Federal Tax

Section 871(m) and Gross Basis U.S. Taxation of Derivative Exposure to U.S. Equities (Portfolio 6590)

  • Section 871(m) and Gross Basis U.S. Taxation of Derivative Exposure to U.S. Equities addresses the circumstances under which equity-based derivative products and financial instruments are taxed under 871(m).


Tax Management Portfolio, Section 871(m) and Gross Basis U.S. Taxation of Derivative Exposure to U.S. Equities, No. 6590, discusses the legislative history and regulatory and other guidance associated with §871(m). Additionally, it provides a practical explanation of the impact of the applicable guidance on taxpayers and withholding agents, including a new category of withholding agents known as a qualified derivatives dealer.

Historically, income from a notional principal contract was sourced by reference to the recipient of the income; therefore, notional principal contract income that referenced equity of a U.S. corporation was deemed foreign source and not subject to U.S. withholding tax when paid to a foreign person. In contrast, substitute dividend payments on securities lending transactions or sale-repurchase transactions with underlying U.S. equities were treated as U.S.-source income and subject to U.S. withholding tax. Such disparity was eliminated by treating dividend equivalent payments related to certain derivatives as a dividend from sources within the United States with the enactment of §871(m) in 2010.

Between 2012 and 2019 Treasury and the Internal Revenue Service issued a series of proposed and final regulations as well as other guidance related to the application of §871(m). Currently applicable guidance focuses on the scope of financial products that are covered under §871(m), when and how dividend equivalents are subject to withholding, who is responsible for making the determination, what exceptions may apply, and who is responsible for any required withholding.

Table of Contents

    1. Background of Dividend Equivalent Rules
    2. Overview
    3. Pre-2010 Rules Applicable to Dividend Equivalents
    4. Wall Street Journal Articles
    5. Legislative History
    6. Regulatory Guidance Under §871(m)
    7. Financial Products Impacted by §871(m)
    8. Overview and §871(m) Statutory Products
    9. Expansion of Products Under §871(m) Regulations
    10. Simple Contracts
    11. Complex Contracts
    12. Combined Transactions
    13. Delta One Contracts
    14. Swaps
    15. Forwards
    16. Futures
    17. Others
    18. Certain Options
    19. Certain Notes
    20. Practical Issues for Derivatives That Are Traditionally Non-Delta One but May Reach Delta One Threshold
    21. Non-Delta One Contracts
    22. Convertible Debt
    23. Options
    24. Structured Notes
    25. Indices
    26. Overview
    27. Qualified Indices
    28. Exclusion From Treatment as Underlying Security Subject to Withholding
    29. Overall Purpose Test
    30. Main Test
    31. Alternative Safe Harbor
    32. Practical Examples of Indices That May Fail Test Despite Appearance of Meeting Objective Requirements

    (1) Due to Definition of “Security” Not Being Met

    (2) Due to Purpose Test Violations

    1. Nonqualified Indices
    2. Generally Look-Through to Components That Are Underlying Securities
    3. Ability to Treat as Single Security in Certain Cases
    4. Impact of Rebalancing
    5. Derivatives and Financial Instruments That Reference Covered Partnerships
    6. Identifying Covered Partnerships
    7. Definition — Dealing, Trading and Investing in Underlying Securities and Related Derivatives and Financial Instruments
    8. Lack of Partnership Requirements to Provide Necessary Source Data (e.g., Values of Assets)
    9. Practical Approach for Assessing Covered Partnership Status

    III. Application of §871(m) Regulations

    1. Dividend Equivalents
    2. Dividend Equivalent Amounts (“DEAs”)
    3. Source of DEAs
    4. Responsible Party Obligations
    5. Custodian
    6. Identify §871(m) Transactions
    7. Apply the Combination and Qualified Index Rules
    8. Identify and Monitor the Underlying Securities
    9. Determine the Clearing Agent
    10. Request Information From the Responsible Party
    11. Determine the Amount of the DEA
    12. Determine Withholding Tax Status of Long Party
    13. Withholding Considerations
    14. Deposit Any Tax Withheld
    15. Report on Form 1042-S and 1042
    16. Qualified Derivative Dealers
    17. Background
    18. Coordination With QI Regime
    19. Eligible Entities
    20. Responsibilities and Liability for Tax
    21. Withholding on Client Trades
    22. Tax and Information Returns
    23. QDD Tax Liability

    (1) Component (A) — Tax on the §871(m) Amount

    (2) Component (B) — Non-Equity Derivatives Dealer Payments

    (3) Component (C) — Payments Other Than Dividend Equivalents

    (4) Reconciliation Schedule

    1. Withholding and Operational Issues
    2. Overview
    3. Timing of Withholding
    4. The “Determination Date”
    5. Default Withholding Timing
    6. Alternative Election
    7. Withholding by QDDs
    8. Covered Partnerships — Special Rule
    9. Period When Withholding Agent Is Responsible for Withholding
    10. Amount Subject to Withholding
    11. DEA for Securities Lending and Sale-Repurchase Transactions
    12. DEA for Simple Contracts
    13. DEA for Complex Contracts
    14. Reporting Requirements
    15. Structured Note Withholding and Reporting
    16. Impact of Corporate Actions Affecting the Underlying Security
    17. Overview
    18. Potential Retesting Event for Scoping Purposes
    19. Potential Trigger for Accruing Additional Dividend Equivalent Amounts

Lauren Lovelace
Lauren Lovelace
Ernst & Young
Janine Burman-Gage
Janine Burman-Gage
Senior Manager International Tax
Ernst & Young
Matthew A Stevens
Ernst & Young LLP
Tara Ferris
Tara Ferris
Ernst & Young
Jonathan Jackel
Jonathan Jackel
Managing Director
Ernst & Young
Sean P. Conroy
Sean P. Conroy
Ernst & Young
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