In a Notice (the New Notice), IRS has announced that it intends to amend the final and temporary regs under Code Sec. 871(m), Code Sec. 1441, Code Sec. 1461, and Code Sec. 1473 (collectively, the section 871(m) regs) to delay the effective/applicability date of certain rules in those regs. IRS also extended the phase-in period in Notice 2016-76 for certain provisions of the regs.
Statutory background. In general, nonresident aliens and foreign corporations are taxed at a flat 30% (or lower treaty rate) on certain types of income, including dividends, that are U.S.-source and not “effectively connected” with a U.S. trade or business. (Code Sec. 871(a), Code Sec. 881(a)) However, according to IRS, many non-U.S. investors enter into swaps or other derivative contracts that pay “dividend equivalents,” instead of directly holding the dividend-paying equities on which they are based, in order to avoid U.S. tax.
Code Sec. 871(m) treats a “dividend equivalent” as a dividend from sources within the U.S. for purposes of (among other Code sections) Code Sec. 871(a) (dealing with the tax on nonresident alien’s income which is unconnected with a U.S. trade or business) and Code Sec. 881 (dealing with the tax on income of foreign corporations not connected with U.S.). Code Sec. 871(m)(2) defines a dividend equivalent as (1) any substitute dividend 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 U.S., (2) any payment made pursuant to a specified notional principal contract (NPC) that (directly or indirectly) is contingent upon or determined by reference to the payment of a dividend from sources within the U.S., or (3) any other payment that IRS determines is “substantially similar” to a specified NPC payment or substitute dividend payment. An NPC is a financial instrument that provides for payments by one party to another at specified intervals calculated by reference to a “specified index” upon a “notional principal amount” in exchange for specified consideration or a promise to pay similar amounts. NPCs include interest rate swaps, currency swaps, basis swaps, interest rate caps and floors, commodity swaps, equity swaps, equity index swaps, and similar agreements.
Earlier guidance. In 2010, IRS published Notice 2010-46, which addressed potential overwithholding in the context of securities lending and sale repurchase agreements. Notice 2010-46 provides a two-part solution to the problem of overwithholding on a chain of dividends and dividend equivalents: (1) it provides an exception from withholding for payments to a qualified securities lender (QSL); and (2) it provides a proposed framework to credit forward prior withholding on a chain of substitute dividends paid pursuant to a chain of securities loans or stock repurchase agreements. The QSL regime requires a person that agrees to act as a QSL to comply with certain withholding and documentation requirements. Withholding agents were permitted to rely on transition rules described in Notice 2010-46 until guidance was developed that would include documentation and substantiation of withholding.
In 2015, IRS issued final and temporary regs (TD 9734) which finalized a portion of a certain 2013 proposed regs and introduced new temporary regs (2015 final regs and 2015 temporary regs, respectively). The preamble stated that the final qualified derivatives dealer (QDD) regs would supplant the proposed regulatory framework described in Notice 2010-46. (See “Final, etc. regs on payments determined by reference to U.S. source dividends.”)
IRS subsequently issued Notice 2016-42, 2016-29 IRB 67 (which contained the proposed qualified intermediary agreement (QI Agreement) that included provisions relating to the QDD regime and reiterated the intent to replace the proposed regulatory framework described in Notice 2010-46 with the QDD regime; see “IRS issues proposed Qualified Intermediary agreement; final version to come by year-end“); Notice 2016-76(which provided for the phased-in application of certain section 871(m) reg provisions and announced that taxpayers could continue to rely on Notice 2010-46 until Jan. 1, 2018; see “IRS phases in dividend equivalent regs & announces that modifications are coming“); and Rev Proc 2017-15, 2017-3 IRB 437 (which provides the final QI Agreement (2017 QI Agreement), including the requirements and obligations applicable to QDDs; see “IRS releases final qualified intermediary withholding agreement“).
In January of 2017, IRS released final and temporary regs (TD 9815; the 2017 regs) which finalized the 2015 notice of proposed rulemaking that was issued in conjunction with the 2015 temporary regs. The effective/applicability dates in the 2017 regs reflect the phased-in application described in Notice 2016-76. Also, consistent with Notice 2016-76 and other announcements, the “Effect on Other Documents” section of the preamble to the 2017 regulations obsoleted Notice 2010-46 as of Jan. 1, 2018. IRS also stated in the preamble that, while it understood that the QSL regime was more convenient for taxpayers than the QI regime, it was difficult for IRS to administer, so the QSL regime was being replaced by incorporating the QDD rules into the existing QI framework. (See “Final, temporary regs flesh out dividend equivalent rules“.)
IRS subsequently issued Notice 2017-42, 2017-34 IRB 212 (which extended certain transition relief; see “IRS intends to delay dividend equivalent regs’ effective date & extends prior phase-in period“) and Notice 2018-5, 2018-6 IRB 341 (which permits withholding agents to apply the transition rules from Notice 2010-46 in 2018 and 2019; see “IRS further extends transitional substitute dividend payment rules“).
New guidance—extended phase-in for delta-one and non-delta-one transactions. IRS has determined that it’s appropriate for taxpayers and withholding agents to delay certain provisions in the section 871(m) regs for non-delta-one transactions, including transactions that are combined transactions under Reg. § 1.871-15(n). Accordingly, IRS announced in the New Notice that it intends to revise the effective/applicability date for Reg. §1.871-15(d)(2) and Reg. § 1.871-15(e) to provide that these rules will not apply to any payment made with respect to any non-delta-one transaction issued before Jan. 1, 2021. (Notice 2018-72, Section III)
Observation: In general, a “delta-based standard” is one that measures the change in the value of an instrument relative to a change in the value of the underlying security. The delta of an NPC or an equity linked instrument (ELI) is the ratio of the change in the fair market value (FMV) of the NPC or ELI to the change in the FMV of the referenced property, determined in a commercially reasonable manner. A delta of one means that for any change in the value of a derivative there is expected to be an identical change in the value of the underlying security.
Good faith standard. Notice 2016-76 provided that IRS will take into account the extent to which the taxpayer or withholding agent made a good faith effort to comply with the section 871(m) regs with respect to (1) delta-one transactions in 2017 and (2) non-delta-one transactions in 2018 in its enforcement of those regs. Notice 2017-42 extended the period during which the good faith effort standard applied to (1) any delta-one transaction in 2017 and 2018, and (2) any non-delta-one transaction that is a section 871(m) transaction under Reg. §1.871-15(d)(2) or Reg. § 1.871-15(e) in 2019.
The New Notice also further extends the periods during which the enforcement standards provided by Notice 2016-76 and Notice 2017-42 will apply. Consistent with this extension, IRS will take into account the extent to which the taxpayer or withholding agent made a good faith effort to comply with the section 871(m) regs in their enforcement for (1) any delta-one transaction in 2017 through 2020, and (2) any non-delta-one transaction that is a section 871(m) transaction pursuant to Reg. §1.871-15(d)(2) or Reg. § 1.871-15(e) in 2021. (Notice 2018-72, Section III)
Similarly, for purposes of IRS’s enforcement and administration of the QDD rules in the section 871(m) regs and the relevant provisions of the 2017 QI Agreement, the New Notice extends through 2020 the period during which IRS will take into account the extent to which the QDD made a good faith effort to comply with the section 871(m) regs and the relevant provisions of the 2017 QI Agreement. In addition, IRS intends to revise the 2017 QI Agreement to provide that a QDD will be considered to satisfy the obligations that apply specifically to a QDD under that agreement for 2017 through 2020 provided that the QDD makes a good faith effort to comply with the relevant provisions of the 2017 QI Agreement. (Notice 2018-72, Section III)
Extension of simplified standard for determining “combined transactions.” Notice 2016-76 provided a simplified standard for withholding agents to determine whether transactions entered into in 2017 are combined transactions. Specifically, a withholding agent is required to combine transactions entered into in 2017 for purposes of determining whether the transactions are section 871(m) transactions only when the transactions are over-the-counter transactions that are priced, marketed, or sold in connection with each other. Withholding agents are not required to combine any transactions that are listed securities entered into in 2017. Notice 2017-42extended the period during which this simplified standard for combined transactions applies to include 2018.
The New Notice further extends the period during which the simplified standard for combined transactions applies to include 2019 and 2020. (Notice 2018-72, Section IV)
Transactions that are entered into in 2017 through 2020 that are combined under the simplified standard will continue to be treated as combined transactions for future years and will not cease to be combined transactions as a result of applying Reg. §1.871-15(n) or disposing of less than all of the potential section 871(m) transactions that are combined under this rule. Transactions that are entered into in 2017 through 2020 that are not combined under the simplified standard will not become combined transactions as a result of applying Reg. §1.871-15(n) to these transactions in future years, unless a reissuance or other event causes the transactions to be retested to determine whether they are section 871(m) transactions. The simplified standard applies only to withholding agents and does not apply to taxpayers that are long parties to potential section 871(m) transactions. (Notice 2018-72, Section IV)
Extension of phase-in relief for QDDs. Reg. § 1.871-15T(q)(1) of the 2015 temporary regs provided that when a QDD received a dividend or dividend equivalent payment and the QDD was contractually obligated to make an offsetting dividend equivalent payment on the same underlying security in an amount that was less than the dividend and dividend equivalent amount received, the QDD would be liable for tax under Code Sec. 871(a) or Code Sec. 881 for the difference. Reg. §1.1441-1(b)(4)(xxii) of the 2015 final regs provided that a withholding agent who made a payment of a dividend to a qualified intermediary acting as a QDD was not required to withhold on that payment if the withholding agent reliably associated the payment with a valid qualified intermediary withholding form containing a certification described in Reg. §1.1441-1(e)(3)(ii)(E).
In response to comments, in the 2017 final regs, IRS adopted the net delta exposure method as a more administrable and accurate method for a QDD to determine its residual exposure to underlying securities. In adopting this approach, due to tax avoidance concerns, the 2017 final regs revised Reg. §1.871-15(q)(1) and Reg. § 1.1441-1(b)(4)(xxii) to provide that a QDD remains liable for tax under Code Sec. 881(a)(1) and subject to withholding under chapters 3 and 4 on dividends. However, to allow taxpayers time to implement the net delta approach, the 2017 QI Agreement and the 2017 final regs provided that dividends and dividend equivalents received by a QDD in its equity derivatives dealer capacity in 2017 will not be subject to tax under Code Sec. 881(a)(1) or subject to withholding under chapters 3 and 4.
Notice 2017-42 subsequently announced IRS’s intent to amend those provisions to provide that a QDD will not be subject to tax on dividends and dividend equivalents received in 2017 and 2018 in its equity derivatives dealer capacity or withholding on those dividends (including deemed dividends). The New Notice extends this relief to dividends and dividend equivalents received in 2019 and 2020. (Notice 2018-72, Section V)
Section 4.01(1) of Rev Proc 2017-15 provided that a QDD would be required to compute its section 871(m) amount using the net delta approach beginning in 2018. Notice 2017-42 subsequently delayed the beginning year to 2019. The New Notice extends it further to 2021. The New Notice clarified that a QDD will remain liable for tax under Code Sec. 881(a)(1) on dividends and dividend equivalents that it receives in any capacity other than as an equity derivatives dealer, and on any other U.S. source FDAP payments that it receives (whether or not in its equity derivatives dealer capacity). In addition, a QDD is responsible for withholding on dividend equivalents it pays to a foreign person on a Code Sec. 871(m) transaction, whether acting in its capacity as an equity derivatives dealer or otherwise. (Notice 2018-72, Section V)
Finally, section 10.01(C) of the 2017 QI Agreement provides that:
For calendar year 2017, a QDD is not required to perform a periodic review with respect to its QDD activities (as otherwise required by section 10.04 of this Agreement) or provide the factual information specified in Appendix I.
Notice 2017-42 provides that a QDD is not required to perform a periodic review with respect to its QDD activities for 2017 or 2018. The New Notice extends this relief period to include 2019 and 2020. (Notice 2018-72, Section V)
Extension of transition rules from Notice 2010-46. Notice 2018-5 provided that, notwithstanding the preamble to the 2017 regs, withholding agents may apply the transition rules described in Notice 2010-46, Part III, for payments made in 2018 and 2019. The New Notice provides that withholding agents may also apply the transition rules described in Notice 2010-46, Part III, for payments made in 2020. (Notice 2018-72, Section VI)
Taxpayer reliance. Taxpayers may rely on the provisions of the New Notice pending promulgation of the described amendments to the section 871(m) regs and the 2017 QI Agreement. Withholding agents may rely on the simplified standard for determining whether transactions are combined transactions as described in section IV and may apply the QSL transition rules described in section VI. (Notice 2018-72, Section VII)