The IRS recently issued final and temporary regulations (the “Final Regulations”) with respect to withholding on U.S. source dividend equivalent payments made pursuant to swaps and other equity-linked instruments (“ELIs”). The Final Regulations retain the basic “delta test” framework of the regulations that were issued in proposed form at the end of 2013 (the “Proposed Regulations”). However, there are a number of important revisions and clarifications from the Proposed Regulations.

By way of background, the Final Regulations are issued pursuant to Section 871(m).¹ Section 871(m) mandates that dividend equivalent payments under swaps and ELIs be considered as dividends from sources within the United States, thereby subjecting such payments to the same 30% withholding tax to which actual dividends from U.S. sources are subject. The Final Regulations set forth the rules for determining when a dividend equivalent exists. The Final Regulations, like the Proposed Regulations, are expansive in scope, and apply Section 871(m) not only to a potentially large number of swaps but also to ELIs, such as options, futures, forwards, contingent debt and convertible debt. The law in its current state applies to a much narrower range of swaps, and does not apply to ELIs at all.

For more information on the current state of the law and the Proposed Regulations, see our previous memorandum titled “New Proposed Regulations Represent a Major Change in the IRS’s Approach to Withholding on Dividend Equivalent Payments.”

Highlights from the Final Regulations

• Change in Delta Test. The Final Regulations set 0.80 as the delta test rather than the 0.70 test in the Proposed Regulations. Delta is the ratio of the change in the fair market value of a swap or ELI to a small change in the fair market value of the number of shares of the underlying security. Typically, a small change is a change of less than 1%.
• Time for Testing Delta. Delta is tested when the instrument is issued and is not retested when an instrument is purchased or otherwise acquired in the secondary market. However, an issuance can result from a deemed exchange for tax purposes, for example, by reason of a significant change to the instrument’s terms.
• Baskets. If a short party issues a contact that references a basket of 10 or more underlying securities and uses an exchange-traded security (such as an ETF) that references substantially the same underlying securities to hedge the contract at the time it is issued, the short party may use the hedge security to determine the delta of the security it is issuing rather than determining the delta of each security referenced in the basket.
• Complex Contracts. The Final Regulations provide for a new class of contacts to which the delta test will not apply. These contracts are ones with indeterminate deltas and are labeled as “complex contracts”. These contacts are subject to a new “substantial equivalence test” rather than the delta test. Contracts that are not complex contracts are known as “simple contracts”.
• Withholding Would Not Apply to Direct Ownership. The Final Regulations retain the provision of the Proposed Regulations that provides that a payment referencing a distribution on an underlying security is not a dividend equivalent to the extent that the distribution would not be subject to tax pursuant to Section 871 or 881 if the long party owned the underlying security directly. For example, if a swap references stock in a regulated investment company (a “RIC”) that pays a dividend that includes a capital gains dividend that would not be subject to withholding if the RIC stock were held directly by the long party, then the payment under the swap is not a dividend equivalent to the extent that it is determined by reference to the capital gains dividend.
• Compensation. Dividend equivalent withholding will not apply to compensation that is generally subject to withholding or has a specific exception therefrom.
• Estimated and Implicit Dividends. The Final Regulations retain the rule of the Proposed Regulations that treats estimated and implicit dividends as dividend equivalents. An example of such a transaction is a price swap where the long party is not expressly entitled to receive payments based on regular dividends but where estimated dividends are taken into account in setting the price of the underlying securities referenced in the price return swap. The withholding tax could be in excess of the premium received.
• Amount of a Dividend Equivalent. The amount of a dividend equivalent for each underlying security equals the amount of the per-share dividend, multiplied by the number of shares referenced, multiplied by the applicable delta. In a change from the Proposed Regulations, the Final Regulations provide that for a simple contract this formula references the delta of the transaction at the time the contract is issued, rather than when a dividend is paid.
• Elimination of One Year or Less Rule. The Final Regulations eliminate the special rule which provided that for contracts with a term of one year or less the amount of a dividend equivalent is determined when the long party disposes of the contract. Under that rule, for example, a long party that acquires an option subject to Section 871(m) with a term of one year or less would not have incurred a withholding tax if the option lapsed. Eliminating that rules means that a dividend equivalent amount must be determined for any option, including a short-term option, that is subject to Section 871(m).
• Qualified Indices. The Final Regulations generally retain the criteria of the Proposed Regulations for identifying qualified indices, with modifications to clarify intent and improve functionality. To the extent that a swap or ELI provides for payments with respect to a qualified index, it does not give rise to dividend equivalent payments. Generally, a qualified index is a passive, diversified index of publicly traded securities that is widely used by market participants, such as the S&P 500.
• Combined Transactions: Presumptions for Brokers. The Final Regulations provide brokers acting as short parties with two presumptions they can apply to determine their liability to withhold. The presumptions are not available to a long party.
• Derivatives Referenced to Partnership Interests. Section 871(m) applies to derivatives that reference a partnership interest only when the partnership is either a dealer or trader in securities, has significant investments in securities, or holds an interest in a lower-tier partnership that engages in those activities.
• Contingent Debt Instruments. The Final Regulations provide that contingent interest will not qualify for the portfolio interest exemption to withholding tax to the extent that the contingent interest payment is a dividend equivalent. The embedded option is tested for delta separately from the debt instrument in which it is embedded.
• Convertible Debt Instruments. The Final Regulations do not provide an exception for convertible debt, which was requested by numerous commentators to the Proposed Regulations. As with contingent debt, the embedded option is tested for delta separately from the debt instrument in which it is embedded and such test is performed at the time that the convertible debt is issued. As convertible debt is ordinarily issued with a delta on the embedded option of less than 0.80, the Final Regulations are unlikely to have a significant impact on convertible debt instruments.
• Convertible Debt Adjustments. A dividend equivalent under Section 871(m) of the Code will be reduced by any amount treated in accordance with Section 305(b) and (c) as a dividend with respect to the referenced underlying security. Section 305 treats certain changes to the conversion ratio or conversion price of a convertible debt instrument as a distribution of property that could be characterized as a dividend in certain circumstances.
• Amounts Subject to Withholding. A withholding agent’s obligations do not arise until an actual payment is made or there is a final settlement of a position. Accordingly, a withholding agent is not obligated to withhold on a dividend equivalent until the later of when a payment is made or when the amount of a dividend equivalent is determined. A payment will generally occur when a long party receives or makes a payment, when there is a final settlement of a contract, or when a long party sells or otherwise disposes of a contract. In the case of a disposal, it is not clear whether the short party or the transferee has withholding responsibility, and, if the short party how the short party would know about the transfer.

Effective Dates

The Final Regulations generally will apply to transactions issued on or after January 1, 2017. Accordingly, prior to such date, the current four criteria specified in the statute and current final regulations continue to apply. With respect to contracts issued during 2016, however, the Final Regulations will also apply to any payment of a dividend equivalent made on or after January 1, 2018.

If you have any questions regarding Section 871(m), please contact Jonathan P. Brose (212-574-1615; brose@sewkis.com), Ronald P. Cima (212-574-1471; cima@sewkis.com), James C. Cofer (212-574-1688; cofer@sewkis.com) or Daniel C. Murphy (212-574-1210; murphyd@sewkis.com).

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¹ All section references are to sections of the Internal Revenue Code of 1986, as amended.