The IRS Further Extends Certain Transitional Rules Under Section 871(m)

In response to challenges in the implementation of Section 871(m) of the Internal Revenue Code and comments from the financial industry, the US Internal Revenue Service (the “IRS”) has issued a series of notices, providing for transitional rules. On May 22, 2024, the IRS published Notice 2024-44, which is the latest notice extending the application of certain transitional rules (the “Notice”). As described in more detail below, the Notice maintains the current state of play and extends (i) the exemption for non-delta-one transactions, (ii) the simplified standard for determining whether transactions are combined transactions, (iii) the relief for qualified derivatives dealers, and (iv) the transition rules for payments to qualified securities lenders. Further, the Notice reaffirms that an anti-abuse rule will continue to apply to the application of Section 871(m), including for the purpose of determining whether a transaction is a delta-one transaction. 

Overview of Section 871(m)

Prior to the enactment of Section 871(m), the source of income paid with respect to derivatives (e.g., total-return swaps) referencing US equities was generally determined by reference to the residence of the payee, while dividends paid by a US corporation were (and are) treated as US-source and subject to US withholding tax. Accordingly, non-US persons could enter into total-return swaps that provided them full economic exposure to the stock of US corporations (including dividends) without being subject to the 30% US withholding tax that would apply if dividends were paid to them directly. Section 871(m) was enacted primarily to prevent that perceived abuse. Section 871(m) generally provides that “dividend equivalent payments” made on certain derivatives and securities lending transactions that reference US equities are treated as US-source income subject to US withholding tax. 

“Dividend equivalent payments” generally include (i) any substitute dividend payment made pursuant to a securities lending or sale-repurchase transaction that is contingent upon, or determined by reference to, the payment of a US-source dividend, (ii) payments made under certain derivatives, i.e., notional principal contracts and equity-linked instruments that are contingent upon, or determined by reference to, the payment of US-source dividends, and (iii) other payments that are substantially similar to (i) and (ii) (as determined by the IRS).  

Treasury Regulations promulgated under Section 871(m) (the “Regulations”) provide that Section 871(m) would generally apply to notional principal contracts and equity linked instruments that have a delta of 0.8 or greater with respect to the underlying US equity security (in the case of “simple contracts”) or satisfy a “substantial equivalence test” (in the case of “complex contracts”). However, as explained below, the application of Section 871(m) to non-delta-one transactions is currently delayed. “Delta” is generally defined as the ratio of the change in the fair market value of the derivative to a small change in the fair market value of the number of shares of the underlying security referenced in the derivative. The application of Section 871(m) is subject to certain exceptions (for example, in the case of derivatives linked to certain broad-based indices). 

The implementation of Section 871(m) has proved to be challenging for market participants, including issuers of structured products, clearing systems, brokers and custodians. Those challenges  include (but are not limited to) the potential for cascading withholding (for example, where a structured product issuer hedges by buying the underlying US security and is subject to withholding tax on the actual dividend while also being obligated to withhold on the dividend equivalent), withholding requirements in the absence of cash payments, the calculation of delta (which in certain cases needs to be calculated on multiple dates), and the need to establish adequate communication channels between issuers, clearing systems and custodians, and complex operational processes to effect withholding.   

Reliefs Extended by the Notice

Extension of the Exemption for Non-Delta-One Transactions. The Notice provides that Section 871(m) will not apply to payments on any non-delta-one transaction issued before January 1, 2027. Moreover, the Notice confirms that the IRS will continue to take into account the extent to which a taxpayer or withholding agent made a good faith effort to comply with the Regulations with respect to delta-one transactions between 2017 and 2026, and with respect to non-delta-one transactions in 2027. Without further extensions, Section 871(m) will begin to apply to notional principal contracts and equity linked instruments with a delta of 0.8 or greater (in the case of “simple contracts”) or that meet the “substantial equivalence test” (in the case of “complex contracts”) issued on or after January 1, 2027. 

Extension of the Simplified Standard for Determining Whether Transactions are Combined Transactions. The Regulations contain special combined transaction rules, which may treat transactions that otherwise would not be subject to US withholding tax as subject to US withholding tax to the extent two or more transactions referencing the same underlying security, if viewed together, replicate the economics of a transaction that would be subject to US withholding tax. Under the simplified standard, withholding agents are required to combine transactions only when the transactions are over-the-counter transactions that are priced, marketed or sold in connection with each other, and are not required to combine any transactions that are listed securities. The Notice extends the period during which the simplified standard applies until the end of 2026. 

Extension of Exemption from US Tax on Dividends for Qualified Derivatives Dealers. The Notice extends the current exemption from US tax and US withholding tax for dividend and dividend equivalent payments received by a qualified derivatives dealer in its capacity as an equity derivatives dealer until the end of 2026 (preventing cascading US withholding tax issues for transactions through non-US dealers). A qualified derivatives dealer will still be liable for US taxes with respect to dividends and dividend equivalent payments that it receives in any capacity other than as an equity derivatives dealer (as well as other US-source fixed, determinable, annual or periodical income). 

Extension of Qualified Securities Lenders Transition Rules. Generally, qualified securities lenders are required to comply with certain withholding and documentation requirements. The Notice extends certain transition rules issued under previous notices which provide an exception from withholding for payments to a qualified securities lender. 

Key Takeaways 

As mentioned above, the Notice generally maintains the current status quo while Treasury and the IRS continue to evaluate the Regulations and the challenges created by Section 871(m). The Notice indicates that the IRS will take into account comments already received and welcomes additional comments, which gives key stakeholders an opportunity to suggest further changes. The Notice further indicates that Treasury and the IRS intend to provide sufficient time for taxpayers and withholding agents to implement any changes made to the Regulations.