The Internal Revenue Service on September 17, 2015 released final and temporary regulations under Section 871(m) of the Internal Revenue Code that prescribe rules for treating ‘dividend equivalent payments’ with respect to US equities as US source dividend income subject to US information reporting and withholding. These regulations will have a significant impact on asset managers whose portfolios contain instruments linked to US equities, including a broad range of equity derivatives as well as equity-linked notes and convertible debt instruments.
The final regulations generally refine the tests provided in proposed regulations issued on December 5, 2013 and address many of the comments made with respect to the proposed regulations. See our Tax Alert: New guidance on US withholding on dividend equivalent payments on swaps over US equities for more information. The net effect of the revisions has been positive for asset managers, but substantial work remains for them to be ready for the January 1, 2017 effective date.
Observation: The primary concern for most asset managers is determining the types of transactions covered by the scope of these rules. While Section 871(m) originally was directed at equity swaps which represented the equivalent of ownership of the underlying US equity for which no reporting or withholding was required, the regulations apply to a much broader range of instruments. For example, for derivatives over US equities that provide something less than ‘total return,’ the potential for withholding depends on a complex set of scoping rules. Similarly, certain index derivatives are excluded from the scope of dividend-equivalent withholding.
The regulations also provide a so-called ‘combination rule’ under which separate transactions may need to be tested in combination to determine the presence of a dividend equivalent under Section 871(m). This rule creates additional challenges for asset managers. Both withholding agents (basing their determination on their information) and asset managers are responsible for applying this rule, which can be challenging where multiple brokers or custodians are being used.