The Internal Revenue Service (“IRS”) announced that the IRS would amend the final regulations promulgated under Internal Revenue Code Section 871(m), which provides that dividend-equivalent payments in respect of swaps and other similar arrangements referencing U.S. equity securities would be subject to U.S. withholding tax. Withholding taxes imposed under Section 871(m) affect non-U.S. persons that are parties to specified notional principal contracts, securities lending and repurchase agreements, equity-linked instruments (e.g., forwards and futures) and substantially similar financial instruments. Section 871(m) withholding is currently being phased-in as of January 1, 2017 and was scheduled to come into full effect beginning January 1, 2018. The IRS announced that it would extend the phase-in period during which the Section 871(m) rules are coming into effect. This Memorandum1 discusses the extension of the phase-in period of the Section 871(m) rules.
Extension of Phase-In Year
As discussed in our December 2016 memorandum, starting January 1, 2017 parties were required to withhold at a rate of 30% (or at a reduced rate of withholding if benefits of a tax treaty are available) of the amount of dividend-equivalent payments on delta-one transactions2. Withholding on non-delta-one transactions (i.e., transactions with a delta that is not equal to one (1)) was scheduled to begin on January 1, 2018. During this phase-in period, the IRS is taking into account whether a withholding agent has made a good faith effort to comply with the Section 871(m) rules. Notice 2017-42 announces that the IRS will extend this phase-in period until January 1, 2019. Therefore, dividend-equivalent withholding on non-delta-one transactions will begin on January 1, 2019, and dividend-equivalent withholding during 2017 and 2018 will be required for delta-one transactions only.
Extension of Simplified Standard for Identifying Combined Transactions
The IRS currently allows short parties to transactions subject to Section 871(m) to presume that multiple transactions should not be treated as a single, combined transaction when the long party either (i) holds the transactions in separate accounts or (ii) entered into the transactions more than two business days apart. Short parties to transactions subject to Section 871(m) that are (and will be) generally obligated to withhold on dividend-equivalent payments are entitled to this presumption unless the party has actual knowledge that the transactions should be treated as a single combined transaction. The availability of this presumption for determining whether transactions are treated as combined transactions will be extended through 2018.
Extension of Phase-In Relief for Qualified Derivatives Dealers (“QDDs”)
Dividends and dividend-equivalents paid to QDDs in 2017 in the QDD’s capacity as an equity derivatives dealer are not subject to Section 871(m) withholding. The IRS will extend this treatment through 2018. Additionally, beginning January 1, 2019 (rather than January 1, 2018 as originally scheduled), a QDD will be required to compute its Section 871(m) amount using a net delta approach. Finally, a QDD will not be required to perform a periodic review with respect to its QDD activities until 2019.
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1 We have previously published memoranda discussing the development and implementation of the Section 871(m) rules in December 2016, in October 2015, in December 2013, and in February 2012.
2 Delta-one transactions have a delta of one. A transaction’s delta is the ratio of the value of the contract to the value of the referenced asset(s). Where a delta is greater than 0.80, the transaction will generally be subject to 871(m) withholding after the phase-in period ends.
