On January 1, 2017, new regulations will take effect, significantly expanding tax withholding requirements for U.S. source dividend equivalent payments (DEPs) to non-U.S. persons. Payments covered by the new rules will be subject to the same 30% U.S. withholding tax (less under certain tax treaties) as U.S. source dividends.
Funds whose portfolios include derivatives and other instruments linked to U.S. equities should coordinate with brokers and dealers to ensure that all parties understand their responsibilities under the new rules. Note, however, that on December 2, 2016, the IRS issued transitional relief that delays withholding on non-delta one transactions until January 1, 2018, and simplifies certain aspects of the rules.
Beyond Equity Swaps
In 2010, Congress enacted Internal Revenue Code Sec. 871(m) to prevent the use of equity swaps and similar contracts to avoid U.S. tax withholding on dividend payments to non-U.S. persons. Previously, payments to non-U.S. persons under these contracts were sourced to the recipient’s jurisdiction and were not subject to withholding.
Sec. 871(m) mandates withholding on DEPs in connection with certain equity swaps, referred to as specified notional principal contracts (SNPCs), as if they were U.S. source dividends. These transactions are considered to be economically equivalent to stock ownership. For example, a swap in which the counterparty transfers the underlying stock to the foreign person at the termination of the transaction is an SNPC.
The new regulations expand Sec. 871(m) to cover:
- All types of notional principal contracts (NPCs), and
- Equity-linked instruments (ELIs), such as options, futures, forwards, contingent debt, and convertible debt.
They also establish an objective test for determining whether an equity derivative is economically equivalent to stock ownership. Generally, withholding is required if an NPC or ELI has a delta of 0.80 or higher. Delta is generally the ratio of the change in a derivative’s fair market value to a change in the fair market value of the underlying security. The closer a derivative’s delta is to 1.0, the more closely its economic performance mirrors that of the underlying security.
Under the regulations, delta is tested only when an instrument is issued. Retesting is not required when an instrument is purchased or otherwise acquired in the secondary market, unless its terms are significantly modified. The obligation to withhold does not arise until an actual payment is made or there is a final settlement of a transaction. Withholding is not required for payments made to qualified derivatives dealers (QDDs) who assume responsibility for withholding and reporting DEPs. In addition, there is an exception for contracts that reference a qualified index (QI), such as the S&P 500.
Simple vs. Complex Contracts
The IRS recognizes the difficulty of applying the delta test to exotic derivatives. For this reason, the test is applied only to simple contracts — those that determine the payout with reference to a single, fixed number of shares of one or more issuers with a single maturity date. Simple contracts would include most swaps, options, forwards, futures, and convertible debt. For complex contracts (any contract that is not a simple contract), temporary regulations outline a new substantial equivalence test for determining delta.
Combining Related Transactions
The regulations contain a combination rule designed to thwart attempts to avoid the delta threshold by entering into multiple transactions linked to the same underlying security. Under this rule, two or more transactions are treated as a single transaction subject to withholding if they are entered into in connection with one another, and they are economically equivalent, on a combined basis, to a single transaction with a delta of 0.8 or more.
The combination rule permits short parties and the IRS, but not long parties, to rely on certain presumptions in determining whether transactions should be combined.
Effective Date and Transitional Relief
The expanded withholding requirements generally apply to payments under contracts entered into, or materially modified, on or after January 1, 2017. Pre-2017 contracts are grandfathered under the new rules, with one exception; for contracts entered into during 2016 that would be covered by the new rules, but are not SNPCs under existing rules, withholding will be required on payments made on or after January 1, 2018.
On December 2, 2016, the IRS issued Notice 2016-76, which provides transitional relief and other additional guidance. Key changes include:
- The new withholding requirements will take effect January 1, 2017 with respect to delta one contracts only (including combined transactions). For non-delta one contracts, the requirements won’t take effect until January 1, 2018.
- For 2017 transactions, withholding agents (but not long parties) may apply a simplified “combined transaction” standard. They are required to combine transactions only if they are over-the-counter transactions that are priced, marketed, or sold in connection with each other. Withholding agents are not required to combine any 2017 transactions that are listed securities.
- 2017 and 2018 are designated as “phase-in years” for delta one and non-delta one contracts, respectively. The Notice provides for relaxed administration and enforcement during those years — including relief from penalties — for withholding agents that make a good faith effort to comply.
The Notice also clarifies procedures for applying for and certifying QDD status and designates 2017 as a phase-in year for QDDs.
Generally, brokers and dealers will be responsible for applying the delta and substantial equivalence tests and withholding on DEPs that fall within the scope of the new regulations. But that does not mean that funds play a passive role when it comes to compliance with Sec. 871(m). For one thing, if a broker or dealer fails to meet its withholding obligations, the fund may be held responsible. So, it is in a fund’s best interests to coordinate with brokers and dealers to ensure that these tests are performed and documented properly. In addition, funds will need to:
- Take an active role in identifying transactions subject to the combination rule. Brokers and dealers may not have access to the information needed to make these determinations, particularly when a fund maintains accounts at several firms.
- Consider Sec. 871(m) tax liabilities when calculating net asset values (NAVs).
- In the case of funds that are structured as U.S. partnerships, withhold and report on DEP income allocated to any non-U.S. investors.
- Monitor compliance with the QDD and QI exceptions.
Notice 2016-76 greatly simplifies funds’ responsibilities during 2017, but it’s important to begin preparing soon for the more complex requirements that take effect in 2018.
For more information on these new regulations, please contact your Untracht Early advisor.