By Paul S. Epstein and Harrison Cohen

On 19 January 2012, the U.S. Treasury and the Internal Revenue Service (IRS) released temporary and proposed regulations under §871(m). Enacted in 2010 as part of the HIRE Act, ¹ the provision provides that “dividend equivalents” on “specified notional principal contracts” (“specified NPCs”) constitute U.S. source dividends for purposes of the U.S. gross-basis tax on foreign persons. ² Thus, foreign taxpayers and their U.S. withholding agents cannot rely on Reg. §1.863-7 to exempt them from the tax on the dividend equivalents paid and received on specified NPCs. ³ Moreover, §871(m)(3)(A)(v) and (B) give the Secretary of the Treasury relatively unbounded discretion, particularly in the case of payments after 18 March 2012, to treat any NPC as a “specified NPC” (or as not a specified NPC).

Effective for payments through the end of calendar 2012, the new temporary regulations make it clear that there will be no expansion of the definition of specified NPC beyond those NPCs already treated as “specified” since September 2010. In addition, for payments after 2012, the new proposed regulations indicate just how far the specified NPC definition would be expanded, and indicate the scope of what would be viewed as “substantially similar” to dividend equivalents on specified NPCs, stock loans and repos. The regulations expressly provide for retroactive characterization of payments on a contract as dividend equivalents where the contract becomes a specified NPC status only after it was entered into and some contract payments have already been made. ⁴

For immediate attention – The proposed regulation’s imposition of withholding tax on payments under existing specified NPC contracts if they remain in effect on 1 January 2013 means that contracts with more than 11 months of remaining life must be reviewed this year in order to determine whether they will be subject to withholding after 2012. Such existing contracts must be tested under the new definition of specified NPC that will apply for payments on or after 1 January 2013, and not just the definition that applies through 31 December 2012.

This alert summarizes the temporary and proposed regulations, providing a general overview along with a discussion of potential implications for dealers and offshore funds.

Temporary regulations for payments made through 31 December 2012

Section 871(m)(3)(A), effective for payments since September 2010, defines specified NPCs only as those falling in any one of the following five categories:

1. In connection with entering into the contract, any long party to the contract transfers the underlying security to any short party to the contract (referred to as “crossing in”);
2. In connection with the termination of the contract, any short party to the contract transfers the underlying security to any long party to the contract (referred to as “crossing out”);
3. The underlying security is not “readily tradable” on an “established securities market”;
4. In connection with entering into the contract, the underlying security is posted as collateral by any short party to the contract with any long party to the contract; or
5. The contract is identified by the Secretary as a specified NPC.

Section 871(m)(3)(B), on the other hand, provides that, in the case of payments made after 18 March 2012, the term “specified NPC” means any NPC “unless the Secretary determines that such contract is of a type which does not have the potential for tax avoidance.” However, the temporary regulations push back the 18 March 2012 date to 31 December 2012. The temporary regulations make it clear that during the entire year 2012 – both before and after 18 March – the only payments made that will be treated as payments on specified NPCs will be those on NPCs described in clauses (i) through (iv) above (the “four statutory categories” of specified NPC), and thus already treated as specified NPCs with respect to pre-19 March 2012 payments.

Proposed regulations for dividend equivalents and substantially similar payments after 2012

New types of specified NPCs

For payments made on or after 1 January 2013, the proposed regulations would expand the definition of “specified NPC” beyond the four statutory categories listed above, but only within limits. Thus it indicates that the Treasury does not plan to exercise the full scope of its authority to sweep all U.S.-equity based NPCs in the future into the definition of specified NPCs.

For payments made on or after 1 January 2013, the NPCs newly added to the definition of “specified” (the “seven proposed new categories”) would be NPCs entered into under the following circumstances –

1. The long party is “in the market” for the underlying securities on the same day that the NPC is priced or terminated (i.e. the long party disposes of, on the pricing day, or acquires, on the termination day, underlying securities equal to or greater than 10% of the notional principal amount of the NPC); ⁵,
2. The underlying security is not “regularly traded” (based on daily quantities traded during a 30-day testing period) on a “qualified exchange”; ⁶
3. The underlying security is posted as collateral with the long party (subject to a de minimis rule permitting the underlying security to represent up to 10% of the total collateral posted); ⁷
4. The NPC is outstanding less than 90 days (or the long party enters into an offsetting position within that period); ⁸
5. The long party controls the short party’s hedge of its position contractually or by conduct; ⁹
6. The notional principal amount is over 20% of the average daily trading volume of the underlying security during a 30-day testing period, or over 5% of the total public float of that class of security; ¹⁰ and
7. The NPC is entered into on or after the announcement of a special dividend and prior to the ex-dividend date. ¹¹

The preamble to the regulations also states that judicial doctrines will continue to apply to determine whether a contract labeled as an NPC can be treated as ownership of the equity referenced in the contract.

Other features of the proposed regulations especially relevant to specified NPCs include the following:

• Retroactive dividend equivalent treatment where an NPC becomes a “specified NPC” only after having been entered into, including “catch up” withholding liability for payments made before it became “specified.” ¹²
• Rules for deciding whether a security is an “underlying security” for purposes of the above definitions when an NPC references an index rather than a particular security or securities. ¹³
• Relief from specified NPC treatment for NPCs between related parties that are dealers in securities or commodity derivatives, if the NPC hedges another NPC entered into with an unrelated person. This would have some effect of preventing cascading withholding taxes on a chain of related NPCs. ¹⁴

The proposed regulations would not grandfather NPCs entered into prior to 1 January 2013. Therefore, even if an NPC was entered into prior to 1 January 2013 and is not a specified NPC under the four statutory categories, a post-2012 payment on that contract would be treated as a dividend equivalent if the NPC fits within one of the seven proposed new categories. As noted above, when an NPC becomes “specified” on a date during its term, the general proposed rule is that payments after that date are subject to “catch up” withholding liabilities to cover tax on payments before that date. It does not appear that Treasury intended that post-2012 payments on a contract that fits only within one of the seven proposed new categories (and in none of the four statutory categories) be subjected to “catch up” liability relating to pre-2013 payments on the contract; however, the proposed regulations are not as clear on this point as they could be.

“Substantially similar payments”

In addition to dividend equivalents on specified NPCs, securities loans and repos, §871(m)(2) treats as a “dividend equivalent” any other payment determined by the Secretary to be substantially similar to a dividend equivalent on a specified NPC, securities loan or repo. ¹⁵ The proposed regulations would treat as “substantially similar” payments, and thus dividend equivalents, any payments (including the payment of any purchase price or adjustment to the price) that are made pursuant to an “equity-linked instrument” (ELI) and that are contingent on or determined by reference to a U.S. source dividend (including a redemption distribution that gives rise to a dividend under §301). ¹⁶ Payment by a withholding agent of the tax liability of the beneficial owner of a dividend equivalent would also be treated as substantially similar to the payment of a dividend equivalent. ¹⁷

An ELI is any combination of financial instruments that references one or more underlying securities to determine its value, and includes futures, forward and option contracts and other contractual arrangements. At first blush, the proposed regulation might appear to make all dividend-referencing/contingent payments on ELIs dividend equivalents, rather than bestowing such treatment solely on payments on ELIs that fall within one of the four statutory categories or seven proposed new categories that apply to determine whether an NPC is a specified NPC. However, Prop. Reg. §1.871-15(d)(2)(ii) seems to treat ELIs in the same way as NPCs in this respect; it states that an ELI that provides for a payment that is a substantially similar payment is treated as an NPC for purposes of the statutory and regulatory provisions defining “specified NPC” and the general regulatory rules on dividend equivalents. ¹⁸

Estimates of dividends allow exception from dividend equivalent treatment

A payment pursuant to a specified NPC or any substantially similar payment would not be a “dividend equivalent” under the proposed regulations if the payment is determined by reference to an estimate of expected dividends and the dividend is not adjusted in any way for the amount of an actual dividend. ¹⁹ An estimate of expected dividends would not include pricing that takes into account an announced dividend. ²⁰

This proposed rule would appear to except payments on single stock futures contracts from dividend equivalent status, so long as they are entered into before the dividends are announced, even if, for example, there is only a short waiting period after the announcement before the dividend record date. Once a dividend has been announced, however, dividend equivalent treatment would attach to dividend-referencing/contingent payments on the ELI, regardless of whether risks other than the risk of disparity between actual and estimated dividends affect the return on the contract. ²¹

The proposed exception for estimated dividends is significant when some of the current or proposed categories of “specified NPC” are compared with current practice in the futures market. The long party on a single-stock futures contract often “crosses in,” transferring the stock to the futures exchange; at maturity, the long party often “crosses out,” taking delivery of the shares. ²² These transfers could cause the futures contract to be treated like an NPC that is a specified NPC under the proposed regulations. However, because there is no payment referencing the actual dividend on the stock (as opposed to the market’s estimate of the dividend), the proposed regulations appear not to treat any payments on the futures contract as a dividend equivalent. Clarifying the applicability to ELIs generally of the proposed and statutory categories for specified NPC status may be warranted to confirm that the proposed regulations are consistent with the above logic.

Coordination with existing guidance on dividend equivalents

Neither the proposed or temporary regulations, nor their preambles, mention Notice 2010-46, the post-HIRE Act guidance on dividend equivalents arising from stock loans and repos.²³ Notice 2010-46 did not address the definition of specified NPCs or the intended treatment of payments made pursuant to equity NPCs after 18 March 2012. In particular the notice did not ameliorate cascading gross-basis tax imposed on a chain of payments that includes both dividend equivalents on specified NPCs and dividend equivalents on stock loans or repos. ²⁴ The relief from cascading gross-basis tax was limited in Notice 2010-46 to a chain of dividend equivalents made only pursuant to stock loans and repos. Notice 2010-46 left it for future guidance to provide any coordinated relief for stock and stock loan hedges of specified NPCs entered into as a dealer with customers. Such future guidance will not be found in the new temporary and proposed regulations, however. They do not provide cascading tax relief for serial customer transactions entered into by a swap dealer. Limited relief would be provided for equity NPC dealers under the proposed regulations, but only if offsetting NPCs are entered into with related-party dealers. ²⁵

Accordingly, the “Qualified Securities Lender” and “credit forward” regimes provided by Notice 2010-46 to offshore securities lending operations are not available to specified NPCs under the proposed or temporary §871(m) regulations. ²⁶ A foreign broker-dealer that is the short party on a specified NPC with a foreign customer, and that hedges its market risk by holding the underlying stock (or a loan of the stock), would appear to remain subject to cascading tax liabilities as principal and withholding agent unless the hedging transaction is wholly effectively connected with the conduct of a trade or business in the U.S. (ECI). Similarly, the limited relief referred to above for related-party interdealer NPCs appears to require, as a practical matter, that a hedging transaction in the underlying securities carried out by the related dealer be wholly taxed by the U.S. (either because that dealer is a domestic corporation or is a foreign corporation to which the transaction is taxed as ECI) if cascading gross-basis tax is to be avoided on the series of dividend equivalents. To address the constraints of the related-party hedging provision, foreign banks and broker-dealers will need to determine whether their activities of hedging customer NPCs can feasibly and economically be maintained in a separate securities dealer entity, and whether there are added regulatory costs to doing so.

Selected other features of the proposed and temporary regulations

Anti-abuse rule – The proposed regulations would provide an anti-abuse rule treating payments made with respect to transactions entered into with a principal purpose of avoiding the regulations as dividend equivalents “to the extent necessary to prevent the avoidance of these rules.” ²⁷

Coordination with proposed global dealing regulations – The temporary and proposed regulations add a sentence to the former Reg. §1.863-7(a)(1) stating that it does not apply to a dividend equivalent under §871(m), but omit the language proposed in 1999 that would have stated that Reg. §1.863-7(a)(1) does not apply to income from a global dealing operation sourced under Prop. Reg. §1.863-3(h). ²⁸ Treasury and the IRS may wish to clarify whether they have repudiated the thought behind the missing clause, or whether its omission was a mere drafting oversight.

Treaties – The proposed regulations would treat dividend equivalents under §871(m) as dividends for purposes of income tax treaties. Treasury and the IRS have apparently taken the view that the U.S. income tax treaties with all relevant jurisdictions have dividend articles that permit the U.S. to define dividends in accordance with U.S. internal laws like §871(m). ²⁹

Income of foreign governments – For purposes of determining the investment income of a foreign government eligible for §892, the proposed regulations would treat dividend equivalents as “income from investments in stocks.”³⁰

Conclusion

The temporary and proposed regulations provide substantial clarity on the conditions for specified NPC and dividend equivalent treatment. Most of the rules are objective tests, although some will present administrative challenges to taxpayers that trade in substantial volume. The treatment of payments made with respect to equity-linked instruments that are priced before dividends are announced appears to provide an objective benchmark separating futures, forwards and options that do generate dividend equivalents from those that do not, although the dividing line may be a different one than would be desired by active market traders.

Delaying the §871(m)(3)(B) expansion of the specified NPC definition until 2013 is a welcome administrative accommodation to the timeframe needed by trading desks in the U.S. and abroad to implement the new rules. However, for payments on or after 1 January 2013, some clarifications may be needed, for example on the interaction of the proposed rule for “substantially similar” payments with the rules for “specified NPCs.” Written comments on this and other concerns must be submitted to the Treasury and IRS by 6 April 2012, with a public hearing scheduled for 27 April 2012.

¹ TD 9572, 77 Fed. Reg. 3108 (23 January 2012); REG-120282-10, 77 Fed. Reg. 3202 (23 January 2012). See §541 of the Hiring Incentives to Restore Employment Act (“HIRE Act”), Pub. L. No. 111-147, 124 Stat. 71 (18 March 2010).
² The term “gross-basis tax” is used here to refer to the U.S. tax, if any, that is imposed on the income of a nonresident alien individual, a foreign corporation or a foreign organization that is a private foundation, by §§871(a), 881, 1441 through 1464 or 4948(a) of the U.S. Internal Revenue Code (the “Code”). The tax is imposed at the rate of 30% of the gross amount, unless the rate is reduced by treaty or the income is exempted by internal law (e.g. §892 for foreign governments). Where a treaty applies, it may reduce the rate on portfolio dividends to as low as 15% (and a few select treaties reduce the portfolio dividend rate to 10%).
³ Regulations dating from 1997 did the same thing for substitute payments on securities lending transactions and on sale-repurchase agreements (repos); the HIRE Act incorporated such treatment into §871(m). See §871(m)(2)(A).
⁴ Prop. Regs. §1.871-16(d).
⁵ Prop. Reg. §1.871-16(c)(1).
⁶ Prop. Reg. §1.871-16(c)(2).
⁷ Prop. Reg. §1.871-16(c)(3).
⁸ Prop. Reg. §1.871-16(c)(4).
⁹ Prop. Reg. §1.871-16(c)(5).
¹⁰ Prop. Reg.§1.871-16(c)(6).
¹¹ Prop. Reg. §1.871-16(c)(7).
¹² Prop. Reg. §1.871-16(d).
¹³ If an NPC references more than one security or a “customized index,” each security or component of such customized index is treated as an underlying security in a separate NPC for purposes of §871(m) and the proposed regulations. Prop. Reg. §1.871-16(f)(1). The term customized index means any index, as determined on the date that the long party and short party enter into an NPC, that is (A) a “narrow-based index”; or (B) any other index unless futures contracts or option contracts on such index trade on a qualified board or exchange, as defined in §1256(g)(7). Prop. Reg. §1.871-16(f)(3)(i).
The term narrow-based index means an index meeting any of the following four criteria:
(A) The index has nine or fewer component securities;
(B) A component security comprises more than 30% of the index’s weighting;
(C) The five highest weighted component securities in the aggregate comprise more than 60% of the index’s weighting; or
(D) The lowest weighted component securities comprising, in the aggregate, 25% of the index’s weighting have an aggregate dollar value of average daily trading volume of less than USD 50,000,000 (or in the case of an index with 15 or more component securities, USD 30,000,000), except that if there are two or more securities with equal weighting that could be included in the calculation of the lowest weighted component securities comprising, in the aggregate, 25% of the index’s weighting, such securities shall be ranked from lowest to highest dollar value of average daily trading volume and shall be included in the calculation based on their ranking starting with the lowest ranked security. Prop. Reg. §1.871-16(f)(3)(ii).
For purposes of determining whether an index is a narrow-based index, the method for determining the aggregate dollar value of average daily trading volume is the method described in Rule 3a55-1(b)(1), 17 CFR 240.3a55-1(b)(1), under the Securities Exchange Act of 1934, as in effect on 23 January 2012. Prop. Reg. §1.871-16(f)(3)(iii).
¹⁴ Prop. Reg. §1.871-16(e)(2).
¹⁵ Section 871(m)(2)(C).
¹⁶ Prop. Reg. §1.871-15(d)(1)(ii).
¹⁷ In this case, the amount treated as a dividend equivalent under §871(m)(2)(C) and Prop. Reg. §1.871-15(d)(1)(i) will be the tax amount “grossed up” under the formula that appears in current Reg. §1.1441-3(f)(1), making the amount of the dividend equivalent equal to the tax payment divided by the excess of 1 over the tax rate. Treating tax payments as dividend equivalents appears aimed at the amendments to the Master ISDA contract published by ISDA in response to the HIRE Act. The gross-up formula applies under Reg. §1.1441-3(f) when a withholding agent owes the beneficial owner’s tax contractually or has paid the full dividend without withholding and, under the facts and circumstances, must satisfy its withholding liability as withholding agent under Reg. §1.1441-7.
¹⁸ Prop. Reg. §1.871-15(d)(2)(ii) reads: “An [ELI] that provides for a payment that is a substantially similar payment within the meaning of paragraph (d) of this section is treated as [an NPC] for purposes of section 871(m)(3), this section, and section 1.871-16.”
¹⁹ Prop. Reg. §1.871-15(b)(2)(i).
²⁰ Prop. Reg. §1.871-15(b)(2)(ii).
²¹ If a single stock future was entered into after the dividend was announced, and subsequently a corporate action or announcement or other widely-publicized event occurred before the dividend record date, the price of the future could likely change whether or not the dividend was reduced by the subsequent event. The regulation provides no exception to dividend equivalent treatment in this circumstance if the contract was entered into after the dividend was announced but before the event. Accordingly, an event that causes a corporation to reduce but not cancel a dividend in its entirety would appear to not qualify for the exception from dividend equivalent treatment.
²² The crossing-in transaction often follows very shortly on the heels of an acquisition undertaken for that purpose. Transacting in this manner often provides advantageous financing of the overall transaction.
²³ 2010-24 I.R.B. 757.
²⁴ Section 871(m)(6) provides authority for, but does not require, the Secretary to reduce tax imposed on a chain of dividend equivalent payments. Accordingly, the statute does not require the Secretary to coordinate stock lending transactions with specified NPCs.
²⁵ Prop. Reg. §1.871-16(e)(2).
²⁶ Notice 97-66, 1997-2 C.B. 328, provided overwithholding relief under the final regulations and was withdrawn by Notice 2010-46 as of 10 May 2010 for certain identified abusive transactions and in its entirety for substitute payments made on or after 14 September 2010.
²⁷ Prop. Reg. §1.871-15(e).
²⁸ Prop. Reg. §1.863-7(a)(1) as proposed in REG-208299-90, 63 Fed. Reg. 11177 (6 March 1998), proposed the following amended version of the second sentence of Reg. §1.863-7(a)(1) to permit allocations and split-sourcing of NPC income earned in connection of a global securities dealing operation: “This section does not apply to income from a section 988 transaction (as defined in section 988(c) and §1.988-1(a)), or to income from a global dealing operation (as defined in §1.482-8(a)(2)(i)) that is sourced under the rules of §1.863-3(h).” (Proposed new language underscored.)
²⁹ See, e.g., Article X(3) of the U.S.-Canada income tax treaty: “For purposes of this Article, the term ‘dividends’ means income from shares or other rights, not being debt-claims, participating in profits, as well as income that is subjected to the same taxation treatment as income from shares under the laws of the State of which the payer is resident.” (Emphasis added.)
³⁰ Prop. Reg. §1.892-3(a)(6).