What s News in Tax Analysis That Matters from Washington National Tax

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1 What s News in Tax Analysis That Matters from Washington National Tax An Overview of the Section 871(m) Proposed Regulations On December 4, 2013, the Treasury Department and the IRS issued new final regulations (the Final Regulations ) and proposed regulations (the Proposed Regulations ) with respect to the imposition of a withholding tax on dividend equivalent payments under section 871(m) of the Code. This article provides an overview of the Proposed Regulations, offers insights, and raises questions that taxpayers and the IRS will need to consider if the Proposed Regulations are finalized in substantially similar form. I. Background Monday, June 23, 2014 by Charles Kaufman, Washington National Tax Charles Kaufman is a senior manager with the Passthroughs group in WNT. U.S. source dividend payments made to a foreign person are generally subject to a 30 percent withholding tax. 1 Similarly, substitute dividend payments made to a foreign person on securities loans, sale-repurchase agreements, and substantially similar agreements with respect to U.S. equity securities are generally subject to a 30 percent withholding tax. 2 Prior to the enactment of the Hiring Incentives to Restore Employment Act (the Hire Act ) in 2010, dividend equivalent payments made to a foreign person under notional principal contracts ( NPCs ), such as equity swaps, were generally not subject to a U.S. withholding tax. 3 However, Congress and the IRS became concerned that this rule permitted U.S. financial institutions and foreigners to use NPCs to improperly avoid withholding on U.S. source dividends. 4 As a result, in March 2010, section 871(m) 5 was enacted to address this perceived abuse Section 871(a)(1)(A). Section (a)(6). Section (b) (the source of NPC income is determined by reference to the residence of the recipient). Staff Report, Permanent Subcommittee on Investigations, Dividend Tax Abuse: How Offshore Entities Dodge Taxes on U.S. Stock Dividends, (2008). Originally enacted as section 871(l) and later redesignated section 871(m). entity. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International.

2 An Overview of the Section 871(m) Proposed Regulations page 2 Section 871(m) reverses the rule contained in section by providing that payments made pursuant to a specified notional principal contract ( SNPC ) that directly (or indirectly) is contingent upon, or determined by reference to the payment of a dividend from sources within the United States are treated as a U.S. source dividend. 6 The term specified notional principal contract is defined as an NPC that satisfies one of the following: In connection with entering into the contract, any long party to the contract transfers the underlying security to any short party to the contract ( cross-in ); In connection with the termination of the contract, any short party to the contract transfers the underlying security to any long party to the contract ( cross-out ); The underlying security is not readily tradable on an established securities market; or In connection with entering into the contract, the underlying security is posted as collateral by any short party to the contract with any long party to the contract The above four factors are sometimes referred to as the four-factor test. 7 In addition, section 871(m) provides an anti-abuse rule under which any NPC will be treated as a SNPC if identified by the Secretary as such. 8 In addition, section 871(m)(3)(B) provides that payments on any NPC made after March 18, 2012, 9 that are contingent upon, or determined by reference to the payment of a dividend from sources within the United States are subject to withholding, unless Treasury determines that the NPC is of a type that does not have the potential for tax avoidance. 10 Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended (the Code ) or the applicable regulations promulgated pursuant to the Code (the regulations ). On January 19, 2012, Treasury and the IRS issued (1) temporary regulations that extended the then-current definition of an SNPC for payments made on an NPC before January 1, 2013, 11 and (2) proposed Section 871(m)(1),(2). Section 871(m)(3)(A). Section 871(m)(3)(A). This date has been extended to January 1, Section 871(m)(3)(B). T.D (Jan. 19, 2012).

3 An Overview of the Section 871(m) Proposed Regulations page 3 regulations that would have redefined the term specified notional principal contract with respect to payments on an NPC made on or after January 1, 2013 (the Prior Proposed Regulations ). 12 The Prior Proposed Regulations would have broadened the definition of SNPC by replacing the current four-factor test with the seven factor-test listed below. Under the Prior Proposed Regulations an NPC would be treated as an SNPC if it was included in any of the following seven categories: 1. The long party to the NPC is in the market with respect to the underlying security on the same day or days that the parties price the NPC or on the same day or days that the NPC terminates ( contemporaneous transfers of the underlying securities ). 2. The underlying security in the NPC is not regularly traded. 3. The short party to the NPC posts the underlying security with the long party as collateral and the underlying security posted as collateral represents more than 10 percent of the total fair market value of all the collateral posted by the short party on any date that the NPC is outstanding. 4. The NPC has a term of fewer than 90 days. 5. Either (1) the long party controls contractually or by conduct the short party s hedge of the short position or (2) the long party enters into an NPC using an underlying equity control program. 6. The notional principal amount of the underlying security in the NPC is greater than (1) five percent of the total public float of that class of security or (2) 20 percent of the 30-day average daily trading volume determined as of the close of the business day immediately preceding the first day in the term of an NPC. 7. The NPC is entered into on or after the announcement of a special dividend and prior to the ex-dividend date. On August 31, 2012, Treasury and the IRS extended the current rules to payments on NPCs made on or before December 31, REG (Jan. 19, 2012). T.D (Aug. 31, 2012).

4 An Overview of the Section 871(m) Proposed Regulations page 4 II. Final Regulations The Final Regulations extend the current rules (i.e., the four-factor test) through December 31, In addition, the Final Regulations: Modify section to provide that the general source rule for NPCs does not apply to dividend equivalent payments under section 871(m) Amend section 1441 to require a withholding agent to withhold tax owed with respect to dividend equivalent payments (consistent with changes made in the 2012 temporary regulations) Reinstate the examples in section (a)(3) relating to the definition of a withholding agent (inadvertently deleted by the 2012 temporary regulations) Adopt the rule contained in the 2012 temporary regulations that section 871(m) applies to dividend equivalents payments received by foreign corporations Clarify that a financial intermediary or custodian that satisfies the definition of a withholding agent under section (a) is considered a withholding agent for purposes of section 871(m) Withdraw rules that would have permitted a withholding agent to use the distributing corporation s estimates to determine the amount of a dividend equivalent payment Finalize portions of the 2012 proposed regulations relating to the treatment of dividend equivalent payments under section 871(m) as dividends for purposes of sections 892 and 894 III. Proposed Regulations In general, the Proposed Regulations would impose a U.S. withholding tax on dividend equivalent payments made on or after January 1, 2016, on NPCs or equity-linked instruments ( ELIs ) that reference U.S. equities in which the delta with respect to such equities is 0.7 or greater. In the case of ELIs, the Proposed Regulations provide a grandfathering rule by limiting the proposed rules to ELIs that are issued at least 90 days after

5 An Overview of the Section 871(m) Proposed Regulations page 5 the Proposed Regulations are finalized. 14 The Proposed Regulations represent a dramatic shift in the government s approach to cross-border derivative payments with respect to U.S. equities by significantly broadening the extent to which U.S. withholding tax is imposed on the derivatives. Also, the Proposed Regulations mark the first time the IRS has proposed a delta-based rule. The use of delta could have broad application in other areas of taxation such as with respect to constructive ownership and constructive sale transactions. A. Delta The Proposed Regulations define delta as the ratio of the change in the fair market value of an NPC or ELI to the change in the fair market value of the property referenced by the NPC or ELI. 15 For example, if a foreigner purchases a call option that references 100 shares of U.S. stock and the value of the option is expected to change by $0.80 for every $0.01 change in the price of a share of the underlying stock, the call option has a delta of 0.8 (0.8/(.01x100 shares)). The delta of an NPC or ELI must be determined in a commercially reasonable manner. 16 If a taxpayer calculates delta for non-tax business purposes that delta would generally be treated as the delta for purposes of section 871(m) as well. 17 If the delta of an instrument is not reasonably expected to vary throughout the instrument s term, then the instrument is treated as having a delta of 1.0 with respect to an adjusted number of reference shares. 18 For example, if an NPC provides a foreigner with 50 percent of the upside, downside, and dividends on 100 shares of stock and the value of the NPC is expected to change $.50 for every $1 change in the price of the stock (i.e., the delta is 0.5) and the delta is not reasonably expected to vary throughout the term of the instrument, the NPC will be treated as having a delta of 1.0 with respect to 50 shares (instead of having a delta of 0.5 with respect to 100 shares). 19 The delta rule described provides planning opportunities for foreigners to avoid the application of a 30 percent withholding tax under section 871(m) IRS Notice Initially, the Proposed Regulations would have applied to ELIs acquired on or after March 5, However, the IRS extended this grandfathering rule. Proposed section (g)(1). Proposed section (g)(1). Proposed section (g)(1). Proposed section (g)(2). Proposed section (g)(3), Ex.3.

6 An Overview of the Section 871(m) Proposed Regulations page 6 by utilizing instruments that provide for dividend equivalent payments but have a variable delta of less than 0.7. For example, foreign investors may consider investing in dividend return only swaps that provide no upside or downside exposure, because the swaps would generally have a delta below 0.7 and thus would not be subject to withholding under section 871(m). Also, it is noteworthy that the Proposed Regulations offer little guidance as to how to calculate the delta of an instrument and what methods of delta determination will be treated as commercially reasonable. B. Definition of Divided Equivalent The Proposed Regulations adopt a broad definition of dividend equivalents to include actual dividends, estimate dividends, and any implicit dividends. 20 Implicit dividends include payments that take into account an actual or estimated dividend in computing one or more of the terms of a transaction including interest rate, notional amount, purchase price, premium, upfront payment, or strike price. 21 In addition, dividend equivalent payments include gross amounts that reference the payment of a U.S. source dividend and are used to compute any net amounts under an instrument. 22 For example, consider a transaction in which a foreign investor enters into a price return swap that provides the foreigner with upside and downside exposure on 100 shares of ABC Corporation stock and in return the foreigner must pay a LIBOR-based rate to its counterparty. The swap does not entitle the foreign investor to dividend equivalent payments but the LIBOR-based rate is reduced to reflect annual dividends on the ABC shares. Under the Proposed Regulations, the foreign investor is treated as receiving dividend equivalent payments because the LIBOR leg of the swap is reduced to reflect estimated dividends. 23 One can question whether the reduced cost to the foreigner resulting from the reduced LIBOR-based rate should properly be treated as a payment to the foreign investor. Even if the cost to the foreigner of entering into the price return swap is less than the cost of entering into a total return swap, query whether section 871(m) provides sufficient Proposed section (h)(2). Proposed section (h)(2)(ii). Proposed section (h)(1). Proposed section (h)(4), Ex. 2.

7 An Overview of the Section 871(m) Proposed Regulations page 7 statutory authority to tax the foregone costs. 24 Moreover, the Proposed Regulations would seem to cover payments on virtually all equity swaps or ELIs that reference dividend-paying stocks, as it is difficult to fathom any such instrument that would not at least implicitly account for estimated dividend payments when pricing the instrument in an arm s-length transaction. The Proposed Regulations establish a presumption that dividend equivalent payments with respect to an ELI will be equal to the actual per share dividends on the underlying security. 25 If, however, the short party, at the time the instrument is acquired, provides in writing a reasonable estimated dividend, the dividend equivalent will equal the lesser of (1) the estimated dividend amount and (2) the actual dividend amount paid on the underlying stock. 26 C. Amount of Dividend Equivalent Payment Under the Proposed Regulations, if a transaction is subject to withholding tax under section 871(m), the amount of the tax is equal to 30 percent of the amount of a dividend equivalent. For securities lending transactions or sale-repurchase transactions the amount of the dividend equivalent is the full amount of the actual per share dividend paid on the underlying security. 27 However, for NPCs or ELIs, the amount of the dividend equivalent is reduced to account for the delta of the transaction. Specifically, the amount of the dividend equivalent is the product of (1) the amount of the per share dividend, (2) the number of reference shares, and (3) the delta of the transaction. 28 For example, if a foreign investor enters into an equity swap with a delta of 0.8 on 100 shares of ABC stock and ABC pays an actual dividend of $1.00 per share, then the amount of the dividend equivalent payment subject to withholding would be $80, i.e., ($1.00)(100)(0.8) rather than $100 (the actual dividend on 100 shares of ABC stock). Interestingly, the delta used to determine the amount of a dividend equivalent payment differs from the delta used to determine whether an See, D. Hariton, Will the New SWAP Regs Work to Implement Section 871(m)? 2014 TNT 14-2 (Jan. 22, 2014). Proposed section (h)(2)(iii). Proposed section (h)(2)(iv). Proposed section (i)(1)(i). Proposed section (i)(1)(ii)(A).

8 An Overview of the Section 871(m) Proposed Regulations page 8 instrument is subject to section 871(m) (i.e., whether it meets the 0.7 threshold discussed in Part III. A. above). Although the latter delta is determined at the time the transaction is entered into, the delta used to determine the amount of a dividend equivalent payment is determined at the earlier of (1) the underlying stock s ex-dividend date or (2) the record date with respect to the dividend. 29 If, however, an instrument has a term that is one year or less its delta is determined when the long party (e.g., the foreign investor) disposes of the instrument. 30 Also, the delta of an option at lapse is treated as zero 31 and the delta of an option when it is exercised is treated as one. 32 Therefore, if a foreigner enters into an option with a term of less than one year and the option lapses, the foreigner will not be subject to withholding under section 871(m), as the amount of the dividend equivalent with respect to the option would be zero (because the delta is zero). It is unclear why the Proposed Regulations require the use of a new delta and do not simply use the initial delta to determine the amount of dividend equivalent payment. Moreover, as this new delta must be determined at each ex-dividend date and/or record date (with respect to an instrument that has a term of more than a year and pays multiple dividends over the term of the instrument), this rule may impose a significant administrative burden on the parties to keep track of delta at various times. D. Combined Transactions The Proposed Regulations contain what is in essence an anti-abuse provision to prevent taxpayers from avoiding section 871(m) by entering into multiple transactions referencing the same underlying security. Under the Proposed Regulations, if a foreign person (or related person) enters into two or more positions (regardless of whether they are with the same counterparty) in connection with each other with respect to the same underlying U.S. stock, the positions are combined to determine their delta and thus withholding tax obligations. 33 For example, if a foreigner purchases a call option with a delta of 0.6 with respect to a U.S. stock and sells a put with respect to the underlying stock such that the combined Proposed section (i)(2)(i). Proposed section (i)(2)((ii). Proposed section (i)(1)(ii)(C)(2). Proposed section (i)(1)(ii)(C)(3). Proposed section (l)(1).

9 An Overview of the Section 871(m) Proposed Regulations page 9 delta of the put/call combination is 0.9, the foreigner would be subject to withholding tax under section 871(m) with respect to dividend equivalent payments on both the put and call. Combined transactions are tested each time the foreigner (long party) enters into a transaction. 34 The above combination rule cannot be used to lower the delta of a transaction. For example, if a foreigner purchases a call option with a delta of 0.8 with respect to a U.S. stock and three months later sells a put with respect to the same underlying U.S. stock and the combined delta of the put/call combination at the time is 0.5, the foreigner would nevertheless be subject to withholding tax under section 871(m) on the call option. 35 The combination rule raises a number of questions. First, the Proposed Regulations do not define the term in connection with. Consider a scenario in which on day one a foreigner (1) purchases a call option with respect to a U.S. stock and (2) writes a put option with respect to the stock and on day two (3) purchases a call option with respect to the stock. Query whether the second call option should be treated as in connection with the positions acquired on day one. Furthermore, it is unclear if the termination of a leg of a combined transaction would require retesting of delta with respect to other positions. Moreover, enforcement issues may arise with respect to the combination rule. As discussed below, in general the short party is required to determine whether payments under an instrument are subject to withholding under 871(m) 36 but is not required to obtain information from its (foreign) counterparty regarding other positions held by the counterparty. Therefore, if for example, a foreigner purchased a position with a delta of 0.5 with respect to an underlying U.S. stock and then purchased a position with a delta of 0.4 (with respect to the underlying U.S. stock) from a different U.S. counterparty, such that the combined delta of the two positions equals or exceeds 0.7, neither U.S. counterparty would be obligated to withhold unless it knows about the other transaction Proposed section (l)(2). Proposed section (l)(3). Unless the long party is a broker or dealer and the short party is not. See Part III. H. below.

10 An Overview of the Section 871(m) Proposed Regulations page 10 E. Exceptions The Proposed Regulations provide exceptions to the withholding obligation under section 871(m) for (1) qualified dealers, (2) certain corporate acquisitions, and (3) payments made with respect to a qualified index. 1. Qualified Dealer The Proposed Regulations provide that dividend equivalent payments to a foreign dealer are exempt from withholding tax if the dealer enters into the transaction in its capacity as a dealer and is a long party with respect to the underlying security. 37 A qualified dealer is any dealer that (1) is subject to regulatory authority in the jurisdiction in which it was created or organized and (2) provides written certification to the short party that (i) it is acting in its capacity as a dealer in securities and (ii) it will withhold and deposit any tax imposed under section 871(m) on transactions that it enters into as a short party in its capacity as a dealer in securities. 38 Seemingly, the certification in clause (2)(ii) above, would require the foreign dealer to represent that it will withhold on every transaction subject to section 871(m) in which it is the short party and not specifically with respect to the transaction in which the dividend equivalent is paid to the foreign dealer. It is unclear why the Proposed Regulations require such broad certification. The rationale for the qualified dealer exception is that non-proprietary dealer transactions have little potential for tax avoidance 39 presumably because the dealer will hedge its long position with respect to the underlying U.S. stock with an offsetting short position. Therefore, it should be sufficient for the qualified dealer to represent that it will withhold under section 871(m) on the offsetting short positions (as opposed to all transactions that it enters into as a short party in its capacity as a dealer). 2. Corporate Acquisition Exception The Proposed Regulations provide an exception to section 871(m) for transactions that require the long party to acquire ownership of the underlying security as part of a plan pursuant to which one or more persons (including the long party) are obligated to acquire underlying securities representing more than 50 percent of the value of the entity Proposed section (j)(1)(i). Proposed section (j)(1)(ii). See Preamble to Proposed Regulations, 78 Fed. Reg (Dec. 5, 2013).

11 An Overview of the Section 871(m) Proposed Regulations page 11 issuing the underlying securities. 40 The long party must provide written certification to the short party that it satisfies the above requirements for this exception Qualified Index Exception The Proposed Regulations provide an exemption from U.S. withholding tax under section 871(m) for dividend equivalent payments made with respect to a qualified index by treating a qualified index as a single security that is not an underlying security. 42 There are two types of qualified indices. First, a qualified index is an index that: References 25 or more component underlying securities; References only long positions on component underlying securities; Contains no component underlying security that represents more than 10 percent of the weighting of the underlying securities in the index; Is modified or rebalanced only according to predefined objective rules at set dates or intervals; Does not provide a dividend yield from component underlying securities that is greater than 1.5 times the current dividend yield of the S&P 500 Index as reported for the month immediately preceding the date the long party enters into or acquires the instrument; and Is referenced by futures or option contracts that trade on either a national securities exchange that is registered with the Securities and Exchange Commission or domestic board of trade designated as a contract marker by the Commodities Futures Trading Commission. 43 This exemption appears to have been intended to enable a foreigner to hold an ELI or NPC that references the S&P 500 Index (or a similar index) without being subject to withholding tax under section 871(m). Ironically, Proposed section (j)(2). Proposed section (j)(2). Proposed section (k)(1). Proposed section (k)(2).

12 An Overview of the Section 871(m) Proposed Regulations page 12 as drafted, the S&P 500 Index may not fall within the definition of a qualified index. For example, arguably the S&P 500 Index is not, modified or rebalanced only according to predefined objective rules at set dates or intervals, but rather stocks can be added or dropped based on the discretion of the index s sponsor. 44 Also some broad indices are referenced by exchange traded funds and not by exchanged traded futures or options contracts and would thus not be treated as qualified indices under the Proposed Regulations. In fact, as currently drafted it is not clear if any index would satisfy the criteria to be treated as a qualified index. Finally, it is unclear why the qualified index exception applies only to an index that is referenced by futures or option contracts that trade on a U.S. exchange (or board of trade) but not if the futures or option contracts trade on a foreign exchange. As a result, dividend equivalent payments with respect to certain international equity indices would be subject to withholding unless the indices qualify under the alternative definition of qualified index discussed below. The second type of qualified index is one that (1) is comprised solely of long positions in assets and (2) no more than 10 percent of its components (by weight) are U.S. stocks. 45 Therefore, if for example, an equity swap referenced an index of international equities in which U.S. equities comprised 10 percent or less of the index s weighting, dividend equivalent payments with respect to the swap would not be subject to withholding under section 871(m). The determination of whether an index is a qualified index is made at the time that a long party acquires an instrument and is determinative only with respect to the transaction. 46 Thus, an index may be qualified with respect to a transaction entered into on day one but not respect to a transaction entered into on day two. F. Instruments that Reference Partnership (or other Passthrough Entities) The Proposed Regulations provide a look-through rule under which an instrument that references an interest in an entity that is not a C corporation (e.g., a partnership) is treated as referencing the allocable See S&P Dow Jones Indices, S&P U.S. Indices: Methodology 6-7(2013), available at Proposed section (k)(3). Proposed section (k)(1).

13 An Overview of the Section 871(m) Proposed Regulations page 13 portion of any U.S. stock or equity-linked instruments held by that entity directly or indirectly. 47 For example, if a foreigner enters into a total return swap over an interest in a master limited partnership ( MLP, such swap, an MLP Swap ) and 40 percent of the value of the referenced MLP interest is attributable to U.S. stock, the MLP swap is treated as referencing 40 percent of the U.S. stock. Alternatively, if for example, a foreigner enters into an MLP swap over an MLP that owns a an interest in a lower-tier partnership and 80 percent of the value of the lower-tier interest is attributed to U.S. stocks and 50 percent of the value of the referenced MLP interest is attributable to its ownership of the lower-tier partnership, the referenced MLP interest will be treated as referencing 40 percent of the U.S. stocks (i.e., 0.8 x 0.5). In practice, it may be difficult to comply with the above look-through rules as counterparties may not be able to obtain the necessary partnership information to determine if payments are subject to withholding under section 871(m). The Proposed Regulations provide an exception to the above look-through rules if the underlying U.S. stock and ELIs represent no more than 10 percent of the value of the referenced interest in the pass-through entity at the time the long party acquires the instrument and there is no plan or intention for acquisitions or dispositions that would cause underlying securities to represent more than 10 percent of the value of the referenced interest. 48 However, this exception may be of limited use because it may be difficult for a counterparty to determine that there is no plan or intention for acquisitions or dispositions that would cause underlying securities to represent more than 10 percent of the value of the referenced interest. G. Anti-Abuse Provision The Proposed Regulations contain a broad anti-abuse provision providing that if a taxpayer (directly or through the use of a related person) acquires an instrument with a principal purpose of avoiding the application of the Proposed Regulations, the IRS may treat any payment with respect to the transaction as a dividend equivalent payment to the extent necessary to prevent the avoidance of the section 871(m) rules. 49 In addition, the IRS may (1) adjust the delta of a transaction (2) change the number of shares, Proposed section (m)(1). Proposed section (m)(2). Proposed section (n).

14 An Overview of the Section 871(m) Proposed Regulations page 14 (3) adjust an estimated dividend amount, (4) adjust the timing of payments, or (5) combine separate or disregard transactions or indices to reflect the substance of a transaction. 50 H. Reporting Requirements The Proposed Regulations posit that a financial institution is usually in the best position to undertake the responsibility to report the tax consequences of a transaction to which section 871(m) may apply. 51 Therefore, if only one party to a transaction is a broker or dealer, then the broker or dealer is required to exercise reasonable diligence to determine whether the transaction is subject to withholding under section 871(m) and to report to its counterparty the timing and amount of any dividend equivalent payments. 52 In addition, within 14 days after request, the broker or dealer must provide its counterparty the following information: The amount of each dividend equivalent The delta of the instrument The amount of any tax withheld The estimated dividend amount Any other information necessary to apply the rules set forth in the Proposed Regulations 53 If either (1) both parties to a transaction are brokers or dealers or (2) neither party is a broker or dealer, the short party must determine whether payments under an instrument are subject to withholding under section 871(m) and the short party is subject to the above reporting requirements. 54 The above reporting requirements would impose a potentially onerous burden on financial institutions. For example, U.S. brokers acting as short parties would need to calculate the delta for each equity linked instrument referencing U.S. stocks on each day they enter into a transaction with a foreign counterparty with respect to the instrument. In addition, U.S Proposed section (n). See Preamble to Proposed Regulations, 78 Fed. Reg (Dec. 5, 2013). Proposed section (o)(1). Proposed section (o)(3). Proposed section (o)(1).

15 An Overview of the Section 871(m) Proposed Regulations page 15 brokers would need to determine whether an index is a qualified index each day they enter into an instrument with a foreigner that references an index. Also, to determine the amount of a dividend equivalent payment with respect to an instrument, U.S. brokers would have to determine the delta of the instrument at the earlier of the underlying stock s ex-dividend date or record date with respect to the dividend. In addition, U.S. brokers would be required to compute the combined delta of multiple instruments if the instruments are entered into in connection with each other with respect to the same underlying U.S. stock. Moreover, U.S. brokers may be required to compute and provide the above information even when facing a U.S. counterparty. For example, a U.S. broker that enters into an equity swap (referencing U.S. stock) with a U.S. partnership that has foreign partners would be required to provide information to the U.S. partnership with respect to dividend equivalent payments on the swap. Therefore, brokers, dealers, and short parties should consider putting into place sophisticated tracking and information reporting systems if the Proposed Regulations are adopted in substantially similar form. I. Withholding Matters Under the Proposed Regulations, withholding agents 55 (such as a U.S. short party with respect to an SNPC or ELI) are required to withhold on the amount of a dividend equivalent payment. 56 Failure by the agents to withhold can result in liability to the agents for amounts required to be withheld. The Proposed Regulations attempt to ease the withholding burden on withholding agents who do not have control over money or property of their foreign counterparties by providing that a withholding agent is not required to withhold under section 871(m) until the amount of the dividend equivalent payment has been determined and either (1) money or other property is paid to or from the long party, (2) the withholding agent has custody or control over money or property of the long party at any time on or after the amount of a dividend equivalent payment is determined, or (3) the transaction provides for an upfront payment or prepayment of the purchase price. 57 Also, the Proposed Regulations provide that for purposes of withholding under section 871(m), a withholding agent may rely on information As the term is defined in section (a). Proposed section (h)(1). Proposed section (d)(5)(i), (ii).

16 An Overview of the Section 871(m) Proposed Regulations page 16 received from the party required (under the Proposed Regulations) to determine whether section 871(m) is applicable to the transaction. 58 However, it may not rely on the information if it has actual knowledge or reason to know that the information received is incorrect. 59 IV. Conclusion The Proposed Regulations would dramatically expand the scope of section 871(m) and the extent to which U.S. withholding tax is imposed on financial instruments. Moreover, the delta-based approach set forth in the Proposed Regulations raises a number of questions and issues that the IRS should consider before finalizing the Proposed Regulations. Finally, U.S. brokers, dealers, and short parties should consider putting into place sophisticated tracking and information systems to comply with the requirements under section 871(m) if the Proposed Regulations are finalized in substantially similar form. KPMG s What's News in Tax is a publication from Washington National Tax that contains thoughtful analysis of new developments and practical, relevant discussions of existing rules and recurring tax issues. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of KPMG LLP Proposed section (h)(2). Proposed section (h)(2).