IRS Releases Transition Guidance for the Dividend Equivalent Rules

Tax Law Update | 12.12.16

On December 2, 2016, the Internal Revenue Service (the “IRS”) issued Notice 2016-76 (the “Notice”), which provides highly anticipated guidance regarding “dividend equivalent” payments under section 871(m) of the Internal Revenue Code of 1986, as amended (the “Code”). The Notice will be of particular interest to taxpayers, withholding agents, and qualified derivatives dealers (“QDDs”) who deal in notional principal contracts (“NPCs”), sales-repurchase agreements, and other derivative arrangements.

The Notice provides the following guidance:

  • In providing relief in the administration and enforcement (including penalties) of the regulations under Code section 871(m) during 2017, the IRS will take into account the extent to which a taxpayer or withholding agent make a good faith effort to comply with such regulations with respect to any delta-one transaction.
  • In providing relief in the administration and enforcement (including penalties) of the regulations under Code section 871(m) during 2018, the IRS will take into account the extent to which a taxpayer or withholding agent make a good faith effort to comply with such regulations with respect to any non-delta-one transaction.
  • For 2017, withholding agents may rely on a simplified standard for determining whether transactions are “combined transactions.”
  • For 2017, withholding agents may remit amounts withheld from dividend equivalent payments on a quarterly basis.
  • Beginning in 2017, a QDD section 871(m) amount is to be determined by calculating the net delta exposure of the QDD.
  • In enforcing the QDD provisions of the regulations under Code section 871(m) during 2017, the IRS will take into account the extent to which a QDD makes a good faith effort to comply with the QDD provisions in the qualified intermediary (“QI”) agreement.
  • Prospective QDDs may apply for QDD status on or before March 31, 2017, and if accepted by the IRS, be treated as having QDD status as of January 1, 2017.
  • Before receiving a QI-EIN, QDDs may provide a statement on a Form W-8IMY that the QDD is “awaiting a QI-EIN,” and withholding agents may rely on this statement, to the extent permitted in the Notice.
  • The Code section 871(m) regulations will not apply to certain existing exchange-traded notes specifically identified in the Notice until January 1, 2020.

Phased-In Application of section 871(m) for Delta-One and Non Delta-One Transactions

Under the Notice, 2017 and 2018 will be phase-in years for NPCs and ELIs that are “delta-one” and “non-delta-one” transactions, respectively.  Pursuant to the Notice, for any payment made on or after January 1, 2017, with respect to any transaction issued on or after January 1, 2017, any NPC or ELI that has a delta of one with respect to an underlying security when the NPC or ELI is issued is a specified NPC or specified ELI, respectively.  For any payment made on or after January 1, 2018, with respect to any transaction issued on or after January 1, 2018, (a) a “simple” NPC or “simple” ELI that has a delta of 0.8 or greater with respect to an underlying security when the NPC or ELI is issued is a specified NPC or specified ELI, respectively, and (b) a “complex” NPC or “complex” ELI that meets a substantial equivalence test with respect to an underlying security at the time of issuance is a specified NPC or specified ELI, respectively.

The Notice does not define the term “delta-one transaction,” however, it seems implicit that the methodology set forth in Treasury Regulations section 1.871-15(g) should be used in making this determination.  The Notice is also unclear on the scope of its application to NPCs or ELIs that have a delta of one in 2017.  Under the regulations, the delta test only applies to simple NPCs or simple ELIs.  Complex NPCs and complex ELIs are governed by the substantial equivalence test; the delta of such a complex instrument is not relevant for purposes of determining whether it is a specified NPC or specified ELI.  However, the Notice could be read to cause a complex NPC (or complex ELI) that has a delta of one to be a specified NPC (or specified ELI) during 2017 without regard to application of the substantial equivalence test.

Although not discussed in the Notice, it should be noted that certain events could cause NPCs or ELIs issued before January 1, 2017, (in the case of an NPC or ELI that has a delta of one) or before January 1, 2018, (in the case of any other NPC or ELI) to be deemed to be issued on or after January 1, 2017, or January 1, 2018, as the case may be.  For example, a significant modification of the terms of an NPC or ELI could be deemed a new issuance, bringing the NPC or ELI within the definition of a specified NPC or specified ELI.

For purposes of enforcing the Code section 871(m) regulations for the applicable phase-in year, the IRS will take into account the extent to which the taxpayer or withholding agent made a good faith effort to comply with the regulations.  Absent a good faith effort, no relief will be forthcoming from administration or enforcement of the regulations, including the imposition of penalties.


Simplified Standard for Determining Whether Transactions are Combined Transactions

Treasury Regulations section 1.871-15(n) aggregates multiple transactions into one deemed transaction when (1) a long party (or related person) enters into multiple transactions that reference the same underlying security, (2) the combined potential Code section 871(m) transactions replicate the economics of a transaction that would be a Code section 871(m) transaction, and (3) the transactions were entered into in connection with each other.  Under the current regulations, a broker acting as a short party may presume that transactions are not connected as long as (1) the long party holds the transactions in separate accounts or (2) the transactions were entered into two or more business days apart, as long as the broker has no actual knowledge to the contrary or knowledge that the transaction has been arranged so as to avoid the application of Code section 871(m). 

Compliance with this combination rule by withholding agents has required the development of novel and complicated systems to identify transactions entered into in connection with each other.  To ease the burden of compliance while these systems are being developed and implemented, the Notice provides for a simplified standard for combining transactions entered into in 2017.  Under the new standard, a withholding agent will only be required to aggregate over-the-counter transactions that are priced, marketed, or sold in connection with each other.  Moreover, withholding agents will not be required to combine any transactions that are listed securities which are entered into in 2017.

Transactions that are either combined or not combined under this simplified standard will continue to be treated as such for future years, unless a reissuance or other event causes transactions that were not combined under the simplified standard to be retested to determine whether they are Code section 871(m) transactions.  The simplified standard applies only to withholding agents and does not apply to taxpayers that are long parties to potential Code section 871(m) transactions.


Phase-in Year for Qualified Derivatives Dealers

Because a dividend equivalent is subject to U.S. withholding tax in the same manner as an actual dividend, an unintentional result known as “cascading withholding taxes” can occur.  This can occur where a non-U.S. person owns a share of U.S. stock and loans the stock to a second non-U.S. person.  In a typical securities lending transaction, the second non-U.S. person must make payments equal to all dividends paid on the stock during the term of the transaction to the first person.  The stock issuer will withhold 30% of the dividend that it pays to the second non-U.S. person if such person holds the stock over the dividend record date.  If, under Code section 871(m), the second non-U.S. person is then required to withhold 30% of the amount of the dividend equivalent that it pays to the first non-U.S. person, there will have been multiple levels of withholding tax imposed on the same dividend.  This situation also occurs where a non-U.S. entity issues a structured product that references a U.S. stock and purchases shares of the referenced stock to hedge its payment obligations on the structured note.  A tangential problem results when a non-U.S. entity issues a structured note referencing U.S. stock to a U.S. person.  If the non-U.S. entity incurs U.S. withholding tax on dividends paid on any stock held as a hedge of its obligations under the structured note, it is not economical for the non-U.S. entity to issue the note because the U.S. holder would not accept that its return should be reduced by the withholding tax imposed on the issuer.  The concept of a QDD addresses these problems.  Specifically, dividend equivalent payments to a QDD are not be subject to U.S. withholding taxes when received by the QDD in its capacity as a dealer and a QDD can receive dividends on its hedge shares without the imposition of U.S. federal income tax, provided that it meets certain requirements. 

An entity may apply for status as a QDD and implement the QDD regime provided for in the regulations under Code section 871(m).  When a QDD provides a valid withholding certificate to a withholding agent, the withholding agent will not be required to withhold on certain payments made to the QDD when the QDD is acting as a principal (that is, not as an intermediary).  To be a QDD, an entity must enter into a QI agreement and be an eligible entity.  A QI is an “eligible entity” if it is one of the three following types of entities: (1) a dealer in securities that is subject to regulatory supervision as a dealer by a governmental authority in the jurisdiction in which it is organized or operates; (2) a bank subject to regulatory supervision as a bank by a governmental authority in the jurisdiction in which it is organized or operates and that issues potential Code section 871(m) transactions to customers and receives dividends or dividend equivalent payments pursuant to potential Code section 871(m) transactions to hedge those transactions issued to customers; or (3) an entity that is wholly-owned by a bank subject to regulatory supervision as a bank by a governmental authority in the jurisdiction in which it is organized or operates and that issues potential Code section 871(m) transactions to customers and receives dividends or dividend equivalent payments pursuant to potential Code section 871(m) transactions to hedge those transactions issued to customers. 

A QDD (other than a foreign branch of a U.S. financial institution acting as a QDD) must determine and pay any “QDD tax liability.”  A QDD tax liability is the sum of a QDD's liability under Code sections 871(a) and 881 for (a) its “section 871(m) amount”; (b) its dividends that are not on underlying securities associated with potential Code section 871(m) transactions and its dividend equivalent payments received as a QDD in its non-dealer capacity; and (c) any other U.S. source FDAP payments received as a QDD with respect to potential Code section 871(m) transactions or underlying securities that are not dividend or dividend equivalent payments.

    1. Net Delta Computation for QDD Section 871(m) Amount

Under pre-Notice law, a QDD is liable for tax on dividends on physical shares or deemed dividends (together “actual dividends”) received by the QDD.  Current regulations, however, provide that a QDD is exempt from withholding (both generally and for FATCA purposes) on actual dividends and dividend equivalents that the QDD receives in its capacity as an equity derivatives dealer.  The QDD remains liable for tax under Code section 881 to the extent that dividends and dividend equivalent payments the QDD receives on an underlying security exceed the dividend equivalent payments the QDD is obligated to make with respect to the same dividend on the same underlying security.  As a result of this approach, if a QDD hedged the issuance of a structured note referencing an index by holding the individual components of the index, the QDD would be subject to a withholding tax on dividends paid on the individual components.  Because of this QDDs would likely seek to hedge transactions through their U.S. branches in a back-to-back transaction with the U.S. branch, which would hold the shares as a hedge.  Thus, the regime would have resulted in an unavoidable tax on those QDDs without U.S. branches.

Following a suggestion made by the Securities Industry and Financial Markets Association (“SIFMA”) [1] to address this problem, the Notice indicates that the IRS intends to make a major revision to these rules by providing that a QDD will remain liable for tax under Code section 881(a)(1), and subject to withholding, on the actual dividends it receives, and that the QI agreement will provide that a QDD’s “section 871(m) amount” will be determined by calculating the net delta exposure (measured in number of shares) of the QDD on the applicable date, multiplied by the relevant dividend amount per share.  A QDD’s net delta exposure will be determined by aggregating the delta of all physical positions and potential Code section 871(m) transactions with respect to an underlying security entered into by the QDD in its equity derivatives dealer capacity.  The use of the net delta method should eliminate the need for a back-to-back transaction through a QDD’s U.S. branch because net delta is determined by reference to both potential and actual Code section 871(m) transactions, rather than just actual Code section 871(m) transactions.

A QDD's tax liability on the section 871(m) amount associated with an underlying security will be reduced (but not below zero) by the amount of tax paid by the QDD in its capacity as an equity derivatives dealer under Code section 881(a)(1) on the receipt of the same dividend payment on that same underlying security.

     2. General Phase-In Year for QDDs

In providing relief in the administration and enforcement (including the imposition of penalties) of the QDD rules during 2017, the IRS will take into account the extent to which the QDD made a good faith effort to comply with the Code section 871(m) regulations and the relevant provisions of the QI agreement.

     3. Effective Date of the QI Agreement

The proposed QI agreement described in Notice 2016-42 provides a three-month window in which to apply for a QI agreement within a calendar year. In particular, a QI agreement will be effective as of January 1 in any given year in which the QI applies either (a) on or before March 31 of that year, or (b) after March 31 if no reportable payment has yet been received.

Applications submitted after March 31 for which reportable payments have been received prior to March 31 will be applicable as of the first day of the first month in which both (a) the QI application is complete and (b) the QI has received its QI-EIN.  For a QI that is renewing its QI agreement, the effective date of the QI agreement when renewed by March 31, 2017 will be January 1, 2017.

    4. Certifying QDD Status and Depositing Withheld Amounts Pending Receipt of QI-EIN

Depending upon whether a QI application has yet been approved, an applicant will either provide a QDD with a W-8IMY that has the applicants QI-EIN or indicates that it is awaiting the EIN.

The Notice provides that a withholding agent that receives a W-8IMY that indicates that an applicant is still waiting to receive its QI-EIN may treat the applicant as a QDD unless it has reason to know that the applicant is not a QDD.  While a withholding agent doesn’t need to undergo any specific diligence procedures in this respect, it may only rely on a W-8IMY that says “awaiting EIN” for up to six months after receipt.

The IRS will not assess any penalties for a QDD's failure to deposit withheld amounts before the date the QDD receives its QI-EIN, provided that the QDD is current on its required deposits within a three day window after receipt of the QI-EIN.  In addition, if a QDD applies to enroll in the Electronic Federal Tax Payment Systems (“EFTPS”) within 30 days of receiving a QI-EIN, no penalty will be assessed for the QDD's failure to deposit withheld amounts, provided that the QDD is current on its required deposits, again within a three day window.  The Notice does not address the imposition of interest; thus, it appears that interest will still be charged even though penalties will be waived.


List of Exchange Traded Notes (ETNs) with Delayed Effective Date

ETNs referencing underlying securities and which are delta-one transactions will generally become subject to Code section 871(m) on January 1, 2017.  To account for certain ETNs whose existence predate the 2015 final regulations and which have been in continuous distribution, as well as to permit issuers time to unwind the identified ETNs, maintain fungibility, and preserve market liquidity, the Treasury Department and the IRS will provide appropriate relief for the following ETNs (identified by name, ticker symbol, and CUSIP number) until January 1, 2020: 

ETNs
ETNs


Adjusting Under-withholding Before the Due Date (Without Extensions) for Filing Form 1042

Notwithstanding the general rule that a withholding agent is liable to the extent it fails to withhold as required under Treasury Regulations section 1.1461-2(b), a withholding agent that fails to withhold on a dividend equivalent payment made to a foreign person may rely on the procedures in Treasury Regulations section 1.1461-2(b) to adjust its under-withholding without penalty before March 15 of the year following the year in which the under-withholding occurred.


Conclusion

The general theme of Notice 2016-76 is a taxpayer-friendly one.  Importantly, under the new and rather widespread “good faith” compliance standards, taxpayers, QDDs, and withholding agents alike may rest easier that earnest efforts to comply with the applicable rules will be respected in both delta-one and non-delta-one scenarios.  Simplification of the complicated standards for combining transactions appear to be an equally encouraging development.  Overall, it appears that Notice 2016-76 will serve as a welcome addition to existing authority relating to the taxation of NPCs and dividend equivalent payments under Code Section 871(m).


 [1] Letter of Payson Peabody, August 31, 2016.