On December 5, 2013 the Treasury and the IRS issued proposed regulations under section 871 (m) (the “2013 Proposed Regulations”) addressing the taxation of cross-border payments of “dividend equivalents” (i.e., payments that are not in the form of a dividend but have the economics of a dividend). These regulations replace proposed regulations issued in January 2012 (the “2012 Proposed Regulations”). Also on December 5, the IRS finalized temporary regulations issued in 2012.  These regulations (the “Final Regulations”) are effective for payments made through December 31, 2015.[1]  Thus, for the next two years the current rules governing the taxation of dividend equivalents continue in effect.
 
The 2013 Proposed Regulations are part of a lengthy, continuing and comprehensive effort by the United States government to tax amounts paid to non-U.S. investors that may be viewed as substitutes for U.S. source dividends.[2] As discussed below, these regulations are broader and more complex than the 2012 Proposed Regulations.
 
Background
 
Non-U.S. investors generally are subject to a 30-percent gross-basis withholding tax on U.S. source dividend payments not effectively connected with a U.S. trade or business.[3] An applicable U.S. income tax treaty may reduce or eliminate this tax, however.  Non-U.S. investors have sought to avoid this tax through the use of alternative investments that provide economics the same as, or similar to, a direct investment in shares of a U.S. company, but without the U.S. withholding tax. The two principal alternatives have been securities lending transactions and notional principal contracts (“NPCs”).
 
In 1997 Treasury and the IRS issued regulations eliminating securities lending as a route to avoiding the U.S. withholding tax on dividends.  A substitute payment made under a securities lending transaction involving shares of a U.S. issuer is considered to be from U.S. sources.[4] Regulations further provide that such amounts are taxed as dividends, i.e., subject to U.S. withholding tax when paid to a foreign investor.[5] 
 
NPCs written on U.S. equities (i.e., equity swaps) are the other avenue that non-U.S. taxpayers may have followed to avoid U.S. withholding tax. For many years IRS regulations generally provided that the source of income from an NPC is determined by reference to the residence of the taxpayer earning that income.[6]  Income earned on such contracts, therefore, generally is not subject to U.S. withholding tax when earned by a non-U.S. investor.
 
Congress added section 871(m) to the Internal Revenue Code in 2010 as part of the Hiring Incentives to Restore Employment Act of 2010.[7] Section 871(m) provides that certain "dividend equivalent" payments, including "any substitute dividends made pursuant to a securities lending or sale-repurchase transaction that (directly or indirectly) is contingent upon, or determined by reference to, the payment of a dividend from sources within the United States," are treated as U.S.-source dividends, effective for payments made on or after September 14, 2010. Dividend equivalent payments also include payments under a "specified notional principal contract" that are contingent upon or determined by reference to the payment of a dividend from sources within the United States, as well as any other payment determined by the IRS to be substantially similar to the enumerated dividend equivalents.[8] Thus, section 871(m) reverses the general sourcing rule for payments made under an NPC to a non-U.S. investor when the contract is a "specified NPC."
 
Section 871(m) provides that a specified NPC includes:
   
In addition, the statute defines "specified NPC" to mean “in the case of payments made after the date which is 2 years after the date of the enactment of this subsection, any notional principal contract unless the Secretary determines that such contract is of a type which does not have the potential for tax avoidance [emphasis added].”[9] The Temporary Regulations referenced the statutory definition of “specified NPC.” The Final Regulations extend the statutory definition for another two years – through December 31, 2015.
 
The 2012 Proposed Regulations
 
The 2012 Proposed Regulations would have replaced the definition of "specified NPC" found in section 871(m)(3) with a seven-factor test sometimes referred to as the “seven deadly sins.”[10]
Section 871(m)(2)(C) also allows the Treasury and IRS to write regulations expanding the definition of dividend equivalent payments to include any payments substantially similar to either (i) substitute dividends made pursuant to a securities lending or sale-repurchase transaction that directly or indirectly are contingent upon, or determined by reference to, the payment of a dividend from U.S. sources or (ii) payments under a “specified notional principal contract” that are contingent upon or determined by reference to the payment of U.S. source dividends.
 
The 2012 Proposed Regulations defined “substantially similar payments” as: (i) gross-up amounts paid by a short party in satisfaction of the long party’s tax liability with respect to a dividend equivalent; and (ii) payments calculated by reference to a dividend from U.S. sources that are made pursuant to an equity-linked instrument (“ELI”) other than an NPC.[11] The 2012 Proposed Regulations also provided guidance on withholding and included an anti-avoidance rule.
 
The 2013 Proposed Regulations
   
The 2013 Proposed Regulations treat a “dividend equivalent” as a dividend from sources within the United States for most income tax purposes. [12] A dividend equivalent may arise in (i) a securities lending arrangement, (ii) a specified NPC, (iii) a specified ELI, and (iv) a payment in satisfaction of a tax liability with respect to a dividend equivalent made by a withholding agent.
 
These new regulations generally would apply prospectively to payments made after the date the regulations are finalized. There are special effective dates for specified NPC’s and specified ELIs, however. The 2013 Proposed Regulations would apply to payments made pursuant to a specified NPC on or after January 1, 2016. With respect to specified ELIs, the 2013 Proposed Regulations would apply to payments made on or after January 1, 2016 but only if the ELI was acquired by the long party on or after March 5, 2014.
   
The 2013 Proposed Regulations reject the seven-factor test of the 2012 Proposed Regulations. The preamble to the regulations characterizes the test as too difficult to administer. The 2013 Proposed Regulations adopt a more general rule based on the “delta” of the NPC or ELI.  Delta is defined as the ratio of the change in the fair market value of an NPC or ELI to the change in the fair market value of the property referenced by the NPC or ELI.[13]  An NPC or ELI is a “specified” NPC or ELI when its delta with respect to an underlying security is 0.7 or greater on the date the transaction is entered into.[14]
 
Delta normally is determined for commercial purposes (e.g., pricing NPCs and ELIs) and should be readily available to taxpayers and verifiable by the government. The preamble to the regulations describes the delta-based standard as “simpler and more administrable” than the earlier seven-factor test.
 
The scope of the 2013 Proposed Regulations is significantly broader than the scope of the 2012 Proposed Regulations for at least two reasons. First, the use of a delta of 0.7 increases the scope of section 871(m) to includes derivatives that are priced based on other factors besides the value of the underlying security, e.g., volatility or the time value of money. Second, the definition of ELI is quite broad and includes forward contracts, futures contracts, options, debt instruments convertible into underlying equity securities and debt instruments with payments linked to underlying securities.  Finally, the 2013 Proposed regulations include a rule that would exclude contingent debt obligations paying contingent interest that is a dividend equivalent from the exception in section 871(h)(4) to withholding on payments of portfolio interest.
 
The preamble to the 2013 Proposed Regulations does not explain why a delta of 0.7 was chosen as the cutoff point for a transaction to fall within section 871(m) as opposed to a delta closer to 1.  Perhaps the government reasoned that a non-U.S. investor (e.g., a hedge fund located in a tax haven) may be indifferent between a direct investment in shares of a U.S. company carrying a 30% withholding tax on dividends and a derivative with a delta of 0.7 written on shares of a U.S. company.  With the derivative the investor trying to avoid U.S. withholding tax is buying something besides a pure equity tracking feature (e.g., volatility or the time value of money) that it very likely may not value.
 
Payment of dividend equivalents and withholding
 
A payment of a dividend equivalent includes any amount that references an actual or estimated payment of dividends.[15]  Thus, withholding may be required even if the payment is based on an estimated dividend but the dividend is never paid. As under the 2012 Proposed Regulations, the payment of a dividend equivalent is determined on a gross basis. Thus, withholding is required provided the long party to the transaction determines the gross amount owing by reference to the payment of a dividend, even if the long party actually makes no payment because of an offsetting obligation by the short party.
 
The amount of the dividend equivalent generally is the product of (i) the amount of the per-share dividend with respect to the underlying security, (ii) the number of shares of the underlying security referenced by the transaction, and (iii) the delta of the transaction with respect to the underlying security at the time the amount of the dividend equivalent is determined.[16] The amount of the dividend equivalent is generally determined on the earlier of the date that the underlying security becomes ex-dividend and the record date of the dividend.[17]
   
The 2013 Proposed Regulations generally require a stock index to be broken into its component stocks and the rules of section 871(m) be applied to each stock.[18]  However, a “qualified index” is not treated as an underlying security and is not broken into its underlying securities for purposes of applying section 871(m).[19] Such an index therefore is outside the scope of the regulations. 
 
In general, an index is a “qualified index” if, inter alia, it references 25 or more securities, it references only long positions in such securities, and contains no single security the represents more than 10% of the weighting of the underlying securities in the index.[20]  The determination is made at the time the long party acquires the index and is determinative only with respect to that transaction.
   
The 2013 Proposed Regulations contain an exception for certain significant equity investments (i.e., when there is a plan to purchase more than 50 percent of the entity issuing the underlying security) and an exception for transaction by “qualified dealers.”[21]  A qualified dealer is defined as a “dealer” as defined in section 475 that is regulated in the jurisdiction in which it is organized.  A qualified dealer with a long position must certify to the short party that it is acting in its capacity as a dealer (i.e., not investing for its own account) and that it will withhold any tax due under section 871(m) when entering into a transaction as a short party in its capacity as a dealer.
 
The definition of “dividend equivalent” also contains some exceptions.[22] For example, distributions of capital gains by a regulated investment company that would not be subject to withholding are excluded from the definition. Also, transactions treated as taxable dividends under section 305 are excluded.
   
The 2013 Proposed Regulations also address “combined transactions” that might be used to avoid the regulations.[23] For example, a transaction in which a taxpayer replicates a long position in a security by purchasing a call option on a security with a delta less than 0.7 and selling a call option on the same security with a delta less than 0.7 is combined and tested. The regulations also provide rules for interest in entities that are not taxable as corporations.[24] Thus, the regulations cannot be avoided by holding US securities in a pass-through entity, such as a partnership.
 
The 2013 Proposed Regulations also include rules addressing information reporting.  Amendments are also made to the regulations under section 1441 to address certain withholding issues, e.g., when the withholding obligation arises and certain exemptions.
 
Observations
 
If the 2013 Proposed Regulations are finalized in their current form, investing in derivatives written on shares of U.S. companies will be subject to a withholding tax in virtually all cases (including, apparently, transactions between two non-US persons).  While some U.S. income tax treaties eliminate the withholding tax on dividends, this treaty rule is intended for portfolio investments but for substantial investments by non-U.S. corporate shareholders.  
 
One has to wonder whether U.S. broker-dealers and funds that write such derivatives will be willing to implement systems to track non-U.S. investors and collect the tax they owe, especially when this tax is quite likely to diminish demand for these products.  Perhaps U.S. broker-dealers will approach Treasury to agree to eliminate this withholding tax by treaty.  One also has to wonder whether other governments that are hungry for revenue will follow the lead of the United States and implement an approach similar to section 871(m).