Holiday Party: The IRS Releases Final Regulations On Cross-Border Dividend Equivalents Paid On Swaps And In Security Lending Transactions


Article by Mark H. Leeds1, Jonathan A. Sambur, Jared B. Goldberger, Donald C. Morris and James R. Barry

Keywords: IRS, final regulations, cross-border dividend, swaps, security lending

The waiting for the final regulations addressing when US federal income tax withholding would be imposed on dividend equivalent payments made to non-US persons under notional principal contracts ("NPCs" or "swaps") and in security lending transactions bore a strong similarity to the plight of nine-year-old Ralphie in Jean Shepherd's "A Christmas Story." Ralphie suspects that his parents have gotten him a Red Ryder BB gun as a Christmas present, but until Christmas morning arrives, he doesn't know for sure. The anticipation, brilliantly portrayed in both the book2 and the movie, is palpable. It's fair to say that participants in the swap and securities lending markets exhibited at least the same degree of eagerness for final regulations under Section 871(m) of the Internal Revenue Code of 1986, as amended (the "Code") as Ralphie did for his BB gun. Well, unlike Ralphie, we got our present early this year. On December 4, 2013, final regulations were issued for dividend equivalents paid prior to 2016 and regulations have been proposed for dividend equivalents paid after such date.


    In 1991, the IRS promulgated a regulation providing that income from a swap is sourced to the residence of the payee.3 This rule created the potential for a discontinuity with respect to equity swaps and total return swaps, on one hand, and actual stock ownership, on the other. Specifically, if a non-US person4 held a stock directly, unless an income tax treaty provided for a total exemption from US federal income tax, any dividends paid on a US stock would be treated as US source income and subject to either 15% (most tax treaties) or 30% US federal income tax withholding.5 In contrast, a dividend equivalent payment6 made to a non-US person under a swap in respect of a dividend paid on a US stock included in the specified index7 would be treated as non-US source income and not be subject to US federal income tax withholding. Congress became dissatisfied with these results.8 The IRS perceived that banks and non-US taxpayers abused this disparity through a variety of transactions and initiated an audit campaign to curtail these perceived abuses.9

    In March 2010, Congress addressed the perceived abuse through the passage of the HIRE Act.10 Specifically, Section 541 of the HIRE Act enacted Code § 871(m). Code § 871(m)(1) provides that a dividend equivalent "shall be treated as a dividend from sources within the United States." For the period from the effective date of the HIRE Act, dividend equivalents paid or credited on certain swaps and in securities lending transactions could be subject to withholding.11 Accordingly, Code § 871(m) reverses the rule contained in the 1989 Treasury Regulation for dividend equivalents on certain swaps. As a result, certain dividend equivalents are subject to the same US federal income tax withholding that an actual dividend would be subject to. Indeed, Temporary Regulations amended the 1991 regulation to specifically state that it no longer applied to dividend equivalents and these regulations have now been finalized.12

    In January 2012, the IRS released three sets of rules. First, a set of rules was provided for payments on swaps made or credited on or after January 23, 2012 and before January 1, 2013.13 These rules generally followed the rules that had been in effect since 2010. Second, a set of new rules for dividend equivalents were proposed to be effective after final regulations are published.14 Third, rules were proposed to expand the categories of swaps affected by the dividend equivalent withholding rules (referred to as "specified notional principal contracts" or "specified NPCs") beginning in 2013.15 The proposed regulations were pulled by the IRS in August 201216 and practitioners have been waiting for revised guidance since that time.


    The 2013 Regulations provide final regulations for dividend equivalents paid before 2016 and address certain technical comments raised by practitioners. First, they provide that the four categories of statute-specified swaps that can give rise to dividend equivalents remain the sole types of equity derivative transactions (apart from securities loans) that can give rise to US source dividend equivalents. Second, they make payers of dividend equivalents absolutely liable for the correct amount of withholding even if the portion of a distribution that constitutes a dividend cannot be determined at the time that the dividend equivalent is paid.

    1. The Existing Categories Of Transactions That Can Give Rise To US Source Dividend Equivalents Remain Unchanged For Payments Before January 1, 2016

      In Code § 871(m)(3)(B), Congress provided the IRS with the right to revise the statutory rules for the withholding of US federal income tax on derivatives referencing US stocks for payments made after March 18, 2012. The applicable tax rules also provide the IRS with the right to extend the withholding rules for dividend equivalents from swaps to financial contracts other than swaps.17 The legislative history accompanying the enactment of the statute provided, "under this rule, for example, the [IRS] may conclude that payments made under certain forward contracts . . . that reference stock of US corporation are dividend equivalents."18 In the new regulation package, the IRS chose not to exercise grants of authority for payments made prior to January 1, 2016.

      Specifically, in new final Treasury Regulation § 1.871-15(d), the IRS spells out that only four types of swap transactions can give rise to dividend equivalents that when paid or credited to the account of a non-US person prior to January 1, 2016:

      The non-US person, in connection with entering into the swap, transfers the underlying security to the short party; The short party, in connection with closing or terminating the swap, transfers the underlying security to the non-US person; The underlying security is not readily tradable on an established securities exchange; or In connection with the opening of the swap, the short party posted the underlying security to the non-US person. These four transactions, known as "specified notional principal contracts," dovetail with the four Congressional-specified transactions that give rise to dividend equivalents subject to withholding when paid or credited to a non-US person for periods prior to March 18, 2012.19 B. Other Technical Aspects Of The Final Dividend Equivalent Regulations

      The final 2013 dividend equivalent regulations make a number of technical changes and clarifications. First, the regulations regarding the impact of tax treaties on the amount to be withheld have been amended to specifically provide that dividend equivalents are eligible for a reduced rate of withholding in those cases in which a tax treaty provides for a lower withholding rate on actual dividends.20 Second, foreign sovereign entities who can receive dividends exempt from US withholding tax may receive dividend equivalents free from US withholding tax.21

      Code § 871(m)(5) provides that the word "payment" as used in Code § 871(m) includes any gross amount used to compute any net amount payable to or by a taxpayer. This rule ensures that a dividend equivalent subsumed in another payment retains its character as a US source income item, potentially subject to withholding. For example, assume that in a single-stock equity swap over a US Stock, the bank counterparty ("ShortCo") has an obligation to make dividend equivalents payments to a non-US person ("LongCo"). LongCo has an obligation to make so-called funding payments to ShortCo. The funding payments equal the product of the value of the stock included in the specified index and an objective interest rate index. On a payment date, ShortCo's obligation to make a dividend equivalent payment to LongCo is $500 and LongCo's obligation to make a funding payment to ShortCo is also $500. As a result, no money passes hands between the counterparties. On these facts, ShortCo is considered to have made a $500 dividend equivalent payment to LongCo. The final withholding regulations specifically impose a withholding requirement on ShortCo in this situation.22

      The preamble to the final regulations makes clear that any person who is treated as a withholding agent (including custodians and financial intermediaries) can be treated as a withholding agent on dividend equivalents. Interestingly, the same issue arose under the Foreign Account Tax Compliance Act ("FATCA") and the IRS ultimately limited withholding responsibility to only those persons who had knowledge that the payment was a with-holdable payment. The initial IRS-proposed FATCA regulations provided that, "when multiple withholding agents that are brokers are involved in effecting a sale, each broker must determine whether it is required to withhold on its payment of gross proceeds by reference to the chapter 4 [FATCA] status of its payee."23 This language was interpreted by the banking community as imposing FATCA withholding responsibility both on executing brokers and Clearing Organizations.24

      In January 2013, the IRS released final FATCA regulations that superseded and replaced the proposed regulations.25 The final regulations deleted what had been Proposed Treasury Regulation § 1.1471-2(a)(2)(v). Instead, a regulation with the same title ("Payments of gross proceeds") was left as a placeholder and was reserved.26 While the rule that provided for cascading broker responsibility was deleted, the final regulation addressing when a person acting as an agent is a FATCA withholding agent was expanded. Under the expanded FATCA agency rule, a person treated as a withholding agent has an obligation to withhold only to the extent that "it has control over or custody of...

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