On January 19, 2012, the Treasury Department released proposed Treasury Regulations (the “Proposed Regulations”) which greatly expand the potential for a 30% U.S. withholding tax to be imposed on dividend equivalent payments made to foreign persons (including offshore private investment funds) on certain equity swaps on U.S. securities. Managers of offshore private investment funds that enter into equity swaps (or similar transactions) with respect to U.S. securities should be aware of these Proposed Regulations when entering into transactions where payments could be made on or after January 1, 2013. In addition, fund managers and swap counterparties will need to carefully examine their swap agreements to determine whether such agreements provide for a gross-up of this withholding tax.

Section 871(m) of the Internal Revenue Code, enacted in 2010 as part of the Hiring Incentives to Restore Employment Act, provides that dividend equivalent payments determined with reference to an underlying U.S. equity security which are made as part of a “specified notional principal contract” (a “Specified NPC”), a securities lending transaction or a sale-repurchase transaction, or any other transaction determined by the Secretary of the Treasury to be substantially similar to either of the above, are treated as U.S.-source income. Such payments received by a foreign person or entity are therefore subject to a 30% U.S. withholding tax in the same manner as dividend income (unless reduced by an applicable tax treaty).

Section 871(m) lists certain factors any of which would cause a given notional principal contract to be treated as a Specified NPC. Section 871(m) also provides that in the case of payments made after March 18, 2012, all notional principal contracts will be treated as Specified NPCs unless the Secretary of the Treasury determines that the contracts are of a type which do not have the potential for tax avoidance.

Current Definition of Specified NPC

Under current law, a Specified NPC is any notional principal contract where any of the following conditions are satisfied: (i) in connection with entering into such contract, any long party to the contract transfers the underlying security to any short party to the contract (“crossing in”), (ii) in connection with the termination of such contract, any short party to the contract transfers the underlying security to any long party to the contract (“crossing out”), (iii) the underlying security is not readily tradable on an established securities market, or (iv) in connection with entering into such contract, the underlying security is posted as collateral by any short party to the contract with any long party to the contract.

At the same time that it issued the Proposed Regulations, the Treasury Department also issued temporary Treasury Regulations which provide that the current definition of Specified NPC will continue to apply with respect to payments made before January 1, 2013.

Proposed Definition of Specified NPC

The Proposed Regulations provide that with respect to payments made on or after January 1, 2013 a Specified NPC is a notional principal contract which satisfies any one of the following seven criteria:

1. A contract would be a Specified NPC if the contract has a term of fewer than 90 days (including the date the contract is terminated but not the date it was entered into).
2. A contract would be a Specified NPC if the notional principal amount of the underlying security is greater than (a) 5% of the total public float of that class of security or (b) 20% of the 30-day average daily trading volume determined as of the close of the business day immediately preceding the first day in the term of the contract.
3. A contract would be a Specified NPC if the contract is entered into on or after the announcement of a special dividend and prior to the ex-dividend date.
4. A contract would be a Specified NPC if the underlying security is not regularly traded. In general, an underlying security would be regularly traded if it is listed on one or more qualified exchanges at the time the contract is priced and the security was traded on at least 15 trading days during the 30 trading days prior to the date the contract is priced.
5. A contract would be a Specified NPC if the long party to the contract is “in the market” with respect to the underlying security on the same day or days that the parties price the contract or on the same day or days that the contract terminates. In general, the long party is considered to be “in the market” if the long party (i) sells or otherwise disposes of the underlying security on the same day or days that the parties price the contract, (ii) purchases or otherwise acquires the underlying security on the same day or days that the contract terminates, or (iii) either purchases or disposes of the underlying security at a price that is set or calculated in such a way as to be substantially identical to or determined by reference to an amount used to price or terminate the contract.
6. A contract would be a Specified NPC if the short party to the contract posts the underlying security with the long party as collateral and the underlying security posted as collateral represents more than 10% of the total fair market value of all the collateral posted by the short party on any date that the contract is outstanding.
7. A contract would be a Specified NPC if (a) the long party controls (contractually or by conduct) the short party’s hedge of the short position or (b) the long party enters into a contract using an “underlying equity control program”. In general, an “underlying equity control program” is any system or procedure that permits (a) a long party to direct how a short party hedges its risk under the contract, or (b) a long party to acquire (or cause the short party to acquire) the underlying security and to instruct the short party to execute such acquisition in the form of a notional principal contract after acquiring the underlying security.

The Proposed Regulations indicate that a contract (including one in existence before 2013) that is not a Specified NPC at the inception of the contract may become a Specified NPC during its term, which could cause withholding tax to become payable with respect to prior dividend equivalent payments made on or after January 1, 2013.

Substantially Similar Payments

The Proposed Regulations provide that the following payments are considered payments substantially similar to payments made on Specified NPCs, securities lending transactions or sale-repurchase transactions and are therefore dividend equivalent payments subject to withholding tax: (i) any payment of a beneficial owner’s tax liability with respect to a dividend equivalent made by a withholding agent (i.e., gross-up payments), and (ii) any payment, including the payment of the purchase price or an adjustment to the purchase price, made pursuant to an “equity-linked instrument” that is contingent upon or determined by reference to a U.S. source dividend. An “equity linked instrument” is a financial instrument or combination of financial instruments that references one or more underlying securities to determine its value, including a futures contract, forward contract, option, or other contractual arrangement.

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The Proposed Regulations will be the subject of comments and a public hearing and, accordingly, the final Treasury Regulations that are ultimately issued may differ from the Proposed Regulations.

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If you have any questions regarding this Memorandum, please contact one of the attorneys listed below.