On December 4, 2013, the Internal Revenue Service took the following two regulatory actions with respect to withholding on U.S. source dividend equivalent payments made pursuant to swaps and other equity-linked instruments (“ELIs”):

• the temporary regulations defining a specified notional principal contract (an “NPC”) by reference to a four-factor test (discussed below) were finalized and made applicable to payments made on NPCs prior to January 1, 2016; and
• the proposed regulations defining a specified NPC (and ELI) by reference to a seven-factor test were withdrawn and replaced with new proposed regulations applying a single-factor test based on the “delta” of the derivative which, if finalized, will be applicable to payments made on or after January 1, 2016.

Final Regulations

The final regulations extend the applicability of the definition for a specified NPC currently in effect under temporary regulations to payments made under specified NPCs prior to January 1, 2016. Under the current definition, which had been set to expire at the end of 2013, a specified NPC is an NPC that has present any of the following factors:

• a long party, in connection with entering into an NPC, transfers the underlying security to the short party;
• a short party, in connection with the termination of an NPC, transfers the underlying security to the long party;
• the underlying security is not readily tradable on an established securities market; or
• the short party, in connection with entering into an NPC, posts the underlying security as collateral.

The final regulations also:

• make clear that financial intermediaries and custodians that are withholding agents will be responsible for withholding on dividend equivalent payments;
• provide that withholding is on the gross amount used in computing any net payment amount;
• provide that dividend equivalent payments are subject to reduction by treaty as if they were dividends; and
• provide that foreign sovereign entities (such as sovereign wealth funds) may receive dividend equivalent payments free of withholding.

New Proposed Regulations

The new proposed regulations, if finalized, will apply to payments made under specified NPCs on or after January 1, 2016. These regulations will also apply to dividend equivalent payments made under specified ELIs. ELIs are equity-linked instruments such as futures, forwards, options, debt instruments and other contractual arrangements that reference the value of one or more underlying securities.

The new proposed regulations represent a major change in the IRS’s approach to defining specified NPCs and ELIs. The withdrawn proposed regulations applied a seven-factor test that generally expanded upon the four-factor test discussed above. These factors were intended to identify transactions that were motivated by tax avoidance. The IRS has completely abandoned that approach with the new proposed regulations, which adopt a single factor that is based on the relationship of the value of the derivative to its underlying security. This test will apply regardless of whether tax avoidance indicia are present.

The single-factor test is referred to as “delta”. If the delta of an NPC or ELI is 0.70 or greater, such transaction will be a specified NPC or specified ELI, and withholding on dividend equivalent payments will apply to such transaction. Delta is defined as the ratio of the change in the fair market value of an NPC or ELI to the change in the fair market value of the property referenced by the NPC or ELI. If an NPC or ELI is expected to have a delta that is not reasonably expected to vary during the term of the transaction, the instrument will be treated as having a delta of 1.0. It would appear that most single stock NPCs would have deltas of 1.0.

The new proposed regulations also contain these noteworthy features:

• estimated dividends are no longer excepted from the definition of dividend equivalents;
• dividend equivalents include any contractual term that is calculated based on an actual or estimated dividend, meaning that NPCs such as price return swaps would be included as specified NPCs because the anticipated dividend payments are presumed to be taken into account in determining the terms of the NPC;
• for a transaction that references multiple securities, a separate delta must be determined with respect to each underlying security;
• multiple transactions entered into by a long party (as a long party) referencing the same underlying security will be considered to be a single transaction;
• a transaction referencing a “qualified index” will not be a specified NPC or ELI;
• withholding will not apply to dividend equivalent payments to certain foreign dealers; and
• contingent interest will not qualify for the portfolio interest exemption to withholding to the extent that the interest is a dividend equivalent.

We will continue to keep you updated on any developments regarding withholding on dividend equivalents. If you have any questions regarding this topic, please contact: Jim Cofer (212/574-1688, cofer@sewkis.com), Ron Cima (212/574-1471, cima@sewkis.com), Jon Brose (212/574-1615, brose@sewkis.com), or Dan Murphy (212/574-1210, murphyd@sewkis.com).