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IRS Issues Regulations on Dividend Equivalent Payments
Practical Law Legal Update w-000-6039 (Approx. 3 pages)
IRS Issues Regulations on Dividend Equivalent Payments
by Practical Law Finance
| Published on 23 Sep 2015 • USA (National/Federal) |
The IRS and Treasury Department recently issued final and temporary Treasury regulations addressing the treatment of dividend equivalent payments on US equity swaps and other US-equity linked instruments.
The IRS and Treasury Department recently issued final and temporary Treasury regulations under IRC Section 871(m) addressing the treatment of dividend equivalent payments on US equity swaps and certain other US-equity linked instruments held by foreign persons. The IRS and Treasury Department previously issued final and proposed regulations on dividend equivalent payments in December 2013 (for more information on these earlier regulations, see Legal Update, IRS Issues Final and New Proposed Regulations on Dividend Equivalent Payments) (2013 Regulations). IRC Section 871(m), enacted in 2010, treats dividend equivalent payments as US-source dividends subject to US withholding tax (unless eliminated by an applicable income tax treaty).
Under IRC Section 871(m), 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" (NPC) 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.
The final Treasury regulations retain the basic approach of the 2013 Regulations and define a dividend equivalent as any of the following:
- Any substitute dividend that references a US source dividend made pursuant to a securities lending or sale-repurchase transaction.
- Any payment that references a US source dividend made pursuant to a "specified NPC".
- Any payment that references a US source dividend made pursuant to a "specified equity-linked instrument" (ELI). ELIs include futures and forward contracts, options, debt instruments and other instruments that reference the value of one or more underlying securities.
- Any other substantially similar payment.
The final Treasury regulations also retain the single-factor delta threshold to determine whether an NPC or ELI is a specified NPC or specified ELI.
Partly in response to industry comments, the final and temporary Treasury regulations also make several significant changes to the 2013 Regulations, including:
- Delaying the effective date. The Treasury regulations will only apply to:
- specified NPCs and specified ELIs that are issued on or after January 1, 2017; and
- dividend equivalent payments made on or after January 1, 2018 with respect to a specified NPC or specified ELI issued on or after January 1, 2016 and before January 1, 2017.
- Adopting a higher (0.80) delta threshold to determine whether a simple NPC or ELI is an IRC Section 871(m) transaction. Under this test, an NPC or ELI that has a delta of 0.80 or greater with respect to an underlying security is a specified NPC or specified ELI. Under the 2013 Regulations, the delta threshold was 0.70.
- Applying the delta threshold test solely at the time an NPC or ELI is issued. It is not re-tested when the instrument is purchased or otherwise acquired in the secondary market. Under the 2013 Regulations, the delta threshold test was applied each time a contract is acquired. This change should remove most ordinary convertible bonds from the scope of 871(m).
- Adopting a separate "substantial equivalence" test to determine if a complex NPC or ELI (that is, one with an indeterminate delta) is a specified NPC or specified ELI.
- Requiring withholding agents to withhold on dividend equivalent payments on a specified NPC or specified ELI only on the later of when actual payments are made or when the amount of a dividend equivalent is determined (rather than withholding on deemed dividend payments).