U.S. trade or business). This treatment generally aligns with the U.S. tax treatment for a foreign person directly receiving dividends paid by a U.S. corporation. A dividend equivalent payment is generally any payment pursuant to a securities lending transaction, sale-repurchase transaction or specified notional principal contract (NPC) that is contingent on or determined by reference to the payment of a dividend from an underlying security of a U.S. issuer, as well as any other payments determined by the Treasury Secretary to be substantially similar to those described above.
On Sept. 17, 2015, Treasury and the IRS issued final regulations and temporary regulations, both of which were amended and clarified in January 2017 (collectively referred to as the pre-2019 regulations). Taking into account comments received regarding earlier proposed regulations, the pre-2019 regulations expanded the application of Section 871(m) to cover specified instruments with embedded equity-linked components (ELIs). The pre-2019 regulations apply whether the counterparty holding the short position is a U.S. or non-U.S. person. The new regulations do not change these aspects of the existing rules.
Initially, under Section 871(m), an NPC was a specified NPC if it satisfied a statutory four-factor test. That test was met if the underlying stock was (1) crossed in at the outset of the transaction, (2) crossed out at the termination of the transaction, (3) not readily tradable on an established securities market or (4) posted as collateral to the foreign person in connection with the transaction. However, the pre-2019 regulations phased out the statutory four-factor test and replaced it with a delta-based test, which is described in more detail below.
The pre-2019 regulations require withholding on dividend equivalent payments only when an actual payment is made to or by the long party or the long party sells, exchanges or otherwise disposes of the equity derivative (including by final settlement). A disposition includes the lapse of an option even where the option holder is not receiving a payment. The transfer of a Section 871(m) transaction to an account not maintained by the same withholding agent (e.g., broker) also constitutes a disposition. The pre-2019 regulations expressly exempt premiums and other upfront payments from withholding. The new regulations do not modify these portions of the existing rules.
On April 21, 2017, the President issued Executive Order 13789 (82 FR 19317), a directive designed to reduce tax regulatory burdens, which instructed the Treasury Secretary to submit to the President a final report recommending specific actions to mitigate the burden imposed by certain Treasury regulations. On Oct. 16, 2017, the Secretary published that final report (82 FR 48013), which indicated, among other things, that the Treasury Department continues to analyze all recently issued significant regulations and is considering possible reforms of several recent regulations, including the pre-2019 regulations under Section 871(m). The preamble to the new regulations makes it clear that pursuant to EO 13789, Treasury and the IRS continue to study and consider possible reforms to the provisions of the pre-2019 regulations that are not specifically addressed by the new regulations.
Party Responsible for Determining Whether Section 871(m) Applies
The new regulations provide two points of clarification regarding which party to a potential Section 871(m) transaction is responsible for determining whether Section 871(m) applies.
First, the new regulations clarify which party to a transaction is responsible for determining whether such transaction is a Section 871(m) transaction. The final pre-2019 regulations provide that in the context of a single broker or dealer (i.e., a transaction in which only one party is a broker or dealer), the broker or dealer is required to determine whether the transaction is a Section 871(m) transaction. The new regulations provide that if both parties are or neither party is a broker or dealer, the short party must determine whether the transaction is a Section 871(m) transaction. For more complex transactions, the new regulations provide the following rules regarding which party is responsible for determining whether a transaction is a Section 871(m) transaction:
- For a transaction in which both the short party and an agent or intermediary acting on behalf of the short party are brokers or dealers, the short party must determine whether the transaction is a Section 871(m) transaction.
- For a transaction in which the short party is not a broker or a dealer and more than one agent or intermediary acting on behalf of the short party is a broker or a dealer, the broker or dealer that is a party to the transaction and closest to the short party in the payment chain must determine whether the transaction is a Section 871(m) transaction.
- For a transaction in which neither the short party nor any agent or intermediary acting on behalf of the short party is a broker or a dealer, the long party and an agent or intermediary acting on behalf of the long party are brokers or dealers, or more than one agent or intermediary acting on behalf of the long party is a broker or a dealer, the broker or dealer that is a party to the transaction and closest to the long party in the payment chain must determine whether the transaction is a Section 871(m) transaction.
- For a transaction that is traded on an exchange and cleared by a clearing organization and for which more than one broker or dealer acts as an agent or intermediary between the short party and a foreign payee, the broker or dealer that has an ongoing customer relationship with the foreign payee with respect to that transaction (generally the clearing firm) must determine whether the transaction is a Section 871(m) transaction.
- When a potential Section 871(m) transaction is a structured note, warrant, convertible stock or convertible debt, the issuer is the party responsible for determining whether the transaction is a Section 871(m) transaction. (This rule presumably overrides any of the foregoing rules in the case of transactions to which both rules would otherwise apply.)
Second, the new regulations define “broker” as a broker within the meaning provided in Section 6045(c) (other than any corporation that is a broker solely because it regularly redeems its own shares), which generally includes a dealer, barter exchange and any other person who regularly acts as a middleman with respect to property or services for consideration. (“Dealer” was defined in prior guidance.)
The Delta Test
The pre-2019 regulations provide that Section 871(m) withholding applies to dividend equivalent payments with respect to an equity derivative where the “delta test” (for simple contracts) or the “substantial equivalence test” (for complex contracts) is satisfied upon the testing time of the derivative described below or upon a subsequent significant modification of the terms of the derivative. A simple contract generally is an equity derivative that (1) references a single, fixed number of shares (known when the derivative is issued; the number may be adjustable to avoid dilution) of one or more issuers to determine payments and (2) has a single maturity or exercise date on which all amounts (other than any upfront or periodic payments) are required to be calculated. For example, an American-style option would satisfy the second requirement. A complex contract is any contract that is not a simple contract.
Delta refers to the ratio of a change in the fair market value of a contract to a change in the fair market value of the property referenced by the contract. The more closely the derivative instrument is correlated to the underlying security, the closer the delta is to one (a “delta one transaction”). The delta test is satisfied in a simple contract where the delta of the derivative is equal to or greater than 0.80. Complex contracts are subject to the substantial equivalence test (not the delta test).
Under the pre-2019 regulations, delta is tested on the earlier of the pricing date or the issue date of the transaction (although the delta on the issue date must be used if the pricing date is more than 14 days prior to the issue date, and the delta at close of business prior to the date of issue must be used with respect to options listed on most regulated exchanges). With respect to options listed on a regulated exchange, the pre-2019 regulations provided that the delta is determined based on the delta of the option at the close of business on the business day before the date of issuance. Under Section 871(m), a regulated exchange is limited to (a) a national securities exchange that is registered with the Securities and Exchange Commission or a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission (CFTC) or (b) a foreign exchange or board of trade that is a qualified board or exchange as determined by the Secretary of the Treasury or that has a staff no-action letter from the CFTC permitting direct access from the U.S. that is effective on the applicable testing date, provided that the referenced component underlying securities in the aggregate comprises less than 50 percent of the weighting of the component securities in the index. The 2017 temporary regulations expanded the term “regulated exchange” to include certain other foreign exchanges.
The new regulations generally do not modify the delta test, with one narrow exception. The new regulations finalize the rule set forth in the 2017 proposed regulations that the delta of an option that is listed on a foreign regulated exchange that meets the following four requirements may be calculated based on the delta of that option at the close of business on the business day before the date of issuance: the exchange (1) is regulated by a government agency in the jurisdiction in which the market is located; (2) maintains trade volume, listing, financial disclosure, surveillance and other requirements designed to protect investors and to prevent fraud and manipulation; (3) has rules to promote active trading of listed options; and (4) had an average trading volume in excess of $10 billion per day during the prior calendar year.
The Section 871(m) rules contained in the pre-2019 regulations and the new regulations apply (1) as of Jan. 1, 2017, with respect to delta one transactions issued on or after Jan. 1, 2017 (per the terms of the pre-2019 regulations themselves) and (2) with respect to non-delta one transactions issued on or after Jan. 1, 2023 (per the Notice).
Consistent with prior notices (taking into account the new extension to applicability), the Notice provides that in enforcing the regulations, the IRS will take into account the extent to which the taxpayer or withholding agent made a good-faith effort to comply with the regulations for (1) any delta one transaction in 2017 through 2022 and (2) (i) simple NPCs or ELIs with a delta of 0.8 or greater and (ii) complex NPCs or ELIs that meet the substantial equivalence test in 2023. In each case, an anti-abuse rule set forth in the pre-2019 regulations remains in full effect throughout the phase-in years.
The Notice provides further guidance regarding other topics, including the qualified derivatives dealer (QDD) regime and the determination of whether transactions are combined transactions (for purposes of testing delta) during the phase-in period.