The IRS on Dec. 5 issued final (T.D. 9648) and proposed (REG-120282-10) regulations under Section 871(m), which discusses dividend equivalents.

Section 871(m)(1) provides that, for purposes of Sections 871(a), 881 and 4948(a), as well as under chapters 3 and 4 of the Internal Revenue Code, a dividend equivalent is treated as a dividend from sources within the United States.

Specifically, Section 871(m)(2) defines a dividend equivalent as (1) a substitute dividend made pursuant to a securities lending or sale-repurchase transaction that is directly or indirectly contingent upon or determined by reference to, the U.S.-source dividend, (2) any payment made pursuant to a "specified notional principal contract" (NPC) that directly or indirectly is contingent upon or determined by reference to a U.S.-source dividend, and (3) any other payment that the Treasury Department determines to be substantially similar to those types of payments.

Regarding payments made on or before Jan. 23, 2012, Section 871(m)(3)(A) provides that a specified NPC is any NPC as defined in Treas. Reg. Section 1.446-3(c) if any of the following requirements are met: 

  • In connection with entering into such a contract, any long party to the contract transfers the underlying security to any short party to the contract
  • In connection with terminating such a contract, any short party to the contract transfers the underlying security to any long party to the contract
  • The underlying security is not readily tradable on an established securities market
  • In connection with entering into such a contract, the underlying security is posted as collateral by any short party to the contract with any long party to the contract
  • Such a contract is identified by the Treasury Department as a specified NPC

However, for payments made after Jan. 23, 2012, Section 871(m)(3)(B) provides that a specified NPC is any NPC unless the Treasury Department determines that the type of contract does not have the potential for tax avoidance.

The final regulations adopt the corresponding temporary regulations (T.D. 9572) with minimal changes. Significantly, the new, final regulations under Treas. Reg. Section 1.1441-2 includes dividend equivalents described in Section 871(m) as an amount that is subject to withholding.

However, the proposed regulations under Treas. Reg. Section 1.871-15(c)(2)(i) provide that if the long party owned the underlying security, a payment under Section 871(m) would not be a dividend equivalent to the extent the distribution is not subject to tax under Sections 871 or 881, or subject to withholding under chapters 3 or 4. In addition, the proposed regulations under Treas. Reg. Section 1.871-15(c)(2)(ii) hold that a payment pursuant to Section 871(m) is not a dividend equivalent if the payment is treated as a distribution taxable as a dividend under Section 305.

The following summarizes certain highlights of the proposed regulations:

Specified ELI

Proposed Treas. Reg. Section 1.871-15(a)(4) defines an ELI as a financial transaction (other than a securities lending, sale-repurchase transaction or an NPC) that references the value of one or more underlying securities. For example, an ELI is a futures contract, forward contract, option, debt instrument or other contractual arrangement that references the value of one or more underlying securities.

With respect to payments made on or after Jan. 1, 2016, a specified ELI is defined under Prop. Treas. Reg. Section 1.871-15(e) as any ELI acquired on or after March 5, 2014, that has a delta of 0.70 or greater with respect to the underlying security at the time it was acquired by a long party. 

If an ELI references more than one underlying security, the ELI is a specified ELI only with respect to underlying securities for which the ELI has a delta of 0.70 or greater. For example, if an ELI references security A and security B, and it has a 0.90 delta with respect to security A and a 0.30 delta with respect to security B, the ELI is a Specified ELI only with respect to security A and is not a Specified ELI with respect to security B. This is found under Prop. Treas. Reg. Section 1.871-15(e).

Substantially similar payment

A substantially similar payment is defined in Prop. Treas. Reg. Section 1.871-15(f)(1) to include any payment made by a withholding agent in satisfaction of a tax liability with respect to a dividend equivalent.

Specified NPC

Prop. Treas. Reg. Section 1.871-15(d)(2) provides that, with respect to payments made on or after Jan. 1, 2016, a specified NPC is an NPC that has a delta of 0.70 or greater with respect to the underlying security.

Similar to the test for a specified ELI, if an NPC references more than one underlying security, the NPC is a specified NPC only with respect to underlying securities for which the NPC has a delta of 0.70 or greater. For example, if an NPC references security A and security B, and it has a 1.0 delta with respect to security A and a 1.0 delta with respect to security B, the NPC is a specified NPC with respect to both security A and security B. See Prop. Treas. Reg. Section 1.871-15(d)(2).

Among other things, the new proposed regulations provide that a dividend equivalent includes any payment from a "specified equity-linked instrument" (ELI) and any "substantially similar payments" described in Treas. Reg. Section 1.871-15(f). The proposed regulations also provide for a new definition for a specified NPC from the definition provided in the old proposed regulations (Treas. Reg. Section 1.871-15(c)(1)).

Delta

Delta is defined under Prop. Treas. Reg. Section 1.871-15(g)(1) as the ratio of the change in the fair market value of an NPC or an ELI and the change in the fair market value of the property referenced by the NPC or ELI. 

If an NPC or an ELI contains more than one reference to a single underlying security, all references to that security are taken into account in determining the delta with respect to that underlying security.

If an NPC or an ELI references more than one underlying security, a separate delta must be determined with respect to each underlying security without taking into account any other underlying security or other property or liability. If a taxpayer calculates delta for nontax business purposes, such delta is used for the purposes of Prop. Treas. Reg. Section 1.871-15.

Effective date

The proposed regulations, which replace the withdrawn proposed regulations that were issued in January 2012, are generally effective upon the adoption of the final regulations. However, certain provisions in the proposed regulations apply on different dates. 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.