IRS Proposes New Regulations for Payments on Equity Swaps and Other Equity Derivatives and Extends Current Rules through 2015

The IRS and the Treasury have published Final Regulations and Proposed Regulations under Section 871(m) of the Internal Revenue Code providing for the withholding of tax on payments under equity swaps and certain other equity-linked instruments that are contingent upon, or determined by reference to, U.S.-source dividends. The Final Regulations adopt with minimal changes the rules adopted in Temporary Regulations issued in 2012. Very generally, these rules require withholding on payments that are contingent on, or determined by reference to, U.S.-source dividends that are made to a non-U.S. person on an equity swap if (i) the non-U.S. person transfers the underlying stock to the counterparty in connection with the transaction (i.e., "crosses in"), (ii) the counterparty transfers the underlying stock to the non-U.S. person at the termination of the transaction (i.e., "crosses out"), (iii) the underlying stock is not readily tradable on an established securities market, or (iv) the underlying stock is posted as collateral to the non-U.S. person in connection with the transaction. The Final Regulations extend these rules to payments made on such notional principal contracts through December 31, 2015.

The new Proposed Regulations replace the proposed regulations that were issued in 2012 and would have replaced the four-factor approach described above with a seven-factor approach. According to the Preamble to the new Proposed Regulations, the IRS and the Treasury have concluded that this seven-factor approach would not accurately identify tax avoidance transactions and would be difficult to administer. Instead, under the new Proposed Regulations, payments and credits to a non-U.S. person under an equity swap that are contingent upon or determined by reference to U.S.-source dividends would be subject generally to withholding tax if, at the time the long party acquired or entered into the swap, the "delta" of the swap - that is, the ratio of the change in fair market value of the derivative to the change in the fair market value of the underlying stock - was 0.70 or greater or such delta was reasonably expected to remain constant throughout the term of the swap. The new Proposed Regulations would also extend these rules to futures contracts, forward contracts, options, debt instruments and other contractual arrangements that referenced the stock of one or more U.S. corporations that have a delta of 0.70 or greater and that are acquired or entered into by the long party on or after March 5, 2014. The new Proposed Regulations would be effective for payments made on such equity swaps and derivatives on or after January 1, 2016.

The Final Regulations and new Proposed Regulations are linked below.

See: IRS Section 871(m) Final Regulations and Removal of Temporary Regulations; IRS Section 871(m) Proposed Rulemaking.