IRS Issues Final Regulations on ''Dividend Equivalents''
The IRS released final regulations that address withholding on U.S.-source dividend equivalents under Section 871(m) of the Code. The final regulations replace the proposed regulations issued on December 5, 2013 (the "2013 proposed regulations").
Like the 2013 proposed regulations, the final regulations define a "dividend equivalent" as (i) any substitute dividend that references a U.S.-source dividend made under a securities lending or repurchase agreement transaction, (ii) any payment under a "specified NPC" (or specified notional principal contract) that references a U.S.-source dividend, (iii) any payment under a "specified ELI" (or specified equity-linked instrument) that references a U.S.-source dividend or (iv) any substantially similar payment. In addition, as in the proposed regulations, dividend equivalents include estimated and implicit dividends. The final regulations exclude certain payments from the definition of "dividend equivalent": (i) payments that would not have been subject to withholding if the long party had held the underlying directly, (ii) distributions that are taxable as a dividend under section 305 of the Code, (iii) payments made pursuant to certain due bills, (iv) equity-based compensation and (v) certain corporate acquisitions in which one or more persons (including the taxpayer) acquire a controlling interest in the securities issuer.
The definition of "dividend equivalent" is largely unchanged. The final regulations bifurcate financial instruments into "simple contracts" and "complex contracts." A simple contract references a fixed number of shares of one or more issuers, and has a single maturity or exercise date (such as an American-style option). Any other contract is a complex contract.
Delta increases to 0.80 for "simple contracts." Notional principal contracts ("NPCs") or equity-linked instruments ("ELIs") that are simple and have a delta of 0.80 or higher will be defined as "specified NPCs" or "specified ELIs", respectively, and will be subject to withholding under section 871(m). (The 2013 proposed regulations suggested a delta of 0.70.) Delta is calculated when the instrument is originally issued (or significantly modified for tax purposes), but is not otherwise subject to re-testing (e.g., upon purchase on the secondary market).
"Complex contracts" will be subject to a new "substantial equivalence" test. Acknowledging that a delta test is unworkable for many structured notes, the IRS proposed a "substantial equivalence" test for complex contracts (such as digital options, steepeners, path-dependent options, and other structured notes). Under the proposed test generally, the change in value of a complex contract is compared to a hypothetical one-standard deviation increase and decrease of the referenced underlying. These changes are compared to the changes in value of the initial hedge against the contract. When this proportionate difference is equal to or less than the difference for a benchmark contract with a delta of 0.80 and the initial hedge for the benchmark contract, the complex contract will be treated as subject to 871(m) withholding. To the extent that a contract cannot be measured adequately under the substantial equivalence test, "a taxpayer must use the principles of the substantial equivalence test to reasonably determine whether the complex contract is a section 871(m) transaction." Rules that are applicable to complex contracts are issued in temporary form, and the IRS has requested comments on their substance and ability to be administrated.
The amount of a dividend equivalent. For simple contracts, the amount of a dividend equivalent is the aggregate dividend for the referenced shares, multiplied by the delta applicable to the ELI on its issue date. (The 2013 proposed regulations referenced the delta applicable on the dividend payment date.) Under complex contracts, the amount of a dividend equivalent is the per-share dividend, multiplied by the number of shares under the initial hedge. The final regulations also eliminate the special rule for short-term options and require dividend equivalent amounts to be determined for short-term options if they are specified ELIs.
In 2017, withholding for specified ELIs will be phased in. Specified ELIs issued in 2017 will be subject to withholding under these final regulations. In addition, dividend equivalent payments made beginning in 2018 with respect to specified ELIs issued during the 2016 calendar year also will be subject to withholding under the final regulations.
The Phaseout of the QSL regime. The IRS has indicated that it will phase out the qualified securities lender ("QSL") regime and expand the qualified intermediary ("QI") regime to incorporate taxpayers acting as dealers with respect to NPCs and ELIs. Eligible QIs may be treated as qualified derivatives dealers ("QDDs"). QDDs will not be subject to withholding on dividends or dividend equivalent payments received in their capacity as dealers. The final regulations do not incorporate the credit forward system for prior withholding proposed under Notice 2010-46.