IRS Issues Dividend-Equivalent Rules for Notional Principal Contracts and Equity-Linked Investments

The IRS on Thursday issued final, temporary, and proposed regulations under Sec. 871(m) that apply to nonresident alien individuals and foreign corporations that hold certain financial products providing for payments that are contingent upon or determined by reference to U.S.-source dividend payments, and guidance for withholding agents responsible for withholding U.S. tax on these payments (T.D. 9734). These rules also finalize proposed regulations issued in 2013 with some changes (78 Fed. Reg. 73128).

Sec. 871(m) was enacted by the Hiring Incentives to Restore Employment Act, P.L. 111-147, in 2010. It treats as U.S.-source dividends, transactions that provide for a payment contingent upon or determined by reference to a U.S.-source dividend (dividend equivalent), such as securities loans, sale-repurchase transactions, and certain notional principal contracts called “specified notional principal contracts” (specified NPCs).

Dividend equivalent

The final regulations define a dividend equivalent as (1) any substitute dividend that refers to a U.S.-source dividend made under a securities lending or sale-repurchase transaction; (2) any payment that refers to a U.S.-source dividend made under a specified NPC; (3) any payment that refers to a U.S.-source dividend made under a specified equity-linked investment (ELI); or (4) any other substantially similar payment. A payment refers to a U.S.-source dividend if the payment is directly or indirectly contingent upon a U.S.-source dividend or determined by reference to such a dividend. Transactions described in (3) and (4) are added to the definitions of dividend equivalents under the IRS regulatory authority granted in Sec. 871(m)(2)(c).

An ELI is defined as any financial transaction (other than a securities lending or sale-repurchase transaction or an NPC) that refers to the value of one or more underlying securities. Common examples of ELIs are forward contracts, futures contracts, options, debt instruments convertible into underlying securities, and debt instruments that have payments linked to underlying securities.

Delta

To determine whether an NPC or an ELI is subject to withholding, the 2013 proposed regulations set forth a single-factor test that employs a delta threshold. Delta refers to the ratio of a change in the fair market value (FMV) of a contract to a small change in the property’s FMV referred to by the contract, which is widely used by participants in the derivatives markets.

Under the 2013 proposed regulations, any NPC or ELI with a delta of 0.70 or greater when the long party acquired the transaction was considered a Sec. 871(m) transaction subject to withholding. In response to comments received, the final regulations adopted here raise the delta test to 0.80 from 0.70.

The final regulations also change the time for testing delta in response to comments. The IRS was persuaded that the difficulties of testing delta each time an NPC or ELI is acquired outweigh the benefits. So an ELI’s or NPC’s delta is determined only when the instrument is issued. The regulations do not require retesting when the instrument is purchased or otherwise acquired in the secondary market.

Simple contracts vs. complex contracts

Under the final regulations, however, the IRS distinguishes between simple contracts and complex contracts and applies the above delta rules only to simple contracts. A simple contract is a contract that refers to a single, fixed number of shares of one or more issuers to determine the payout, and the number of shares must be known when the contract is issued. In addition, the contract must have a single maturity or exercise date on which all amounts (other than any upfront payment or any periodic payments) are required to be calculated for the underlying security.

A complex contract is any contract that is not a simple contract. Contracts with indeterminate deltas are classified as complex contracts, which are subject to a new substantial equivalence test, which measures the change in value of a complex contract when the price of the underlying security referred to by that contract is hypothetically increased by one standard deviation or decreased by one standard deviation and compares that change to the change in value of the shares of the underlying security that would be held to hedge the complex contract when the contract is issued at each testing price.

The smaller the proportionate difference between the change in value of the complex contract and the change in value of its initial hedge at multiple testing prices, the more equivalence there is between the contract and the referenced underlying security. When this difference is equal to or less than the difference for a simple contract benchmark with a delta of 0.80 and its initial hedge, the complex contract is treated as substantially equivalent to the underlying security.

Qualified derivatives dealers

The final rules expand the existing qualified intermediary requirements so they apply to qualified derivatives dealers (QDDs), which is a qualified intermediary that acts as a QDD. A qualified intermediary that acts as a QDD will not be subject to withholding on dividends or payments that may be dividend equivalents made with respect to potential Sec. 871(m) transactions that the QDD receives while acting in its capacity as a dealer.

Effective dates

So that brokers have enough time to update their systems to implement these rules, they apply to transactions issued on or after Jan. 1, 2017. For transactions issued on or after Jan. 1, 2016, and before Jan. 1, 2017, that are Sec. 871(m) transactions, the rules apply to any payment of a dividend equivalent made after Jan. 1, 2018.

—Sally P. Schreiber (sschreiber@aicpa.org) is a Tax Adviser senior editor.