The final and temporary regulations promulgated by the Internal Revenue Service (the “IRS”) in 2015 under section 871(m) of the Internal Revenue Code of 1986, as amended (the “Code”), create a new and extraordinary set of withholding rules with respect to dividend equivalents actually or deemed paid to non-US persons.2 Financial institutions, as the purveyors of equity swaps and other financial products linked to US stocks and securities, are the taxpayers that will be required to implement the new withholding rules. The rules were originally scheduled to become fully effective for financial products issued in 2017. With only days to go before the new rules were to take effect, the IRS answered industry pleas to provide more time to retool their withholding systems. The IRS responded in Notice 2016-76 and this article discusses the revised rules for withholding on dividend equivalents contained in the Notice. Brief Background In 1991, the IRS promulgated a regulation providing that income from a swap (notional principal contract, or NPC, in tax parlance) is sourced to the residence of the payee.3 This rule created the potential for a discontinuity with respect to equity swaps and total return swaps, on one hand, and actual stock ownership, on the other. Specifically, if a non-US person held a US stock directly, dividends paid on the stock would be treated as US-source income. Unless an income tax treaty provided for a total exemption from US federal income tax, the non-US stockholder would be subject to either 15 percent (most tax treaties) or 30 percent US (non-treaty rate) federal income tax withholding.4 In contrast, a dividend equivalent payment5 made to a non-US person under a swap in respect of a dividend paid on a US stock included in the specified index6 would be treated as non-USsource income and not be subject to US federal income tax withholding. Congress and the IRS perceived that banks and non-US taxpayers abused this disparity through a variety of transactions and initiated an audit campaign to curtail these perceived abuses.7 In March 2010, Congress addressed the perceived abuse through the passage of the HIRE Act.8 Specifically, Section 541 of the HIRE Act enacted Code § 871(m). Code § 871(m)(1) provides that a dividend equivalent “shall be treated as a dividend from sources within the United States.” For the period from the effective date of the HIRE Act, dividend equivalents paid or credited on certain swaps and in securities-lending transactions could be subject to withholding.9 Accordingly, Code § 871(m) reverses the rule contained in the 1991 Treasury Regulation for dividend equivalents on certain swaps. As a result, certain dividend equivalents are subject to the same US federal income tax withholding to which an actual dividend would be subject. Indeed, the IRS issued Temporary Regulations to 2 Mayer Brown | Stress Relief: IRS Notice 2016-76 Eases the Implementation Rules for Cross-Border Dividend Equivalent Withholding amend the 1991 regulation to specify that it no longer applied to dividend equivalents. This change has now been finalized.10 In 2012, the IRS released three sets of rules to implement and expand the rules in Code § 871(m).11 These proposed regulations were pulled by the IRS in August 2012.12 The IRS replaced these regulations with a new set in 2013.13 These regulations, in turn, were replaced with the current final and temporary regulations issued in 2015 (the “2015 Regulations”).14 The last set of regulations was complemented by the issuance of rules for Qualified Derivatives Dealers (“QDDs”).15 QDDs are electing financial institutions that issue swaps and equity-linked instruments that are pay or credit amounts subject to withholding under Code § 871(m). This article does not discuss the 2015 Code § 871(m) regulations. The discussion herein is limited to the changes made to such rules by Notice 2016-75 and assumes a working familiarity with Code § 871(m) and the existing regulatory scheme. Effective Date and Other Implementation Changes After some dilly-dallying, the IRS specified in the 2015 Regulations that only specified NPCs and equity-linked instruments issued on or after January 1, 2017 would be subject to the revised rules contained in the 2015 Regulations.16 This effective date created substantial challenges for withholding agents, mostly financial institutions, that have not been able to develop the systems necessary to determine the correct amount to be withheld and to effectuate the withholding itself. The IRS has issued two rules to help alleviate these challenges. First, the only dividend equivalents paid on specified NPCs and ELIs that will be subject to withholding on or after January 1, 2017 are those that are issued on or after such date and have a delta of 1.0.17 A financial product that has a delta of 1.0 very closely tracks the reference security. The theory behind leaving the effective date as of January 1, 2017 for delta one products is that these products do not pose significant computational withholding tax challenges, are easily identified and withholding can be implemented consistent with existing systems. Withholding on dividend equivalents paid on specified NPCs and ELIs with deltas of less than 1.0 (but 0.80 or greater) is required only if the transaction is opened or issued on or after January 1, 2018.18 The IRS has cautioned taxpayers that an anti-abuse rule will apply with respect to this delayed effective date.19 This admonition should prevent taxpayers issuing financial products that come very close to being delta one transactions in 2017 and taking the position that such products are entitled to the delayed effective date. Second, the IRS stated that it will audit withholding agents under specified NPCs and ELIs in 2017 and 2018 with a “light touch” if they have made good-faith efforts to comply with Code § 871(m). The IRS laid out four goodfaith efforts that will support enforcement relief for a taxpayer: (1) it has made efforts to update its withholding systems, (2) it has attempted to determine whether transactions should be combined, (3) it has issued section 871(m) information on ELIs that it issued and (4) it has implemented the substantial equivalent test (the “SET”). In addition, the IRS eased the deposit requirements for withheld tax on dividend equivalents by allowing deposits to be made on the last day of a calendar quarter. Retention of the QSL System Through 2017 The final Code § 871(m) regulations specified that the qualified securities lending rules would expire at the end of 2016 and the QDD regime would be the only avenue for securities lenders to avoid cascading withholding taxes.20 In a single sentence in Notice 2016-76, the IRS extended, through the end of 2017, the three regimes in Notice 2010-46 available to securities 3 Mayer Brown | Stress Relief: IRS Notice 2016-76 Eases the Implementation Rules for Cross-Border Dividend Equivalent Withholding lenders to avoid multiple withholding on the same economic dividend. Specifically, each of the QSL regime, the credit-forward system and presumption rules are extended through 2017 for securities-lending transactions. Combined Transactions The final 2015 Regulations contain rules requiring withholding agents to determine if two or more transactions with a single non-US counterparty, each of which standing alone would not be considered to give rise to dividend equivalents, should be combined and thereby generate taxable dividend equivalents.21 Notice 2016-76 provides substantial relief to withholding agents to enable them to develop systems to determine if this rule will apply. Under a transitional rule applicable to 2017 only, withholding agents transactions will be required to combine transactions only if they consist of over-the-counter (“OTC”) positions and are priced, marketed or sold in connection with each other.22 Withholding agents will not be required to combine transactions in listed positions in 2017. Furthermore, positions will not be retested for combination after the end of the transitional period unless a reissuance (or other retesting event) occurs after such period. The transitional rule does not apply to long parties, that is, nonUS persons who hold the positions. Changes to the QDD Rules The QDD regime was promulgated by the IRS to prevent the phenomenon of cascading withholding taxes.23 To illustrate, assume that non-US person “A” owns a share of US stock. “A” loans the stock to non-US person “B.” As is typical in securities-lending transactions, B must make payments equal to all dividends paid on the stock during the term of the transaction to A. B holds the stock over the dividend record date. The stock issuer withholds 30 percent of the dividend that it pays to B. If B is then required to withhold 30 percent of the amount of the dividend equivalent that it pays to A, there will have been multiple levels of withholding tax imposed on the same dividend. The QDD rules were promulgated pursuant to a Congressional mandate allowing the IRS to address this overwithholding when it added Code § 871(m) to the tax law.24 The most extensive changes to the Code § 871(m) withholding regime by Notice 2016-76 are made to the QDD rules. THE NET DELTA CALCULATION Under the original QI Agreement contained in Notice 2016-42, QDDs have a section 871(m) tax liability equal to the amount of dividends and dividend equivalents that they receive over the sum of dividends equivalents paid to non-US persons and amounts of dividend equivalents that they pay to US persons that would be treated as dividend equivalents if paid to non-US persons. As a result of the operation of this regime, if a QDD hedged the issuance of an ELI referencing a qualified index by holding the individual components of the index, the QDD would be subject to a withholding tax on dividends paid on the components. Similarly, if a QDD issued a financial product that escaped the dividend equivalent withholding rules by virtue of having a delta of less than 0.80, the QDD would remain subject to US tax on dividends paid on any shares held as a hedge of the low delta transaction. These challenges would have resulted in QDDs being required to hedge transactions using physical shares through their US branches. Thus, the regime would have resulted in tax on those QDDs without US branches or those that were caught unawares. In order alleviate this trap for the unwary, the IRS has changed the methodology to be used by QDDs to determine their section 871(m) tax liability. The change follows a suggestion made by the Securities Industry and Financial Markets Association (“SIFMA”) in a letter to the IRS.25 Under the new method, referred to as the “Net Delta Method,” a QDD will determine its “section 871(m) amount” by multiplying the net delta exposure by the relevant dividend 4 Mayer Brown | Stress Relief: IRS Notice 2016-76 Eases the Implementation Rules for Cross-Border Dividend Equivalent Withholding amount. The net delta exposure includes all physical positions and potential section 871(m) transactions entered into by the QDD in its equity derivatives dealer capacity.26 Since net delta is determined by reference to potential section 871(m) transactions (and not only actual section 871(m) transactions), the use of the net delta method should eliminate the need for back-to-back transactions through US branches of QDDs. WITHHOLDING ON PAYMENTS TO QDDS Under the original version of the QDD rules, payments of dividends and dividend equivalents to QDDs were not subject to US federal income tax withholding. The QDD selfassessed any tax liability that it might have by calculating its section 871(m) tax liability. Notice 2016-76 presages a significant change to this taxing regime by requiring that withholding agents withhold on actual dividends paid to QDDs.27 This rule does not require withholding on the payment of dividend equivalents made to QDDs. Although not entirely clear, it strongly appears that this withholding will be in lieu of withholding that the QDD itself would have been required to undertake with respect to specified NPCs and ELIs that it issues, not a second layer of tax. For example, assume that a QDD issues a total return equity swap to a non-US person with respect to 100 shares of a US Stock and purchases 100 shares of such stock as a hedge of its obligations under the equity swap. Under the original QDD regime, the custodian of the hedge shares would not have withheld on dividends paid on the hedge shares and the QDD would have withheld on dividend equivalents paid on the equity swap. The regime would continue to apply if the QDD hedged with a derivative instead of physical shares. Under the revised regime, the custodian of the hedge shares will withhold on dividends paid on the hedge shares. It appears that the QDD will not withhold on the dividend equivalents paid on the equity swap. Since the QDD will provide a Form W-8IMY to the custodian, it can specify the withholding rate applicable to the equity swap counterparty (or holder of an ELI, as the case may be) so that the custodian withholds at the rate applicable to the counterparty and not the QDD itself. The fact that upstream withholding has occurred does not relieve the QDD of residual withholding responsibility. If we are correct that the upstream withholding alleviates the requirement on the part of the QDD to withhold, for many smaller QDDs, the change requiring withholding on actual dividends paid to a QDD will be a welcome change because it will alleviate the necessity of building withholding tax systems. In other words, if the only activities with respect to US stocks and securities undertaken by the QDD is the issuance of structured products that include US stocks and securities and are hedged through the holding of physical shares, the withholding will be undertaken by the upstream withholding agent. As a result, the QDD issuer will not be required to undertake withholding and remittance itself. ELECTING QDD STATUS, TAX REMITTANCES AND OTHER ANCILLARY QDD MATTERS The IRS is aware that many financial institutions will be required to substantially retool their internal processes and procedures to be able meet the requirements specified in Notice 2016-42 to act as a QDD. Thus, Notice 2016-76 provides that the IRS will take into account good-faith efforts to comply with the QDD processes and procedures in auditing QDD compliance for 2017.28 In addition, the IRS will permit prospective QDDs to submit their applications to be QDDs after March 31st of a given year, and if the applicant has not received any reportable payments before the date that the application was submitted, QDD status will be granted as of the beginning of such year. The IRS will also permit companies 5 Mayer Brown | Stress Relief: IRS Notice 2016-76 Eases the Implementation Rules for Cross-Border Dividend Equivalent Withholding that have submitted QDD applications, or intend to submit applications prior to March 31, 2017, to treat themselves as QDDs through the end of the six-month period beginning after the month in which the application has been submitted. (Rules are also included allowing prospective QDDs to note that their QI-EIN is pending.) The rules for the QDD to make deposits of withheld taxes are also eased to allow the QDD to wait until it has received its QI-EIN to make such deposits. Applicable withholding rules permit a withholding agent, under limited circumstances, to satisfy its withholding obligation from cash held on behalf of the payee if the withholding agent fails to withhold on a withholdable payment.29 In Notice 2016-76, the IRS has extended these rules to allow withholding agents who fail to withhold on a dividend equivalent payment to adjust its withholding on amounts paid to the payee prior to March 15th of the succeeding taxable year. This rule applies to all withholding agents and not just QDDs. Grandfathering for Exchange-Traded Notes (“ETNs”) Many banks and other financial institutions issue ETNs on a continuous distribution basis. When ETNs are issued in this manner, the terms are set pursuant to a prospectus and when the issuer receives an order for an issuance of the ETN, it issues the ETN at that time. All ETNs issued pursuant to a single offering are fungible and are assigned the same CUSIP code. Under the pre-Notice 2017-76 regime, if an ETN issued pursuant to a continuous distribution scheme was issued prior to January 1, 2017, it would not be subject to dividend equivalent withholding. In contrast, if the same ETN was issued after such date, it would be subject to such withholding. This would have been true even though there was no way to distinguish between the two ETNs. Notice 2016-76 offers relief for continuously distributed ETNs, provided that the original ETN was issued before September 18, 2015, the date of the issuance of the final Code § 871(m) regulations. Specifically, ETNs issued pursuant to a continuous distribution originally started before September 18, 2015, but those issued on or after January 1, 2017 will be subject to Code § 871(m) withholding only on or after January 1, 2020. The relief is qualified, however, because only enumerated ETNs are entitled to this relief. In Notice 2016-76, the IRS has invited other issuers of ETNs issued pursuant to continuous distribution schemes first offered before September 18, 2015 to apply for exemption. It is worth noting that the same challenge exists with respect to exchange-traded options, but Notice 2016-76 does not offer any relief for such securities. Concluding Observations Notice 2016-76 provides a welcome respite to financial institutions grappling with the implementation of Code § 871(m) withholding. In particular, the announcement by the IRS that it understands that financial institutions are likely to experiences some hiccups in their initial year of operation and to excuse such missteps shows that the IRS understands the substantial operational challenges that Code § 871(m) has imposed. In addition, the provision of an additional year before non-delta one products become subject to Code § 871(m) should assist financial institutions in getting the new withholding regime operational.