IRS Issues Regulations on Dividend Equivalent Payments | Practical Law

IRS Issues Regulations on Dividend Equivalent Payments | Practical Law

An update on recently issued temporary and proposed regulations addressing the treatment of dividend equivalent payments.

IRS Issues Regulations on Dividend Equivalent Payments

Practical Law Legal Update 0-517-3793 (Approx. 4 pages)

IRS Issues Regulations on Dividend Equivalent Payments

by PLC Finance
Published on 25 Jan 2012 • USA (National/Federal)
An update on recently issued temporary and proposed regulations addressing the treatment of dividend equivalent payments.
The IRS and Treasury Department recently issued temporary and proposed regulations addressing the treatment of dividend equivalent payments. IRC Section 871(m), enacted in 2010, requires a US withholding tax on a "dividend equivalent payment" made to a non-US person. A dividend equivalent payment is any of the following:
  • A substitute dividend payment made under a securities lending or sale-repurchase transaction if the payment is contingent on or determined by reference to the payment of a dividend from US sources.
  • A payment under a "specified notional principal contract" if the payment is contingent on or determined by reference to the payment of a dividend from US sources.
  • Any other payment determined by the Secretary of the Treasury to be substantially similar to the two previous categories.
IRC Section 871(m) applies to cross-border dividend equivalent payments on a limited set of "specified notional principal contracts" until March 18, 2012. As originally enacted, IRC Section 871(m) would apply to cross-border dividend equivalent payments made after March 18, 2012 on all notional principal contracts unless the Secretary of the Treasury determines that a contract is not of a type having the potential for tax avoidance.
The temporary regulations extend the more limited statutory definition of specified notional principal contract in IRC Section 871(m) through the end of 2012. The proposed regulations provide a revised definition of specified notional principal contract for dividend equivalent payments made on or after January 1, 2013.
Under the proposed regulations, a notional principal contract is a specified principal contract if any of the following apply:
  • The long party (meaning the party that is entitled to receive any payment contingent on or determined by reference to the payment of a dividend) is "in the market" with respect to the underlying security on the same day or days that the parties price the notional principal contract or that the notional principal contract terminates, subject to a de minimis exception. The long party is in the market for the underlying security, for example, if it sells the underlying security on the same day the parties price the contract.
  • The underlying security is not regularly traded.
  • The short party to the notional principal contract posts the underlying security as collateral with the long party and the amount posted as collateral 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.
  • The notional principal contract has a term of fewer than 90 days (including notional principal contracts terminated within 90 days).
  • The long party controls or directs the short party's hedge of its short position or enters into the contract using an underlying "equity control program."
  • The notional principal amount of the underlying security is greater than either:
    • 5% of the total public float of that class of security.
    • 20% of the 30-day average daily trading volume in the underlying security, determined as of the close of the business day immediately preceding the first day in the term of the notional principal contract (and determined by aggregating all the notional principal contracts of the long party referencing the same underlying security).
  • The notional principal contract is entered into on or after the announcement of a special dividend on the underlying security and before the ex-dividend date.
Under the proposed regulations, a notional principal contract can become a specified notional principal contract during the term of the contract. US withholding tax would then apply both to dividend equivalent payments made to a foreign counterparty after the date the contract becomes a specified notional principal contact and to prior dividend equivalent payments made to a foreign counterparty under the contract on or after January 1, 2013.
The proposed regulations also include the following payments as "substantially similar" to dividend equivalent payments potentially subject to US withholding tax:
  • Any payment of a beneficial owner's tax liability (for example, a tax gross-up) with respect to a dividend equivalent made by a withholding agent.
  • Any payment under an equity-linked instrument that is contingent on or determined by reference to a dividend from US sources. An equity-linked instrument includes a futures or forward contract, option or other contractual arrangement.
The proposed regulations will not be effective until finalized. A hearing on the proposed regulations is scheduled for April 27, 2012.