Global Tax Alert | 6 December 2013

US IRS releases Section 871(m) final and proposed regulations on dividend equivalent payments on notional principal contracts and other equity-linked instruments

  • Share

Executive summary

On 4 December 2013, the Treasury Department and the Internal Revenue Service released final (T.D. 9648) (the final regulations) and proposed (REG-120282-10) regulations (the 2013 proposed regulations) under Section 871(m). In general, the final regulations merely extend the applicability of the four factor statutory definition of specified notional principal contract (specified NPC) to payments made before 1 January 2016. The 2013 proposed regulations, however, would streamline the definition of specified NPC at the cost of expanding the scope of Section 871(m) far beyond that contemplated by the proposed regulations issued in 2012 (the 2012 proposed regulations).

Detailed discussion


Payments on notional principal contracts (NPCs) are generally sourced by reference to the residence of the recipient, thus generally exempting from US withholding tax payments made to a non-US person under an NPC. In 2010, however, Congress enacted Section 871(m), which treats certain dividend related payments made on NPCs as US-source income and subject to withholding when paid to a non-US person. In particular, gross “dividend equivalent” amounts between 4 September 2010 through 18 March 2012 on an NPC would be US source if the NPC possessed at least one of the following features:

  • A “cross-in” (where the long party transfers the underlying securities to the short party in connection with entering into such a contract)
  • A “cross-out” (where the short party transfers the underlying securities to the long party upon termination of the contract)
  • The underlying security was not “readily tradable on an established securities market” or
  • In connection with entering into the NPC, the underlying security is posted as collateral by any short party to any long party

Under Section 871(m), payments made after 18 March 2012 on any NPC would be subject to withholding unless the Secretary determined that the contract did not have a tax avoidance potential.

On 23 January 2012, the Treasury Department and the IRS released temporary (T.D. 9572) and proposed (REG-120282-10) regulations (the 2012 proposed regulations) providing guidance under Section 871(m). The temporary regulations extended the interim statutory definition of a specified NPC from 18 March 2012 until 31 December 2012. Later temporary regulations further extended this date to 31 December 2013. The 2012 proposed regulations provided a seven factor test for when an NPC would be considered a specified NPC and also subjected certain non-NPC “equity linked instruments” (ELIs) to withholding tax under Section 871(m).

Final regulations and 2013 proposed regulations

The final regulations further extend the effectiveness of the statutory four factor regime to cover payments (including calculations of payments) made on or before 31 December 2015. The proposed regulations withdraw the 2012 proposed regulations and provide new rules, which radically depart from the 2012 proposed regulations in two major respects. First, while the 2013 proposed regulations abandon the complicated seven factor test for a specified NPC, they substantially expand the types of derivatives that can potentially produce US source payments. The 2013 proposed regulations adopt an entirely different approach than the 2012 proposed regulations: they nod in the direction of improved administrability and adopt an approach based on economic analysis rather than the mechanics of who holds what position when. Second, the class of payments that will be considered to reflect dividends on the underlying US equity has also been considerably expanded.

Specified NPCs and ELIs under the 2013 proposed regulations

The proposed regulations expand the definition of a dividend equivalent to include (1) any payment made pursuant to a specified NPC that references a US source dividend payment or (2) any payment made pursuant to a specified ELI that references a US source dividend payment. For this purpose, an ELI is defined as a financial transaction, other than securities lending or sale-repurchase transaction or an NPC that references the value of one or more securities. An ELI includes forwards, futures, options, debt instruments convertible into underlying securities, and debt instruments with payments linked to underlying securities.

An ELI or an NPC will be specified if it has a delta of 0.70 or greater with respect to a US stock when the long party acquires or enters into the transaction. The delta of an NPC or ELI is the ratio of the change in fair market value of the NPC or ELI to the change in the fair market value of the property referenced by the NPC or ELI. The proposed regulations provide that if the delta of an NPC or an ELI is not reasonably expected to vary during the term of the transaction, the NPC or ELI has a constant delta deemed to be 1.0 with the number shares of the underlying security adjusted to reflect the constant delta of 1.0.

The proposed regulations treat multiple transactions as a single transaction 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. Thus, for example, a long call option and a short put option will be aggregated to determine the delta.

Payment and calculation of dividend equivalent

Unlike the 2012 proposed regulations, the 2013 proposed regulations provide that a payment of a dividend equivalent includes any amount that references an actual or estimated payment of dividends, whether the reference is explicit or implicit. 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 Section 871(m) transaction, including interest rate, notional amount, purchase price, upfront payment, strike price or any other amount paid or received pursuant to the potential Section 871(m) transaction. Thus, for example, a price return swap (which, unlike a total return swap, does not adjust during the term for actual dividends on the underlying reference stock) normally would be a specified NPC or ELI because the parties would take expected dividends into account when striking the terms and it likely would have a delta at or near 1.0.

For a specified NPC or a specified ELI, the dividend equivalent is equal to the per share dividend amount with respect to the underlying security multiplied by the number of shares of the underlying security referenced in the contract multiplied by the delta of the transaction at the time the amount of the dividend equivalent is determined. The proposed regulations provide that the amount of the dividend equivalent is determined on the earlier of the ex-dividend date or the record date for the dividend. If the Section 871(m) transaction has a term of one year or less, the amount of the dividend equivalent is determined when the long party disposes of the transaction.


The proposed regulations also contain a broad anti-abuse rule which allows the Commissioner to treat any payment made with respect to a transaction as a dividend equivalent if the taxpayer acquires a transaction with a principal purpose of avoiding the application of these rules.


Withholding agents will be required to perform withholding to the extent a payment is reclassified as US source. This will be troublesome for withholding agents that are not parties to the transaction, since they might have no way of knowing whether a particular transaction is a specified NPC or a specified ELI.

Effective date

In general, the proposed regulations will apply to payments made on or after the date the regulations are finalized. The definition of specified NPC will apply to payments made pursuant to a specified NPC on or after 1 January 2016. There is no limitation as to when the specified NPC is entered into, so the proposed regulations could apply to current NPCs that have payments after 1 January 2016. For specified ELIs, in contrast, the proposed regulations will apply to payments made on or after 1 January 2016, but only with respect to an ELI that was acquired or entered into by the long party on or after 90 days after the publication of proposed regulations. Thus, the

proposed regulations could apply to specified ELIs entered into after 4 March 2014.


Final regulations

While the continuation of the four-factor test means that taxpayers will not face a new taxing regime under Section 871(m) until 2016, taxpayers still need to ensure that their NPCs are not specified NPCs under this test. Additionally, taxpayers should continue to be aware that their current transactions could be challenged under existing judicial doctrines, such as common law ownership of the stock underlying the NPC.

Proposed regulations

If the 2013 proposed regulations are finalized in their current form, dividend-related payments on all delta one derivatives over US equities will be subject to US withholding tax in the hands of non-US investors. Moreover, payments on many non-delta one derivatives will also be subject to such tax, because the delta necessary for exemption (i.e., a delta below 0.70) is fairly low. Additionally, even a taxpayer who enters into a derivative that does not provide for dividend linked payments at all could be subject to withholding tax on payments deemed to have been made under such derivative. Moreover, because the 2013 proposed regulations will apply to payments made on specified ELIs entered into after 4 March 2014 and to payments on specified NPCs, regardless of when they were entered into, taxpayers should start considering the application of the proposed regulations to their current and contemplated transactions.

For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP, International Tax Services — Capital Markets, Washington, DC
  • David Golden
    +1 202 327 6526
  • Alan Munro
    +1 202 327 7773
  • Matthew Stevens
    +1 202 327 6846
  • Petya Kirilova
    +1 202 327 6075
Ernst & Young LLP, International Tax Services — Capital Markets, Boston
  • Matthew Blum
    +1 617 585 0340
Ernst & Young LLP, International Tax Services — Capital Markets, New York
  • Karla Johnsen
    +1 212 773 5510
  • Menna Eltaki
    +1 212 773 5193

EYG no. CM4024