United States: US Treasury Department Publishes Long-Awaited "Dividend Equivalent" Regulations

New Regulations Provide Temporary Relief, but More Stringent Prospective Witholding Tax Rules, for Non-US Investors in Equity Derivatives Referencing US Stock

On January 19, 2012, the US Treasury Department (the "IRS") issued temporary and proposed regulations targeted at "dividend equivalent" payments. These regulations are the US Government's latest response to transactions thought by some to be abusive, in which non-US persons use equity derivatives to retain an economic exposure to US shares over a dividend payment date while avoiding US withholding tax on the dividend.

The new withholding tax rules affect notional principal contracts ("NPCs") and other equity-linked derivatives which provide for payments to non-US persons that are determined by reference to dividends paid by a US corporation. The temporary rules, which maintain current (but expiring) statutory provisions for the remainder of 2012, are effective immediately. The proposed rules, which would impose withholding tax on dividend equivalents in a broader group of transactions than the current statutory provisions, largely relate to payments made on or after January 1, 2013.

Background

Section 871(m) of the US Internal Revenue Code was enacted as part of the Hiring Incentives to Restore Employment Act in March 2010. Section 871(m) applies to securities loans, sale-repurchase transactions (repos), certain notional principal contracts ("NPCs") defined as "specified notional principal contracts" ("specified NPCs"), and similar transactions, that provide for a payment contingent upon or determined by reference to a US-source dividend ("dividend equivalent"). If section 871(m) applies to treat a payment as a dividend equivalent, the payment is treated as a US-source dividend for withholding, reporting, and certain other US tax purposes.

Section 871(m) generally applies to any dividend equivalent payment made after September 14, 2010. Although section 871(m) only classifies certain enumerated types of NPCs as specified NPCs, those statutory classifications expire two years after enactment, or March 18, 2012. For payments made after March 18, 2012, section 871(m)(3)(B) provides that all NPCs will be specified NPCs unless the IRS issues guidance providing otherwise. In the temporary and proposed regulations, the IRS uses its regulatory authority under section 871(m) to exclude those NPCs that it determines to be of a type which does not have the potential for tax avoidance. Absent this regulatory action, all NPCs would be treated as specified NPCs.

Temporary Regulations

The temporary regulations generally provide that the existing statutory definition of specified NPC will continue to apply for the remainder of 2012. The preamble to the temporary regulations states that this extension is needed "to allow taxpayers and withholding agents to modify their systems and other operating procedures to comply" with the rules set out in the proposed regulations. The temporary regulations make some additional modifications to other regulatory rules which the IRS described as intended to "clarify the application of section 871(m)."

The preamble to the temporary regulations notes that, notwithstanding the rules in the temporary regulations, the IRS may continue to challenge transactions under other regulatory or judicial anti-abuse principles.

Proposed Regulations

Dividend Equivalent

The proposed regulations define a dividend equivalent as:

• any substitute dividend made pursuant to a securities lending, a sale-repurchase transaction, or a substantially similar transaction that is contingent upon or determined by reference to the payment of a dividend from sources within the United States,
• any payment made pursuant to a specified NPC that is contingent upon or determined by reference to the payment of a dividend from sources within the United States, or
• any "substantially similar payment" as defined in the proposed regulations.

Under the proposed regulations, a "substantially similar payment" includes (i) any gross-up amount paid by a short party in respect of the long party's tax liability with respect to a dividend equivalent, as well as (ii) a payment calculated by reference to a US-source dividend that is made pursuant to an equity-linked instrument other than an NPC. An equity-linked instrument includes a futures contract, forward contract, or other contractual arrangement that references one or more underlying securities to determine its value. Such an instrument will be treated as an NPC for purposes of section 871(m)(3) and the proposed regulations. This provision will become effective when the proposed regulations are finalized, even if that occurs prior to January 1, 2013.

A dividend equivalent is determined on a gross basis. For example, because swap counterparties generally net their payment obligations that fall due on the same date and in the same currency, with only the party with the larger obligation making the net payment to the other, any gross amount determined by reference to a dividend that is used in computing the net payment may be treated as a dividend equivalent.

Certain payments that are contingent or based on estimated dividends are excluded from the definition of dividend equivalent.

Specified NPC

For payments after December 31, 2012, a NPC will be a specified NPC if:

• the long party to the NPC is "in the market" with respect to the underlying security on the same day or days that the parties price the NPC or on the same day or days that the NPC terminates;
• the underlying security in the NPC is not regularly traded;
• the short party to the NPC posts the underlying security with the long party as collateral and the underlying security posted as collateral represents more than ten percent of the total fair market value of all the collateral posted by the short party on any date that the NPC is outstanding;
• the NPC has a term of less than 90 days;
• the long party controls short party's hedge;
• the notional principal amount represents a significant percentage of trading volume; or
• the NPC is entered into on or after the date on which a special dividend is announced and prior to the ex-dividend date.

In the Market

A long party is "in the market" if it sells more than a de minimis amount of the underlying security on the same day or days that the parties price the NPC, purchases such an amount of the underlying security on the same day or days that the NPC terminates, or sells or purchases such an amount of the underlying security on other days at a price that is determined by reference to an amount used to price or terminate the NPC (for example, through a forward contract). The de minimis threshold for this purpose is an amount of the underlying securities that is less than 10 percent of the notional principal amount of the NPC.

Equity swap market participants should note that the "in the market" provision is markedly broader than the "crossing-in" and "crossing-out" standard in the statute, which required a transfer of shares between a long party and a short party to the same contract. The proposed regulations potentially trigger specified NPC status based on the long party's transactions in the underlying security with any person.

This provision may make it impossible for the short party to know, at the time it enters into a swap, whether the swap is a specified NPC and whether it should withhold on dividend equivalents. The proposed regulations are silent as to whether a short party may rely on representations of a long party to avoid withholding on a specified NPC. The IRS has indicated informally, however, that it intends short parties to be able to rely on such representations in certain circumstances.

Regularly Traded

Under the proposed regulations, an underlying security will be considered regularly traded if it is listed on one or more "qualified exchanges" at the time the NPC is priced and was traded (in quantities that exceed ten percent of the 30-day average daily trading volume) on at least 15 trading days during the 30 trading days prior to the date the parties priced the NPC. A qualified exchange means a national securities exchange that is registered with the Securities and Exchange Commission or the national market system established pursuant to section 11A of the Securities Exchange Act of 1934.

Term of an NPC

In determining whether the term of an NPC is less than 90 days, the proposed regulations focus on the number of days that the contract is actually outstanding, rather than the stated term of the contract. An NPC's term will include the date on which the NPC is terminated but not the date on which it was entered.

Importantly, an NPC will be treated as terminated, in whole or in part, on the date that the long party enters into any position that offsets a portion of the long party's position with respect to an underlying security in the NPC. Because the long party may enter into this offsetting position within 90 days, and with any party, this provision also appears to make it impossible for a short party to know at closing whether its swap is a specified NPC. Here, too, the IRS has indicated informally that it intends short parties to be able to rely on representations of the long party in certain circumstances.

Significant Percentage of Trading Volume

Under the proposed regulations, the notional principal amount of an NPC will represent a significant percentage of trading volume if the amount of the underlying security referenced in the NPC is greater than either 5 percent of the total public float of that class of security or 20 percent of the 30-day average daily trading volume determined as of the close of the business day immediately preceding the first day in the term of an NPC.

In making this determination, a taxpayer must aggregate the notional principal amounts of all NPCs for which the taxpayer is the long party that reference the same underlying security.

This provision also makes it impossible for the short party to know if it has entered into a specified NPC. As noted above, the IRS has suggested that short parties may cure this informational asymmetry with representations and/or other contractual protections.

Equity Index Transactions

The proposed regulations appear to provide favorable treatment for index trades, so long as the index is not a customized index (as described below).

If an NPC references a customized index, each security or component of the index is treated as an underlying security in a separate NPC for purposes of section 871(m) and the proposed regulations. As a result, the NPC potentially could be a specified NPC if the long party transacts in any of the stocks comprising the index in the manner described above.

The implication for a non-customized index (such as the S&P 500), in contrast, is that an NPC would not become a specified NPC as a result of the long party being in the market, unless the long party transacted in all of the stocks comprising the index. Cautious taxpayers may not want to rely on this implication, however, until the point is clarified through further guidance.

A customized index includes a narrow-based index (generally defined based on the definition of that term in section 3(a)(55)(B) of the Securities Exchange Act of 1934), or any other index unless futures contracts or options contracts on the index trade on a qualified board or exchange.

NPCs that Become Specified NPCs

The proposed regulations explicitly contemplate that an NPC that initially is not a specified NPC may become a specified NPC during the term of the contract. This may occur, for example, if an NPC terminates or is deemed to terminate early, the mix of posted collateral changes, or the long party enters into other NPCs that result in an underlying security aggregating to be a significant percentage of trading volume.

In such a case, the treatment of payments as dividend equivalents is retroactive, and withholding obligations for prior payments must be satisfied by the next payment date under the NPC. This may result in imposition of withholding liability on a payer or intermediary, if the next payment is insufficient to meet the cumulative withholding tax.

Related Parties

To prevent taxpayers from avoiding these rules through the use of related parties, the proposed regulations provide that each related person (as defined in the regulations) is treated as a party to the contract. This provision may expand the scope of representations or other contractual provisions that a short party may require to confirm that an NPC is not a specified NPC.

Conversely, in recognition of practices employed by many swap dealers to transfer risk from one entity to another within an affiliated group, the regulations provide that an NPC entered into between two related swap dealers will not be a specified NPC if the NPC hedges risk associated with another NPC entered into with a third party. This taxpayer-favorable rule will apply where both NPCs were entered into by the related persons in the ordinary course of their business as a dealer in securities or commodities derivatives.

Responding to the Proposed Regulations

The IRS requested comments on the proposed regulations by April 6, 2012, and scheduled a public hearing for April 27, 2012. Affected taxpayers should consider not only how to implement these proposed regulations but whether to suggest modifications to the proposed regulations.

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.