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

Description

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

  3. Nonqualified Indices
  4. Generally Look-Through to Components That Are Underlying Securities
  5. Ability to Treat as Single Security in Certain Cases
  6. Impact of Rebalancing
  7. Derivatives and Financial Instruments That Reference Covered Partnerships
  8. Identifying Covered Partnerships
  9. Definition — Dealing, Trading and Investing in Underlying Securities and Related Derivatives and Financial Instruments
  10. Lack of Partnership Requirements to Provide Necessary Source Data (e.g., Values of Assets)
  11. 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