On December 4, 2013, the Treasury Department and the Internal Revenue Service (the “IRS”) released new final and proposed regulations under section 871(m) of the Internal Revenue Code regarding the imposition of US federal withholding tax on certain equity-linked payments. Under the final regulations, swap payments made after March 18, 2012, but prior to January 1, 2016, will continue to be subject to the existing sourcing rules contained in section 871(m). Under the proposed regulations, beginning January 1, 2016, payments made under swaps and certain other financial instruments with respect to US equities that have a “delta” of 0.7 or greater would be treated as US source income under section 871(m) (generally regardless of whether such payments are determined by reference to US-source dividends) and, thus, potentially subject to US withholding tax. The proposed regulations represent a fundamental change in the government’s approach to cross-border derivative payments with respect to US equities by replacing a proposed regime that would subject to withholding tax only transactions that have specific indices of tax avoidance with a new system that essentially treats all cross-border equity derivatives on US equities with a sufficiently high delta as abusive tax avoidance transactions. The proposed regulations raise many difficult questions relating to tax policy, economic impact on markets and companies and administrability, among others.

While many market participants will be relieved that the current rules on “specified NPCs” are extended through December 31, 2015, there should be a great deal of concern that the new proposed regulations, as described fully below, generally would treat all equity swaps, forwards, options and other derivatives that have a delta of 0.7 or greater as subject to section 871(m) withholding without regard to whether any specific indicia of tax avoidance is present. As explained in the preamble to the new regulations, the Treasury Department and the IRS believe that all equity swaps and other derivatives captured by the new proposed regulations, subject only to two narrow exceptions, have the “the potential for tax avoidance’’ and thus would be subject to section 871(m) withholding. This is in sharp contrast to the prior proposed regulations which allowed market participants to avoid potential section 871(m) withholding on equity swaps so long as none of seven particular factors was present (or, alternatively, so long as payments were not actually contingent on or determined by reference to dividends on the underlying security). While the approach taken in the proposed regulations may be simpler in certain respects (perhaps in response to comments concerning the complexity of the prior proposed regulations), the broad and over-inclusive nature of the single factor approach may have substantial adverse effects on markets and investors.