Generally, payments of dividends are sourced based on the residence of the payor while payments on swaps are sourced based on the residence of the recipient.1 Prior to the enactment of Section 871(m) of the Code,2 these sourcing rules created a disparity; dividends paid to foreign persons were subject to a U.S. withholding tax3 while dividend equivalent payments made pursuant to a swap may not have been subject to a U.S. withholding tax.
Congress felt this disparity in treatment was improper. In response, it enacted Section 871(m) on March 18, 2010, which treats a dividend equivalent payment as a dividend from sources within the United States for purposes of Sections 871(a), 881, 4948(a) and Chapters 3 and 4. A dividend equivalent payment is:
- any substitute dividend made pursuant to a securities lending or salerepurchase transaction that (directly or indirectly) is contingent upon, or determined by reference to, the payment of a dividend from sources within the United States;
- any payment made pursuant to a specified notional principal contract that (directly or indirectly) is contingent upon, or determined by reference to, the payment of a dividend from sources within the United States; and
- any other payment that the Secretary determines is “substantially similar” to a specified notional principal contract or substitute dividend payment.4
For payments made after March 18, 2012, a specified notional principal contract is any notional principal contract unless the Secretary determines that such contract is of a type which does not have the potential for tax avoidance.5 A payment is any gross amount used in computing any net amount transferred to or from the taxpayer.6
On December 5, 2013, Treasury and the IRS withdrew proposed regulations they had issued under Section 871(m) in 2012 (the “2012 Proposed Regulations”)7 and issued new proposed regulations (the “2013 Proposed Regulations”).8 Under the 2013 Proposed Regulations, whether a securities lending, sale-repurchase transaction, specified notional principal contract, or specified equity linked instrument is subject to Section 871(m) is determined by comparing the change in fair market value of the securities lending, sale-repurchase transaction, notional principal contract, or equity linked instrument to the change in fair market value of the property referenced by those contracts; this is referred to as the “delta.”9 If the contract has a delta of 0.70 or greater at the time the long party acquires the notional principal contract or equity linked instrument, then such contract is subject to Section 871(m).10 On March 4, 2014, the IRS announced that it intended to limit specified equity linked instruments to those equity linked instruments issued on or after 90 days after the date the regulations are finalized.11
The 2013 Proposed Regulations define dividend equivalent as any amount that implicitly or explicitly references the payment of a U.S. source dividend or is calculated based on an actual or estimated dividend.12 As a result, a notional principal contract that provides for a payment based on the appreciation but not payments based on any regular dividends is still treated as a dividend equivalent payment because the anticipated dividends are presumed to have been taken into account in determining the other terms of the notional principal contract, including the price.13
The method used to calculate the dividend equivalent amount depends on the type of contract and whether the contract includes a reasonable estimate of future dividends. For a security lending or sale-repurchase contract, the dividend equivalent amount is equal to the actual per share dividend amounts paid on the underlying security multiplied by the number of shares transferred.14 For a specified notional principal contract or specified equity linked instrument, the dividend equivalent amount equals the per share dividend amount with respect to the underlying security multiplied by the number of shares of the underlying security referenced in the contract (subject to adjustments) multiplied by the delta of the transaction with respect to the underlying security at the time that the amount of the dividend equivalent is determined.15 The delta used to calculate the dividend equivalent amount may differ from the delta used to determine whether a transaction is subject to Section 871(m).16
The 2013 Proposed Regulations generally will apply to payments made on or after the date the final regulations are published. However, the definition of specified notional principal contract will apply to payments made pursuant to a specified notional principal on or after January 1, 2016 and the definition of specified equity linked instrument will apply to payments made on or after January 1, 2016 on an equity linked instrument that was acquired by the long party on or after March 5, 2014.
The delta based standard of the 2013 Proposed Regulations uses an objective test to determine whether a notional principal contract or equity linked instrument17 will be subject to Section 871(m). This should provide greater certainty for financial institutions and should be easier to apply than the seven factor standard of the 2012 Proposed Regulations.