IRS issues final regulations on dividend equivalents from U.S. sources

Tax Hot Topics: Final regulations on dividend equivalentsThe IRS on Sept. 18 issued final and temporary regulations (T.D. 9734) under Section 871(m), which relates to “dividend equivalents.”
Section 871(m)(1) states that for purposes of Sections 871(a), 881 and 4948(a), and Chapters 3 and 4, a dividend equivalent is treated as a dividend from sources within the United States.

A dividend equivalent is defined in Section 871(m)(2) as (i) any substitute dividend made pursuant to a securities lending or a sale-repurchase transaction that directly or indirectly is contingent upon, or determined by reference to, the payment of a dividend from sources within the United States; (ii) any payment made pursuant to a specified notional principal contract that directly or indirectly is contingent upon, or determined by reference to, the payment of a dividend from sources within the United States; and (iii) any other payment determined by the Secretary to be substantially similar to the payments previously described.

The newly issued final regulations under Treas. Reg. Sec. 1.871-15(c)(1) state that a dividend equivalent includes a payment that references the payment of an actual dividend under (i) a securities lending or sale-repurchase transaction, (ii) a specified notional principal contract (specified NPC), (iii) a specified equity-linked instrument (specified ELI) or (iv) any other substantially similar payment. The regulations also provide for certain exceptions to a dividend equivalent under Treas. Reg. Sec. 1.871-15(c)(2).

The regulations define (i) the term “specified NPC” under Treas. Reg. Sec. 1.871-15(d), (ii) the term “specified ELI” under Treas. Reg. Sec. 1.871-15(e), and (iii) “other substantially similar payments” under Treas. Reg. Sec. 1.871-15(f).  In determining whether there’s a specified NPC or a specified ELI, there are separate tests depending whether a contract is a “simple contract” or a “complex contract” as defined in Treas. Reg. Sec. 1.871-15(a)(14). The temporary regulations under Treas. Reg. Sec. 1.871-15T(h) provide guidance about complex contracts.

Treas. Reg. Secs. 1.871-15(k) and (l) describe exceptions for certain transactions that the long party is obligated to acquire more than 50% of the value of the underlying security (in other words an M&A transaction) and transactions that reference certain indices that are based on a diverse basket of publicly traded securities.  

The regulations also include rules for determining when there is a “payment” of a dividend equivalent and the amount of a dividend equivalent under Treas. Reg. Secs. 1.871-15(i) and (j). Additional rules address derivatives that reference partnerships (Treas. Reg. Sec. 1.871-15(m)) and when two or more transactions should be treated as a single transaction (Treas. Reg. Sec. 1.871-15(n)).

An anti-abuse rule may apply to certain transactions that are entered into principally to avoid the application of the regulation under Treas. Reg. Sec. 1.871-15(o). The regulations also impose requirements on brokers and dealers under certain circumstances under Treas. Reg. Sec. 1.871-15(p).

In determining the amount of withholding tax related to dividend equivalent, a payment of a dividend equivalent is not considered to be made until the later of when (i) the amount of a dividend equivalent is determined under Treas. Reg. Sec. 1.871-15(j)(2), or (ii) a payment occurs with respect to the Section 871(m) transaction. The withholding rules are found under Treas. Reg. Sec. 1.1441-2.  

The final regulations are effective for any payment made on or after Jan. 1, 2017, related to transactions issued on or after Jan. 1, 2017. However, the final regulations apply only to payments made on or after Jan. 1, 2018 for transactions issued in 2016.

Jeff Borghino
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Andy Cordonnier
+1 202 521 1502

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