On 17 September 2015, the US government released final and temporary regulations under IRC Section 871(m) (“the regulations”) affecting non-US persons that hold financial products such as certain notional principal contracts, derivatives and other equity-linked instruments (ELIs) with payments that reference (or are deemed to reference) dividends on US equity securities. Parties to such contracts may become responsible for imposing US withholding tax on any such dividend equivalent payments that are made to a non-US person, or, in certain circumstances, may also be required to self-assess tax on their own trading in such instruments as US withholding tax may not always be satisfied at source.
In particular, asset managers that trade instruments that are within the scope of the rules will need to consider the application of the rules to each type of affected trade to determine their identification, withholding and reporting responsibilities.
Prior to Section 871(m) becoming effective, payments on notional principal contracts (NPCs) were generally sourced by reference to the residence of the recipient, thus making them non-US source and exempt from US withholding tax. In 2010, however, Congress enacted Section 871(m), which, at the time, affected dividend equivalent payments made on a narrow class of NPCs. On December 4, 2013, pursuant to statutory authority, the IRS released proposed regulations under Section 871(m) that would have broadened the scope of instruments on which withholding was required to include payments on derivative instruments over US dividend-paying stocks that have a delta (defined below) of 0.7 or greater at the time the instrument is issued. Under the final regulations, the delta measurement was changed to 0.8 or greater and a new test for contracts with indeterminate deltas was introduced.
The regulations will be effective to payments made on transactions issued on or after 1 January 2017.
As originally issued, the regulations also applied to specified ELIs issued on or after 1 January 2016, and before 1 January 2017, but only to payments on such contracts that were to be made on or after 1 January 2018. On 4 December 2015, Treasury and the Internal Revenue Service released corrections to the regulations removing specified ELIs entered into during calendar year 2016 from the scope of the regulations. Therefore, specified ELIs become subject to Section 871(m) and its regulations if they are issued on or after 1 January 2017.
The delta and substantial equivalence tests
The ‘delta’ of an instrument is a measure of the relationship between changes in value of the instrument and changes in value of the underlying stock. If an instrument has a delta of 1, changes in the value of the instrument should mirror changes in the value of the stock exactly.
Under the regulations, any NPC or ELI that has a delta of 0.8 or greater at the time of issuance would be a Section 871(m) in-scope transaction subject to withholding on dividend equivalent payments, which is a taxpayer favourable change from prior proposed regulations which required continuous testing of the delta at each payment date and a more inclusive delta of 0.7. The delta test is used for simple contracts.
The delta of certain types of ‘exotic’ derivatives, such as ‘binary’ and ‘digital’ options, is indeterminate and thus the regulations introduced a new ‘substantial equivalence test’ to deal with such complex contracts. Very generally, the substantial equivalence test uses an in-scope contract as a benchmark to compare with the complex contract using the level at which the short party would need to vary the number of shares of stock in its hedge as the price of the underlying security changes.
Long parties (and agents thereof) must treat two or more transactions as combined for purposes of testing and application of the rules if they reference the same underlying security and the combined transactions replicate the economics of a transaction that would be a Section 871(m) in-scope transaction. Funds could be trading the same or similar products across brokers which will need to be tracked in case such multiple transactions may need to be treated as a single transaction for Section 871(m) purposes.
This is particularly important where the payments on such products are not withheld on by the short party due to certain favourable presumptive rules that allow the short party, in certain instances, to not combine contracts that are in different accounts or that are separated by at least two business days. Note that such presumptive rules are not applicable to the long party. The burden of the tax is a joint and several liability, but the long party should be self-assessing the tax in circumstances where it is not withheld at source.
What payments are affected?
Generally, for the purpose of these regulations, a “dividend equivalent” is defined as:
The amount of the dividend equivalent is calculated slightly differently for each dividend equivalent defined above. Generally for a simple contract, the dividend equivalent amount is calculated by multiplying the per-share dividend amount with respect to the underlying security times by the number of notional shares of the underlying by the delta of the 871(m) transaction.
Withholding under Section 871(m)
Generally, a withholding agent is not obligated to withhold on a dividend equivalent until the later of when a payment is made with respect to a Section 871(m) transaction or when the amount of a dividend equivalent is determined.
A payment with respect to a Section 871(m) transaction must generally occur when the long party receives a gross payment, when there is a final settlement of the Section 871(m) transaction, or when the long party sells or otherwise disposes of the Section 871(m) transaction.
Exceptions to the Section 871(m) rules
Certain transactions and payments may be treated as out of scope for Section 871(m) purposes such as compensation paid under certain restricted stock plans, return of capital distributions, ‘due bills’ related to extraordinary dividends, specific insurance contracts, derivatives related to a qualified index, etc.
Brokers serving the asset management industry in the US have begun preparing for the implementation of Section 871(m), and while some UK brokers have also started to analyse the impact, preparations for readiness are beginning to ramp up this quarter. Globally, asset managers are becoming familiar with the rules, and some are working to determine the impact on their business and understand the level of assistance that their service providers may be able to provide as well as the level of effort that will be required in-house.
Given the scope of transactions covered, the complexity of the regulations and the detailed rules on exempted transactions, Section 871(m) will require that affected parties spend time during 2016 to determine readiness, implement operational changes, make necessary changes to legal and service level agreements and make any necessary systems changes prior to the January 1, 2017 effective date. This would include:
Application of the Section 871(m) regulations is complex, and it is strongly recommended that funds take specific advice where their strategies may be impacted.