Section 871(m) and Gross Basis U.S. Taxation of Derivative Exposure to U.S. Equities (Portfolio 6590)
At a glance
-
- Background of Dividend Equivalent Rules
- Overview
- Pre-2010 Rules Applicable to Dividend Equivalents
- Wall Street Journal Articles
- Legislative History
- Regulatory Guidance Under §871(m)
- Financial Products Impacted by §871(m)
- Overview and §871(m) Statutory Products
- Expansion of Products Under §871(m) Regulations
- Simple Contracts
- Complex Contracts
- Combined Transactions
- Delta One Contracts
- Swaps
- Forwards
- Futures
- Others
- Certain Options
- Certain Notes
- Practical Issues for Derivatives That Are Traditionally Non-Delta One but May Reach Delta One Threshold
- Non-Delta One Contracts
- Convertible Debt
- Options
- Structured Notes
- Indices
- Overview
- Qualified Indices
- Exclusion From Treatment as Underlying Security Subject to Withholding
- Overall Purpose Test
- Main Test
- Alternative Safe Harbor
- 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
- Nonqualified Indices
- Generally Look-Through to Components That Are Underlying Securities
- Ability to Treat as Single Security in Certain Cases
- Impact of Rebalancing
- Derivatives and Financial Instruments That Reference Covered Partnerships
- Identifying Covered Partnerships
- Definition — Dealing, Trading and Investing in Underlying Securities and Related Derivatives and Financial Instruments
- Lack of Partnership Requirements to Provide Necessary Source Data (e.g., Values of Assets)
- Practical Approach for Assessing Covered Partnership Status
III. Application of §871(m) Regulations
- Dividend Equivalents
- Dividend Equivalent Amounts (“DEAs”)
- Source of DEAs
- Responsible Party Obligations
- Custodian
- Identify §871(m) Transactions
- Apply the Combination and Qualified Index Rules
- Identify and Monitor the Underlying Securities
- Determine the Clearing Agent
- Request Information From the Responsible Party
- Determine the Amount of the DEA
- Determine Withholding Tax Status of Long Party
- Withholding Considerations
- Deposit Any Tax Withheld
- Report on Form 1042-S and 1042
- Qualified Derivative Dealers
- Background
- Coordination With QI Regime
- Eligible Entities
- Responsibilities and Liability for Tax
- Withholding on Client Trades
- Tax and Information Returns
- 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
- Withholding and Operational Issues
- Overview
- Timing of Withholding
- The “Determination Date”
- Default Withholding Timing
- Alternative Election
- Withholding by QDDs
- Covered Partnerships — Special Rule
- Period When Withholding Agent Is Responsible for Withholding
- Amount Subject to Withholding
- DEA for Securities Lending and Sale-Repurchase Transactions
- DEA for Simple Contracts
- DEA for Complex Contracts
- Reporting Requirements
- Structured Note Withholding and Reporting
- Impact of Corporate Actions Affecting the Underlying Security
- Overview
- Potential Retesting Event for Scoping Purposes
- Potential Trigger for Accruing Additional Dividend Equivalent Amounts
Abstract
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.