The title for this article borrows a quote from US President Andrew Jackson. While it has been reported that President Donald Trump styles himself in the mode of President Jackson, it is the parallel between the policies of the seventh president and those of President Barack Obama that is truly striking. Jackson famously vetoed the charter of the second US National Bank. In a similar vein, President Obama used the federal apparatus to impose massive regulatory burdens, and billions in fines, on banks. As part of this assault, under President Obama, the Internal Revenue Service (IRS) used an antiparking statute, section 871(m) of the Internal Revenue Code of 1986, as amended (the Code), to impose US tax withholding on an array of equity-linked instruments (ELIs) and swaps. On January 19, 2016, President Obama’s last day in office, the IRS released 88 pages of revisions to these rules. The changes are discussed herein. On the day following the release of the new temporary and final regulations, President Trump signed an executive order that institutes a moratorium on all federal rulemaking until the new administration can review all regulations in process. Since the revised regulations were not already submitted to the Federal Register on January 20, 2017, they will be withdrawn. Such temporary regulatory freezes are common in changes of administrations. Accordingly, it is possible that the revised regulations described below may be allowed to become effective in the near future.2 Mutual Fund Relief In general, when two brokers are party to a potential ELI, it is the responsibility of the short party to determine whether withholding is required and the amount of the dividend equivalent.3 The definition of “broker” for this purpose includes open-end mutual funds.4 New temporary regulations no longer treat an openend mutual fund as a broker if the sole reason it is treated as a broker is because it regularly redeems its own shares.5 New Limitations on CRA Coordination The IRS, under President Obama, proposed a withholding requirement for conversion rate adjustments (CRAs) made on convertible securities.6 Under the prior final regulation, no withholding was required under the dividend equivalent rules if withholding was imposed under the CRA rules.7 The revised regulations provide for no reduction in dividend equivalent withholding if the long party holds a derivative over a convertible security that experiences a taxable CRA.8 The rationale for this denial of a credit forward is that the long party under the derivative does not hold the convertible security and, therefore, does not experience a taxable CRA. Thus, the possibility of cascading 2 Mayer Brown | I Have Always Been Afraid of Banks: the IRS Revamps Cross‐Border Dividend Equivalent Rules on President Obama’s Last Day in Office withholding will be presented in transactions referencing convertible securities in which the short party holds the reference security. Corporate Actions The computation of the amounts to be withheld on simple contracts is not complicated, while the determination of the amount to be withheld on complex contracts is a significant burden. A contract cannot be a simple contract if the number of shares referenced in the contract cannot be ascertained at the time of the contract issuance.9 Under the revised regulations, a contract will not be considered to reference an unascertainable number of shares if the number of shares can be adjusted for corporate actions, such as mergers, stock splits or cash dividends.10 Rules for Determining Delta The delta of an ELI or swap transaction is determined at the time that the transaction is opened.11 These rules have been refined by the revised regulations. Under the revised regulations, delta is determined on the earlier of the date that the transaction is priced and the issue date, but if the pricing date is more than 14 calendar days before the transaction is issued, the issue date must be used to determine the delta of the transaction. The relevant time is referred to as the “calculation time.”12 The rules for exchange-traded options have been made more administrable. Under the revised regulations, the delta of an exchange-traded option is determined based upon the delta at the close of the business day prior to the day on which the option was issued.13 The prior final regulations provided that if an issuer of an ELI or swap that referenced 10 or more underlying securities held an exchangetraded security or fund (ETF) as a hedge of its position under the ELI or swap, the delta of the transaction could be determined with reference to the ETF. Under the revised regulations, an ETF may be used to determine delta even if the issuer does not hold the ETF as a hedge, provided that the ETF would “fully hedge” the swap or ELI.14 Market participants had asked for a safe harbor in the event that delta was miscalculated provided that the issuer used a third-party service to determine delta. Market participants had also asked that the delta in reopenings be determined using the delta from when the transaction was first opened. The IRS has denied both requests. The SET Is Tightened The substantial equivalence test provides a methodology for testing the dividend equivalence of complex contracts, that is, contracts with deltas that can vary over the life of the transaction. The IRS has narrowed the calculation of the SET in the revised regulations. Under the revised final regulations, the benchmark contract must consistently apply reasonable inputs and maturity date, and must use terms that are consistent with the economics of the complex contract being tested.15 In addition, a detailed example of the application of the SET has been included in the revised final regulations.16 Timing of the Payment of a Dividend Equivalent Under the prior final regulations, the long party to an ELI or swap was subject to tax on dividend equivalents on the earlier of the record date and the day prior to the ex-dividend date.17 A withholding agent, however, was not required to withhold until cash changed hands on the product or the long party disposed of the transaction.18 When these dates spanned a tax year end, a long party could be taxable on a dividend equivalent for which withholding would be undertaken in a subsequent year. In order to fix this challenge, the IRS has provided that a long party is subject to tax on a dividend equivalent in the tax year in which the short 3 Mayer Brown | I Have Always Been Afraid of Banks: the IRS Revamps Cross‐Border Dividend Equivalent Rules on President Obama’s Last Day in Office party (or other withholding agent) is required to undertake the withholding.19 The IRS has also promulgated an anti-abuse regulation that prevents passporting the withholding tax liability. If a holder of an ELI or swap on which a dividend equivalent adjustment has been made but on which withholding has not yet occurred transfers the ELI or swap to a third party, the original holder will be taxed on the embedded dividend equivalent. Narrowing of the Qualified Index Rules Dividend equivalents paid on qualified indices are not subject to US dividend equivalent withholding. One category of a qualified index is an index comprising 10 percent or less of US components. Under the revised final regulations, only widely traded indices will be eligible for the 10 percent safe harbor.20 A customized index with any amount of US securities will be disaggregated, and dividend equivalents paid with respect to the US components will be subject to US federal income tax withholding. A rule of administrative convenience provides that in the first year in which a qualified index is in use, its dividend yield is determined by using the aggregate dividend yield of the components in the preceding year.21 Combined Transactions The IRS has retained the rule that transactions are subject to combination in 2017 only if they are priced, marketed or sold in connection with each other. The IRS also retained the rule contained in the prior final regulations for 2018 and thereafter. These transactions are subject to combination if they are entered into in the same account within two business days of each other (or the broker has special knowledge that the transactions are end runs around the withholding rules). The preamble to the revised final regulations confirms that transactions are combined only if they would result in a simple contract. The Party Responsible for Determining the Delta of a Transaction The prior final and temporary regulations did not reflect an understanding of the roles of intermediaries in ELI issuances and, as a result, it was unclear which party had the burden for determining delta and reporting information on the transaction. Revised temporary regulations now provide cascading rules of responsibility: 1. The short party is responsible for determining delta when both the short party and its agent are brokers or dealers.22 2. If the short party is not a broker or dealer but one or more agents acting on its behalf is a broker or dealer, the broker or dealer closest to the short party must determine delta. 3. If neither the short party nor its agent is a broker or dealer, but an intermediary acting on behalf of the long party is a broker or dealer, the long party intermediary is responsible for determining delta. 4. The broker or dealer that has the ongoing relationship with the non-US customer must determine delta for exchange-traded ELIs.23 5. The issuer in structured note transactions, warrants and convertible financial instruments must determine delta in such transactions.24 Qualified Derivatives Dealers The United Kingdom, Germany, Spain, France and Italy (the G5 countries) wrote a letter to the US Treasury stating their position that dividend equivalent payments do not qualify as dividends under the applicable United States tax treaty when paid by non-US entities and that the imposition of US tax on these payments is beyond the taxing authority of the IRS.25 The IRS, in order to enforce the withholding tax over the position of these tax treaty partners, has amended the form of Qualified Intermediary 4 Mayer Brown | I Have Always Been Afraid of Banks: the IRS Revamps Cross‐Border Dividend Equivalent Rules on President Obama’s Last Day in Office (QI) Agreement to provide that any entity that desires to act as a QI and a qualified derivatives dealer (QDD) must treat a dividend equivalent as a dividend for withholding tax purposes. The final withholding regulations reiterate this requirement.26 The final revised regulations expand the universe of entities that can qualify as QDDs to include bank holding companies and direct and indirect subsidiaries of bank holding companies provided that the company (i) issues potential section 871(m) transactions to customers and (ii) receives dividends or dividend equivalent payments in transactions that hedge the section 871(m) transactions issued to customers.27 In Notice 2016-76, the IRS announced that it would allow QDDs to determine their tax liability with respect to section 871(m) transactions using either a net delta calculation or by tracking the QDD’s liability under the regular withholding tax rules. The IRS has rethought this latitude and, beginning in 2018, QDDs will be required to use the net delta approach.28 The revised final regulations contain three detailed examples illustrating how net delta is calculated.29 In addition, in a complete reversal of previous IRS guidance, QDDs will be subject to withholding tax on all actual dividends received beginning in 2018. As a practical matter, QDDs will not be able to hedge their customer transactions by holding physical shares. In addition, the IRS will now mandate full tax reporting on the payment of all dividends and dividend equivalents paid to QDDs. Many market participants had requested that a QDD be able to withhold on dividend equivalents at the earlier date of when the dividend is paid on the underlying security and when a payment is made with respect to the ELI or swap. Under the revised temporary regulations, withholding agents may withhold at either time.30 Thus, withholding is permitted when the actual dividend is paid, when a payment is made with respect to the transaction or when the long party disposes of the transaction. Withholding may not be undertaken at the date on which the underlying security pays a dividend. Under the new rules, if an ELI or swap is transferred and dividend equivalents have been accrued but not withheld upon prior to the transfer, the transferring broker must withhold at the time of transfer. QSLs In Notice 2016-76, the IRS announced that qualified securities lending (QSL) rules would remain in effect for 2017, but this regime would not be available beginning in 2018. In the final revised regulations, the IRS reiterated that it would not extend the QSL or credit forward rules beyond 2017. Concluding Observations Many practitioners, consistent with the position of the G5, believe that the IRS far exceeded its mandate under Code section 871(m) when it sought to treat dividend equivalents as dividends in transactions that did not involve parking securities in the hands of tax-indifferent parties. The cost to industry of attempting to comply with these IRS rules has been in the hundreds of millions of dollars, if not more. These rules have made the stocks and securities of US issuers much less attractive to international investors. The Obama administration was fairly indifferent to the tax compliance burdens that it placed on banking institutions and the effect of such rules on capital markets. One hopes that the Trump Administration will rethink this approach. For more information about the topics raised in this article, contact any of the following lawyers or your regular Mayer Brown contact. Mark H. Leeds +1 212 506 2499 email@example.com 5 Mayer Brown | I Have Always Been Afraid of Banks: the IRS Revamps Cross‐Border Dividend Equivalent Rules on President Obama’s Last Day in Office James R. Barry +1 312 701 7169 firstname.lastname@example.org Hayden D. Brown +1 704 444 3512 email@example.com Jonathan A. Sambur +1 202 263 3256 firstname.lastname@example.org Endnotes 1 Mark Leeds (email@example.com, (212) 506- 2499) is a tax partner with the New York office of Mayer Brown. Mark’s legal practice focuses on federal income tax issues presented by financial products and the activities of financial institutions. Mark will address cross-border tax issues at the 6th Annual IBA Tax Conference: Current International Tax Issues in CrossBorder Corporate Finance and Capital Markets on January 31, 2017 in London. The author thanks Robert Gordon of Twenty-First Securities for his comments and suggestions. Mistakes and omissions, however, remain the sole responsibility of the author. 2 The citations in the endnotes reflect the designation of the revised regulations assuming, that they are promulgated as originally stated. 3 Treas. Reg. § 1.871-15(p)(1). 4 See Code § 6045(c). 5 Temp. Treas. Reg. § 1.871-15T(a)(1). 6 See Leeds, Withholding On Air: The IRS Imposes Withholding Tax Rules for Adjustments on Convertible Debt and Equity (April 2016), available at https://m.mayerbrown.com/files/Publication/9524d01c -fb2e-4a59-80cfbb939fadaf2f/Presentation/PublicationAttachment/979f 793e-9d49-4806-9de5-c1b905babe3e/160418-UPDATETax.pdf 7 Prior Treas. Reg. § 1.871-15(c)(2)(ii). 8 Id. As revised by T.D. 9815 (Jan. 19, 2017). 9 Treas. Reg. § 1.871-15(a)(14)(i). 10 Treas. Reg. § 1.871-15(a)(14)(i). 11 Treas. Reg. § 1.871-15(g)(2). 12 Treas. Reg. § 1.871-15(g)(2)(ii). 13 Treas. Reg. § 1.871-15(g)(4). 14 Treas. Reg. § 1.871-15(g)(3). 15 Treas. Reg. § 1.871-15(h)(1). 16 Treas. Reg. § 1.871-15(h)(7). 17 Treas. Reg. § 1.871-15(j). 18 Treas. Reg. § 1.1441-2(e)(8). 19 Treas. Reg. § 1.871-15(j)(4). 20 Treas. Reg. § 1.871-15(l)(4). 21 Treas. Reg. § 1.871-15(l)(2)(ii). 22 Temp. Treas. Reg. § 1.871-15T(g)(5)(ii). 23 Temp. Treas. Reg. § 1.871-15T(g)(5)(iii). 24 Temp. Treas. Reg. § 1.871-15T(g)(5)(iv). 25 See Payson Peabody, Managing Director & Tax Counsel, Securities Industry and Financial Markets Association letter to various IRS employees, dated November 16, 2016. 26 Treas. Reg. § 1.1441-1(e)(5)(v)(B)(6)(C). 27 Treas. Reg. § 1.1441-1(e)(5)(v)(F). 28 Treas. Reg. § 1.871-15(r)(3). 29 Treas. Reg. § 1.871-15(q)(5). 30 Temp. Treas. Reg. § 1.1441-2(e)(7)(v).