Broader U.S. Withholding on Dividend Equivalent Amounts is Effective Beginning on January 1, 2017, for Agreements Entered Into On or After Such Date
Section 871(m) of the U.S. Internal Revenue Code of 1986, as amended, was enacted in 2010 and imposes a 30% U.S. withholding tax (subject to reduction by an applicable tax treaty) on dividend equivalent amounts paid (or deemed paid) on certain swaps and equity linked instruments referencing U.S. equities if the long party to the instrument is a non-U.S. person under U.S. tax law (such as an offshore hedge fund). For example, beginning January 1, 2017, if your offshore fund (directly or through a master fund) enters a swap referencing a U.S. corporation, then payments on the swap referencing dividends paid on the underlying stock or adjustments to the terms of the swap to take into account such dividends would be subject to 30% U.S. tax withholding.
Final regulations and temporary regulations under Section 871(m) were issued by the IRS on September 17, 2015. (Please click here to see our prior newsletter discussing the final and temporary regulations under Section 871(m).)
The IRS has recently indicated that it will issue guidance before the end of the year which will delay the effective date to January 1, 2018, for instruments other than instruments with a delta of one (i.e., other than for derivatives that vary 100% with the value of the referenced securities).
Law and Background
Section 871(m) generally applies to securities lending and repo transactions, specified notional principal contracts (e.g., equity swaps on U.S. equities) and specified equity linked instruments. An equity linked instrument is a financial transaction that references the value of one or more underlying securities. Specified equity linked instruments include futures, forwards, options, convertible debt and other contractual arrangements, in each case which reference U.S. equities.
Under the final regulations, notional principal contracts and equity linked instruments are classified as either simple or complex. Simple contracts are subject to withholding where the delta of the contracts is 0.8 or higher. A contract is a simple contract if it references a single, fixed number of shares of one or more issuers. The delta of a transaction is the ratio of the change in value of the contract to a change in value of the underlying securities. Complex contracts (i.e., contracts other than simple contracts) are tested under a substantial equivalence test that measures whether the performance of the complex contract closely tracks the performance of the underlying securities.
If two or more contracts are entered into in connection with each other, the contracts may be combined and treated as subject to Section 871(m). For example, two contracts may not be subject to 871(m) independently but when combined may be subject to withholding. The combination rules are complicated and difficult to apply.
The regulations do not require withholding on dividend equivalent amounts made with respect to a qualified index, which is generally a broad based index such as the S&P 500.
Transactions entered into before January 1, 2017, are grandfathered and generally will not be subject to withholding under the final regulations (but may be subject to withholding under existing law, i.e., crossing in or out, private securities, or where the underlying security is posted as collateral). A modification of a grandfathered transaction may cause the transaction to no longer be grandfathered.
What to Do
Offshore hedge funds should identify their transactions that may be subject to Section 871(m) and estimate the amount of withholding tax that may be imposed.
Offshore funds considering entering into such transactions may wish to enter into them before January 1, 2017, so that they are grandfathered.
Domestic funds with foreign investors will also need to consider the effect of Section 871(m).
If a hedge fund’s counterparty to a transaction is a broker or dealer, then the broker or dealer is responsible for determining whether Section 871(m) applies (i.e., calculating the delta of the transaction) and the timing and amount of any withholding. If both parties or neither party is a broker or dealer, then the short party must determine whether Section 871(m) applies.
A hedge fund that is the short party to an 871(m) transaction may be a withholding agent. However, if the transaction is cleared on an exchange or made through a broker or dealer, the clearing organization or broker may also be a withholding agent. If a hedge fund fails to withhold because the broker or dealer either fails to determine that a transaction is subject to Section 871(m) or fails to provide information regarding the timing and amount of any withholding, then the IRS may collect any underwithheld amount from the broker or dealer that was required to make such determination or provide such information. As a practical matter, it may be that 871(m) withholding is generally done by brokers or dealers.
Where a hedge fund is a party to an 871(m) transaction and the counterparty is not a broker or dealer, the fund may have significant obligations, including determining delta and the timing and amount of withholding. A hedge fund that is the short party to a derivative should determine if any of its counterparties are not brokers or dealers and whether the hedge fund is able to comply with any computational, withholding and information reporting obligations it may have with respect to its transactions with those counterparties.
ISDAs have generally been amended or are in the process of being amended to provide that withholding under Section 871(m) is not required to be grossed up. Hedge funds should review their ISDA documentation to determine who bears the risk of withholding tax imposed by Section 871(m) and whether their ISDAs need to be amended. Most funds have not adhered to the ISDA 2015 Section 871(m) protocol, although some funds are considering doing so.
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