Withholding Tax on Dividend Equivalent Payments: IRS and Treasury Issue Temporary and Proposed Regulations on “Dividend Equivalents” on “Specified Notional Principal Contracts”

Sullivan & Cromwell LLP - January 24, 2012

Section 871(m) of the Code requires taxpayers to treat certain “dividend equivalent” payments on “specified notional principal contracts” (“specified NPCs”), among other types of transactions, as U.S.-source dividends, thereby subjecting them to the withholding and information reporting rules applicable to regular dividends paid in respect of shares of a U.S. corporation. On January 19, 2012, Treasury and the IRS issued temporary and proposed regulations (the “Regulations,” and each the “Temporary Regulations” and the “Proposed Regulations”) under Section 871(m) providing guidance on the definition of dividend equivalent payments and specified NPCs for this purpose.

The Temporary Regulations generally extend the current rules for payments made this year. More specifically, they extend the statutory definition of a specified NPC provided in Section 871(m)(3)(A) to payments made before January 1, 2013, thereby limiting the application of Section 871(m) for the remainder of 2012 to transactions that meet the statutory definition (or are found to do so via the application of a judicial doctrine). The Proposed Regulations would apply to payments made on or after January 1, 2013. They would expand the universe of specified NPCs through application of a seven-factor test (each of which can cause an NPC to be a specified NPC). The Proposed Regulations would also extend the application of Section 871(m) to foreign-owned equity-linked financial instruments, including options, forwards and other derivatives that are linked to dividends paid on U.S. equities.