IRS Amends Temporary Treasury Regulations under Section 871(m)

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          On August 31, 2012, the U.S. Internal Revenue Service (the “IRS”) amended Temporary Treasury Regulations (the “Temporary Regulations”) under Section 871(m) of the U.S. Internal Revenue Code of 1986, as amended (the “Code”),[1] that were originally issued on January 23, 2012, postponing the effective date for the new regulatory scheme contemplated by Proposed Treasury Regulations also issued on January 23, 2012 (the “Proposed Regulations”).  The Temporary Regulations now extend the definition of “specified notional principal contract” that is set forth in Section 871(m)(3)(A) to payments made before January 1, 2014.

A.     Treatment of Dividend Equivalents under Section 871(m)

         Section 871(m) treats certain dividend equivalent payments as U.S. source income for withholding tax purposes.  Accordingly, unless reduced by an applicable income tax treaty with the United States, such payments generally are subject to U.S. withholding tax at a rate of 30%.  Under Section 871(m), dividend equivalent payments include:

(A)       any substitute dividend made pursuant to a securities
lending or a sale-repurchase transaction that (directly or indirectly) is contingent upon, or determined by reference to, the payment of a dividend from sources within the United States;

(B)       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

(C)       any other payment determined by the Secretary to be substantially similar to a payment described above.

B.     Section 871(m) Definition of “Specified Notional Principal Contract”

         A specified notional principal contract is defined in Section 871(m)(3)(A) as any notional principal contract if:

(i)         in connection with entering into such contract, any long party to the contract transfers the underlying security to any short party to the contract;

(ii)        in connection with the termination of such contract, any short party to the contract transfers the underlying security to any long party to the contract;

(iii)       the underlying security is not readily tradable on an established securities market;

(iv)       in connection with entering into such contract, the underlying security is posted as collateral by any short party to the contract with any long party to the contract; or

(v)        such contract is identified by the Secretary as a specified notional principal contract.

However, for payments made after March 18, 2012, Section 871(m)(3)(B) defines “specified notional principal contract” as any notional principal contract unless the Secretary determines that such contract is of a type which does not have the potential for tax avoidance.

C.     Proposed Regulations and Temporary Regulations under Section 871(m)

         The original Temporary Regulations extended until January 1, 2013, the current statutory scheme (i.e., the definition of “specified notional principal contract” that is set forth in Section 871(m)(3)(A) would continue to apply until January 1, 2013).  The Proposed Regulations, which are effective for payments made after finalization, set forth a new definition of “specified notional principal contract.”  Under the Proposed Regulations, a “specified notional principal contract” is defined as any notional principal contract if:

(1)        the long party to the contract is “in the market” on the same day that the parties price the contract or when the contract terminates (very generally, a long party would be “in the market” if it (x) sells the underlying security on the same day or days that the parties price the contract, (y) purchases the underlying security on the same day or days that the contract terminates, or (z) sells or purchases the underlying security on other days at a price that is determined by reference to an amount used to price or terminate the contract);

(2)        the underlying security is not regularly traded;

(3)        the short party posts the underlying security with the long party as collateral, and the underlying security represents more than 10% of the total fair market value of all the collateral posted by the short party on any date that the contract is outstanding;

(4)        the term of the contract is fewer than 90 days;

(5)        the long party controls the short party’s hedge of its short position (including using certain underlying equity control programs);

(6)        the notional principal amount is greater than:  (i) 5% of the total public float of the underlying security or (ii) 20% of the 30-day daily average trading volume, as determined at the close of business on the day immediately before the first day of the contract’s term; or

(7)        the contract is entered into on or after the announcement of a special dividend and before the ex-dividend date.

D.     Comments to Proposed Regulations and Temporary Regulations under Section 871(m) and IRS Response

         Commentators on the Proposed Regulations have noted that they pose many challenges for the withholding tax system and expand the contexts in which a non-U.S. person may be required to act as a withholding agent.  It was further noted that Section 871(m) is principally aimed at arrangements that provide synthetic exposure to the full economic risk and reward of an underlying security (so-called total return or delta one transactions).  However, the Proposed Regulations could apply more broadly to other arrangements, including options and other instruments that are not economic substitutes for actual ownership.  In this regard, the amendment to the Temporary Regulations acknowledges that Treasury and the IRS received numerous comments that the proposed effective date of January 1, 2013, would not allow taxpayers enough time to build and test the systems required to implement the withholding rules for specified notional principal contracts.  In response to these comments, the amended Temporary Regulations effectively delay the applicability of Section 871(m)(3)(B) and the definition of “specified notional principal contract” that is set forth in the Proposed Regulations until January 1, 2014.


[1]  Unless otherwise indicated, all Section references herein are to the Code.


Rider 1

Circular 230 Disclaimer: To ensure compliance with requirements imposed by the IRS, please note that any tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding tax-related penalties that may be imposed on the taxpayer.