In 2010, the US Congress adopted the Hiring Incentives to Restore Employment (Hire) Act which imposed US withholding tax on dividend equivalents embedded in certain cross-border equity swaps that are paid by US persons to foreign counterparties. At the same time, Congress gave the US Treasury authority to expand the scope of the Hire Act US withholding tax rules to other equity derivative instruments. Since then, the Treasury Department has floated a number of proposals to do just that; however, none of the proposals have had much traction. On December 5 2013, the Internal Revenue Service (IRS) proposed a wholly new approach and issued new proposed regulations under the Internal Revenue Code to expand the US withholding tax rules to dividend equivalents on derivatives, including forwards, options, and structured notes. Most surprisingly, the Treasury put a date on the proposed rules: if finally adopted, they will apply from 2016 to payments on certain equity-linked instruments (ELIs) acquired on or after March 5 2014.
The new proposed regulations introduce a single factor test for determining when an instrument has the potential for tax avoidance through payment of dividend equivalent amounts. The single factor test asks whether a swap or ELI has a so-called delta of .70 or greater. If so, the proposed regulations treat payments on the instrument that reference dividends paid on a US corporation's stock as dividend equivalents that are subject to US withholding tax. A swap or ELI's delta is the ratio of the change in the fair market value of the instrument to the change in the fair market value of the underlying property referenced by the instrument. If adopted as final regulations, the proposed regulations would apply to payments on or after January 1 2016 with respect to swaps and ELIs that meet the new single factor test.
Further highlights of the proposed regulations include:
- ELIs include futures, forwards, options, debt instruments and other contractual arrangements (such as structured notes) that reference the value of underlying securities;
- The regulations will apply to payments made on or after January 1 2016 on ELIs acquired by a long party on or after March 5 2014. Accordingly, an ELI already outstanding or issued before March 5 2014 will be subject to the new rules if it is acquired by a secondary market purchaser on or after March 5 2014. This limited grandfather for instruments acquired before March 5 2014, however, does not apply to swaps.
- Swaps and ELIs with a delta that is "not reasonably expected to vary" during the term of the transaction are treated as having a delta of 1.0.
- For purposes of determining whether a swap is subject to the proposed rules, the delta of a swap or ELI is determined as of the date it is acquired and is not retested in the hands of the same holder.
- Secondary market purchasers test a swap or ELI's delta when the instrument is acquired. Accordingly, a single issue of instruments may include some instruments that carry dividend equivalents subject to US withholding tax and others that are not.
- If an ELI references more than one underlying security, then it is subject to the new rules with respect to any underlying security for which it has a delta of .70 or greater. Thus, an ELI with multiple underlying securities will be "tainted" if any one of them has a delta of greater than .70 when it is acquired.
- The payment of a dividend equivalent includes any amount that references an actual or estimated payment of dividends, whether the reference is explicit or implicit, including actual or estimated dividend payments that are implicitly taken into account in computing one or more of the terms of the transaction (that is, "price return" only instruments may be covered). The prior regulations had carved out estimated dividends from dividend equivalent treatment.
- Swaps and ELIs that reference qualified indices are carved out from the dividend equivalent rules and should not give rise to dividend equivalent amounts.
- Broker-dealers who are a party to a transaction that is potentially covered by the proposed rules are required to determine whether the transaction is covered and report the timing and amount of any dividend equivalent. If both parties to such a potential transaction are broker-dealers, or neither party is a broker-dealer, the short party is responsible for making these determinations.
Thomas Humphreys, Remmelt Reigersman and David Goett
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