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The 871(m) rule

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Jonathan P Brose (pictured), Brett R Cotler, and Craig T Hickernell ​of Seward & Kissel LLP​ write on the US's Section 871(m) rules which are being phased in at the moment and the likely impact for non-US investors.

Section 871(m) of the Internal Revenue Code subjects non-US investors to a 30 per cent withholding tax on dividend-equivalent payments on notional principal contracts (NPCs) (ie, swaps) and equity-linked instruments (ELIs) (eg, forwards, futures, options) that reference US equities. 

Section 871(m) has been gradually phased-in and is expected to come into full effect in 2018. This article provides an overview of determining how to classify transactions for 871(m) purposes, whether a transaction is required to be withheld upon, and how a non-US investor satisfies its obligations under Section 871(m).

Generally, the 871(m) rules apply to NPCs and ELIs that sufficiently correlate with or that are substantially equivalent to US equity securities, depending on if the transaction is classified as a simple or complex contract. A broker or dealer determines whether a transaction is simple or complex, but if neither party to the transaction is a broker or dealer, this obligation falls on the short party. Simple contracts reference a single, fixed number of shares with a set or determinable maturity date. Complex contracts are any contracts that are not simple contracts. 

Further, the 871(m) rules instruct short parties to combine multiple transactions, treating them as a single transaction. A short party should treat two or more transactions as a single transaction when the long party enters into multiple transactions referencing the same asset, the combined transactions replicate the economics of an 871(m) transaction, and the transactions were entered into in connection with each other. 

The short party may presume that transactions are not entered into in connection with another transaction if the long party holds the transactions in separate accounts or enters into the transactions more than two business days apart, unless the short party has actual knowledge that the transactions should be treated as a single, combined transaction. Without guidance on how to combine transactions, taxpayers may combine transactions using any reasonable method. 

Once categorised as simple or complex, the short party or broker determines whether to withhold and whether an exception from withholding may apply. Section 871(m) withholding tax applies to dividend-equivalents paid on simple contracts that have a delta of at least 0.8 and on complex contracts that meet the substantial equivalence test. These tests are measured at the earlier of the instrument’s pricing or issuance, unless the contract is issued more than 14 days after pricing, in which case delta is determined at issuance. In other words, Section 871(m) subjects to withholding simple contracts that are highly correlative to and complex contracts that are substantially equivalent to owning the underlying asset. 

Section 871(m) includes several exceptions, including one for dividend-equivalents paid on contracts referencing qualified indices. Qualified indices are non-US indices and indices that reference only long positions of at least 25 securities and meet certain weighting and other requirements. A safe harbour exists for an index in which US securities comprise less than 10 per cent of the index’s weighting. Indices relying on the safe harbour must be widely traded and not formed for tax avoidance purposes. If an exception does not apply to a contract that satisfies the delta or substantial equivalence tests, the short party or broker should withhold on the dividend-equivalent amount.

The dividend-equivalent amount is the product of the delta times the number of reference shares times the dividend-per-share amount when a payment is made or when a dividend-equivalent is determined. Unless reduced by an income tax treaty, the short party should withhold 30 per cent of the dividend-equivalent and remit such amount to the IRS. Withholding should occur when the long party makes or receives a payment, when final settlement is made, or when the long party exits the transaction. Thus, when a long party pays the depreciation on a security net of a dividend-equivalent amount, the short party must remit to the IRS the amount it would have withheld had it been paying the dividend-equivalent to the long party. 

The current 871(m) rules do not provide relief for this so-called ‘cashless withholding’, but adherence to the ISDA 2015 Section 871(m) Protocol by swap counterparties, effectively amending the documentation between them, ensures that the long party will bear any liability for 871(m) withholding. The 2015 Protocol replaces any ISDA 2010 HIRE Act Protocol previously in place for swap transactions entered into on or after January 1, 2017. Swap counterparties may receive requests from dealers to adhere to the 2015 Protocol as a condition to entering into swap transactions that are subject to the 871(m) rules.

The 871(m) rules are complex, containing various rules and exceptions. You should consult your tax advisors to determine your withholding and reporting obligations in a potential 871(m) transaction. 

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