Tax Regs Address Overwithholding With Qualified Derivatives Dealers Exemption

Section 871(m) treats payments under equity derivative contracts that reference U.S.-source dividends as if they are equivalent to U.S.-source dividends, potentially triggering a U.S. withholding tax.

Reg. section 1.871-15(q) interprets section 871(m) to exempt qualified derivatives dealers (QDDs) from tax and withholding requirements if overwithholding would occur. Published September 12, 2022, Notice 2022-37, 2022-37 IRB 234, delays the applicability date of some of the QDD provisions.

Dividend equivalents treated as U.S.-source dividend income are subject to a 30 percent U.S. tax when received by nonresident alien individuals and foreign corporations. The tax must be withheld by the dividend equivalent payer.

Final regs published in T.D. 9734 on September 18, 2015, generally became effective on that date. Those regs were revised and supplemented by final regs published January 24, 2017 (T.D. 9815), and December 17, 2019 (T.D. 9887).

The regs provide guidance to NRAs and foreign corporations holding financial products that provide for payments contingent upon, or determined by reference to, U.S.-source dividend payments. They also provide guidance to withholding agents responsible for withholding U.S. tax on dividend equivalent payments.

This article covers the guidance for QDDs in reg. section 1.871-15(q). Previous articles covered:

• the delta calculation in paragraph (g) that determines whether a simple contract is a section 871(m) transaction (Tax Notes Int’l, July 3, 2023, p. 33);
• the substantial equivalence test in paragraph (h) that determines whether a complex contract is a section 871(m) transaction (Tax Notes Int’l, July 10, 2023, p. 204);
• the description of dividend equivalent payments and amounts in paragraphs (i) and (j) (Tax Notes Int’l, July 24, 2023, p. 415);
• the definition of dividend equivalents (and exceptions) in subparagraphs (c)(1) and (2), and the antiabuse rule in paragraph (o) (Tax Notes Int’l, July 31, 2023, p. 557);
• the exception to withholding in paragraph (l) for potential section 871(m) transactions that reference qualified indexes (Tax Notes Int’l, Aug. 7, 2023, p. 709); and
• the requirements in paragraph (n) to combine transactions when testing whether they are subject to section 871(m) (Tax Notes Int’l, Aug. 14, 2023, p. 1066).

Section 871(m)nder section 871(a)(1), U.S.-source income of an NRA (other than capital gains) that is not connected with a U.S. business is subject to a 30 percent tax. This includes U.S.-source dividend income. Section 871(m)(1)-(7) addresses treatment under section 871(a) of dividend equivalents paid to an NRA. Reg. section 1.881-2(b)(3) directs taxpayers to section 871(m) and regs for rules applicable to dividend equivalents paid to foreign corporations.

The general rule in paragraph (m)(1) is that a dividend equivalent is treated as a U.S.-source dividend subject to the 30 percent tax. Paragraph (m)(2) generally defines a dividend equivalent as a payment contingent upon, or determined by reference to, a U.S.-source dividend. The descriptions in subparagraphs (m)(2)(A)-(C) are:

(A) any substitute dividend made under a securities lending or sale-repurchase transaction that is directly or indirectly contingent on, or determined by reference to, the payment of a dividend from U.S. sources;

(B) any payment made under a specified notional principal contract (NPC) that is directly or indirectly contingent on, or determined by reference to, the payment of a dividend from U.S. sources; and

(C) any other payment determined by the secretary to be substantially similar to a payment described in subparagraph (A) or (B).

The definition of specified NPC in paragraph (m)(3) is divided between payments made before and those made after the date that is two years after the March 18, 2010, enactment date of subsection (m) in the Hiring Incentives to Restore Employment Act.

Under the temporary definition in subparagraph (m)(3)(A) for payments made before March 18, 2012, a specified NPC has one of the following characteristics described in clauses (i)-(v):

(i) for entering into the contract, a long party transfers the underlying security to a short party;

(ii) for terminating the contract, a short party transfers the underlying security to a long party;

(iii) the underlying security is not readily tradable on an established securities market;

(iv) for entering into the contract, the underlying security is posted as collateral by a short party with a long party; or

(v) the contract is identified by the secretary as a specified NPC.

Under the definition in subparagraph (m)(3)(B) for payments made after March 18, 2012, all NPCs are specified NPCs unless the secretary determines that the contract does not have the potential for tax avoidance.

Subparagraph (m)(4)(A) defines long party as a party to the contract entitled to receive a payment that is contingent upon, or determined by reference to, the payment of a dividend from sources within the United States on the underlying security. Subparagraph (m)(4)(B) defines short party as a party to the contract that is not a long party.

Subparagraph (m)(4)(C) defines underlying security as the security requiring the dividend payment referred to in subparagraph (m)(2)(B). An index or fixed basket of securities is treated as a single security.

Under paragraph (m)(5), a payment includes a gross amount used in computing the net amount that is transferred to or from the taxpayer.

To prevent overwithholding on a chain of dividends or dividend equivalents, paragraph (m)(6) allows the secretary to reduce tax to the extent the taxpayer can establish that tax has been paid on another dividend equivalent in the chain, is not otherwise due, or is appropriate to address the role of financial intermediaries in the chain. This concern is addressed by the QDD provisions in reg. section 1.871-15(q)(1)-(5).

Paragraph (m)(7) describes coordination with withholding requirements under chapters 3 (sections 1441-1464) and 4 (sections 1471-1474). Each person that is a party to a contract or other arrangement that provides for the payment of a dividend equivalent is treated as having control of the payment.

The practical effect of section 871(m) is to change the source of a dividend equivalent payment from non-U.S. to U.S. The payment’s source is determined by the underlying U.S. security rather than the long party’s residence.

Reg. Section 1.871-15Reg. section 1.871-15(a)-(r) interprets section 871(m). The guidance includes:

• 15 definitions (with two examples);
• a general rule that treats dividend equivalents as U.S.-source dividends;
• a definition of dividend equivalent, along with five exceptions;
• a definition of specified NPC;
• a definition of specified equity-linked instrument (ELI);
• a description of substantially similar payments;
• a calculation of delta (with two examples);
• a test for substantial equivalence (with one example);
• a description of dividend equivalent payments (with two examples);
• the amount of a dividend equivalent;
• a limit on treating corporate acquisitions as section 871(m) transactions;
• treatment of derivatives that reference indexes;
• treatment of derivatives held by partnerships;
• treatment of combined transactions;
• an antiabuse rule;
• information reporting requirements (with one example);
• a definition of QDD (with three examples); and
• applicability dates.

Definitions

Subparagraphs (a)(1)-(15) provide definitions, some of which are particularly relevant to the application of the QDD rules in paragraph (q).

Subparagraph (a)(1) defines a broker by cross-reference to its meaning in section 6045(c), except that it does not include any corporation that is a broker solely because it regularly redeems its own shares.

Subparagraph (a)(4) defines an ELI as a financial transaction (other than a securities lending transaction, sale-repurchase transaction, or NPC) that references the fair market value of one or more underlying securities — for example, a futures contract, forward contract, option, debt instrument, or other contractual arrangement that references the FMV of one or more underlying securities.

Subparagraph (a)(5) defines an initial hedge as the number of underlying security shares that a short party would need to fully hedge an NPC or ELI (whether the NPC or ELI is a complex contract or simple a contract benchmark within the meaning of subparagraph (h)(2)) at the calculation time for the NPC or ELI, even if the short party does not, in fact, fully hedge the NPC or ELI.

Subparagraph (a)(7) defines an NPC by cross-reference to its meaning in reg. section 1.446-3(c).

Subparagraph (a)(9) provides a multifaceted definition of transaction parties. A long party is entitled to receive a dividend equivalent, and a short party is obligated to pay a dividend equivalent. A party includes a long or short party, an agent acting on behalf of a long or short party, and a transaction intermediary.

If a potential section 871(m) transaction references more than one underlying security, the long party and short party are determined separately for each underlying security. A person is both a long and a short party when it is:

• entitled to receive a payment that references a dividend payment on an underlying security; and
• obligated to make a payment that references a dividend payment on another underlying security.

Subparagraph (a)(12) defines a section 871(m) transaction as a securities lending transaction, sale-repurchase transaction, specified NPC, or specified ELI. A potential section 871(m) transaction is a securities lending or sale-repurchase transaction, NPC, or ELI that references one or more underlying securities.

Subparagraph (a)(14) distinguishes between simple and complex contracts. A simple contract is an NPC or ELI that, for each underlying security, allows all amounts to be paid or received on the maturity, exercise, or other payment date to be calculated by reference to a single, fixed number of shares.

This assumes that the number of shares can be ascertained at the calculation time of the contract and that there is a single maturity or exercise date for which all amounts (other than upfront or periodic payments) are required to be calculated for the underlying security. A complex contract is generally an NPC or ELI that is not a simple contract.

Subparagraph (a)(15) defines an underlying security as an interest in an entity if that interest could give rise to a U.S.-source dividend under reg. section 1.861-3. If a potential section 871(m) transaction references an interest in more than one entity or different interests in the same entity, each referenced interest is a separate underlying security.

General Rule

Paragraph (b) repeats the general rule in section 871(m)(1) that treats a dividend equivalent as a dividend from sources within the United States in applying:

• section 871(a) (noneffectively connected income of NRAs);
• section 881 (non-ECI of foreign corporations);
• section 892 (income of foreign governments and international organizations);
• section 894 (income affected by a treaty);
• section 4948(a) (taxation and denial of exemptions for some foreign organizations); and
• chapters 3 and 4 (withholding on foreign persons and some foreign accounts).

Dividend Equivalents

Subparagraph (c)(1) describes payments that are dividend equivalents, and subparagraph (c)(2) provides exceptions.

Subdivisions (c)(1)(i)-(iv) define a dividend equivalent as a payment that:

• references a dividend from an underlying security under a securities lending or sale-repurchase transaction;
• references a dividend from an underlying security under a specified NPC described in paragraph (d);
• references a dividend from an underlying security under a specified ELI described in paragraph (e); or
• is any other substantially similar payment as described in paragraph (f).

Specified NPCs and ELIs

Specified NPCs. Paragraph (d) defines specified NPCs. Subparagraph (d)(1) generally repeats the conditions in the temporary definition in section 871(m)(3)(A) and applies them to payments made after March 18, 2012, and before January 1, 2017.

Subparagraph (d)(2) applies to specified NPCs entered into on or after January 1, 2017, and treats simple and complex NPCs differently.

Under subdivision (d)(2)(i), a simple NPC that has a delta of 0.8 or greater in an underlying security at the calculation time is a specified NPC. Under subdivision (d)(2)(ii), a complex NPC that meets the substantial equivalence test in paragraph (h) at the calculation time is a specified NPC.

Specified ELIs. Paragraph (e) defines specified ELIs. Under subparagraph (e)(1), a simple ELI that has a delta of 0.8 or greater at the calculation time is a specified ELI. Under subparagraph (e)(2), a complex ELI that meets the substantial equivalence test in paragraph (h) at the calculation time is a specified ELI.

Delta and Substantial Equivalence

The delta calculation applies to determine whether simple NPCs and ELIs are specified. The substantial equivalence test applies to make this determination for complex NPCs and ELIs.

Delta. The delta calculation covered in subparagraphs (g)(1)-(5) determines whether a simple contract is a specified contract and therefore a section 871(m) transaction. The delta reveals the extent to which a derivative instrument traces its underlying security’s value. The higher a derivative’s delta, the more economically equivalent it is and the more closely its FMV tracks that of the underlying security. A delta-one derivative tracks the underlying security on a dollar-for-dollar basis.

A derivative instrument with a delta of 0.8 means that for every $1 the underlying security’s FMV varies, the derivative instrument’s FMV varies by $0.80. Simple contracts with a delta of at least 0.8 (and complex contracts meeting the substantial equivalence test) are replicating the economic benefits of holding U.S. securities and are subject to section 871(m).

Delta is the ratio of change in the FMV of an NPC or ELI to a small change in the FMV of the number of shares of the underlying security (as determined under subparagraph (j)(3)):

delta = change in FMV of NPC or ELI/change in FMV of underlying security sharesSubstantial Equivalence. The substantial equivalence test covered in subparagraphs (h)(1)-(7) applies to determine whether a complex contract is a specified contract and therefore a section 871(m) transaction. The test assesses whether a complex contract substantially replicates the economic performance of the underlying security by comparing at various testing prices for the security:

• the differences between the expected changes in the FMV of the complex contract and its initial hedge; and
• the differences between the expected changes in the FMV of a simple contract benchmark (as described in subparagraph (h)(2)) and its initial hedge.

The complex contract is a section 871(m) contract if, when the substantial equivalence test is applied at the calculation time for the complex contract, the expected change in the FMV of the complex contract and its initial hedge is equal to or less than the expected change in the FMV of the simple contract benchmark and its initial hedge.

Exceptions to Dividend Equivalents

Subdivisions (c)(2)(i)-(v) provide exceptions to dividend equivalent status for:

• distributions not subject to tax under section 871(a) or 881;
• dividend equivalents received by a long party on an instrument that gives rise to a dividend under section 305(b) or (c);
• payments made under a due bill;
• payments made under annuity, endowment, or life insurance contracts; and
• payments made under employee compensation arrangements.

Paragraph (k) of the regs provides an exception for payments related to corporate acquisition transactions that, as part of a plan, obligate the long party to acquire underlying securities representing more than 50 percent of the issuer’s FMV.

Paragraph (l) provides that payments under contracts that reference qualified indexes are generally not subject to U.S. tax withholding under section 871(m). Qualified indexes are widely used passive indexes based on a diverse basket of publicly traded securities.

Combined Transactions

Paragraph (n) operates to combine potential section 871(m) transactions to determine whether they collectively meet the tests for being subject to section 871(m). The goal of these rules is to prevent taxpayers from splitting a section 871(m) transaction into component transactions to avoid dividend equivalent treatment.

QDDs

The QDD rules are intended to prevent multiple withholdings on the same dividend stream. For example, if a foreign corporation owns U.S. stock and enters into a short forward contract with another foreign corporation, it generally will be subject to withholding on dividends paid on the stock. It will also have to withhold on dividend equivalent payments under the forward contract. The withholding tax on the dividend equivalent payments is effectively a second withholding tax.

Foreign financial institutions and clearing houses can receive U.S.-source dividends and dividend equivalent payments without being subject to withholding tax if they certify to the withholding agent that they are receiving the payments as custodians and not beneficial owners and they have entered into a qualified intermediary agreement with the IRS under which they assume primary withholding responsibility.

However, absent the QDD rules, dealers cannot act as QIs if they received the payments as beneficial owners of a hedge to transactions in which they are short parties. The regs address potential overwithholding by expanding the QI regime in section 1441 regs to include QDDs.

Therefore, regs under sections 871 and 1441 govern dividends and dividend equivalents received by a QDD. This article covers the section 871 provisions.

Reg. section 1.871-15(q) addresses taxation of dividend and dividend equivalent payments made to a QDD.

The guidance in subparagraphs (q)(1)-(5) include:

• a general description of a QDD’s tax liability on dividend equivalent payments;
• a capacity presumption for transactions reflected in a QDD’s equity derivatives dealer book;
• a definition of the “section 871(m) amount” for each dividend on each underlying security;
• a description of the net delta exposure calculation; and
• three examples.

Sections 881 and 1441. Section 881 generally taxes income of foreign corporations that is not connected to a U.S. business. Section 881(a)(1) imposes a 30 percent tax on U.S.-sourced interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income.

Section 1441 generally requires the payers of these types of income to deduct and withhold the 30 percent tax when the income recipient is an NRA. Section 1442 requires payers to comply with the section 1441 withholding requirements when the income recipient is a foreign corporation.

Reg. section 1.1441-1(e)(5) provides guidance on QIs and withholding certificates, agreements, and statements. Reg. section 1.1441-1(e)(6) provides guidance on QDDs and prescribes the circumstances in which a QI can act as a QDD.

Reg. section 1.1441-1(b)(4)(xxii) provides that a withholding agent making a payment to a QI acting as a QDD is not required to withhold on specific payments if the agent can associate the payment with a valid QI withholding certificate (as described in reg. section 1.1441(e)(3)(ii)). Withholding is not required on a payment:

• made under a potential section 871(m) transaction that is not an underlying security;
• of a dividend equivalent; or
• of a dividend in 2017.

QDD Tax Liability. Under reg. section 1.871-15(q)(1), a QDD described in reg. section 1.1441-1(e)(6) that receives a dividend equivalent payment in its equity derivatives dealer capacity will not be liable for tax under section 881 on that payment, provided that the dealer complies with its obligations under the QI withholding agreement described in reg. section 1.1441-1(e)(5)-(6).

A QDD is liable for tax under section 881(a)(1) on its section 871(m) amount for each dividend on each underlying security. This tax liability is reduced (but not below zero) by the amount of tax paid by the QDD under section 881(a)(1) on dividends it receives on that underlying security on that same dividend in its capacity as an equity derivatives dealer.

Also, a QDD is liable for tax under section 881(a)(1) for all dividend equivalents not received in its equity derivatives dealer capacity. A QDD is also liable for tax under section 881(a)(1) for all dividends it receives, other than dividends received in 2017, in its equity derivatives dealer capacity.

Paragraph (q) does not apply to a QDD that is a foreign branch of a U.S. financial institution (within the meaning of reg. section 1.1471-5(e)).

Capacity Presumption. Under subparagraph (q)(2), in determining the QDD’s tax liability, transactions properly reflected in a QDD’s equity derivatives dealer book are presumed to be held by the dealer in its equity derivatives dealer capacity. To determine whether a dealer is acting in its equity derivatives dealer capacity, only the dealer’s activities as an equity derivatives dealer are taken into account.

A dividend or dividend equivalent is treated as received by a QDD not acting in its equity derivatives dealer capacity if received by a QDD acting as a proprietary trader.

Section 871(m) Amount. Under subparagraph (q)(3), for each dividend on each underlying security, the section 871(m) amount is the product of:

• the QDD’s net delta exposure to the underlying security for the applicable dividend; and
• the applicable dividend amount per share.

Net Delta Exposure. Under subdivisions (q)(4)(A)-(B), the net delta exposure to an underlying security is based on the aggregate number of shares of an underlying security to which the QDD has exposure because of positions in the security (including owning the security). The net delta exposure measured in the number of shares compares the long and short positions and equals:

• the number of shares in the underlying security in which the QDD has positions with FMVs that move in the same direction as the security (the long positions); minus
• the number of shares in which the QDD has positions with FMVs that move in the opposite direction from the security (the short positions).

The net delta exposure calculation only includes long positions and short positions that the QDD holds in its equity derivatives dealer capacity (as described in subparagraph (q)(2)). Any long positions or short positions that are treated as effectively connected with the QDD’s U.S. trade or business are excluded from the net delta exposure calculation.

The net delta exposure to an underlying security is determined at the end of the day on the date provided in subparagraph (j)(2) for the applicable dividend. This is the earlier of:

• the record date of the dividend; and
• the day before the ex-dividend date.

For example, if a specified NPC provides for a payment at settlement that takes into account an earlier dividend payment, the amount of the dividend equivalent is determined on the earlier of the record date or the day before the ex-dividend date for that dividend.

Net delta must be determined in a commercially reasonable manner. If a QDD calculates net delta for nontax business purposes, the net delta ordinarily will be the delta used for that purpose, subject to the modifications required by this definition.

Each QDD must determine its net delta exposure separately only taking into account transactions that are recognized and attributable to that QDD under U.S. tax law.

Examples. Subparagraph (q)(5) provides three examples that illustrate the rules of paragraph (q). Example 1 illustrates the results of a forward contract between a foreign equity derivatives dealer and a foreign customer that is hedged with a total return swap between the foreign dealer and a U.S. broker.

Foreign bank FB is a QI that acts as a QDD. On April 1, year 1, FB enters into a cash settled forward contract initiated by a foreign customer that:

• entitles the customer to receive from FB all appreciation and dividends on 100 shares of stock X; and
• obligates the customer to pay FB any depreciation on 100 shares of stock X at the end of three years.

FB hedges the forward contract by entering into a total return swap contract with a domestic broker that is maintained as a hedge for the duration of the forward contract. The swap contract:

• entitles FB to receive an amount equal to all dividends on 100 shares of stock X;
• obligates FB to pay an amount referenced to a floating interest rate each quarter; and
• provides for FB to receive from or pay to the broker (as the case may be) the difference between:
• the FMV of 100 shares of stock X at the inception of the swap; and
• the FMV of 100 shares at the end of three years.

Stock X pays a quarterly dividend of $0.25 per share.

At the end of the day on the date provided in subparagraph (j)(2) for the dividend, FB owns the forward contract and the total return swap. FB does not own any shares of stock X or any other transactions that reference stock X.

FB provides valid documentation to the broker that FB will receive payments under the swap contract in its capacity as a QDD, and FB contemporaneously enters both the swap contract with the broker and the forward contract with the customer on its equity derivatives dealer books.

At the end of the day on the date provided in subparagraph (j)(2) for the dividend, FB is a long party on a delta-one contract (the total return swap with the broker) and also a short party on a delta-one contract (the forward contract with the customer). Under reg. section 1.1441-1(b)(4)(xxii), the broker is not obligated to withhold tax on the dividend equivalent payments to FB on the swap contract referenced to stock X dividends because the broker may rely upon valid documentation to treat the payment as made to FB acting as a QDD.

Under subparagraph (q)(1), FB is not liable for tax under sections 871(m) and 881 on the payments it receives from the broker referenced to stock X dividends because FB’s net delta exposure on the 100 shares of stock X is zero at the end of the day on the date provided in subparagraph (j)(2) for the dividend.

The net delta exposure is zero because the taxpayer has:

• 100 shares of stock X long position exposure because of the total return swap; minus
• 100 shares of stock X short position exposure because of the forward contract.

FB is required to withhold tax on dividend equivalent payments to the customer on the forward contract in accordance with reg. section 1.1441-2(e)(7).

Example 2 illustrates an at-the-money call option contract (meaning the contract price is close or equal to the spot price) entered into by a foreign equity derivatives dealer that is hedged with a total return swap. The facts are the same as in Example 1, but the customer purchases from FB an at-the-money call option on 100 shares of stock X with a term of one year. The call option has a delta of 0.5, and FB hedges the call option by entering into a total return swap that references 50 shares of stock X with the broker.

At the end of the day on the date provided in subparagraph (j)(2) for the dividend, the call option has a delta of 0.6, FB hedges the call option with a total return swap that references 60 shares of stock X with the broker, and FB has no shares of stock X or other transactions that reference stock X.

At the end of the day on the date provided in subparagraph (j)(2) for the dividend, FB is a long party on 60 shares of stock X through the total return swap and a short party on the call option. Because the option has a delta of less than 0.8 at the calculation time, it is not a section 871(m) transaction. Therefore, there will be no dividend equivalent payments made by FB to the customer that are subject to withholding.

Under reg. section 1.1441-1(b)(4)(xxii), the broker is not obligated to withhold tax on the dividend equivalents on stock X paid to FB because the broker has valid documentation that it may rely upon to treat the dividend equivalents as paid to FB acting as a QDD.

The net delta exposure is zero at the end of the day on the date provided in subparagraph (j)(2) for the dividend because:

• FB has a long position of 60 shares because of the total return swap; minus
• FB’s short position of 60 shares because of the option.

Example 3 illustrates an in-the-money call option contract (meaning the contract price is less than the spot price) entered into by a foreign equity derivatives dealer that is hedged by ownership of the underlying security. The facts are the same as Example 2, but the customer purchases from FB an in-the-money call option on 100 shares of stock X with a term of one year. The call option has a delta of 0.8, and FB hedges the call option by purchasing 80 shares of stock X, which are held in an account with the broker, who also acts as paying agent.

The price of stock X declines substantially and the option lapses unexercised. At the end of the day on the date provided in subparagraph (j)(2) for the dividend, the call option has a delta of 0.48 and FB has reduced its hedge to 50 shares of stock X with the broker. Also on that date, FB owns no other shares of stock X or any other transactions that reference stock X in its equity derivatives dealer capacity.

At the end of the day on the date provided in subparagraph (j)(2) for the dividend, FB is a long party on 50 shares of stock X and a short party on an option. Because the option has a delta of 0.8 at the calculation time, it is a section 871(m) transaction. Therefore, FB is required to withhold tax on dividend equivalent payments to the customer on the option contract in accordance with reg. section 1.1441-2(e)(7).

The broker is required to withhold tax on the dividends paid to FB. Assuming that FB is a qualified resident of a country with a treaty that allows withholding on dividends at a 15 percent rate, the broker is required to withhold tax on the dividends paid on the 50 shares of stock X held by FB.

FB’s net delta exposure is two shares of stock X at the end of the day on the date provided in subparagraph (j)(2) because:

• FB has a long position of 50 shares; minus
• FB’s short position of 48 shares because of the option.

FB’s section 871(m) amount is $0.50 ($0.50 = net delta exposure of two shares * $0.25 dividend per share). FB’s section 881 tax on the $0.50 is reduced (but not below zero) by the section 881 tax paid by the QDD.

Notice 2022-37

Notice 2022-37 extends transition relief provided in Notice 2020-2, 2020-3 IRB 327, for two years through 2024. The notice provides a useful summary of the history of regs under section 871(m) and successive extensions of their applicability dates.

General Extensions

Published June 14, 2010, Notice 2010-46, 2010-24 IRB 757, addresses potential overwithholding on securities lending and sale-repurchase agreements. It provides a two-part solution to the problem of overwithholding on a chain of dividends and dividend equivalents.

First, it provides an exception from withholding for payments to a qualified securities lender (QSL). Second, it provides a proposed framework to credit forward prior withholding on a chain of substitute dividends paid on a chain of securities lending, or stock repurchase agreements.

The QSL regime requires the person that agrees to act as a QSL to comply with withholding and documentation requirements. Treasury and the IRS permitted withholding agents to rely on transition rules provided in Part III of Notice 2010-46 until guidance was developed that would include documentation and substantiation of withholding.

The preamble to the 2015 temporary regs (published with the 2015 final regs and finalized in 2017) indicated that final QDD regs would supplant the framework proposed in Notice 2010-46. Published July 18, 2016, Notice 2016-42, 2016-29 IRB 67, contained a proposed QI agreement that included provisions relating to the QDD regime and reiterated the intent to replace the framework proposed in Notice 2010-46 with the QDD regime.

Published December 19, 2016, Notice 2016-76, 2016-51 IRB 1, provided for the phased-in application of some provisions of the section 871(m) regs to allow for their orderly implementation and announced that taxpayers may continue to rely on Notice 2010-46 until January 1, 2018. The applicability dates in the 2017 final regs reflect the phased-in application described in Notice 2016-76 (see reg. section 1.871-15(r)).

Published January 17, 2017, Rev. Proc. 2017-15, 2017-3 IRB 437, sets forth the final QI agreement (2017 QI agreement), including the requirements and obligations applicable to QDDs, and provided that taxpayers may continue to rely on Notice 2010-46 during 2017.

Consistent with Notice 2016-76, the 2017 final regs’ preamble made Notice 2010-46 obsolete as of January 1, 2018. In response to a comment requesting that the QSL regime remain, the preamble noted that while the QSL regime was administratively more convenient for taxpayers than the QI regime, it created administrability problems for the IRS, especially verification. The QSL regime was replaced by incorporating the QDD rules into the existing QI framework, including rules for pooled reporting on Form 1042-S and the QI requirements for compliance review and certification.

Published August 21, 2017, Notice 2017-42, 2017-34 IRB 212, extended some of 2016 transition relief. Published February 5, 2018, Notice 2018-5, 2018-6 IRB 341, permits withholding agents to apply the transition rules from Notice 2010-46 in 2018 and 2019.

Published October 1, 2018, Notice 2018-72, 2018-40 IRB 522, further extended transition relief and permitted withholding agents to apply the transition rules from Notice 2010-46 in 2020. Published January 13, 2020, Notice 2020-2, extended the phase-in period described in Notice 2018-72 through 2022. This most recent Notice 2022-37 further extends that phase-in period through 2024.

QDD Extension

Part V of Notice 2022-37 is dedicated to describing the extension of phase-in relief for QDDs. In 2015 reg. section 1.871-15T(q)(1) provided that when a QDD received a dividend or dividend equivalent payment and was obligated to make an offsetting dividend equivalent payment on the same underlying security in an amount that was less than the amount received, the QDD would be liable for tax under section 871(a) or 881 for the difference.

Reg. section 1.1441-1(b)(4)(xxii) of the 2015 final regs provided that a withholding agent who made a payment of a dividend to a QI acting as a QDD was not required to withhold on that payment if the withholding agent reliably associated the payment with a valid QI withholding form containing a certification described in reg. section 1.1441-1(e)(3)(ii)(E). The 2017 final regs adopted the net delta exposure method.

In adopting the net delta exposure method, however, Treasury and the IRS were concerned that the exemption from withholding on dividends paid to a QDD combined with the net delta exposure method could cause U.S.-source dividends to escape U.S. tax completely. Therefore, the 2017 final regs revised reg. sections 1.871-15(q)(1) and 1.1441-1(b)(4)(xxii) to provide that a QDD remains liable for tax under section 881(a)(1) and subject to withholding under chapters 3 and 4 on dividends.

However, to allow taxpayers time to implement the net delta exposure method, the 2017 QI agreement and final regs provided that dividends and dividend equivalents received by a QDD in its equity derivatives dealer capacity in 2017 will not be subject to tax under section 881(a)(1) or withholding under chapters 3 and 4.

Notices 2017-42, 2018-72, and 2020-2 announced that Treasury and the IRS intend to amend reg. sections 1.871-15(q)(1) and (r)(3), and 1.1441-1(b)(4)(xxii)(C) to provide that a QDD will not be subject to tax on dividends and dividend equivalents received in 2017-2022 in its equity derivatives dealer capacity or withholding on those dividends (including deemed dividends).

This notice again announces that Treasury and the IRS intend to amend those provisions to provide that a QDD will not be subject to tax on dividends and dividend equivalents received in 2023 and 2024 in its equity derivatives dealer capacity or withholding on those dividends (including deemed dividends).

Section 4.01(1) of Rev. Proc. 2017-15 provides that a QDD will be required to compute its section 871(m) amount using the net delta exposure method beginning in 2018. Notices 2017-42, 2018-72, and 2020-2 provided that a QDD would be required to compute its section 871(m) amount using the net delta exposure method beginning in 2023. This notice provides that a QDD will be required to compute its section 871(m) amount using the net delta exposure method beginning in 2025.

A QDD will remain liable for tax under section 881(a)(1) on dividends and dividend equivalents that it receives in any capacity other than as an equity derivatives dealer and on any other U.S.-source fixed, determinable, annual, and periodic payments that it receives (whether or not in its equity derivatives dealer capacity). Also, a QDD is responsible for withholding on dividend equivalents it pays to a foreign person on a section 871(m) transaction, whether acting in its capacity as an equity derivatives dealer or otherwise.

Finally, section 10.01(C) of the 2017 QI agreement provides that, for calendar year 2017, a QDD is not required to perform a periodic review of its QDD activities (as required by section 10.04 of the agreement) or provide the factual information specified in Appendix I. Notices 2017-42, 2018-72, and 2020-2 provide that a QDD is not required to perform a periodic review of its QDD activities for 2017-2022.

This notice provides that a QDD is not required to perform a periodic review of its QDD activities for 2023 or 2024. Treasury and the IRS anticipate including in the 2023 QI agreement the waiver of a QDD’s periodic review and the other transitional provisions for QDDs for 2023 and 2024.

QSL Extension

Notices 2018-5, 2018-72, and 2020-2 provide that, notwithstanding the 2017 regs’ preamble rendering Notice 2010-26 obsolete, withholding agents may apply the QSL transition rules in Notice 2010-46 for payments made in 2018-2022. This notice provides that withholding agents may also apply those QSL transition rules for payments made in 2023 and 2024.