Withholding Tax on Dividend Equivalent Payments: IRS Issues Interim Guidance on Section 871(m) and the Qualified Derivatives Dealer Program

Sullivan & Cromwell LLP - December 8, 2016

On December 2, 2016, the IRS and Treasury Department issued interim guidance under Section 871(m) in Notice 2016-76 (the “Notice”).  Significant changes made by the Notice include the following:

  • The January 1, 2017 effective date for Section 871(m) withholding will apply only to “delta-one” contracts.  Other contracts will only be subject to Section 871(m) if they are issued on or after January 1, 2018.  This delayed effective date is intended to address industry concerns regarding the feasibility of fully implementing Section 871(m) by January 1, 2017.
  • Although a “combination” rule will still apply for determining whether a contract has a “delta” of one, withholding agents will not need to combine transactions that are entered into in 2017 unless they are over-the-counter transactions that are priced, marketed or sold in connection with each other.
  • Qualified derivatives dealers (“QDDs”) will be required to determine their residual Section 871(m) tax liability for dealer transactions under a “net delta” methodology that evaluates a QDD’s aggregate dealer position in a given U.S. stock. This change from prior guidance was apparently made in response to concerns that the previous methodology could have caused a fully hedged QDD to owe residual Section 871(m) tax in certain unintended circumstances.  However, the use of a “net delta” approach means that a QDD may be subject to tax on dealer positions with a “delta” of less than 0.8.
  • By contrast to the approach taken in prior guidance, actual dividends paid to a QDD will remain subject to U.S. withholding tax.  In the absence of additional guidance, this rule may result in the imposition of more than one level of tax on the same dividend.
  • “Qualified securities lenders” will be entitled to rely on Notice 2010-46 (including the “credit-forward” rules) until January 1, 2018. 
  • The effective date of the new Section 871(m) rules for certain exchange-traded notes will be postponed until January 1, 2020.  The Notice identifies a list of 25 such structured notes, but indicates that the IRS and Treasury Department are willing to consider extending comparable relief to other exchange-traded notes if those products were outstanding before September 18, 2015.