IRS Issues Final Regulations and New Proposed Regulations Regarding Withholding on Derivatives on U.S. Stocks

by Orrick, Herrington & Sutcliffe LLP
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On December 5, 2013, the Internal Revenue Service ("IRS") issued final regulations (the "Final Regulations") and proposed regulations (the "2013 Proposed Regulations") under section 871(m), which address withholding on certain equity-linked notional principal contracts ("NPCs") and other financial instruments.  These regulations are targeted at derivatives referencing U.S. stocks in which non-U.S. persons receive a "dividend equivalent" while arguably avoiding U.S. withholding tax but will impact many common corporate transactions, including merger and acquisition transactions and equity based compensation arrangements.

Background

Section 871(m) was added by section 541 of the Hiring Incentives to Restore Employment Act (the "HIRE Act").[1]  This is discussed in our Tax Law Update dated April 1,  2010.   Section 871(m) provides that payments made pursuant to certain specified NPCs shall be treated as dividends from sources within the United States.  For NPC payments made on or after September 14, 2010, and on or before March 18, 2012, section 871(m)(3)(A) defines any NPC as a specified NPC if (1) the long party transferred the underlying security to the short party in connection with entering into the NPC, (2) the short party transferred the underlying security to the long party in connection with the termination of the NPC, (3) the underlying security is not readily tradable on an established securities market, (4) the short party posted the underlying security as collateral with the long party, or (5) the NPC is identified by the Secretary of the Treasury (the "Secretary") as a specified NPC. For NPC payments made after March 18, 2012, section 871(m)(3)(B) provides that any NPC is a specified NPC unless the Secretary determines that the NPC is of a type that does not have the potential for tax avoidance.

 On January 23, 2012, the IRS and Treasury issued proposed and temporary regulations.  The temporary regulations effectively postponed the effective date of withholding on those NPCs not specifically set out under the statute until January 1, 2014.  The proposed regulations (the "2012 Proposed Regulations") (which were proposed to apply to NPC payments made on or after January 1, 2014) contained a seven-factor test to determine whether an NPC is a specified NPC and also provided a definition for specified equity-linked instruments.  The 2012 Proposed Regulations were widely criticized as being overly inclusive. 

The Final Regulations

 The Final Regulations address the treatment of specified NPCs.  For payments made after March 18, 2012 but before January 1, 2016, a specified NPC is any NPC if  (1)  in connection with entering into the contract, any long party to the contract transfers the underlying security to any short party to the contract, (2) in connection with the termination of the contract, any short party to the contract transfers the underlying security to any long party to the contract, (3)  the underlying security is not readily tradable on an established securities market, or (4) in connection with entering into the contract, the underlying security is posted as collateral by any short party to the contract with any long party to the contract.

The criteria are substantially similar, but not identical, to the criteria used to identify specified NPCs under section 871(m)(3)(A).

The 2013 Proposed Regulations

The 2013 Proposed Regulations address both specified NPCs and "equity-linked instruments."  An equity-linked instrument ("ELI") "is a financial transaction, other than a securities lending or sale-repurchase transaction or an NPC that references the value of one or more underlying securities.  For example, a futures contract, forward contract, option, debt instrument (including convertible debt instruments), or other contractual arrangement that references the value of one or more underlying securities is an ELI."[2]  The 2013 Proposed Regulations carve out transactions where an investor has an obligation to acquire underlying securities representing more than 50% or greater of value of the entity issuing the underlying securities from the scope of section 871(m).[3]  This carve out will still subject many investors, particularly those that invest through pass-through vehicles, to the rules of section 871(m).  Likewise, equity compensation arrangements may fall under section 871(m).

Both specified NPCs and specified ELIs are those contracts for which there is a delta (defined below) of 0.70 or greater.  The use of a bright-line test to determine dividend equivalency is a fundamental change from the seven-factor test.  This test is controversial, as many believe that a 0.70 delta is too low a threshold, a belief that is supported by market practice with respect to the "substantially all" requirement underlying section 1260 constructive ownership transactions.[4]

Delta

Delta is defined as the ratio of change in the fair market value of the contract relative to the change in the fair market value of the referenced equity.[5]  If an NPC or ELI references more than one underlying security, a separate delta must be determined with respect to each "underlying security" without taking into account any other underlying security or other property or liability.  The delta is determined at the time of acquisition for purposes of determining whether an NPC or ELI is a specified NPC or specified ELI.[6]   If the contract has a delta of .70 or more at that time with respect to the underlying security, the instrument is either a specified NPC or a specified ELI.

There will be no withholding if the instrument references a qualified index.  A qualified index is an index that:

(i) references 25 or more component underlying securities;

(ii) references only long positions in component underlying securities;

(iii) contains no component underlying security that represents more than 10 percent of the weighting of the underlying securities in the index;

(iv) is modified or rebalanced only according to "predefined objective rules" at set dates or intervals;

(v) does not provide a dividend yield from component underlying securities that is greater than 1.5 times the current dividend yield of the S&P 500 Index as reported for the month immediately preceding the date the long party acquires the potential section 871(m) transaction; and

(vi) futures contracts or option contracts on the index trade on a national securities exchange that is registered with the Securities and Exchange Commission or a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission.[7]

Under a safe harbor, an index is also a qualified index if the index is comprised solely of long positions in assets and the referenced component underlying securities in the aggregate comprise 10 percent or less of the index's weighting.[8]

While the criteria under which an index may be considered a qualified index seem quite liberal, many indices will fail to meet the predefined objective criteria standard.  For instance, the S&P 500 is modified by operation of a committee and not through objective rules. There are also many indices on which there is no comparable traded futures contract or options   contract.  Many customized indices also contain short positions, either as hedging devices or as part of their strategy, thus disqualifying them from qualified index status.

Withholding on Implicit Dividends

In an important change from the 2012 Proposed Regulations, withholding would be required on "implicit dividends."  A payment includes an actual or estimated dividend payment that is implicitly taken into account in computing one or more of the terms of a potential section 871(m) transaction, including interest rate, notional amount, purchase price, premium, up-front payment, strike price, or any other amount paid or received pursuant to the potential section 871(m) transaction.  A simple forward contract has an implicit dividend because dividend payments are estimated and are built into pricing.

As another example, convertible debt, which is commonly utilized to capitalize start-up companies, would fall within the scope of section 871(m).  Deemed dividends can arise under section 305 upon the occurrence of various events and, when they occur, may be subject to withholding taxation. The 2013 Proposed Regulations provide that section 305 takes precedence over section 871(m), however, the circumstances giving rise to a deemed dividend under section 871(m) are not the same.[9]  Thus, convertible debt issued to, for example, "angel" investors that are offshore might be subject to section 871(m) withholding if the delta threshold is met.

Effective Date

The 2013 Proposed Regulations would be effective for payments made after January 1, 2016; there is no transition rule for preexisting contracts.  For specified ELIs, the 2013 Proposed Regulations would apply to payments made on or after January 1, 2016, but only with respect to an ELI that was acquired by the long party on or after March 5, 2014.   Thus, the effective date of the 2013 Proposed Regulations turns on when an instrument is acquired, not when it is issued.

The Amount of the Dividend Equivalent

For a securities lending or sale-repurchase transaction, the amount of the dividend equivalent for each underlying security equals the amount of the actual per share dividend paid on the underlying security multiplied by the number of shares of the underlying security transferred pursuant to the securities lending or sale-repurchase transaction.  For a specified NPC or a specified ELI, the amount of the dividend equivalent for each underlying security equals: (1) the amount of the per share dividend with respect to the underlying security multiplied by (2) the number of shares of the underlying security of this section multiplied by (3) the delta of the section 871(m) transaction with respect to the underlying security at the time that the amount of the dividend equivalent is determined. This delta is used solely for purposes of determining the amount of the dividend equivalent at that time, and the transaction is not retested to determine if it is a section 871(m) transaction.[10]  The purpose for using the delta at the time of the dividend payment appears to be to allow for adjustments in the underlying hedge maintained by the short party.

Reporting and Withholding

Brokers and dealers that are parties to potential section 871(m) transactions must provide information to the counterparty.  If there is no broker or dealer, the short party must provide this information.  The party to the transaction that is required to determine whether a transaction is a section 871(m) transaction must also determine and report to the counterparty or customer the timing and amount of any dividend equivalent.[11]

A withholding agent is not obligated to withhold until the later of (i) the time that the amount of a dividend equivalent is determined and (ii) the time that the withholding agent is deemed to have control over money or other property of the long party.[12]  For purposes of determining whether a payment is a dividend equivalent and the amount of the dividend equivalent, a withholding agent may rely on the information received from the party to the transaction that is required to determine whether a transaction is a section 871(m) transaction as provided above, unless the withholding agent has actual knowledge or reason to know that the information received is incorrect.[13]

Lastly, parties that take the short position on either a specified NPC or specified ELI should examine their ISDA agreements to determine whether they will be obligated to make gross up payments by reason of the proposed changes.


[1]           Public Law 111-147 (124 Stat. 71).

[2]           Prop. Reg. § 1.871-15(a)(4).

[3]           Prop. Reg. § 1.871–15(j)(2).

[4]           See Senate Report No. 106-201, 106th Congress, 1st Session 32 (1999), for the legislative history    of section 1260.

[5]             Prop. Reg. § 1.871-15(g)(1).

[6]             Prop. Reg. § 1.871-15(d)(2) and (e).

[7]             Prop. Reg. § 1.871-15(k)(2).

[8]             Prop. Reg. § 1.871-15(k)(3).

[9]             Prop. Reg. § 1.871–15(c)(2)(ii).

[10]           Prop. Reg. § 1.871-15(i)(1)(ii).

[11]           Prop. Reg. § 1.871-15(o).

[12]           Prop. Reg. § 1.1441-2(d)(5).

[13]           Prop. Reg. § 1.1441-3(h)(2).

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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