The U.S. Internal Revenue Service (the “IRS”) has released Notice 2016-76, providing anticipated guidance and transition relief for certain dividend equivalent transactions described in section 871(m) of the U.S. Internal Revenue Code of 1986, as amended (the “Code”).
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 regulations released in September of 2015 that were to take effect on January 1, 2017 (together with all temporary and final regulations underlying section 871(m), the “871(m) regulations”), 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.
Notice 2016-76 announces that the U.S. Treasury Department and the IRS intend to provide for a phased-in application of section 871(m) and the 871(m) regulations to U.S. equity-linked swaps and other derivatives (“871(m) transactions”) that are entered into on or after January 1, 2017. More specifically:
The January 1, 2017, effective date will generally apply only to those 871 (m) transactions issued on or after that date that have a delta of 1 (so-called “delta-one” transactions, which may include combined transactions as described below).
A delayed effective date of January 1, 2018, will apply to 871(m) transactions other than delta-one transactions (“non-delta-one” transactions) issued on or after January 1, 2018.
U.S. equity linked swaps entered into before January 1, 2017, that are currently subject to 871(m) withholding will retain such status on and after such date and therefore are not affected by Notice 2016-76.
The IRS will treat 2017 and 2018 as phase-in years for purposes of enforcement of section 871(m) and the underlying regulations. When determining whether to grant relief from enforcement (including penalties), the IRS will take into account the extent to which a taxpayer or withholding agent made a good faith effort to comply with section 871(m) and the 871(m) regulations.
During 2017, withholding agents will be deemed to have satisfied their requirement to timely deposit amounts withheld from dividend equivalent payments if amounts so withheld during any calendar quarter are deposited by the last day of that calendar quarter.
Combination Rule Application
The 871(m) regulations, as 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 industry comment, Notice 2016-76 provides a simplified standard for withholding agents to determine whether section 871(m) transactions entered into in 2017 are combined transactions. Under this simplified standard, a withholding agent will be required to combine transactions entered into in 2017 for purposes of determining whether they are section 871(m) transactions only if the transactions are over-the-counter transactions that are priced, marketed or sold in connection with each other. Transactions that are combined under this simplified standard for 2017 will continue to be treated as combined in future years; transactions entered into in 2017 that are not combined under this standard will not be combined in future years in the absence of a reissuance or other event that requires retesting to determine if they are section 871(m) transactions. This simplified standard will apply only to withholding agents, and not to taxpayers who are long parties to potential section 871(m) transactions.
Qualified Derivatives Dealer (“QDD”) Transition Relief
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 would not be required to withhold on dividend equivalent payments made to QDDs that properly certify their status. The IRS will issue a QI employer identification number (“QI-EIN”) upon approval of a QI application. A QDD must include its QI-EIN on any IRS Form W-8IMY provided to a withholding agent to certify its QDD status.
In response to industry commentary, including the challenges of implementing a QDD regime that has yet to be finalized, Notice 2016-76 provides phase-in relief and other guidance applicable to QDDs that receive dividend equivalent payments as equity derivatives dealers. In particular:
Prospective QDDs that apply for such status on or before March 31, 2017, will, if approved, be treated as having QDD status as of January 1, 2017. Prior to receiving a QI-EIN, a QDD applicant may represent its QDD status on an IRS Form W-8IMY until the end of the sixth month following the end of the month in which it submitted its application. In such case, it should complete the form by entering “awaiting QI-EIN” in lieu of a QI-EIN. A withholding agent may rely on an IRS Form W-8IMY that states “awaiting QI-EIN” for up to six months after receipt.
For 2017, the IRS will take into account the extent to which a QDD made a good faith effort to comply with section 871(m), the 871(m) regulations, and the relevant provisions of its QI agreement, when determining whether to grant relief from enforcement (including penalties).
Notice 2016-76 also announces the intention of the U.S. Treasury Department and the IRS to revise the 871(m) regulations to require withholding agents to withhold on any actual U.S. source dividends paid to a QDD regardless of the capacity in which the QDD receives the dividends. Dividend equivalent payments received by a QDD in its capacity as an equity derivatives dealer would remain free of withholding. To determine its tax liability with respect to any dividend equivalent amounts received in its capacity as an equity derivatives dealer, a QDD would calculate its “section 871(m) amount” based on its net delta exposure, determined by aggregating the delta of all physical positions and potential section 871(m) transactions with respect to an underlying security entered into by the QDD in its capacity as equity derivatives dealer. The QDD’s tax liability on the section 871(m) amount so determined with respect to an underlying security would be reduced (but not below zero) by any tax paid by the QDD in its capacity as an equity derivatives dealer on receipt of the same dividend payment on that underlying security.
Delayed Effective Date for Certain Identified Exchange Traded Notes (“ETNs”)
Based on the general effective dates of the 871(m) regulations, as modified by Notice 2016-76, U.S. equity-linked ETNs that are delta-one transactions generally would be subject to withholding as section 871(m) transactions if issued on or after January 1, 2017, whereas identical ETNs, if issued prior to January 1, 2017, would not be subject to such withholding. The U.S. Treasury Department and the IRS are aware that certain ETNs that were in existence prior to the release of the final 871(m) regulations on September 18, 2015, have remained in continuous distribution using the same ticker symbol and CUSIP code, making them virtually indistinguishable for commercial and other purposes. To preserve market liquidity, the U.S. Treasury Department and the IRS intend to amend the 871(m) regulations to provide for a delayed effective date of January 1, 2020, for certain such ETNs identified (by name, ticker symbol and CUSIP number) in Notice 2016-76. The U.S. Treasury Department and the IRS request comments on whether this list of identified ETNs should be expanded to include other delta-one ETNs that existed before September 18, 2015.