Tax Treatment of Dividend Equivalent Payments under New Temporary and Proposed IRS Regulations, Contributed by Andrew Short and David Makso, Paul Hastings LLP
On January 19, 2012, the IRS released temporary regulations (Temporary Regulations)1 and proposed regulations (Proposed Regulations)2 addressing the treatment of dividend equivalent payments for purposes of Section 871(m) of the Internal Revenue Code of 1986, as amended. These rules were highly anticipated by taxpayers who expected much needed guidance in the area of financial instruments, including equity swaps. However, the new rules fell short of this objective and create new uncertainties with respect to the operation of Section 871(m).
Payments of U.S. sourced dividends are generally subject to withholding at a 30 percent rate unless reduced by treaty. Dividends are U.S. sourced if paid by a U.S. corporation. In contrast, payments on notional principal contracts are sourced by reference to the payee. This difference in treatment allowed planning for non-U.S. persons to escape U.S. tax withholding.
Congress enacted Section 871(m) in 2010 to combat this perceived abuse by treating certain “dividend equivalents” as dividends from U.S. sources and, thus, potentially subject to U.S. tax withholding. A dividend equivalent includes payments pursuant to certain securities loans, sale-repurchase transactions, certain specified notional principal contracts and any substantially similar transactions. Under the statute, a “specified notional principal contract” means any notional principal contract if: (1) in connection with entering into such contract, any long party (i.e., any party entitled to receive payments by reference to an underlying dividend) to the contract transfers the underlying security to any short party (i.e., any other party) to the contract; (2) 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; (3) the underlying security is not readily tradable on an established securities market; (4) in connection with entering into such contract, the underlying security is posted as collateral by any short party to the contract with any long party to the contract; or (5) such contract is identified by the Secretary of the Treasury as a specified notional principal contract. The statute further provides that after March 18, 2012, any notional principal contract is a specified notional principal contract unless the Secretary determines that such contract is of a type which does not have the potential for tax avoidance.
Explanation of the Temporary Regulations
The Temporary Regulations extend the applicability of the statutory definition of specified notional principal contracts through December 31, 2012, thus avoiding the draconian result that all notional principal contracts are specified notional principal contracts after March 18, 2012. This transition period will allow taxpayers and withholding agents to modify their systems and other operating procedures in preparation for the Proposed Regulations, which will apply to dividend equivalents beginning January 1, 2013.
The Temporary Regulations also amend other regulations to clarify the application of Section 871(m) as follows:
- Treasury Regulation § 1.863-7, which generally sources income from notional principal contracts by reference to the residence of the recipient, is amended to provide that it does not apply to a dividend equivalent as defined in Section 871(m);
- Treasury Regulation § 1.881-2 is amended to clarify that Section 871(m) applies to a foreign corporation’s receipt of a dividend equivalent; and
- Temporary Regulations under Section 1441 are also added to determine the amount of a dividend equivalent subject to withholding and to require a withholding agent to withhold tax owed with respect to a dividend equivalent.
The Temporary Regulations are effective January 23, 2012. The text of the Temporary Regulations also serves as the text of the Proposed Regulations.
Explanation of the Proposed Regulations
Most significantly, the Proposed Regulations reverse the presumption that all notional principal contracts other than those specifically enumerated will be specified notional principal contracts. Rather, the IRS and Treasury define the types of contracts that are deemed to have a potential for tax avoidance providing taxpayers with some additional comfort that non abusive transactions will not result in withholding. However, the Proposed Regulations substantially expand the statute’s definition of specified notional principal contracts that have tax avoidance potential with the effect that certain legitimate notional principal contracts may be subject to these rules. Under the Proposed Regulations a notional principal contract will be a specified notional principal contract if one of the following seven factors is met: (1) the long party is “in the market” on the same day that the parties price the notional principal contract or when the notional principal contract terminates; (2) the underlying security is not regularly traded on a qualified exchange; (3) the short party posts the underlying security as collateral and the underlying security represents more than ten percent of the collateral posted by the short party; (4) the term of the notional principal contract has fewer than 90 days; (5) the long party controls the short party’s hedge; (6) the notional principal amount is greater than five percent of the total public float of the underlying security or greater than 20 percent of the 30-day daily average trading volume, as determined at the close of business on the day immediately preceding the first day of the term of the notional principal contract; or (7) the notional principal contract is entered into on or after the announcement of a special dividend and prior to the ex-dividend date. Although withholding agents may rely on these rules when deciding whether to withhold on payments made under notional principal contracts, the Proposed Regulations contain an anti-abuse rule that would treat as dividend equivalents any payments made under transactions entered into with a principal purpose of avoiding the application of these rules.
Given the factual nature of the determination as to whether a contract will be a specified notional principal contract, withholding agents face some uncertainty. A withholding agent can be liable for failing to withhold on a payment made on a notional principal contract even if the withholding agent does not know or have reason to know that the contract was a specified notional principal contract. For example, a withholding agent may not know if the long party is in the market on the same day that the parties price the notional principal contract or when the notional principal contract terminates as required under the first factor above. To determine whether this factor has been met, the IRS recently stated informally that it expects withholding agents to ask for a representation from their counterparties that they are not in the market.3 Another example of the uncertainties raised by the Proposed Regulations is reflected in the fourth factor above which would treat any contracts shorter than 90 days as specified notional principal contracts. Under the Proposed Regulations, a notional principal contract would be treated as terminated if the long party enters into a position that offsets a portion of the long party’s position with respect to the underlying security in the notional principal contract. Thus, a withholding agent that enters into a long term notional principal contract may not know if the long party has entered into such an offsetting position that, for purposes of these rules, would be deemed to terminate the contract before 90 days have passed. Again, it is expected that withholding agents will be able to rely on representations from long parties on this and other facts. However, until these and other issues are officially clarified, some withholding agents may decide to treat all notional principal contracts as specified notional principal contracts to avoid any liability.
The Proposed Regulations clarify several other issues arising under the statute, including the following:
- A payment is not a dividend equivalent if it is determined by reference to an estimate of an expected (but not yet announced) dividend without reference to or adjustment for the amount of any actual dividend;
- For purposes of determining a dividend equivalent, the term payment includes any gross amount even if the contractual obligation is computed on a “net” basis that would reduce or eliminate the gross payment by offsetting obligations to make payments;
- If a notional principal contract references more than one security or a customized index, each security or component security of that index is treated as an underlying security in a separate notional principal contract for purposes of Section 871(m);
- The US withholding tax on a dividend equivalent may be reduced to the extent provided under a US tax treaty; and
- Dividend equivalents are treated as income from investments in stocks for purposes of applying Section 892 which generally exempts foreign governments and their instrumentalities from US tax on their dividend income.
If a notional principal contract that was not a specified notional principal contract on the date it was entered into becomes a specified notional principal contract during its term, it will be treated as though it had been a specified notional principal contract during the entire term of the contract and payments made under the notional principal contract by reference to the payment of a dividend from U.S. sources will be recharacterized as dividend equivalents and all tax owed with respect to such dividend equivalents will be due at the time of the next payment made under the notional principal contract, including a termination payment. This rule applies even if there is not any cash payment on which to withhold because of netting.
Section 871(m), as enacted by Congress, provided the IRS with broad authority to treat all payments made under all notional principal contracts as dividend equivalents after March 18, 2012. The IRS did not exercise its authority to the full extent of the statute. Taxpayers will find it helpful that not all notional principal contracts will be subject to resourcing as specified notional principal contracts. However, the Proposed Regulations will be subject to considerable discussion and analysis in the coming months because some of the factors included in the new definition may be difficult to implement or because they could apply to legitimate notional principal contracts that do not have the potential of tax avoidance.
Andrew Short is a partner in the tax practice of Paul Hastings in the New York office. He represents a broad range of domestic and international clients with respect to the tax aspects involved in planning, structuring and negotiating business operations, transactions and financings. He has considerable experience in the areas of corporate and partnership taxation as it relates to both operating businesses and investment vehicles, international business tax planning (including CFC and PFIC planning), real estate taxation, mergers and acquisitions, in-bound and out-bound foreign financings, commercial lending, equipment leasing (including FSC/ETI transactions and 467 rental structures), project finance, sophisticated financial products, and the application of the unrelated business income tax.
David Makso is an associate in Paul Hastings’ New York office, where he is a member of the firm’s tax practice. His practice focuses on corporate, partnership and international taxation. He primarily advises U.S. and foreign based clients on their cross-border tax planning.
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