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COKALA Tax Information Reporting Solutions, LLC – PO Box 2224 – Ann Arbor, MI 48106 – telephone 734.629.5155

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March 15, 2016

New Final, Temporary and Proposed Regulations on

Dividend Equivalent Payments

Final and temporary IRC §871(m) regulations on dividend equivalents were published in TD 9734 on September 17, 2015, with proposed regulations published a day later on September 18, 2015 in REG-127895. Under these regulations, §871(m) has expanded FATCA and Chapter 3 withholding and reporting responsibilities on a broad range of financial products (traditional, derivative and structured) that are commonly found in retail and institutional markets. For many of us, these new requirements for testing and monitoring security transactions will change the way we have traditionally viewed tax compliance and will require modification of systems, procedures and practices that have been in place for many years.

Except for specified notional principal contracts, many financial products captured by the new §871(m) requirements also fall under IRC §6045, requiring 1099-B reporting of gross proceeds from their sales or other dispositions when paid to U.S. persons, particularly with the addition of 1099-B reporting on options and §1234B securities futures contracts, including single stock futures. Until now, apart from worrying about the FATCA applications to gross proceeds now pushed off to 2019, it has been relatively easy to segregate FATCA and chapter 3 withholding and reporting responsibilities on the security’s income from the mutually exclusive tasks associated with reporting and possible backup withholding on gross proceeds under §6045 when the security was sold or otherwise disposed of. With the advent of these new regulations, this will no longer be true since withholding could be required on the dividend equivalent portion of the proceeds, such as in the context of the substitute dividend repurchase transactions and also on any amount of proceeds where there are outstanding withholdings on dividend equivalent amounts still due. There is a timing disconnect between when you are required to calculate the dividend equivalent withholdable amount and when withholding is required, deferring withholding to an event with cash flow. Another troubling note is that there may be a need to cross over the existing security codings in your master file when applied to non-U.S. investors, switching from a coding indicating the security is debt that pays “interest” to an equity coding designation of payment of “dividends” to enable the applications of the proper treaty rates for withholding and the proper income codes on the 1042-S. Remember that some structured debt is indexed to dividends and the new rules will also possibly capture a few convertible bonds.

Until now, there has been a whole list of securities that we did not have to worry about when it came to processing chapter 3 withholding and 1042-S reporting, that is, the list of securities that never paid withholdable income. This list will need to be rethought as many securities that at one time were on this list might now be considered a potential specified


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“equity linked investment” or “ELI” that could pay dividend equivalents and that now will need to be considered under FATCA and chapter 3. The challenging products under the ELI rules include regulated futures and other securities futures contracts as well as forward contracts, and many structured and derivative finance products. The big target under §871(m) is options, including traditional puts and calls, §1256 options and non-§1256 options, over-the-counter options, basket options, options on one or more specified equities, indexed options if substantially all the components of the index are specified equity securities, options on financial attributes of specified equity securities where the price moves with the dividend, warrants and stock right as long as determined by the broadly defined reference to a U.S.-source dividend, etc. If a combination of products produces a dividend equivalent, then you will only need to look at positions in the same account, much like the rules applied to adjust cost basis, unless tax avoidance is seen at issue.

IRC §871(l) [later changed to §871(m)] came about with FATCA in 2010 as part of the Hiring Incentives to Restore Employment (HIRE) Act and is probably one of the thorniest pieces of compliance legislation we have seen so far, in some ways even topping the complexities of FATCA and the Cost Basis rules for 1099-B reporting. This legislation was initially intended to address concerns about the use of equity swaps and substitute dividend generating repurchase transactions by foreign taxpayers to avoid U.S. withholding tax on U.S. source dividend income. The legislative target was very specific, to stop the avoidance of U.S. withholding where foreign taxpayers either entered into an equity swap or sold stock prior to record date for a dividend, received a substitute dividend escaping withholding, and then bought back the stock from the same counterparties. In the end, Congress knew the legislation would not go far enough just looking at these two transaction types so §871(m)(2)(C) was added to provide for inclusion of “any other payment determined by the Secretary to be substantially similar” to these transactions. These regulations make use of this provision and broadly stretch §871(m) application beyond substitute dividend repurchases and specified notional principal contracts (“SNPC”) to all forms of equity options, including indexed and basket options, contingent debt, future and forward contracts, derivatives and many structured products under a newly coined term “equity linked investment” or “ELI.”

The ELI in particular is a relatively new concept and most see identification of such a withholdable instrument to be a challenge. Transactions issued prior to 2016 are grandfathered, but for transactions entered into in 2016, compliance will be required for payments starting in 2018. The final effective date was pushed out to 2017 for transactions enter into in 2017, but brokers will need to identify and track specified ELIs entered into in 2016 to assure compliance on them in 2018 (see VII below for effective dates). For stock loans and stock sale-repurchase transactions, Notice 2010-46 will continues to apply until the new Qualified Derivatives Dealer (“QDD”) classification is finalized. The delta testing will not begin on SNPC until 2017 and until then the existing rules will continue to apply. Clearly some tracking mechanism will be needed to assure all the transitional requirements are met, particularly for 2016 transactions.

Regulations under § 871(m) already have quite a history since enacted as part of the HIRE Act in 2010, starting with a string of IRS Notices, followed by the 2012 temporary and


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proposed regs which were corrected, amended, and then partially withdrawn in favor of 2013 proposed regulations. 1 And, now we have TD 9734 that mostly finalizes the 2013 version of the proposed regulations, but in response to voluminous comments reflect some critical changes outlined throughout this paper. TD 9734 also adds new materials on §871(m) testing of complex derivatives and for handling payments to dealers, that have been released in proposed and temporary form to allow for more comments. See final and temporary regulations in TD 9734 at http://www.gpo.gov/fdsys/pkg/FR-2015-09-18/pdf/2015-21759.pdf. The proposed regulations were published in REG-127895-14 at http://www.gpo.gov/fdsys/pkg/FR-2015-09-18/pdf/2015-21753.pdf. The proposed and temporary regulations will be the subject of a public hearing on January 16, 2016.

Section 871(m) compliance will impact not just areas involved in tax processing, and in equities, reorg and fixed income operations, but also prime broker and institutional broker desks, stock loan areas, custody, hedging and collateral operations, investment and wealth management, and importantly the legal and tax counsels for all of these areas.

Brokers have many challenges ahead under the new provisions. To name a few: Delta testing financial products that could be considered potential §871(m) transactions; developing calculation modules; modifying systems to link the dividend equivalents to payments in dividend, reorg, stock loan, swap and derivative systems to handle withholdable amounts; applying treaty benefits to amounts not normally considered “dividends” subject to documented claims; changes to the 1042-S and 1042 data flows; handling noticing requirements; internal training and external communications with customers.

Part XII of this paper discusses strategies and approaches to the many challenges of §871(m) compliance.

The rest of this paper is intended to help you learn enough about how the rules work so that you can begin to apply them and maneuver through them.

1 Notice 2010-46 [I.R.B. 2010-26, May 20, 2010] came first after the HIRE Act, offering three sets of transitional rules under then new §871(l). Notice 2010-46 modified and withdrew parts of Notice 97-66, [1997-2 CB 328], the older withholding mechanism for certain securities lending transactions. Section 871(l) was then re-designated §871(m) on August 10, 2010, by H.R. 1586 [P.L. 111-226]. In early 2012, the IRS released proposed and temporary regulations under §871(m) that defined dividend equivalents and specified notional principal contracts (SNPCs). These temporary regulations initially offered a transitional phase-in of the requirements from March 12, 2012 through December 31, 2012. The transitional rules were later extended several times; first, through December 31, 2013, then to January 1, 2015. But, note that substitute dividends involving U.S. stock have long been subject to 30% withholding unless a treaty applies and since 2012, SNPCs have also been subject to withholding and reporting requirements. See instructions to Form 1042-S for tax years 2012-2015. [Proposed Reg. §1.871-15; Temp. Reg. § 1.871-16T(b); T.D. 9572, January 19, 2012; REG 120282-10, January 23, 2012; Announcement 2012-35, I.R.B.2012-38, 356, September 14, 2012; and T.D. 9648, I.R.B. 2013-52, 798, December 4, 2013].

http://www.gpo.gov/fdsys/pkg/FR-2015-09-18/pdf/2015-21759.pdf




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I. Overview

II. What is a “dividend equivalent”?

A. Determination timing – when issued

III. What is excluded from the definition of “dividend equivalent”?

IV. Brokers, long and short parties to the transactions and information sharing provisions

A. Foreign transactions, new QDDs or chain of dividend withholding

V. Determining a §871(m) dividend equivalent

A. Testing timing - when issued

B. Application of “delta” test to a simple transaction

C. Other tests and safe harbors

VI. Notes on convertible and contingent debt

VII. Transitional effective dates

VIII. What is a “payment” for purposes of defining a dividend equivalent?

IX. How and when are §871(m) withholdable amounts calculated on payments?

X. Timing of FATCA and Chapter 3 withholding and other requirements

XI. Special tax reporting and recordkeeping

XII. Strategies and approaches

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I. Overview

IRC § 871(m)(1) provides that a dividend equivalent is treated as a dividend from sources within the United States for purposes of §871(a) (tax on nonresident alien individuals), §881 (tax on foreign corporations), §4948(a)(income of foreign organizations), chapter 3 (withholding on payments to non-U.S. person) and chapter 4 (FATCA). The final regulations add reference to §894 to clarify (as provided in Reg. §1.894-1(c)(2)) that a dividend equivalent is treated as a dividend for purposes of any provision regarding dividends in an income tax treaty.

Key: Dividend equivalents under §871(m) are subject to 30% withholding under IRC chapter 4 (FATCA) or if the payee is FATCA exempt, 30% withholding under Chapter 3 (or a lower rate if there is a valid treaty claim).

The regulations presume a compliance flow that starts at point of issue (or deemed issue) with identifying substitute dividend repurchases, and potential simple and complex transactions (NPCs and ELIs) that could be dividend equivalents (see II, III below). For NPCs and ELIs, testing is required of simple securities through the use of a “delta” and more complex


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securities through use of a benchmark hedge to determine if the security is in fact a dividend equivalent (see V below). But see the transitional effective dates below. Next comes the calculation of the portion of a distribution or deemed distribution that is considered a dividend equivalent and the amount that is subject to withholding (see VIII, IX below).

Obtaining the information needed to identify and test the security is supported by a regulatory scheme of noticing between long and short parties to the transaction and their brokers (see IV below). The Preamble to TD 9734 expressly says “any party to the transaction that is a broker, dealer, or intermediary, a short party, or a withholding agent, must comply with any requirements in the final regulation to make appropriate determinations, and satisfy reporting and withholding obligations, as applicable.” And, there is unique impact on convertible and contingent debt securities (see VI below).

A “payment” includes any gross amount that references a U.S. source dividend and that is used to compute any net amount transferred to or from the taxpayer (see VIII below). Withholding will apply to any gross amount that references the payment of a dividend, whether actual or estimated, explicit or implicit to the extent of the amount determined to be a dividend equivalent. However, a special timing rule has been established for when to withhold and deposit funds with the IRS, as well as special tax reporting and record keeping will now be required (see X, XI below).

To ensure that financial institutions have adequate time to develop systems, the final and temporary §871(m) regulations were delayed and will become effective in 2017 for transactions issued on or after January 1, 2017. But, not all is forgiven for prior §871(m) transactions entered into in 2016. Only transactions entered into prior to 2016 will be grandfathered and subject to the existing requirements. For 2016 transactions, the regulations will apply to any payment of a dividend equivalent made in 2018 and later. Specified notional principal contracts as well as substitute dividend repurchase arrangements and stock loans remain subject to withholding requirements under existing rules with new testing requirements for NPCs to be phased in in 2017. See VII below.

The final regulations retained the anti-abuse provisions for transactions with a principal purpose of §871(m). [§1.871-15(o)] On the international side, a new subcategory of Qualified Intermediary (QI) has been created called a “Qualified Derivatives Dealers” (“QDD”) that will at some point replace the existing provisions for Qualified Securities Lenders (QSLs).

II. What is a “dividend equivalent”?

The final regulations used IRC §871(m)(2)(C) to extend the reach of §871(m) well beyond equity swaps and repurchase arrangements to encompass any payment that references a U.S. source dividend if the payment is directly or indirectly contingent upon a U.S. source dividend or determined by reference to such a dividend. “To reference” has specific meaning. It means to be contingent upon or determined by reference to, directly or indirectly, whether in whole or in part, so the application is very broad and can include indices. Moreover, withholdable payments include implicit payments so withholding might be required even if there is no payment or from payments you are receiving (more below).


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The new regulations define a dividend equivalent as (1) any substitute dividend that references a U.S.-source dividend made pursuant to a securities lending or sale-repurchase transaction [the repurchase transaction that was the initial target of the legislation] ; (2) any payment that references a U.S.-source dividend made pursuant to a specified notional principal contract (SNPC) [the equity swap that was the initial target of the legislation if it meets the “delta” terms ]; (3) any payment that references a U.S.-source dividend made pursuant to a “specified” equity linked investment (ELI) if it meets the “delta” terms(SELI); or (4) any other substantially similar payment.

The definition of an equity linked investment (ELI) broadly expands the possible products to which these rules “might” attach. “Might” is the operative word since in the final regulations determining whether a §871(m) actually transaction exists is a two-step process. First, does the transaction have the potential to be a §871(m) dividend equivalent, and second, does it meet the tests to actually be one (see V. below).

A potential §871(m) transaction is defined as any securities lending or sale-repurchase transaction, NPC, or ELI that references one or more underlying securities. An underlying security is defined as any interest in an entity if a payment with respect to that interest could give rise to a U.S. source dividend. Where a potential transaction references an interest in more than one entity or different interests in the same entity, each referenced interest is a separate underlying security for purposes of applying the rules. The list embraces the different structured products or derivatives, and includes futures contracts, forward contracts, a wide range of options, contingent debt instruments (but many believe the new “delta” test will exclude most if not all convertible debt instruments from covered classification), or any combination of these products as well as other contractual arrangements that reference the value of one or more underlying equity securities or that look to indexes of equities, but there are some complex exceptions. An option is defined to also include an option embedded in any debt instrument, forward contract, NPC, or other potential § 871(m) transaction.

As pointed out in the preamble to this paper, many of the financial products captured by the new § 871(m) requirements also fall under IRC § 6045, requiring 1099-B reporting of gross proceeds when paid to U.S. persons. In the past, transactions under § 6045 were seen as mutually exclusive of FDAP subject to chapter 3 and FATCA withholding requirements. There will be a need to evaluate all primary systems and their tax processing to assure the flexibilities needed to fulfill compliance under these new rules.

Some aspects of the new and proposed rules are not covered in this paper, including those that relate to derivatives that referenced partnership interests. The 2013 proposed regulations treated a transaction that referenced an interest in an entity that is not a C corporation for Federal tax purposes as referencing the allocable portion of any underlying securities and potential §871(m) contracts held directly or indirectly by that entity. The final regulations revise the rules to provide that §871(m) applies to derivatives that reference a partnership interest only when the partnership is either a dealer or trader in securities, has significant investments in securities, or holds an interest in a lower-tier partnership that


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engages in those activities. We reserve this topic to another white paper should we receive comments on the need to do so.

A. Determination timing – when issued

In a change from the 2013 proposed regulations, you are required to determine whether the security is potentially a §871(m) dividend equivalent only when the transaction is considered to be issued. Under the 2013 proposed regulations, the testing period would have also applied at the point of each subsequent sale or other disposition.

Generally the concept of when issued is universally understood for most securities, but consider listed puts and calls as each purchase or writing of the option could be considered an issue. This will mean a great deal of tracking and data collection to meet the record keeping requirements outlined in IV and XI below.

In addition, for purposes of §871(m), the term “issued” will include deemed exchanges under IRC §1001, a provision most thought about in the context of debt instruments. Under §1001 regulations, whenever there is a significant modification of a debt instrument, it will result in a deemed exchange of the original instrument for a modified instrument that differs materially either in kind or in extent [Reg. §1.1001-3(b]). Regulations list several events that could be considered a deemed issuance, including changes in yield, changes in timing and/or amount of payments, changes in the obligor or security, changes in the nature of the instrument such as changing debt to non-debt, certain option exercises unless unilateral and the list goes on.[ Regs. §1.1001-3(c), (d)]

A deemed exchange could arise in the context of convertible, contingent debt and such debt could be considered a potential ELI. But, remember that the potential §871(m) security must meet the “delta” test (see V.B. below) to be considered an actual §871(m) security. Many believe that the increase of the “delta” to 0.80 will eliminate most if not all convertible bonds from classification as dividend equivalents. Testing on deemed exchanges may nonetheless still be required since there is no exclusion per se for convertible debt.

Deemed exchanges under §1001 may also occur in other transactions. In this regard, there is a large exception from the deemed exchange provisions for institutional transfers or assignments of derivative contracts issued on or after July 22, 2011, if:

• Both the party transferring or assigning the rights and obligations and the party to which the rights and obligations are transferred or assigned are either dealers in securities or clearinghouses;

• The terms of the derivative contract permit the transfer or assignment of the contract, whether or not the consent of the non-assigning counterparty is required for the transfer or assignment to be effective; and

• The derivative contract is not otherwise modified in a manner that results in a taxable exchange under §1001. [Reg. §1.1001-4(a)]


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Derivatives under this §1001 exception include an interest rate, currency or equity NPC; certain options, forward contracts, short positions and similar financial instruments as long as (1) not contracts marked-to-market under IRC §1256, or (2) that are not an identified hedge. Not all derivatives will fall under this exception where issuers are not dealers or clearing houses and deemed exchanges can occur.

Where derivatives are outside the exception and are potential ELIs, original issues and §1001 exchanges will need to be tested under the “delta” provisions.

III. What is excluded from the definition of “dividend equivalent”?

Exceptions from §871(m) include:

Domestic annuity, endowment, or life insurance contracts. The temporary regulations provide that there is no dividend equivalent associated with a payment that a foreign person receives pursuant to the terms of an annuity, endowment, or life insurance contract issued by a domestic insurance company (including the foreign or U.S. possession branch of the domestic insurance company). The IRS and Treasury felt that existing compliance requirements under IRC §1441 already substantially covered these payments.

For the time being, foreign annuity, endowment, or life insurance contracts. Consideration is still being given as to whether §871(m) should apply to annuity, endowment, and life insurance contracts that reference U.S. equities when issued by foreign life insurance companies. Until further guidance is issued, the temporary regulations provide that these contracts also do not include a dividend equivalent (1) when issued by a foreign corporation that is predominately engaged in an insurance business and that would be subject to tax under subchapter L if it were a domestic corporation, or (2) when received by a foreign life insurance company as a dividend equivalent when the payment is made according to the terms of an insurance contract, such as reinsurance, by a foreign corporation meeting the same requirements. Comments, particularly on reinsurance arrangements, has been requested.

Payment Referencing Distributions That Are Not Dividends. A payment referencing a distribution on an underlying security is not a dividend equivalent to the extent that the distribution would not be subject to tax pursuant to §871 or §881 if the party owned the underlying security directly. [See §1.871-15(c)(2)(i)] The regulations give as an example: when a NPC references stock in a mutual fund that pays a capital gains dividend that would not be subject to tax if paid directly to the long party, then an NPC payment is not a dividend equivalent to the extent that it is determined by reference to the capital gains dividend.

Section 305 Coordination. Under IRC §305, a change to the conversion ratio or price of a convertible security is treated as a distribution of property to which the dividend rules apply under §301. If a distribution is treated as a §305 dividend, existing Reg. §1.1441-2(d)(1) would require withholding without regard to the fact that there is no payment at that time. The final regulations clarify that a dividend equivalent with respect to a §871(m) transaction does not include any amount treated as a dividend under §305 with respect to the underlying security. The Preamble in TD 9734 says “if a change in the conversion ratio of


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a convertible security that is a §871(m) transaction is treated as a §305 dividend made to the holder of the convertible security, a dividend equivalent is reduced by the amount of the §305 dividend arising from such change. Although a transaction (for example, a change in conversion ratio of a convertible security) may give rise to both a dividend equivalent and a §305 dividend, dividend equivalents and §305 dividends have different characteristics.

Most believe that the increase of the “delta” to 0.80 will eliminate most if not all convertible bonds from classification as dividend equivalents and if true, since §305 is mostly a convertible bond matter, this interface has little value. The Preamble notes that most convertible debt instruments, including those that are convertible securities subject to §305(c), will not be covered by §871(m).

Due Bills after record date. The final regulations provide that a dividend equivalent does not include a payment made pursuant to a due bill that arises from the actions of a securities exchange that apply to all transactions in the stock and when the relevant exchange has set an ex-dividend date that occurs after the record to accommodate a special dividend.

Employee Compensation. Compensation is excluded from §871(m) treatment that is generally subject to withholding or has a specific exception from wage withholding. This exception will cover the portion of equity-based compensation for personal services of a nonresident alien individual that is wages subject to withholding under §3402, excluded from the definition of wages under Reg. §31.3401(a)(6)-1, or exempt from withholding under Reg. §1.1441-4(b). A restricted stock unit paid as compensation where tax is collected by the employer at the time of payment through withholding, will not be a dividend equivalent. The IRS notes that a different result will apply if the restricted stock unit results in the receipt of stock, and dividends are subsequently paid that would be subject to withholding under §871.

Certain Corporate Acquisitions. The final version of Reg. §1.871-15(j) retained the exception when a taxpayer enters into a transaction as part of a plan pursuant to which one or more persons (including the taxpayer) are obligated to acquire more than 50 % of the entity issuing the underlying securities. Comments to reduce the 50% to a lesser percentage were not adopted. The Preamble to TD 9734 expressly says “any party to the transaction that is a broker, dealer, or intermediary, a short party, or a withholding agent, must comply with any requirements in the final regulation to make appropriate determinations, and satisfy reporting and withholding obligations, as applicable.”

IV. Brokers, long and short parties to the transactions and information sharing provisions

Much of the information needed for testing securities under this new regime will be difficult to obtain on a timely basis. Many assumed after the 2013 proposed regulations that the burden to obtain this information, to make the calculations and to withhold and report would fall on the investor’s broker and that remains the most likely result of the final regulations even with the adjustments made in the final version of the regulations. The final regulations still provide if a broker or dealer is a party to a potential §871(m) transaction with a counterparty or customer that is not a broker or dealer, the broker or dealer is required to


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determine whether the potential §871(m) transaction is a dividend equivalent. If both parties to a potential §871(m) transaction are brokers or dealers, or neither party to a potential §871(m) transaction is a broker or dealer, the short party must determine whether the potential §871(m) transaction is a dividend equivalent. The party to the transaction that is required to determine whether a transaction is subject must also determine and report to the counterparty or customer the timing and amount of any dividend equivalent. All reporting must be made using reasonable diligence. [§1.871-15(p)]

Upon request, the party to the transaction must be supplied with the amount of each dividend equivalent, the “delta” of the potential §871(m) transaction, the amount of any tax withheld and deposited, the estimated dividend amount if specified, the identity of any transactions to be combined, and any other information necessary to apply the rules. The determinations are binding on the parties to the transaction and on any person who is a withholding agent with respect to the transaction unless the person knows or has reason to know that the information received is incorrect. The final regulations revised the period for providing requested information from 14 calendar days to 10 business days from the date of the request and allow parties to a transaction to obtain information on potential §871(m) transactions in a variety of ways, including through electronic publication (such as a website). [§1.871-15(p)]

Withholding is required on the amount of the dividend equivalent calculated. For purposes of determining whether a payment is a dividend equivalent and the timing and amount of a dividend equivalent under §871(m), a withholding agent may rely on the information received from the party to the transaction that is required to make those determinations, unless the withholding agent knows or has reason to know that the information is incorrect. When a withholding agent fails to withhold the required amount because the required party fails to reasonably determine or timely provide information regarding whether a transaction is a § 871(m) transaction, the timing and amount of any dividend equivalent, or any other required information, and the withholding agent relied, absent actual knowledge to the contrary, on that party's determination or did not timely receive required information, then the failure to withhold is imputed to the party required to make the determinations. The IRS may collect any underwithheld amount from the party to the transaction that was required to make the determinations or timely provide the information and subject that party to applicable interest and penalties as if the party were a withholding agent with respect to the payment of the dividend equivalent made pursuant to the § 871(m) transaction.

Like other recently issued tax regulations, to understand these regulations we need to learn a new vocabulary. Parties to the transaction are the ones entitled to information to support withholding compliance, and include a “long party”, a “short party” and either party’s agent or intermediary. A long party is defined as the party to a potential §871(m) transaction with respect to an underlying security that would be entitled to receive a payment of a dividend equivalent. A short party is defined as the party that would be obligated to make a payment of a dividend equivalent. A party to the transaction includes any person that is a long party or a


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short party, any agent acting on behalf of the long party or short party, or any person acting as an intermediary with respect to the transaction.

If a party is both a long party and a short party where the transaction references more than one underlying security, the long party and short party are determined separately with respect to each underlying security. A party would be both a long party and a short party when the party is entitled to a payment that references a dividend payment on an underlying security and the same party is obligated to make a payment that references a dividend payment on another underlying security pursuant to the transaction.

Although written estimates of dividends are not required, if prepared when a transaction is issued, the IRS believes a long party will be able to obtain the information from another party to the transaction, whether the short party or a broker. We will see. It will mean a great deal of cooperation between the parties involved, more than what is presently happening. Investor and issuer communication with intermediary brokers will be key to successful risk management.

A. Foreign transactions, new QDDs or chain of dividend withholding

Final Reg. §1.1441-7(a)(3) provides an example to use in sorting through who is a withholding agent on a dividend equivalent. “Example 7. CO is a domestic clearing organization. CO serves as a central counterparty clearing and settlement service provider for derivatives exchanges in the United States. CB is a broker organized in Country X, a foreign country, and a clearing member of CO. CB is a nonqualified intermediary, as defined in §1.1441-1(c)(14). FC is a foreign corporation that has an investment account with CB. FC instructs CB to purchase a call option that is a specified ELI … CB effects the trade for FC on the exchange. The exchange matches FC's order with an order for a written call option with the same terms. The exchange then sends the matched trade to CO, which clears the trade. CB and the clearing member representing the call option seller settle the trade with CO. Upon receiving the matched trade, the option contracts are novated and CO becomes the counterparty to CB and the counterparty to the clearing member representing the call option seller. To the extent that there is a dividend equivalent with respect to the call option, both CO and CB are withholding agents …”

Section 871(m)(1) treats a dividend equivalent as a dividend from sources within the United States and unlike the much older rules for substitute dividends, this result does not look to the residence of the person paying the dividend equivalent. Compliance will be required even for payments made by a foreign payers to a foreign payees. Section 871(m)(6) gave the Treasury discretion to reduce tax on a chain of dividend equivalents to the extent that the taxpayer can establish that tax has been paid with respect to another dividend equivalent in the chain, or is not otherwise due, or as it determines is appropriate to address the role of financial intermediaries in the chain. So there were two choices: follow the chain or develop a qualified intermediary category. Rather than create a new regime, the Treasury and IRS chose to expand the existing qualified intermediary (QI) regime to include a new qualified derivatives dealer (QDD).


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In Notice 2010-46, a framework was proposed to credit forward prior withholding on a chain of substitute dividends paid pursuant to a chain of securities loans or stock repurchase agreements. The Treasury and IRS are studying whether a credit forward system for prior withholding would be appropriate in the context of a chain of dividend equivalents on NPCs or ELIs. In the Preamble to TD 9734, IRS said it was having difficulties verifying that prior withholding in a chain of securities loans had in fact occurred in order to justify the crediting of that prior withholding. The temporary regulations have reserved on the issue of a general credit forward system, and the Treasury and IRS request comments. Until these temporary regulations are finalized and appropriate provisions are incorporated into a new QI agreement some time prior to 2017, the existing provisions for qualified securities lender (QSLs) and the credit-forward rules under Notice 2010-46 will continue to apply for dividend equivalents that are substitute dividend payments made pursuant to a securities lending or a sale-repurchase transaction. At some point in the near future, QSLs will be phased out and fully replaced by QDDs.

These are complex requirements as they relate to qualified intermediaries acting in the new category known as “Qualified Derivatives Dealers.” We reserve details on this topic to another white paper should we receive comments on the need to do so.

V. Determining a §871(m) dividend equivalent

A. Determination timing - when issued

Once you have determined the transaction is a potential §871(m) transaction, that is, that the transaction is a securities lending or sale-repurchase transaction, NPC, or ELI that references one or more underlying equity securities, the next step is to determine if it is actually a §871(m) transaction. In a change from the 2013 proposed regulations, the “delta” of a potential §871(m) transaction also must be determined only when the transaction is considered to be issued (see II.A. above). Each potential NPC or ELI must be tested same time frame that you determine whether the security is a potential §871(m) transaction Under the 2013 proposed regulations, the testing period would have applied also to each subsequent sale or disposition.

B. Application of “delta” test to a simple transaction

Meeting the “delta” test makes an NPC or ELI “specified” and covered under the §871(m) rules. “Delta” refers to the ratio of a change in the fair market value of a contract to a small change in the fair market value of the property referenced by the contract. Under the final requirements, only an NPC or ELI that has a “delta” of 0.80 or greater at the time it is issued is a withholdable specified NPC or specified ELI. The final regulations retained the “delta” test from the 2013 proposed regulations, but increased the threshold to 0.80 from 0.70, which will result in fewer instruments being identified as covered. 2

2 The 2012 proposed regulations as a precursor to the 2013 proposed regulations used a multi-factor test to determine whether an NPC or ELI was a specified contract subject to dividend treatment under §871(m). The 2013


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The “delta” test will only apply to “simple” contracts. Unlike we saw in the implementation of the cost basis regulations for debt and options, more complex §871(m) transactions will not be deferred, but instead will need to be tested differently. The “delta” ratio is intended to measure the sensitivity of the value of a “simple” contract to comparatively small changes in the market value of the referenced securities. Final regulations incorporated this qualification into the definition of “delta”, noting that typically, a small change is a change of less than 1 percent.

To be a “simple” contract, all amounts to be paid or received on maturity, exercise, or any other payment determination date are calculated by reference to a single, fixed number of shares of the underlying security, provided that the number of shares can be ascertained when the contract is issued. In addition, the contract must have a single maturity or exercise date with respect to which all amounts (other than any upfront payment or any periodic payments) are required to be calculated with respect to the underlying security. A contract is considered to have a single exercise date even though it may be exercised by the holder at any time on or before the stated expiration of the contract.

If a simple NPC or ELI contains more than one reference to a single underlying security, all references to that underlying security are taken into account in determining the “delta” with respect to that underlying security. The “delta” with respect to each underlying security must be determined without taking into account any other underlying security or property. The “delta” of an equity derivative that is embedded in a debt instrument or other derivative is determined without taking into account changes in the market value of the debt instrument or other derivative that are not directly related to the equity element of the instrument. So structured products will need to be broken apart for this test. The regulations give us an example where the “delta” of an option embedded in a convertible note is determined without regard to the debt component of a convertible note.

Even if a contract has more than one expiration date, or a continuous expiration period, it does not preclude the contract from being a simple contract. The Preamble to TD 9734 says that “An American-style option is a simple contract even though the option may be exercised by the holder at any time on or before the expiration of the option if amounts due under the contract are determined by reference to a single, fixed number of shares on the exercise date.” The IRS believes that most NPCs and ELIs are expected to be simple contracts and remain subject to the “delta” test in the final regulations.

Some examples from the regulations:

“Delta” calculation for an NPC. The terms of an NPC require LP to pay the short party an amount equal to all of the depreciation in the value of 100 shares of Stock X and an interest-rate based return. In return, the NPC requires the short party to pay LP an amount equal to all of the appreciation in the value of 100 shares of Stock X and any dividends paid by X on those shares. The value of the NPC will change by $1 for each $0.01 change in the price of a

proposed regulations replaced the multi-factor test with a single-factor test that employs a ‘‘delta’’ threshold to determine whether a transaction is covered.


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share of Stock X. When LP entered into the NPC, Stock X had a fair market value of $50 per share. The NPC therefore has a “delta” of 1.0 ($1.00 / ($0.01 x 100)). It is greater than 0.80 and thus will be a specified NPC subject to §871(m).

“Delta” calculation for an option. LP purchases a call option that references 100 shares of Stock Y. At the time LP purchases the call option, the value of the option is expected to change by $0.30 for a $0.01 change in the price of a share of Stock Y. When LP purchases the option, Stock Y has a fair market value of $100 per share. The call option has a “delta” of 0.30 ($0.30 / ($0.01 x 100)). It is less than 0.80 and thus will not be a specified ELI subject to §871(m).

B. Other tests and safe harbors

Short cut for “delta” calculations where contracts reference multiple underlying securities: If a short party issues a contract that references multiple underlying securities and uses an exchange-traded security, such as an exchange-traded fund, that references substantially the same underlying securities to hedge the contract at the time it is issued, the short party may use the hedge security to determine the “delta” of the security it is issuing rather than determining the “delta” of each security referenced in the basket. When the “delta” of a §871(m) transaction is determined this way, the per-share dividend amount for that transaction is determined using the dividend yield for the exchange-traded security that fully hedges the §871(m) transaction. This will approach will make compliance easier for larger basket transactions.

Complex NPC or ELI contracts: Any NPC or ELI that is not a simple contract is a complex contract. An ELI that does not provide the long party with an amount that is calculated by reference to a single, fixed number of shares on the maturity date that can be ascertained at issuance is not a simple ELI. An NPC or ELI that includes a term that discontinuously increases or decreases the amount paid or received (such as a digital option), or that accelerates or extends the maturity is also not a simple contract. For example, a structured note that uses a formula for calculating a return based on the performance of the underlying equities will be considered complex and under this rule. Temporary regulations create a special substantial equivalent test for calculating whether a complex contract will be subject to §871(m) using a benchmark hedge.

VI. Notes on convertible and contingent debt

The final regulations do not provide an exception from §871(m) for convertible or contingent debt so these instruments will need to be tested. But, the final regulations clarify that the “delta” of the convertible feature is tested separately from the “delta” of the debt instrument in making §871(m) calculations.

Per the Preamble, “when the stock price significantly exceeds the conversion price, convertible debt becomes a surrogate for the stock into which the debt can be converted. Accordingly, a convertible debt obligation is a specified ELI if the “delta” of the embedded option at the time the convertible debt is originally issued is 0.80 or higher.”


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Many believe the increase in the test threshold from 0.70 to 0.80 will eliminate most if not all convertible or contingent debt instruments from being classified as a dividend equivalent. The Preamble to the final regulations says “The effect of this rule [requiring testing] … is expected to be minimal because the “delta” of the embedded derivative in a contingent debt or convertible debt instrument is tested only at the time it is issued.”

From a withholding perspective, interest on contingent debt for the most part is already subject to 30% Chapter 3 withholding unless an interest-based treaty claim applies since for the most part it fails to qualify for the “portfolio interest” exemption under IRC §871(h)(4)(A)(i). TD 9734 has added a new provision to Reg. §1.871-14 beginning September 18, 2015, under which contingent interest will fail to qualify as portfolio interest to the extent that the interest is a dividend equivalent. If there is a dividend equivalent, the change will for the most part result in a switch from zero withholding to a dividend-based treaty claim resulting in some withholding on the dividend equivalent as most treaties reduce but do not eliminate withholding on dividends (unlike portfolio interest exemption or an interest-based treaty claim that usually result in “0” withholding) if appropriate W-8BEN or W-8BEN-E treaty claim is on file.

VII. Transitional effective dates

To ensure that financial institutions have adequate time to develop systems, the final and temporary §871(m) regulations were delayed and will become effective in 2017 for transactions issued on or after January 1, 2017. Transactions “issued” on or before December 31, 2015 are grandfathered from the final regulations. But, not all is forgiven for prior §871(m) transactions entered into in 2016. For these transactions, the regulations will apply to any payment of a dividend equivalent made in 2018 and later.

ALERT: The ELI in particular is a relatively new concept and most see identification of such a withholdable instrument to be a challenge. These final effective dates push out to 2017 any withholding requirements, but brokers will need to identify and track specified ELIs, starting for transactions entered into in 2016 to assure compliance on them in 2018.

The effective date was not extended for Reg. §1.871-15(d)(1)(i), covering existing specified notional principal contracts (SNPCs) as currently defined. An NPC that is now treated as a specified NPC will remain a specified NPC on or after January 1, 2017. The notions of simple testing using a “delta” of 0.80 and complex testing will first be effective for SNPC contracts issued in 2017.

For stock loans and stock sale-repurchase transactions, Notice 2010-46 will continue to apply until the new Qualified Derivatives Dealer (“QDD”) classification is finalized.

The chapter 4 (FATCA) regulations were coordinated to be effective when effective for dividends under the §871(m) regulations and when effective for SNPCs. For FATCA grandfathering provisions, Reg. §1.1471-2(b)(2)(i)(A)( 2) will apply to obligations that are executed on or before the date that is six months after the date on which obligations of its type are first treated as giving rise to dividend equivalents.


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VIII. What is a “payment” for purposes of defining a dividend equivalent?

Under § 871(m)(5), a “payment” includes any gross amount that references a U.S. source dividend and that is used to compute any net amount transferred to or from the taxpayer. Following the 2013 proposed regulations, the final regulations expanded upon the statutory definition. Withholding will apply to any gross amount that references the payment of a dividend, whether actual or estimated, explicit or implicit to the extent of the amount determined to be a dividend equivalent. [See §1.871-15(i)(2).] For example, a payment would include a settlement payment on a price-only contract even if paid by the long party (defined as the party entitled to receive the payment). So it will not really matter which direction the payment is being paid.

Under this definition, a payment includes an actual or estimated dividend payment that is implicitly taken into account in computing one or more of the terms of a potential §871(m) transaction, including interest rate, notional amount, purchase price, premium, upfront payment, strike price, or any other amount paid or received pursuant to the potential § 871(m) transaction.

A short party to a transaction is treated as paying a per-share dividend amount equal to

the actual dividend amount unless the short party identifies a reasonable estimated dividend

amount in writing at the time the transaction is issued. To qualify as an estimated dividend

amount, the written estimated dividend amount must separately state the amount estimated

for each anticipated dividend or state a formula that allows each dividend to be determined. A

reasonable estimated dividend amount stated in an offering document or the documents

governing the terms at the time the transaction is issued will also establish the estimated

dividend amount.

If an underlying security is not expected to pay a dividend, a reasonable estimate of the

dividend amount may be zero. If a potential §871(m) transaction provides for a payment based

on an estimated dividend that adjusts to account for the amount of an actual dividend paid, the

payment is treated as referencing the actual dividend amount and not considered to be an

estimated dividend amount.

Any payment in addition to an estimated dividend if determined by reference to a dividend is added to the estimated dividend to determine the per-share dividend amount. For example, a special dividend would also be part of the per-share amount.

This broad definition of “payment” covers when amounts are reflective of a dividend benefit even if not technically paid, such as when the dividend right is embedded in a price reduction (reflects an estimated dividend) or when a foreign investor is not required to pay because of benefit of the dividend offsets their lability. If withholding was required at these points where there is no cash to withhold against, realistically, it would be impossible to withhold. Recognizing this difficulty, the IRS extended the timing for, but did not forgive withholding in the final regulations.


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Alert: The end result is that even if there is no “payment” of a dividend equivalent to the foreign investor, a withholding obligation may arise and must be tracked until an event arises that allows the withholding. See X below.

IX. When and how are §871(m) withholdable amounts calculated on payments?

The value of a dividend equivalent is determined on the earlier of the record date of the dividend or the day prior to the ex-dividend date with respect to the dividend. For example, to determine the portion of dividend equivalent in a SNPC settlement payment, you would determine the dividend equivalent value on the earlier of the dividend record date or the day prior to the ex-dividend date for the dividend.

In making the determination, the number of shares of an underlying security generally is the number of shares of the underlying security stated in the contract adjusted to take into account any factor, fraction, or other modification specified in the contract. For example, in a transaction in which the long party receives or makes payments based on 200 percent of the appreciation or depreciation of 100 shares of stock, the number of shares of the underlying security is 200 shares of the stock.

The calculation formulas are:

For a securities lending or sale-repurchase transaction, the amount of the dividend equivalent for each underlying security equals the amount of the actual per-share dividend paid on the underlying security multiplied by the number of shares of the underlying security.

For simple SNPC and SELIs, the amount of the dividend equivalent for each underlying security equals the per-share dividend amount with respect to the underlying security multiplied by the number of shares of the underlying security multiplied by the “delta” of the transaction at the time the contract was issued (not at the point of dividend payment as was proposed in 2013 regulations) with respect to the underlying security. The final regulations eliminated the special rule for contracts with terms of one year or less as was proposed in the 2013 regulations.

[Formula: per-share dividend X # of shares referenced in the contract X delta measured when issued if 0.80 or greater]

Example from regulations for forward contract to purchase domestic stock. When Stock X is trading at $50 per share, Foreign Investor enters into a forward contract to purchase 100 shares of Stock X in one year. Reasonable estimates of the quarterly dividend are specified in the transaction documents. The price in the forward contract is determined by multiplying the number of shares referenced in the contract by the current price of the shares and an interest rate, and subtracting the value of any dividends expected to be paid during the term of the contract. Assuming that the forward contract is priced using an interest rate of 4 percent and total estimated dividends with a future value of $1 per share during the term of the forward contract, the purchase price set in the forward contract is $5,100 (100 shares x $50 per share x 1.04 - ($1 x 100)). The estimated dividend amount is


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the per-share dividend amount because the estimate is reasonable as specified in the regulations. The estimated per-share dividend amount is a dividend equivalent.

For a complex contract, the amount of the dividend equivalent for each underlying security equals the per-share dividend amount with respect to the underlying security multiplied by the initial hedge for the underlying security. [Formula: per-share dividend X # of shares in initial hedge]

Shortcuts for larger transactions. Along with the simplified “delta” approach covered above, there are other options for large basket transactions. In this regard, a qualified index will not be treated as an underlying security. There is a complex set of limiters in the definition, including the index must reference 25 or more long securities (but there is a de minimis exception). No underlying security may make up greater than 15% of the basket and five or fewer underlying securities together may NOT make up greater than 40% of the basket. The index not provide for a previous year dividend yield greater than 1.5 times the dividend yield of S&P 500 Index for previous calendar year, and the index must be traded through futures or option contracts on an SEC registered exchange, CFTC designated domestic board of trade, or a limited number of foreign exchanges or boards of trade.

In calculating the payment amount for baskets of income with more than 25 underlying securities, the short party may treat the dividends with respect to the referenced underlying securities as paid at the end of the applicable calendar quarter to compute the per-share dividend amount. In addition, if the transaction references the same underlying securities as a security (for example, stock in an exchange-traded fund) or index for which there is a publicly available quarterly dividend yield, the publicly available dividend yield may be used to determine the per-share dividend amount with any adjustment for special dividends.

For the most part, the Treasury and IRS also kept the provisions for use of qualified indexes saying that the rule provides a safe harbor for transactions on passive indices that reference a diverse basket of securities and that are widely used by numerous market participants. To make the rules easier to administer, the final regulations provide that the determination of whether an index is a qualified index is made on the first business day of each calendar year, and that determination applies for all potential §871(m) transactions issued during that calendar year.

Remember that payments are first subject to the FATCA requirements, but even if the payee is exempt from FATCA withholding, a dividend equivalent is treated for Chapter 3 withholding purposes the same as a U.S-source dividend. If the payee has provides a W-8BEN or W-8BEN-E with a viable treaty claim, treaty rates for dividends may be used to lower withholding, but there are still some questions surrounding treaty claims and counsel advice should be sought to assure treaty benefits are available on specific transactions.

X. Timing of FATCA and Chapter 3 withholding and other requirements


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There is a different rule for when to withhold. Although you must calculate the withholding based on the event, final regulations provide that a withholding agent will not be required to actually withhold on a dividend equivalent until the later of (1) when a payment is made on the transaction or (2) when the amount of a dividend equivalent is determined. The IRS believes that a payment with respect to a § 871(m) transaction will generally occur when the long party receives or makes a payment, when there is a final settlement of the §871(m) transaction, or when the long party sells or otherwise disposes of the §871(m) transaction. Under the 2013 version of the regulations, the timing of withholding occurred prior to any cash payments when the amount of a dividend equivalent was fixed pursuant to the terms of the transaction, resulting in withholding always being a retroactive event and placing liabilities on the broker’s books for late deposits, etc. This new final rule is intended to prevent that result. It will however, pose constraints to brokers since they will need to be able to override their system codings to allow for the right withholding treatment and the capture of the proper character of the portion of the payment subject to this withholding for 1042-S reporting purposes.

For options and other contracts that typically require an upfront payment, the final regulations do not treat the option premium or other upfront payment as a payment for withholding purposes. So for these transactions, no withholding is required until there is a final settlement (including, in the case of an option, a lapse) or where the long party sells or otherwise disposes of the option. It is this result that will cause brokers to need to rethink their processing of gross proceeds. See discussion in the preamble to this paper.

ALERT: Lapses of an option will require the short to withhold on any dividend equivalent associated with the option. The IRS suggests that parties may need to modify contractual arrangements to ensure that there are sufficient funds available to satisfy withholding obligations.

Special withholding rule to be used in identifying when transactions are to be combined. The final regulations also retained the general rules from the 2013 proposed regulations that define when transactions are to be combined when a long party (or a related person) enters into two or more transactions that reference the same underlying security and the transactions were entered into in connection with each other. Recognizing the challenges that short parties could face in identifying transactions to be combined, brokers acting as short parties were given two presumptions they can apply to determine their liability to withhold. First, a broker may presume that transactions are not entered into in connection with each other if the long party holds the transactions in separate accounts. Second, a broker may presume that transactions entered into two or more business days apart are not entered into in connection with each other. These presumptions are independent of each other. Thus, a broker acting as a short party is relieved of the obligation to withhold if either of the two presumptions is met. A broker cannot rely on the first presumption if it has actual knowledge that the long party created or used separate accounts to avoid withholding, and neither presumption applies if the broker has actual knowledge that transactions were entered into in connection with each other.


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Who is liable? As pointed out in IV above, withholding is required on the amount of the dividend equivalent calculated. For purposes of determining whether a payment is a dividend equivalent and the timing and amount of a dividend equivalent under § 871(m), a withholding agent may rely on the information received from the party to the transaction that is required (as provided in §1.871-15(p)) to make those determinations, unless the withholding agent knows or has reason to know that the information is incorrect. When a withholding agent fails to withhold the required amount because the required party fails to reasonably determine or timely provide information regarding whether a transaction is a § 871(m) transaction, the timing and amount of any dividend equivalent, or any other required information, and the withholding agent relied, absent actual knowledge to the contrary, on that party's determination or did not timely receive required information, then the failure to withhold is imputed to the party required to make the determinations. The IRS may collect any underwithheld amount from the party to the transaction that was required to make the determinations or timely provide the information and subject that party to applicable interest and penalties as if the party were a withholding agent with respect to the payment of the dividend equivalent made pursuant to the §871(m) transaction.

XI. Special tax reporting and recordkeeping

The 2015 version of the 1042-S instructions define and require special reporting of dividend equivalent payments. If you are paying substitute dividend payments, you are to use income code 34 unless the substitute payments relate to dividends from certain actively traded or publicly offered securities and you have reduced the rate of withholding under an income tax treaty without the recipient supplying a U.S. or foreign TIN on the submitted W-8BEN or W-8BEN-E. For other U.S.-source dividend equivalent payments under §871(m) that are not substitute payments use income code 40.

Form 1042 instructions require you to report in Line 62a the sum of all amounts shown on Form 1042-S, box 2 that are payments of U.S. source FDAP income, minus the sum of all amounts that are U.S. source substitute payments. Line 62b (1) requires you to report the sum of all amounts shown on Form 1042-S, box 2 that are U.S. source substitute dividend payments. In Line 62b (2) you report an amount equal to the total of all amounts shown on Form 1042-S, box 2 that are U.S. source substitute payments other than substitute dividend payments. There are also special reporting requirement should you pay or be a QSL. For now, these reporting requirements are pursuant to Notice 2010-46.

The new regulations generally cross-reference the recordkeeping rules in §1.6001-1 for how a taxpayer establishes whether a transaction is a §871(m) transaction and whether a payment is a dividend equivalent. The final regulations also provide more detailed recordkeeping rules. Any person required to retain records must keep sufficient information to establish whether a transaction is a §871(m) transaction and the amount of a dividend equivalent. To satisfy this requirement, a taxpayer must retain documentation and work papers supporting a “delta” calculation or substantial equivalence calculation (including the number of shares of the initial hedge) and written estimated dividends (if any). The records and


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documentation must be created substantially contemporaneously with the time the potential §871(m) transaction is issued.

XII. Strategies and approaches

Brokers have many assignments ahead to meet the deadlines under these new provisions. To name a few:

1. Identify financial products for “delta” testing that could be considered potential §871(m) transactions, distinguishing simple from complex transactions, retaining issue dates for transitional effective date applications. Find ways to earmark the products in the security master files to enable necessary tracking is accessible by all necessary systems.

This is probably the hardest of the tasks ahead. Until now, there has been a whole list of securities that we did not have to worry about when it came to processing chapter 3 withholding and 1042-S reporting, that is, the list of securities that never paid withholdable income. This list will need to be rethought as many securities that at one time were on this list might now be considered a potential specified “equity linked investment” or “ELI” that could pay dividend equivalents and that now will need to be considered under FATCA and chapter 3. The challenging products under the ELI rules include regulated futures and other securities futures contracts as well as forward contracts, and many structured and derivative finance products.

For many retail brokers, the big target under §871(m) is options, including traditional puts and calls, §1256 options and non-§1256 options, over-the-counter options, basket options, options on one or more specified equities, indexed options if substantially all the components of the index are specified equity securities, options on financial attributes of specified equity securities where the price moves with the dividend, warrants and stock right as long as determined by the broadly defined reference to a U.S.-source dividend, etc. If a combination of products produces a dividend equivalent, then you will only need to look at positions in the same account, much like the rules applied to adjust cost basis, unless tax avoidance is seen at issue.

Except for specified notional principal contracts, many financial products captured by the new §871(m) requirements also fall under IRC §6045, requiring 1099-B reporting of gross proceeds from their sales or other dispositions when paid to U.S. persons, particularly with the addition of 1099-B reporting on options and §1234B securities futures contracts, including single stock futures. As we work through the cost basis tasks and 1099-B realignment for these securities, consider also earmarking them for 871(m) compliance.

Another troubling note is that there may be a need to cross over the existing security codings in your master file when applied to non-U.S. investors, switching from a coding indicating the security is debt that pays “interest” to an equity coding designation of payment of “dividends” only for NRAs to enable the applications of the proper treaty rates for withholding and the proper income codes on the 1042-S. Remember that some


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structured debt is indexed to dividends and the new rules will also possibly capture a few convertible bonds.

2. Develop modules that:

Determine or capture the delta on issuance and record keep the information as part of the securities master,

Track specific amounts subject to withholding to the cash event requiring withholding,

Earmark the transitional effective dates.

Earmark presumption applications and protocols that could apply to avoid withholding and find systemic ways to identify them.

When considering when transactions are to be combined, remember that brokers acting as short parties were given two presumptions they can apply to determine their liability to withhold. First, a broker may presume that transactions are not entered into in connection with each other if the long party holds the transactions in separate accounts. Second, a broker may presume that transactions entered into two or more business days apart are not entered into in connection with each other. These presumptions are independent of each other. Thus, a broker acting as a short party is relieved of the obligation to withhold if either of the two presumptions is met. A broker cannot rely on the first presumption if it has actual knowledge that the long party created or used separate accounts to avoid withholding, and neither presumption applies if the broker has actual knowledge that transactions were entered into in connection with each other.

Apart from worrying about the FATCA applications to gross proceeds now pushed off to 2019, it has been relatively easy to segregate FATCA and chapter 3 withholding and reporting responsibilities on the security’s income from the mutually exclusive tasks associated with reporting and possible backup withholding on gross proceeds under §6045 when the security was sold or otherwise disposed of. With the advent of these new regulations, this will no longer be true since withholding could cross over and be required on the dividend equivalent portion of the sales proceeds, such as in the context of the substitute dividend repurchase transactions and also on any amount of proceeds where there are outstanding withholdings on dividend equivalent amounts still due. There is also a timing disconnect between when you are required to calculate the dividend equivalent withholdable amount and when withholding is required, deferring withholding to an event with cash flow so systems will be need to track the calculation event to the cash flow.

3. Consider how you will store and maintain records at each issue date, remembering listed options are “issued” when purchased or written. Also consider how you plan to document your ELI links to referenced securities or qualified indexes.

4. Consider what modifications will be needed to link the dividend equivalents to payments in dividend, reorg, stock loan, swap and derivative systems to handle withholdable amounts and to accommodate withholding when events occur that require withholding on those amounts.


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5. Consider application of treaty benefits to amounts not normally considered “dividends” subject to documented claims.

6. Data flows to Forms 1042-S and 1042 need to be revamped.

7. Make changes to client documentation process for those that invest in products subject to §871(m) since even the undocumented payee presumption standards will vary on these products from what is currently coded. Withholding as a dividend will be required on sales proceeds. Certain entities that fail to provide a form in the W-8 series (or in some cases even domestic entities that fail to provide a W-9) will be presumed foreign, but the presumptions that apply to make these determinations will vary if the amounts are considered dividends from the presumptions that apply to gross proceeds.

8. Review your contracts and representations to be in compliance with new rules and what you can support. Will this require new disclosures on confirmations?

9. If you are in between parties, consider how you will manage the noticing requirements. As a broker, you will need to be prepared to pass issuer information, such as delta calculations and through to your investors. Although written estimates of dividends are not required, if prepared when a transaction is issued, the IRS believes a long party will be able to obtain the information from another party to the transaction, whether the short party or a broker. We will see. It will mean a great deal of cooperation between the parties involved, more than what is presently happening. Investor and issuer communication with intermediary brokers will be key to successful risk management.

8. Consider how you will re-educate your staff and your clients. Don’t forget new client statement categories.

Section 871(m) compliance will impact not just areas involved in tax processing, and in equities, reorg and fixed income operations, but also prime broker and institutional broker desks, stock loan areas, custody, hedging and collateral operations, investment and wealth management, and importantly the legal and tax counsels for all of these areas.

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