On September 17, 2015, the IRS issued final regulations (the “Final Regulations”) requiring withholding on certain dividend equivalent payments beginning January 1, 2017. (Please see our prior newsletter regarding the delay of imposing withholding on dividend equivalents.) The Final Regulations reflect some important changes suggested in comments to the IRS following the issuance of the previously proposed regulations. The IRS also issued new temporary regulations (the “Temporary Regulations”) to address complex derivatives.
The Final Regulations and the Temporary Regulations are effective as of September 18, 2015, but generally apply to transactions entered into on or after January 1, 2017. Most pre-existing transactions are grandfathered. Transactions entered into before 2016 are not subject to withholding. Transactions entered into during 2016 are subject to withholding on dividend equivalents for payments made on or after January 1, 2018.
Changes to the Delta Test
Whether the dividend equivalent rules apply to a contract depends on the contract’s “delta” – i.e., the ratio of change in value of the contract to a change in the value of the underlying property. The Final Regulations increase the “delta” required for withholding from 0.7 in previously proposed regulations to 0.8, thus generally narrowing application of the rules to contracts that more closely resemble the underlying security. The Final Regulations also remove the requirement that delta be retested each time a contract is acquired, providing instead that delta is tested only on issuance.
The Final Regulations only apply to “simple contracts” – i.e., those referencing a single, fixed number of shares of one or more issuers. The Temporary Regulations set out a different test for complex contracts.
The Final Regulations also make the following noteworthy changes and clarifications:
- Certain deemed dividend rules are coordinated to avoid double withholding;
- Estimated and implicit dividends are treated as dividend equivalents;
- Certain derivatives on an expanded group of qualified indices (including the S&P 500) are excepted from dividend equivalent withholding;
- Derivatives referencing partnership interests are only subject to dividend equivalent withholding if the partnership is a dealer or has significant investments in securities; and
- Withholding is not required until an actual payment is made or a transaction is settled (excluding premiums and other upfront payments).
More complex derivatives are subject to the new “substantial equivalence” test set out in the Temporary Regulations, which compares the delta as between the contract and the underlying property that would be used to hedge it against a simple contract benchmark with a delta of 0.8. The Temporary Regulations also exclude some insurance contracts from the withholding rules.
Impact of the Regulations
The Final Regulations and the Temporary Regulations are the latest in a series of regulations issued or proposed under Section 871(m). Prior proposed regulations have delayed the effective date of expanded withholding and have generated significant comments. The impact of the regulations on the market for such instruments and the views of the industry remain to be seen.