Withholding Tax on Dividend Equivalent Payments: IRS and Treasury Issue Final and Proposed Regulations on Withholding Tax on “Dividend Equivalent Payments”

Sullivan & Cromwell LLP - December 5, 2013
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On December 5, 2013, the Treasury Department and the IRS issued final and proposed regulations (the “Final Regulations” and “New Proposed Regulations”, respectively) relating to “dividend equivalent” payments on certain U.S. equity swaps and other U.S. equity-linked instruments. Section 871(m) of the Internal Revenue Code and previously issued temporary regulations (the “Temporary Regulations”) generally provide that withholding applies to such dividend equivalent payments if (i) in connection with entering into the relevant contract, any long party to the contract transfers the underlying security to any short party to the contract (i.e., so-called “crossing in”), (ii) in connection with the termination of such contract, any short party to the contract transfers the underlying security to any long party to the contract (i.e., so-called “crossing out” ), (iii) the underlying security is not readily tradable on an established securities market, or (iv) in connection with entering into such contract, the underlying security was posted as collateral by any short party to the contract with any long party to the contract. Previously issued proposed regulations (the “Old Proposed Regulations”) further provided that with respect to payments made on or after January 1, 2014, withholding would apply based on the application of a seven-factor test to the relevant equity derivative transaction.

The Final Regulations adopt the Temporary Regulations with minimal changes and extend their effective date by two years. Current law will therefore continue to apply to dividend equivalent payments made before January 1, 2016.

The Old Proposed Regulations have been withdrawn in favor of New Proposed Regulations that would implement a greatly expanded approach to U.S. withholding on U.S. equity derivative transactions and would basically impose withholding in any case where the underlying U.S. equity paid dividends on a current basis. Exceptions would apply for options and other equity derivatives with a “delta” of less than 0.7 and for derivatives on certain recognized equity indexes. The New Proposed Regulations would apply to dividend equivalent payments made after 2015 on all U.S. equity swaps (including swaps in existence today) and on all other U.S. equity derivative transactions (including structured notes, exchange-traded notes, contingent debt instruments, convertible debt instruments, forwards, futures and options referencing U.S. equities) that are acquired after March 5, 2014. Significant aspects of the New Proposed Regulations include the following: 

  1. The New Proposed Regulations would withhold in respect of long positions in U.S. equity swaps and other U.S. equity derivatives in the absence of any “crossing in”, “crossing out” or other factors suggesting that the long position was a continuation or substitute for actual ownership of the underlying U.S. equities. In this regard, the New Proposed Regulations look beyond the four factors set out in the statute (and in the Temporary Regulations), which focus on agency-related issues. The proposed expanded application of withholding on equity swaps is based on a grant of authority to impose withholding “with respect to any notional principal contract unless the Secretary determines that such contract is of a type which does not have the potential for tax avoidance”. The proposed expanded application of withholding on forwards, futures, indexed notes and other equity derivatives appears to be based partly on analogy to the current law treatment of inbound stock loans and repos, although such stock loans and repos do involve long physical ownership (and crossing in and out) that precedes and follows the derivative position. The Treasury Department and the IRS have in any case concluded that other equity derivatives have the same potential for tax avoidance as stock loans, repos and equity swaps.
  2. The New Proposed Regulations would withhold in respect of a derivative on a dividend-paying U.S. equity in the absence of any actual dividend equivalent payment or adjustment for changes in dividends. In such case, withholding would effectively be based (at the taxpayer’s election) on either the amount of the reasonably anticipated dividends or on the dividends actually paid on the underlying equity. This approach would appear to look beyond the language of the statute.
  3. Under the New Proposed Regulations, dividend equivalent payments would generally be deemed made at the time of payment of the underlying dividend, notwithstanding that the associated adjustment in payment was made later — e.g., on termination or maturity. 
  4. Under the New Proposed Regulations, withholding would not apply to options or other equity derivative transactions that had a “delta” of less than 0.7 in relation to the underlying U.S. equities. They would, however, apply to combinations of positions in respect of a particular U.S. equity that, in the aggregate, produced a delta of more than 0.7. Moreover, delta would be determined for this purpose at the time of acquisition, so the status of traded equity derivatives could change for secondary holders. This represents the first appearance of the “delta” concept in U.S. tax regulations. 
  5. Where initial delta was greater than 0.7, withholding would be based on the amount of the relevant dividend equivalent payment multiplied by the delta in effect at the time of the payment. Thus, withholding amounts would change over time.
  6. Under the New Proposed Regulations, withholding would generally not apply to derivative positions in U.S. equity indexes that are referenced by futures or options traded on national securities exchanges or domestic boards of trade and do not provide for high dividend yields (or to worldwide equity indexes with less than 10 percent exposure to U.S. equities).
  7. Under the New Proposed Regulations, structured notes and other equity derivatives offering “enhanced leverage” over U.S. equities (e.g., appreciation equal to twice the increase in value of Stock X, up to a cap) would be treated as correspondingly larger positions (e.g., twice as large) in the underlying U.S. equities and therefore subject to correspondingly more withholding.
  8. The New Proposed Regulations would effectively look through derivative positions in partnerships to significant underlying positions in U.S. equities.
  9. The New Proposed Regulations would generally impose withholding obligations on broker- dealers, including the obligation to determine delta where appropriate. A broker-dealer would not be required to withhold in the absence of any cash received from a counterparty, but the broker-dealer would be required to use any cash of the counterparty that it had within its control to meet its withholding obligations. Broker-dealers would not be required to withhold on other qualified broker-dealers that took long equity positions in the ordinary course of business (so as to mitigate the risk of duplicative withholding in chains of payments made through intermediary broker-dealers).
  10. The New Proposed Regulations would also include a general anti-abuse rule allowing the IRS to withhold in respect of any transaction that had been intentionally structured to avoid the relevant rules.