Treasury Issues Guidance on Withholding on Total Return Swaps
On January 19, 2012, the U.S. Treasury issued both temporary and proposed regulations concerning the treatment of dividend equivalent amounts made pursuant to a specified notional principal contract ("SNPC"). While some questions remain open, this guidance should be helpful to taxpayers in structuring their transactions.
Background — Withholding taxes under the HIRE Act
IRC Sec. 871(m) was enacted in March 2010, as part of the HIRE Act.1 Under these rules, in pertinent part, a dividend equivalent payment made pursuant to a notional principal contract ("NPC") will be subject to a 30 percent withholding tax if paid to a non-U.S. person. This rule applies to the gross amount of the dividend equivalent that is taken into account in calculating a net payment, even if that amount is netted with any financing and stock depreciation charges and so it is possible that the withholding tax is greater than the amount of a payment made under the contract, if any, with respect to the swap received by the offshore fund; indeed the offshore fund may actually have to make a payment to the counterparty and also have withholding tax due.
IRC Sec. 871(m) applies to payments made on "specified notional principal contracts" ("SNPCs") Under the statutory provisions, for payments made between September 14, 2010 through March 18, 2012 [the "transition period"]2, an SNPC includes contracts where:
- In connection with entering into the NPC, the taxpayer transferred the underlying stock to the NPC counterparty ["crosses in"], or
- In connection with terminating the NPC, the taxpayer received the stock back from the NPC counterparty ["crosses out"], or
- Where the underlying stock is not readily tradable, or
- In connection with entering into the NPC, the underlying stock is posted as collateral for the NPC;
- Such contract is identified by the secretary as an SNPC
For payments made after March 18, 2012, the statute provides that a specified NPC is any NPC unless the Secretary determines that such contract does not have the potential for tax avoidance. As discussed below, the proposed regulations actually loosen this rule, such that some NPCs will not be treated as SNPCs.
The temporary regulations effectively extend the first four statutory definitions of an SNPC during the transition period through December 31, 2012.
The proposed regulations, effective for payments made after December 31, 2012, define an NPC and limit the classification of an NPC as being an SNPC to seven situations several of which modify application of the statutory provisions that were extended in the temporary regulations:
- The long party is "in the market" on the same day that the parties price the NPC or when the NPC terminates [the cross in or out trade],
- The underlying security is not regularly traded on a qualified exchange,
- The short party posts the underlying security as collateral and the underlying security represents more than 10 percent of the collateral posted by the short party,
- The term of the NPC is fewer than 90 days [for this purpose, offsetting positions may toll the holding period],
- The long party controls the short party's hedge,
- The notional principal amount is greater than 5 percent of the total public float of the underlying security or greater than 20 percent of the 30-day average trading volume, as determined at the close of business on the day immediately preceding the first day of the term of the NPC, or
- The NPC is entered into on or after the announcement of a special dividend and prior to the ex-dividend date.
Naturally, there is extended guidance in the proposed regulations which explains what each of these provisions means.
The proposed regulations also expand on the statutory concept of a payment which is substantially similar to a dividend equivalent. These include gross-up amounts paid by the short party to satisfy the long party's tax liability with respect to a dividend equivalent, and payments calculated by reference to a dividend from sources within the United States that are made pursuant to an equity-linked instrument other than an NPC, including futures, options and index products.
The text accompanying the proposed regulations states that, "Nothing in these rules precludes the Commissioner from asserting that a contract labeled as an NPC or other equity derivative is in fact an ownership interest in the equity referenced in the contract." In other words, the U.S. Treasury and the IRS will continue to look at situations beyond the seven described above for tax-avoidance potential. The proposed regulations also include a broad anti-abuse rule that may be used to evaluate the business purpose of a contract notwithstanding compliance with the specified NPC requirements.
Exception for expected dividends
The proposed regulations provide that a payment will not be treated as a dividend equivalent, and therefore will not be subject to withholding, 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.
The proposed regulations provide that an NPC referencing a single security, a basket of securities, or a customized index will be subject to these rules. For this purpose, a customized index includes a narrow-based index or any other index unless futures or options contracts referencing the index trade on a qualified board or exchange. Complex computational rules apply to test the customized index and its components for specified NPC status.
Withholding on the gross dividend equivalent
As noted earlier, Sec. 871(m) imposes the withholding tax on the gross amount of a dividend equivalent, regardless of whether the taxpayer actually received that amount. The proposed regulations provide that all tax owed with respect to such dividend equivalent will be due at the time of the next payment made under the NPC, including a termination payment. Significantly, in cases where the tax owed is greater than the next payment under the SNPC, the withholding agent is responsible for reporting and depositing the total amount due with the IRS. The mechanism by which a withholding agent collects the amount due from the taxpayer is left to the discretion of the withholding agent and the taxpayer.
Becoming an SNPC
The proposed regulations also provide that, if an NPC is not an SNPC on the date it is entered into, it may become an SNPC during the term of the contract, with the result that it will be treated as an SNPC during the entire term of the contract.
While we are still assessing the impact of these proposed regulations, it is clear that the stakes are raised for dealers. The good news is that, properly structured, taxpayers may still use some NPCs and other derivatives without running afoul of the withholding regime. The bad news is that dealers will take on significant exposure as withholding agents, which they will undoubtedly seek to limit with modified ISDA terms. The big question is how, other than by representation, would a dealer know what a taxpayer does outside of its account with them?
A public hearing is scheduled for April 27, 2012 and the U.S. Treasury is accepting comments. For additional information or questions, please contact Ted Dougherty, Paul Epstein +1 202 758 1390, or one of your Deloitte engagement team members.
National Managing Partner, Asset Management Tax
Deloitte Tax LLP
+1 212 436 2165
1Technically, the rule was passed as IRC Sec. 871(l), but this was later designated as IRC Sec. 871(m)
2The rule as summarized here assumes the taxpayer is long the NPC