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Dividend Equivalents in Equity Derivative Transactions: Proposed Withholding Tax Regulations under Section 871(m) Broaden the Net

Tuesday, March 6, 2012

Contributed by Jeffrey H. Koppele and Jon T. Hutchens, SNR Denton U.S

On January 19, 2012, the U.S. Treasury Department (IRS) issued temporary and proposed withholding tax regulations under Section 871(m) of the Internal Revenue Code of 1986 (Code).1 These regulations are targeted at “dividend equivalent” payments in equity derivative transactions referencing U.S. stock. The new regulations affect notional principal contracts (NPCs) and other equity-linked instruments that provide for payments to foreign persons, if the payments are determined by reference to dividends paid by a U.S. corporation. This article describes the temporary and proposed regulations, particularly in light of comments that bar associations and other organizations submitted to the IRS in anticipation of the issuance of the regulations.2


In March 2010, the Hiring Incentives to Restore Employment (HIRE) Act added Section 871(m), which applies to securities loans, sale-repurchase transactions (Repos), certain NPCs identified as “specified notional principal contracts” (Specified NPCs), and similar transactions, when they provide for a payment contingent upon or determined by reference to a U.S.-source dividend (Dividend Equivalent). Under this section, a Dividend Equivalent is treated as a U.S.-source dividend for withholding, reporting, and certain other U.S. tax purposes.

Congress enacted Section 871(m) to combat a practice that it saw as abusive. There were a number of variations of this practice, but in each case, by entering into an equity swap, an offshore party would risklessly retain its economic exposure to U.S. shares over a dividend payment date, yet avoid U.S. withholding tax on the dividend.3For a fuller description of Section 871(m) and the circumstances that led to its enactment, see Jeffrey H. Koppele, Sonnenschein, Nath & Rosenthal LLP, HIRE Act Imposes Withholding Tax on Dividend Equivalent Payments Made to Offshore Swap Counterparties, Bloomberg Law Reports® – Derivatives Law, Vol. 1, No. 4(June 14, 2010).

Section 871(m) generally applies to any Dividend Equivalent payment made after September 14, 2010. The statute classifies only certain enumerated types of NPCs as Specified NPCs, but those statutory classifications are set to expire two years after enactment, on March 18, 2012. For payments made on or after March 19, 2012, all NPCs would be considered Specified NPCs, in the absence of IRS guidance providing otherwise. The temporary and proposed regulations issued in January avoided the threat that all NPCs would be treated as Specified NPCs.


The temporary regulations generally provide that the definition of Specified NPC in Section 871(m) will remain in effect for the remainder of 2012. Under that definition, an NPC is considered a Specified NPC if:

  • In connection with entering into the NPC, any long party to the contract (that is, the person who would receive the Dividend Equivalent payment) transfers the underlying security to any short party to the contract;
  • In connection with the termination of the NPC, any short party to the contract transfers the underlying security to any long party to the contract;
  • The underlying security is not readily tradable on an established securities market; or
  • In connection with entering into the NPC, the underlying security is posted as collateral by any short party to the contract with any long party to the contract.4


The proposed regulations largely relate to payments made on or after January 1, 2013. These rules broaden the circumstances under which an NPC will be treated as a Specified NPC, potentially imposing withholding tax on a far larger group of instruments than do the current rules under the statute.


Under the proposed regulations, for payments after December 31, 2012, an NPC will be a Specified NPC if:

  • The long party to the NPC is “in the market” with respect to the underlying security referenced in the NPC 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 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 10 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 an effective term of less than 90 days;
  • The long party controls the short party’s hedge;
  • The notional principal amount represents a significant percentage of the trading volume of the underlying security; 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.5

The proposed regulations include no grandfather clause for contracts entered before January 1, 2013, which means that all Dividend Equivalents paid on or after that date will be potentially subject to withholding if the related swap fails one of the above triggers. Moreover, as discussed below, if an NPC is not initially a Specified NPC, but during its term becomes a Specified NPC, treatment as a Specified NPC is retroactive to the origination of the contract, and withholding tax would be due with respect to all Dividend Equivalents paid over the NPC’s term.6

Certain triggers for Specified NPC status depend on information that may be unavailable to the short party, e.g., whether the long party is in the market or has entered a transaction effectively shortening the term of the NPC to a period of less than 90 days. In such a situation the short party may not know whether to withhold upon payments under the NPC. Indeed, the International Swaps and Derivatives Association, Inc. (ISDA) and the American Bar Association (ABA) requested that the regulations include a rule explicitly allowing a party or a withholding agent to rely on a counterparty’s representations as to liability for withholding tax and the Specified NPC status of a transaction. Although the proposed regulations are silent on this point, an IRS official has indicated in informal remarks that the IRS expects that short parties generally will cure this informational asymmetry by relying on representations of the long party, in the absence of actual knowledge or reason to know of a withholding obligation.7


Under the proposed regulations, 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 amount of the underlying security on the same day or days that the NPC terminates, or sells or purchases such 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).8 A de minimis amount for this purpose is an amount of the underlying security that is less than 10 percent of the notional principal amount of the NPC.9

The “in the market” standard of the proposed regulations is markedly broader than the “crossing-in” and “crossing-out” standard in the statute, which required a transfer of shares in connection with entering into or terminating the NPC, between a long party and a short party to that NPC. The proposed regulations trigger Specified NPC status based on the long party’s transactions in the underlying security with any person, and whether or not in connection with the NPC.

It may be difficult even for long parties to know whether they are themselves in the market with respect to a particular underlying security. For example, multi-strategy hedge funds may not have a mechanism to analyze trades by different portfolio managers to determine if one has sold shares on the same day that another has priced a long position in a swap. Large financial institutions may have information barriers separating trading operations from other parts of the institution. Furthermore, the proposed regulations treat all related parties as parties to the contract, so a long party must provide a representation that none of its affiliates is in the market. These issues may spur requests from taxpayers for a return to the “crossing-in” and “crossing-out” standards that existed in the statute, or at least a rule that a transaction in an underlying security that triggers withholding under Section 871(m) somehow be in connection with the NPC.

An IRS official has stated informally that the proposed regulations’ bright-line standard for being in the market was written to achieve more certainty than would be available under an “in connection with” standard.10 However, given the impracticability of the proposed standard, parties might prefer the vagueness of an “in connection with” rule.


Section 871(m)(3)(A)(iii) provides that an NPC is a Specified NPC if the underlying security is not “readily tradable on an established securities market.” The proposed regulations subtly shift this standard from “readily tradable” to “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 10 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.11 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 (Exchange Act).12

As the New York State Bar Association (NYSBA) explained in its comments, the statute’s “readily tradable” requirement seems directed at ensuring that the underlying security is sufficiently liquid and capable of being hedged. ISDA recommended a rule that hinged on the availability of a quote, similar to Treasury’s most recent definition of the term “traded on an established market,” set forth in proposed regulations relating to original issue discount.13 The proposed standard, however, seems more definite and objective, and in that regard may be beneficial for taxpayers. Complying with the standard may be another matter. Dealers and their counterparties alike may have to build or buy access to technology which will permit them to confirm that an underlying security is regularly traded.


Section 871(m)(3)(A)(iv) treats an NPC as a Specified NPC if, in connection with entering into the NPC, a short party posts the underlying security as collateral to a long party to the contract. The proposed regulations relax this rule, and would treat an NPC as a Specified NPC only if the underlying security that is posted as collateral represents more than ten percent of the total fair market value of collateral on any day during the term of the NPC.14 Although the text of the proposed regulations leaves open the possibility that an increase in the relative value of the underlying security to more than ten percent of total collateral could trigger Specified NPC treatment, an IRS official has indicated in informal remarks that market fluctuations should not on their own create a Specified NPC.15

The proposed regulations adopted the recommendation of the ABA that there be a de minimis exception allowing some stock to be used as collateral. Other commentators requested that a collateral rule not be included at all in the regulations. Where the short party has posted the security as collateral, ISDA wrote, there is no question that beneficial ownership has remained with the long party, and use of the underlying security as collateral does not seem to indicate tax avoidance in any way.

Moreover, the proposed regulations do not retain the “in connection with” qualifier of the statute. This may significantly complicate the situation for an investment fund that wants to enter into an equity swap as the short party, with a non-U.S. swap dealer, where the fund has posted its entire portfolio as collateral for a margin account held by the swap dealer or its affiliate.


Whether an NPC’s term is less than 90 days is determined under the proposed regulations on the basis of the number of days that the contract is actually outstanding, rather than the stated term of the contract.16 An NPC’s term will include the date on which the NPC is terminated, but not the date on which it was entered.17 This less-than-90-day rule may affect offshore investors that use equity swaps as part of a high frequency trading strategy.

Importantly, an NPC will be treated as terminated, in whole or in part, on the date that the long party enters into a position that offsets a portion of its long position with respect to an underlying security in the NPC.18 Because the long party could enter into an offsetting position within 90 days of entering the NPC, and with any counterparty, this provision also appears to make it impossible for a short party to know at closing whether its swap will be a Specified NPC. The proposed regulations do not indicate when a position will be considered to offset a portion of a long position.19

ISDA urged Treasury not to make the term of an NPC a criterion for Specified NPC treatment, at least where a swap remains purely synthetic, i.e., is not converted to or from a physical position. In a purely synthetic swap, ISDA noted, even one of short duration, an investor necessarily takes market risk in both entering into and terminating the swap, and market movements could be more costly to the investor than any withholding tax avoided.

ISDA’s comments also anticipated a significant practical problem with the proposed regulation. It would appear difficult for long parties with extensive trading to monitor all of their own trades─including those of all related parties, as would be required─to avoid taking an offsetting position that inadvertently terminates an NPC prematurely and causes retroactive treatment as a Specified NPC.


The proposed regulations provide that if the long party controls the short party’s hedge of the short position, whether contractually or by course of conduct, then the NPC is a Specified NPC.20 For example, the long party might direct the short party to purchase its hedge from or sell its hedge to a particular party at a certain time and price. This rule also applies if the long party enters into the NPC using an “underlying equity control program,”21defined as a system or procedure that allows the long party to either (1) direct how the short party hedges its risk under the NPC, or (2) acquire economic exposure to an underlying security, but then later use the short party to effectively determine the form of the exposure retroactively.22 An underlying equity control program does not, however, include an electronic trading platform that gives customers the ability to place an order to enter into an NPC, so long as it is not the long party that determines whether and how the short party hedges its position.23


Even if an underlying security is readily tradable, it may trigger classification as a Specified NPC if the notional amount represents a significant percentage of the trading volume of the security. Under the proposed regulations, the notional principal amount of an NPC will represent a significant percentage of trading volume if the notional amount of the underlying security in NPCs in which a party is the long party is greater than either (1) 5 percent of the total public float of that class of security, or (2) 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.24

The text of the proposed regulations suggests that the “5 percent of public float” test could apply at any time during the term of the swap, rather than only at inception. It is not entirely clear whether the IRS intended this result. It also should be noted that the proposed regulations do not define “public float,” a term that is not used elsewhere in Treasury Regulations or the Code, but generally refers to the outstanding shares held by the public, as opposed to insiders. Final regulations may clarify the timing of the 5 percent measurement, and add a definition of “public float.”

In assessing the trading volume of an underlying security, 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. That being the case, this provision also makes it impossible for the short party to know independently if it has entered into a Specified NPC with the long party.


Section 871(m)(4)(C) provides that “any index or fixed basket of securities shall be treated as a single security.” Despite this statutory provision, the proposed regulations provide that if an NPC references multiple securities or a “customized index,” each security or component of the index is treated as an underlying security in a separate NPC.25 Each separate NPC could then be a Specified NPC if the long party transacts in any of the index’s component stocks in a 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 unless the long party transacts in all of the stocks comprising the index in a manner described above. 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,” which is generally defined based on the definition of that term in Section 3(a)(55)(B) of the Exchange Act, and means an index with any one of the following characteristics:

  • Nine or fewer component securities;
  • One component security that constitutes more than 30 percent of the index’s weighting;
  • The five highest-weighted component securities constitute in the aggregate more than 60 percent of the index’s weighting; or
  • The lowest-weighted securities constituting, in the aggregate, 25 percent of the index’s weighting have an aggregate average daily trading volume of less than $50 million ($30 million, in the case of an index with 15 or more component securities).26

In addition to a narrow-based index, a customized index includes any other index unless futures contracts or options contracts on the index trade on a qualified board or exchange. This requirement that futures or options on the index be traded may sweep into the definition of customized index a number of broad-based indices that would seem more appropriately classified as a non-customized index.


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.27


Under the proposed regulations, a “substantially similar payment” includes a payment made pursuant to an equity-linked instrument other than an NPC that is calculated by reference to a U.S.-source dividend.28 An equity-linked instrument includes a futures contract, forward contract, or other contractual arrangement—including a combination of financial instruments—that references one or more underlying securities to determine its value.29 For example, this could include a put-call option combination under which the strike price is adjusted in respect of a dividend paid on the underlying stock. It is not clear whether, or how, this rule would apply to financial instruments, such as options and convertible debentures, that provide for a downward adjustment to the strike price in respect of extraordinary dividends. It is at least arguable that the option-writer or debt issuer in such a situation could incur a withholding obligation, but there is no indication in the statute, nor in the temporary or proposed regulations, of whether Congress or the IRS intended such a result. This broad definition is backed up by an anti-abuse rule that allows the IRS to treat as a Dividend Equivalent any payment made under a transaction or series of transactions that have a principal purpose of avoiding the application of the proposed regulations.30

The proposed definition of “Dividend Equivalent” may prove particularly troublesome for issuers of exchange-traded notes or other financial instruments based on indices in which dividends are reinvested. Because payments under such instruments could constitute substantially similar payments, issuers or their paying agents may be withholding agents for non-U.S. investors. This rule could affect U.S. investors, as well, because the withholding tax would be paid by the issuing entity and would not be reinvested.


The definition of “substantially similar payment” also includes any tax gross-up amount paid by a short party in respect of the long party’s tax liability with respect to a Dividend Equivalent.31


Payments that are based on an estimate of expected dividends are excluded from the definition of “Dividend Equivalent,” provided that the payment is not adjusted to account for the actual amount of the dividend.32 Once a corporate issuer declares, announces, or agrees to the amount of a dividend, a payment based on that dividend can no longer be treated as based on an estimate of an expected dividend.33


A Dividend Equivalent is determined on a gross basis, even if the party entitled to receive the Dividend Equivalent makes a net payment or no payment is made because the net amount is zero.34 Thus, for example, although 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, rather than the net payment itself, can be treated as a Dividend Equivalent.


The rules described above relating to Dividend Equivalents will be effective when the proposed regulations are finalized, i.e., even if that occurs prior to January 1, 2013.35



The proposed regulations state that an NPC that initially is not a Specified NPC may become a Specified NPC during the term of the contract.36 This could occur, for example, if an NPC terminates or is deemed to terminate within 90 days, 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.

If an existing NPC becomes a Specified NPC, Dividend Equivalent treatment is retroactive for all Dividend Equivalents already paid under the NPC.37 The withholding obligations for these prior payments must be satisfied by the next payment date under the NPC.38 This may result in imposition of withholding liability on a party or withholding agent, if the next payment is insufficient to meet the cumulative withholding tax.


To prevent taxpayers from avoiding these rules through the use of related parties, the proposed regulations treat each related person as a party to the contract.39 This provision dramatically expands the scope of representations or other contractual provisions that a short party will require in order to confirm that an NPC is not a Specified NPC. Large financial institutions, among other market participants, may find it difficult to make a representation with respect to trading activities of all affiliates. As a result, where a large non-U.S. institution does not have a U.S. branch or other permanent establishment (and therefore is subject to the withholding regime), it may find the tax burden so great as to foreclose entering equity-based transactions with U.S. short parties.


Conversely, in recognition of practices employed by many swap dealers to transfer risk from one entity to another within an affiliated group, the proposed regulations provide that an NPC entered into between two related swap dealers will not be a Specified NPC if the NPC hedges the risk of another NPC entered into with a third party.40This 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.41


In its comment letter, ISDA argued that the proposed regulations should treat Dividend Equivalents as dividends for tax treaty purposes. The proposed regulations adopt this suggestion, providing that a Dividend Equivalent will be treated in the same way as a dividend for purposes of claiming treaty benefits in the form of reduced or eliminated withholding.42


These administrative rules will be effective when the proposed regulations are finalized, i.e., even if that occurs prior to January 1, 2013.43



NPCs and other financial instruments can be designed to reflect all or part of the economics of an underlying security. Based on the history of the HIRE Act, it can be argued that Section 871(m) was intended to restrict only those instruments that reflect the full economic exposure of an underlying security, and only where the non-U.S. party’s exposure to the underlying security is not meaningfully altered by selling the underlying security and entering into the derivative.44 Accordingly, ISDA recommended limiting the reach of the proposed regulations to NPCs and other contracts that generate “delta one,”45 or close to delta one, exposure to the underlying security, i.e., those that closely reflect changes in the value of the security. ISDA acknowledged that parties could easily circumvent a simple version of such a rule by entering a pair of swaps with separate counterparties, and therefore recommended that the test be applied on an overall, rather than single-transaction, basis.

As described above, however, the proposed regulations impose a simpler test to determine whether a payment under a contract would constitute a Dividend Equivalent, focusing only on whether it is made in respect of a U.S.-source dividend. The proposed rules would apply even where the NPC did not create delta one, or close to delta one, exposure.


An issue explicitly set aside in the temporary and proposed regulations is the problem of cascading withholding taxes. As noted by ISDA, NYSBA, and the ABA, the withholding requirements for Dividend Equivalent payments create the potential for multiple impositions of withholding tax with respect to a single physical dividend payment. Where, for example, a non-U.S. entity enters into an equity swap with a non-U.S. dealer, which then enters into an offsetting swap with a U.S. party, there could be multiple levels of tax imposed in connection with a single dividend payment.

In Notice 2010-46, the IRS identified this issue with respect to securities loans.46 Commentators recommended that the IRS should apply the same principles to treatment of chains of Specified NPCs, exercising its authority under Section 871(m)(6) to ensure that excessive withholding is not imposed on a chain of Dividend Equivalents. The preamble to the temporary regulations states that “the Treasury Department and the IRS anticipate issuing proposed regulations addressing the issues raised in Notice 2010-46.”


The temporary regulations grant taxpayers a reprieve from the threat of the expiration of the Section 871(m) rules. However, the proposed regulations broaden the reach of Dividend Equivalent withholding well beyond the categories in Section 871(m), and in many respects the proposed regulations are of questionable practicability. The IRS has 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 the rules contained in these proposed regulations, but whether to suggest modifications to their current form.

Jeffrey H. Koppele is a Tax Partner and Jon T. Hutchens is a Tax Associate in the New York office of SNR Denton U.S. LLP. They provide advice on both tax and derivatives matters in a wide variety of transactions. E-mail:

The information contained herein has been prepared for informational purposes only and does not constitute legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Any discussions of U.S. federal income tax matters set forth herein were not intended or written to be legal or tax advice to any person and were not intended or written to be used, and cannot be used, by any person for the purpose of avoiding any U.S. federal tax penalties that may be imposed on such person. Each taxpayer should seek advice based on its particular circumstances from an independent tax advisor.  


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