On September 17, 2015, the Internal Revenue Service (the "IRS") issued final regulations under Code Section 871(m) relating to the imposition of U.S. withholding tax on "dividend equivalent" payments on certain U.S. equity swaps and other U.S. equity-linked instruments held by foreign persons. The regulations adopt, with some changes, the 2013 proposed regulations.
Some of the key highlights are:
- The concept of 0.8 "delta" that is tested only at original issuance or at a material modification of the instrument;
- The contracts are divided into "simple contracts" and "complex contracts," where simple contracts are tested by the delta test and complex contracts are tested by specific rules; and
- A dividend equivalent payment is not deemed to be made for withholding tax purposes earlier than when a payment actually is made.
Under Code Sections 871(a) and 881(a), nonresident aliens and foreign corporations are taxed at a flat 30% (or lower treaty rate) on certain types of passive income, including dividends, if they are sourced to the U.S. and are not "effectively connected" with a U.S. trade or business. Payments on notional principal contracts (NPCs) are generally sourced by reference to the residence of the recipient, thus exempting from U.S. withholding tax a payment to a non-U.S. person under a NPC. However, under Code Section 871(m), enacted in 2010, a "dividend equivalent" is treated as a dividend from sources within the United States for purposes of taxing and withholding at source on nonresident aliens and foreign corporations. Therefore, the provision changes the source of income from foreign source to domestic source in certain circumstances, in particular, for dividend equivalent payments. Accordingly, U.S. broker-dealers must withhold tax on the re-sourced payments.
The new regulations also expand the scope of instruments on which withholding is required to include every derivative instrument that related to U.S. dividend-paying stocks and that have a "delta" of 0.8 or greater at the time of issuance.
The "Delta" Test
In determining whether an instrument is a Code Section 871(m) transaction, the regulations provide a "delta" threshold of 0.8. The definition of delta is the ratio of the change in the fair market value of the instrument to a small change in the fair market value of the underlying stock. Typically, a small change is a change of less than 1%. The regulations provide that the delta of a potential Code Section 871(m) transaction is determined only when the Code Section 871(m) transaction is issued; it is not re-tested when, for example, the instrument is purchased or otherwise acquired in a secondary market.
The "delta" test applies only to simple contracts. A simple contract is a contract that references a single, fixed number of shares of one or more issuers to determine the payout. 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 with respect to the underlying security.
On the other hand, 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." That test is included in the temporary regulations. Generally, the substantial equivalence test measures the change in value of a complex contract when the price of the underlying security referenced by that contract is hypothetically increased by one standard deviation or decreased by one standard deviation (each, a "testing price") 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.
Amount of a Dividend Equivalent
The final regulations provide that the dividend equivalent amount of a payment for a simple contract will equal the amount of the per-share dividend, multiplied by the number of shares referenced in the contract, multiplied by the applicable delta. For a complex contract, the amount of the dividend equivalent equals the amount of the per-share dividend multiplied by the number of shares that constitute the initial hedge of the complex contract.
These regulations generally apply to transactions issued on or after January 1, 2017. The existing rules on withholding on swaps that reference U.S. equity securities will continue to apply to payments, including future payments, on contracts entered into before 2017. However, if such a swap entered into during 2016 would be within the scope of withholding under the new rules but not the old rules, withholding will apply to payments made after 2017.
If you have any questions, please contact your Marcum professional.