US Section 871(m) final and temporary regulations address dividend equivalents

Transcription

1 30 January 2017 International Tax Alert US Section 871(m) final and temporary regulations address dividend equivalents EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: This Alert discusses guidance released shortly before a regulatory freeze was implemented by the incoming Administration. Notwithstanding that freeze, however, the guidance was published in the Federal Register as originally scheduled. The status of the guidance is not clear at this time. Executive summary The US Internal Revenue Service (IRS) has issued the long-awaited final regulations under Internal Revenue Code Section 871(m) (TD 9815) that provide additional guidance to entities that hold certain financial products referencing US-source dividends. The regulations clarify some obligations of agents that are responsible for withholding on relevant products and of broker-dealers generally charged with identifying the products that are subject to these rules, provide elections to reduce implementation concerns, and finalize proposed regulations and amend final regulations from The regulations also adopt the qualified derivatives dealer rules announced in Notice and incorporated into the final qualified intermediary (QI) agreement. This Alert assumes that the reader is generally familiar with Section 871(m) and the previously-issued guidance thereunder.

2 2 International Tax Alert Detailed discussion Background Section 871(m) treats dividend equivalent payments made with respect to certain derivative transactions referencing dividend-paying US equities as actual US-source dividends subject to withholding under Sections 1441 and 1442 (chapter 3 or NRA withholding) and 1471 and 1472 (chapter 4 or the Foreign Account Tax Compliance Act (FATCA)). On 4 December 2013, the IRS released proposed regulations that would have broadened the scope of instruments on which withholding was required to include virtually every derivative instrument that related to US dividend-paying stocks and that had a delta of 0.7 or greater at the time it was acquired by the long party to the derivative. Final regulations issued in 2015 generally adopted the approach of the 2013 proposed regulations, with some significant changes, including raising the delta threshold to 0.8. During 2016 and early 2017, the IRS issued numerous pronouncements in the area of US withholding tax and FATCA rules, including the provisions relating to QIs and participating foreign financial institutions (FFIs), and Section 871(m) rules. (See Global Tax Alert, US IRS issues proposed regulations with verification and certification rules for sponsoring entities, trustees of trustee-documented trusts and compliance FIs, dated 12 January 2017 for discussion of the most recent rules on US withholding tax and FATCA, Global Tax Alert, US IRS issues Section 871(m) transition rules, dated 9 December 2016 for discussion of Section 871(m) transition rules, and Global Tax Alert, US IRS releases 2017 Qualified Intermediary Agreement and FFI Agreement, dated 19 January 2017 for information on the QI and FFI Agreements.) Significant changes in final regulations Determining the delta and date of the substantial equivalence test The concept of delta is generally used to determine whether a derivative is in scope. The minimum delta to be within scope is 0.8. Under the 2015 regulations, delta is tested only at original issuance or at a material modification of the instrument; this one-time value for delta is also used for determining the amount of a dividend equivalent. The 2017 regulations determine delta of a simple contract on the earlier of the pricing date or the issue date of the potential Section 871(m) transaction, unless the pricing date is more than 14 calendar days before the issue date, in which case the issue date is used. A similar rule applies to the substantial equivalence test for complex contracts. For an option listed on a regulated exchange (other than a customized version such as a FLEX option), the delta would be determined at the close of business on the day before the issue date. This standard allows market participants to know whether or not a given option is in scope at the time of the trade. Brokers and responsible parties Regulated investment companies (RICs) would not be treated as brokers (and therefore potentially a responsible party to determine whether a transaction is within scope or its dividend equivalent amounts) solely because the RIC redeems its shares. This change may keep RICs in short positions from having to provide delta information to qualified derivatives dealers (QDDs), which already were responsible for assessing their own net delta positions. The 2017 regulations also clarify who is the responsible party in various situations involving multiple brokers and other parties in a chain. The original rules assumed a simple bilateral contract in identifying the responsible party, but bilateral contracts are not the norm for exchange-traded contracts or structured notes. The revised regulations reduce uncertainty about who is the responsible party when more than one could have qualified for that role. Simple versus complex contract A contract cannot be simple unless it references a fixed number of shares. In some cases, the terms of the contract may provide for adjustments to the number of shares referenced to avoid dilution due to mergers, stock splits, cash dividends and similar corporate actions. The regulations provide that such adjustments to maintain the status quo will not make a derivative complex and subject to the substantial equivalence test to determine whether it is in scope. Substantial equivalence test If a contract is complex, part of the analysis to determine whether the contract is in scope for Section 871(m) requires choosing a simple contract that is closely comparable to

3 International Tax Alert 3 the complex contract for purposes of choosing a simple contract benchmark. The 2017 regulations would provide that the simple contract benchmark need not actually exist in the market, but may be a hypothetical simple contract provided that, at the time the substantial equivalence test is applied to the complex contract, the simple contract benchmark references the same underlying security, has a delta of 0.8, and has terms that are consistent with all the material terms of the complex contract, including the maturity date. Amount and timing of taxpayer s liability The dividend equivalent amount for a simple contract equals the amount of the per-share dividend, multiplied by the number of shares referenced in the contract, multiplied by the applicable delta. For a complex contract, the amount of the dividend equivalent equals the amount of the per-share dividend, multiplied by the number of shares that constitute all or part of the initial hedge of the complex contract. A withholding agent is not obligated to withhold on a dividend equivalent until the later of: (i) when a payment is made with respect to the Section 871(m) transaction; or (ii) when the amount of a dividend equivalent is determined. Thus, it is possible that withholding will not be required until after the amount of a dividend equivalent is determined. For this purpose, a payment with respect to a Section 871(m) transaction will generally occur when the long party receives or makes a payment, when there is a final settlement of the Section 871(m) transaction, or when the long party sells or otherwise disposes of the Section 871(m) transaction. The 2017 regulations address the timing of the taxpayer s substantive tax liability. Once the amount of a dividend equivalent subject to tax is determined, it will not change because the tax is withheld at a later date. Thus, for example, a change to the tax rate or in whether the recipient is eligible for treaty benefits between the time that the amount of a dividend equivalent is determined and the time that withholding occurs does not affect tax liability. The rules expressly provide that a long party is only liable for tax on dividend equivalents that arise while that long party is a party to the transaction. The 2017 regulations give withholding agents the flexibility to withhold on either the dividend payment date or the date a cash payment is made. A withholding agent that chooses to withhold on the dividend payment date for the underlying security referenced by the Section 871(m) transaction must apply that election consistently to all Section 871(m) transactions of the same type. A withholding agent withholding on the dividend payment date must notify each payee in writing before the time for determining the long party s first dividend equivalent payment. A withholding agent that withholds on the dividend payment date for the underlying security must attach a statement to its Form 1042 for the year of the change notifying the IRS of the change and when it applies. Qualified indices A derivative with respect to a qualified index will be out of scope for Section 871(m). A specific safe harbor is provided for derivatives based on an index in which the US stock components comprise, in the aggregate, 10% or less of the weighting of all the component securities in the index. The final regulations clarify that the 10% safe harbor can apply only to a widely traded index (i.e., not a custom index) that does not have a principal purpose of tax avoidance. In the year an index is created, qualification is tested on the first business day it is listed and the dividend yield calculation is determined using the dividend yield that the index would have had in the immediately preceding year if it had the same components throughout that year that it has on the listing date. Rules for withholding on dividend equivalents Usually, transferring a security held in custody from one broker or custodian to another is not a taxable event. The 2017 regulations change this rule for Section 871(m) transactions and provide that a payment of a dividend equivalent occurs when a Section 871(m) transaction is transferred to an account not maintained by the same withholding agent or upon a termination of the account relationship. This change avoids requiring a transferee broker to withhold for determination dates before that broker held the security.

4 4 International Tax Alert Combination rule A combination rule requires a taxpayer to combine two or more transactions if, taken together, the transactions would replicate the economics of a Section 871(m) transaction and were entered in connection with each other. Some commentators had suggested that this rule required derivative transactions to be combined even if the resulting combination would be a complex contract rather than a simple contract. The Preamble to the regulations stated that transactions will only be combined into simple transactions. The Preamble also provided that, pending the issuance of additional guidance, taxpayers may adopt any reasonable methodology to combine transactions within the general framework of the final regulations. Effective date As presaged by Notice , implementation of the Section 871(m) regulations for non-delta one transactions is postponed until 1 January 2018, but delta one transactions issued on or after 1 January 2017, are in scope. Implications The regulations adopt a number of taxpayer comments that increase flexibility and reduce burdens on various parties, while rejecting other requests. It remains to be seen what effect, if any, the regulatory freeze might have on the 2017 regulations.

5 International Tax Alert 5 For additional information with respect to this Alert, please contact the following: Ernst & Young LLP, International Tax Services Capital Markets, Washington, DC Alan Munro alan.munro@ey.com Matthew Stevens matthew.stevens@ey.com Ernst & Young LLP, Financial Services Office, Boston Matthew S. Blum matt.blum@ey.com Ernst & Young LLP, Financial Services Office, New York Lauren Lovelace lauren.lovelace@ey.com Tara Ferris tara.ferris@ey.com International Tax Services Global ITS, Alex Postma, Tokyo ITS Director, Americas, Jeffrey Michalak, Detroit ITS Markets Leader, Americas, Stephen O Neil, New York Ernst & Young LLP, National Director of ITS Technical Services, Jose Murillo, Washington ITS Regional Contacts, Ernst & Young LLP (US) Northeast Johnny Lindroos, McLean, VA Financial Services Chris J Housman, New York Central Mark Mukhtar, Detroit Southeast Scott Shell, Charlotte, NC Southwest Amy Ritchie, Austin West Beth Carr, San Jose, CA Canada Ernst & Young LLP (Canada) Albert Anelli, Montreal

6 EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. About Ernst & Young s International Tax Services practices Our dedicated international tax professionals assist our clients with their cross-border tax structuring, planning, reporting and risk management. We work with you to build proactive and truly integrated global tax strategies that address the tax risks of today s businesses and achieve sustainable growth. It s how Ernst & Young makes a difference. International Tax Services 2017 EYGM Limited. All Rights Reserved. EYG no US NY ED None This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. ey.com