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Final Section 871(m) Regulations???
Practicing Law Institute
Taxation of Financial Products & Transactions 2015
January 8, 2015
Panelists:
Kristen M. Garry
Shearman & Sterling LLP
Viva Hammer
Joint Committee on Taxation
Julio M. Jimenez
PricewaterhouseCoopers
Laurence Salva
Citigroup
Background
•
Prior to the enactment of section 871(m), U.S. withholding tax generally was not
imposed on dividend equivalent payments made with respect to equity swaps.
•
Specifically, under Treas. Reg. § 1.863-7, income under a notional principal
contract (“NPC”) is generally sourced by reference to the residence of the recipient.
•
In response to concerns about the use of equity swaps to avoid U.S. withholding tax
on dividends, Congress enacted section 871(m) on March 18, 2010 as part of the
HIRE Act.
•
Section 871(m) treats “dividend equivalent” payments as U.S. source dividend
income.
•
Dividend equivalent payments are defined as any payment made on a specified NPC
(“Specified NPC”) that is contingent upon, or determined by reference to, the
payment of dividends on U.S. securities and any payment that Treasury determines
is “substantially similar.”
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Background (cont’d)
•
Under Section 871(m), Specified NPCs include any NPC where:
• The long party transfers the underlying security to the short party in connection
with entering into the NPC (“crossing-in”);
• The short party transfers the underlying security to the long party in connection
with terminating the NPC (“crossing-out”);
• The underlying security is not readily tradable on an established securities
market;
• In connection with entering into the NPC, the underlying security is posted as
collateral by the short party to the long party; or
• Any other contract identified by the Secretary as a Specified NPC.
•
Section 871(m) also provides that, with respect to payments made after March 18,
2012, any NPC will be treated as a Specified NPC unless the Secretary determines
that such NPC is “of a type which does not have the potential for tax avoidance.”
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Background (cont’d)
•
On January 19, 2012, Treasury and the IRS issued temporary and proposed
regulations under section 871(m).
• The temporary regulations maintained the four statutory categories of Specified
NPCs for payments made until December 31, 2012.
• The proposed regulations were scheduled to be effective for payments on or
after January 1, 2013 and set forth seven categories of Specified NPCs, as well
as expanding the scope of section 871(m) to cover other “equity-linked
instruments” (ELIs), including futures, forwards, options and convertible debt
instruments.
•
On August 31, 2012, the effective date of the temporary regulations was extended to
December 31, 2013, with the proposed regulations then proposed to be effective for
payments on or after January 1, 2014.
•
On December 4, 2013, Treasury and the IRS issued final regulations and new
proposed regulations replacing the prior proposed regulations.
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Current Effective Dates
•
Final Regulations: continue to apply the four categories of Specified NPCs under the
statute to payments on NPCs made on or before December 31, 2015.
•
Proposed Regulations:
• Would apply to all payments made on a Specified NPC on or after January 1,
2016 regardless of when the Specified NPC was executed.
• Would apply to all payments made on a specified ELI (“Specified ELI”) on or
after January 1, 2016 but only with respect to an ELI acquired on or after March
5, 2014.
•
There is no grandfathering for Specified NPCs, and there is limited grandfathering for
Specified ELIs “acquired” prior to March 5, 2014.
•
With the continued absence of final regulations, one has to wonder if the effective
date will be further delayed.
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2013 Proposed Regulations
•
The significant differences between the 2013 proposed regulations and the prior
proposed regulations are:
•
The 2013 proposed regulations eliminate the seven categories of specified NPCs
outlined in the prior proposed regulations, and replace them with a single
category of Specified NPCs and Specified ELIs based on the “delta” of the
transaction.
•
Unlike the prior proposed regulations, the 2013 proposed regulations do not
provide an exception preventing estimated dividends from being treated as
“dividend equivalents” for purposes of section 871(m).
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2013 Proposed Regulations: Delta Test
•
NPCs and ELIs will be treated as Specified NPCs or Specified ELIs if the instrument
has a delta of 0.7 or more on the date the instrument is acquired.
•
For this purpose, delta generally means the following ratio:
• the change in the fair market value of the NPC or ELI, to
• the change in the fair market value of the property referenced by the NPC
or ELI.
•
The delta of an NPC or ELI is deemed to be 1.0 if the ratio set forth in the general
rule is not reasonably expected to vary during the term of the transaction.
•
Delta must be determined in a commercially reasonable manner. That is, if a
taxpayer calculates delta for non-tax business purposes, then the ratio calculated by
the taxpayer is generally treated as the delta for purposes of section 871(m).
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2013 Proposed Regulations: Dividend Equivalents
•
•
A dividend equivalent is any payment pursuant to a Specified NPC or Specified ELI
that “references the payment of a dividend from an underlying security.” For this
purpose:
•
An underlying security generally means stock of a U.S. corporation, and
•
A payment includes any gross amount that is used in computing any net amount
even if the long party receives no actual payment.
A payment includes any amount that references an actual or estimated amount of
dividends, “whether explicit or implicit.”
•
Thus, a payment includes an actual or estimated dividend payment that is
implicitly taken into account in computing one or more terms of the transaction
(e.g., purchase price, upfront payment, premium, etc.).
•
This change would appear to affect the treatment of many “price only”
instruments.
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2013 Proposed Regulations: Calculation of Dividend Equivalents
•
Even if the transaction provides for “payments” based on estimated dividends, the
dividend equivalent is based on the actual dividend amount.
•
•
The amount of a dividend equivalent equals:
•
The actual dividends on the underlying security, multiplied by
•
The delta of the transaction at the time the amount of the dividend equivalent is
determined.
•
•
Exception if there is a written estimate of dividends provided upfront.
For a Specified NPC or Specified ELI with a term of one year or less, the amount of a
dividend equivalent is determined when the long party disposes of the transaction. For
this purpose:
•
The delta of an option when it lapses is treated as zero, and
•
The delta of an option when it is exercised is treated as one.
For transactions with a term of more than one year, the amount of a dividend equivalent
is determined on the earlier of the ex-dividend date and record date for the dividend.
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2013 Proposed Regulations: Qualified Index Exception
•
Under the proposed regulations, a “qualified index” is not treated as an underlying
security, and therefore instruments linked to a qualified index are not subject to the
sourcing rule of section 871(m).
•
An index is a “qualified index” if it:
o References 25 or more component underlying securities;
o References only long positions in the underlying securities;
o Contains no component representing more than 10 percent of the weighting of
the securities in the index;
o Is modified or rebalanced only according to predefined objective rules at set
intervals;
o Does not provide a dividend yield that is 1.5 times the dividend yield of the S&P
500 Index for the prior month; and
o Futures or options on the index trade on a national securities exchange that is
registered with the SEC or a domestic board of trade designated as a contract
market by the CFTC.
•
A transaction referencing a qualified index will not qualify for this exception if, in
connection with such transaction, the taxpayer reduces its exposure to any component
of the index.
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2013 Proposed Regulations: Other Rules
•
Combined Transactions. To prevent the avoidance of section 871(m), the proposed
regulations provide that, in certain circumstances, two or more transactions
referencing the same underlying security will be treated as a single transaction. For
example, a purchased call option and a written put option, each with a delta less than
0.7 may be treated as a combined transaction with a delta in excess of 0.7, but only if
one option was acquired “in connection with” the other.
•
Passthroughs. A transaction that references an interest in an entity that is not a C
corporation may be treated as referencing the underlying securities held by such
entity. This rule will not apply if underlying securities represent 10 percent or less of
the value of the referenced interest in the entity.
•
Anti-abuse rule. If a taxpayer or related person acquires a transaction with a principal
purpose of avoiding the application of section 871(m), the Commissioner may treat
any payment with respect to such transaction as a dividend equivalent by, among
other things, adjusting the delta of the transaction, the timing of payments or the
components of an index.
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2013 Proposed Regulations: Two Exceptions
•
Qualified Dealer Exception – applies where the long party to the transaction is a
“qualified dealer” that enters into a transaction in its capacity as a dealer in securities.
• A qualified dealer is a dealer that is subject to regulatory supervision by the
government where it was organized and provides a written certification that it is
a qualified dealer.
• This exception does not apply with respect to any proprietary position held by a
dealer.
•
Corporate Acquisition Exception – applies to transactions that obligate the long party
to acquire ownership of the underlying security as part of a plan pursuant to which
one or more persons are obligated to acquire more than 50 percent of the issuing
entity’s value.
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2013 Proposed Regulations: Reporting Requirements
•
A broker or dealer that is a party to a potential section 871(m) transaction (or
otherwise the short party) must:
• Determine whether the transaction is subject to section 871(m), and
• Report to the counterparty or customer the amount and timing of dividend
equivalents.
•
Thus, brokers and dealers generally will need to determine the delta of each
transaction entered into by its customer or counterparty:
• At the moment of acquisition (to determine whether the delta is 0.7 or above),
and
• For each section 871(m) transaction, on the date of each underlying dividend (to
determine the amount of the dividend equivalent).
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2013 Proposed Regulations: Withholding Agent Matters
•
A withholding agent is not required to withhold until the later of:
o the time that the amount of the dividend equivalent is determined; and
o the time at which the withholding agent is deemed to have control over property
of the long party.
•
Under the prior proposed regulations, a transaction could be subject to section
871(m) due to facts not in the possession of the withholding agent.
•
Under the 2013 proposed regulations, a withholding agent generally will possess the
information needed to determine whether a transaction is subject to section 871(m)
and where it does not possess such information (under the combined transaction
rule), it will not be held liable for failure to withhold.
•
No relief is provided for cascading withholding tax (other than the qualified dealer
exception).
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