Regardless of whether you know them as the Section 871(m) regulations, HIRE Act, swap regs or just plain dividend withholding tax regulations – the wait is over. At long last the government has reworked the regulations. On December 4, 2013, the IRS and Treasury Department released final and proposed regulations under Section 871(m) of the Internal Revenue Code. The final regulations continue the current statutory rules that industry participants have been using since the enactment of Section 871(m) until January 1, 2016. So, for the next two years it’s business as usual.
The new proposed regulations replace a previous version of the regulations which were proposed in January 2012, and now withdrawn. This is a classic case of “be careful what you wish for.” The 2012 regulations would have imposed U.S. withholding tax on equity derivatives only if one of seven triggers was hit and those triggers each had exceptions and exclusions. The 2012 regulatory package was met with an onslaught of criticism and complaints regarding the cost of compliance and the general impracticality of proper administration. On the one hand the 2012 regulations were horribly complex and difficult to administer but, on the other hand, they did provide a road map for government sanctioned avoidance of U.S. withholding tax related to U.S. source dividends. In contrast, the new proposed regulations are relatively easy to administer but effectively foreclose any opportunity to avoid U.S. withholding tax on U.S. dividends.
The newly proposed regulations will cause any financial contract that references a U.S. equity to be subject to U.S. withholding tax unless, (i) the “delta” of the contract is less than 0.70; (ii) U.S. equities make up less than 10% of the referenced securities; or (iii) the referenced U.S. equities constitute a “qualified index.” The cost of simplicity is a blunt tool that delivers rough justice. The good news is that most routine retail equity derivatives do not have a delta of 0.70 or above and thus will be spared any withholding tax consequences. But that’s the end of the good news!
Derivatives and other synthetic equity instruments (e.g., convertible bonds) will be tested for delta measurement purposes at the time of acquisition. This causes a strange tax phenomenon to occur with respect to instruments that trade in the secondary market. Within a single issue of instruments you could have some instruments subject to withholding tax while others are not – even though they all trade under the same CUSIP and / or are otherwise fungible. That creates an issue for the broker/dealer or other custodian tasked with performing the actual withholding function.
For those that don’t trade for a living the term “delta” refers to a mathematically determined ratio of the rate of change of the value of the underlying physical equity position to the value of the derivative. For example, if a $1 change in the value of a physical share of stock causes a $0.80 change in the value of the derivative then the delta would be said to be 0.80. It’s entirely unclear how Treasury and the IRS determined that a 0.70 delta should be the dividing line between withholding or not withholding. Tax professionals will be tempted to extrapolate the 0.70 delta test to a broader meaning of tax ownership or constructive ownership. If this extrapolation had any merit it would endanger popular understandings under Section 1259 (constructive sales), Section 1260 (constructive ownership), Section 1091 (wash sale), Section 1092 (straddle), as well as others. However, the preamble to the proposed regulations cautions against such extrapolation and specifically states that the proposed regulations, “should not be construed as providing guidance with respect to any other section of the Code. For example, this notice should not be used as a basis for applying the delta standard to interpret other Code sections.”
Below are the highlights of the new proposed 871(m) regulations which would have effect beginning January 1, 2016:
1. Until January 1, 2016, keep doing what you have been doing. The new regs don’t have any effect until that time. But, note the last point below.
2. You thought the 2012 regs were too burdensome, well they have been withdrawn. Now you have simple regs — Every derivative that references a U.S. dividend paying equity is captured (save for minuscule exceptions noted in #3, 4 and 5 below and qualified indices noted in #20 below) and deemed subject to withholding IF the delta of the derivative is equal to or greater than 0.70 (measured at the time the derivative is acquired).
3. There is an exception if the derivative covers a portfolio of securities and U.S. equities comprise 10% or less of the portfolio (fair market value weighted). In such a case the instrument is not covered by 871(m).
4. There is an exception from the rules if the long party to the contract is a qualified dealer (i.e., a licensed securities dealer, acting in its capacity as a dealer, that furnishes the short party with a written certification that it will perform any necessary withholding in its capacity as a short party, should it become one). This exception does not apply to proprietary positions of the dealer – only as it acts for customers in its capacity as a dealer.
5. There is a narrow exception from withholding for corporate acquisitions. If the transaction obligates the long party to acquire ownership of the underlying security as part of a plan to acquire more than 50% of the underlying issuer then it will be exempted from the rule.
6. It does not matter if the derivative provides for dividend pass-through, estimated dividends, or any payments at all. Every derivative that references a dividend paying U.S. equity is presumed to pass on some dividend benefit and is therefore covered. Even price only instruments are picked up (so called “implicit dividends”).
7. Exchange traded options are picked up if delta at acquisition exceeds 0.70. Single stock futures will also be Section 871(m) transactions and subject to withholding. Even convertible bonds are caught by the proposed regulations.
8. You cannot manipulate the delta. Instruments with a delta that is not reasonably expected to vary during the term of the instrument is treated as having a delta of 1. The example shows a swap providing for 50% of price / divs on 100 shares of X stock. Thus, the swap has a 0.50 delta. The example finds a delta of 1.0 on 50 shares of stock. Query what would happen with a swap or equity linked instrument designed to have an initial delta of 0.5 but increase to 1.0 in short order. The delta would vary over the term of the instrument (albeit only initially), and therefore should not run afoul of the “constant delta” rule. But see #9.
9. Anti-Abuse Rule: If taxpayer acquires a transaction or transactions with a “principal purpose” of avoiding the 871(m) rule then the commissioner may treat the transaction as subject to 871(m) to the extent necessary to prevent avoidance. Very broad anti-abuse provision.
10. The delta calculation utilized for non-tax purposes will generally be utilized for 871(m) purposes but delta must be calculated in a commercially reasonable manner in all cases.
11. Swaps entered into prior to Jan. 1, 2016 are NOT grandfathered.
12. Equity linked instruments (i.e., non-swap) are grandfathered if taxpayer acquires the instrument prior to 90 days after the new regs are published (March 5, 2014). Banks are already rushing to issue equity linked instruments to get in front of this date.
13. The amount of withholding is based on a delta adjusted dividend amount (i.e., if delta is 0.80 at time of dividend then withholding is based on 80% of dividend on notional). Delta for purposes of 871(m) qualification is measured at time of derivative acquisition. Delta for purposes of withholding amount is measured at time of dividend payment unless the derivative has a term of one year or less (with no extension options), in which case the dividend equivalent amount is measured at termination / maturity / disposition only. Thus, options with a term of 1 year or less that finish out of the money and lapse incur no 871(m) withholding tax.
14. If derivative has initial delta above .7, withholding will continue even if delta falls below .7 at later date. Likewise, if initial delta is below .7 the instrument will not become subject to withholding if delta subsequently rises above .7
15. The IRS will continue to pursue non-statutory theories of tax ownership / withholding in appropriate circumstances.
16. Section 871(m) dividend equivalents are treated as real dividends for treaty purposes.
17. Section 305 dividend inclusions are not included as dividends for 871(m) purposes.
18. If the underlying payment would not have been subject to U.S. withholding (i.e., return of capital distribution or RIC capital gain distribution) then there is no 871(m) withholding.
19. The dividend equivalent amount is presumed to be the actual per share dividend paid on the underlying shares (as adjusted for delta), unless the “short party” identifies a reasonable estimated dividend amount in writing at the inception of the trade. Presumably this will only happen in the “implicit dividend” cases (i.e., price only swap situations) or estimated dividend cases, where the short party needs to identify the exact amount the long party is obtaining to forego dividends.
20. An index (or portfolio) derivative will be dissected into its underlying components with delta tested on a per-underlying basis (and treated as a series of separate derivatives) UNLESS the index is a “Qualified Index” —- meaning an index that (i) references 25 or more underlying securities; (ii) references only long positions; (iii) no component underlying security represents more than 10% of the index by weight; (iv) is modified or rebalanced only according to predefined objective rules at set dates or intervals; (v) does not provide a dividend yield greater than 1.5 times the S&P500 div yield (as of the immediately preceding month); and (vi) futures or options on such index (price only or total return) trade on a national securities exchange or board of trade. If the derivative references a “Qualified Index” then it is not subject to 871(m). This is a very helpful rule as many (but not all) major indices will qualify although those utilizing price / market cap weighting need to be monitored. Some indices will qualify one day but not another due to the 10% single security weight limit and/or the dividend yield limit.
21. Broker dealers will need to report the delta figures to users of potential 871(m) instruments.
22. Two or more transactions entered into “in connection with each other” on the same underlying equity (or equities) by the same counterparty (or related parties) must be aggregated for the delta test (regardless of time lag between entering into positions). However, withholding agent is not liable for withholding on combined trade if it “did not know” about the corresponding trade or trades. Thus, an offshore fund could go long an at-the-money call option at one broker and go short an at-the-money put at another broker on the same underlying (thereby creating a delta one exposure) without U.S. withholding tax. However the cost will be prohibitive unless the two counterparties find each other for hedging purposes.
23. The takeaway here is as follows: (i) Until 2016, simply follow the statutory test and don’t run afoul of common law tax ownership – this provides broad trading practices for the next two years; (ii) there is no mention of MLP swaps in the proposed regulations – go ahead and trade them, again, being mindful of common law tax ownership; (iii) single stock futures are fair game and can be used with impunity for the next two years but then the party is over; and (iv) post 2016 hopefully we’ll get the delta test pushed to a more reasonable 90% level but be prepared to deal with the 70% test.
For any questions or comments, contact your regular WithumSmith+Brown partner.