Section 871(m) dividend equivalent rules phase-in period extended

In brief

The IRS on August 23 issued Notice 2022-37, providing an extension of the transition relief phase-in period of the regulations under Section 871(m) (the Section 871(m) Regulations) for select transactions through 2024. Notice 2022-37 extends a phase-in period that previously had been provided for certain provisions of the Section 871(m) Regulations and permits withholding agents to apply the transition rules from Notice 2010-46 in 2023 and 2024.

Notice 2022-37 also provides for the anti-abuse rule in Treas. Reg. sec. 1.871-15(o) to continue to apply to the phased-in application of the Section 871(m) Regulations and that, as a result, a transaction that otherwise would not be treated as a Section 871(m) transaction may be treated as such. 

Action to consider: Treasury and the IRS are continuing to evaluate the Section 871(m) Regulations and are requesting any additional comments regarding ‘tax policy considerations, legal authority for, and the IRS administrative feasibility of any suggested modifications’ to the Section 871(m) Regulations.

Notices

Treasury and the IRS separately issued a number of notices that provide transition rules, provide a phase-in period for certain provisions of the Section 871(m) Regulations, and defer the effective date for portions of the regulations under Section 871(m) (see Notices 2010-46, 2016-76, 2017-42, 2018-5, 2018-72, and 2020-2). The various notices provide the following: 

• Transactions in-scope based on their delta are limited to ‘delta one’ transactions; as a result, transactions with a delta less than 1 but greater than 0.8 (delta .80 transactions) generally will not be in scope until a specified date; 
• The simplified combination rule will continue to apply for withholding agents until a specified date; 
• Withholding on actual and deemed dividends paid to QDDs is deferred until a specified date; 
• The good-faith periods for the implementation of Section 871(m) are extended; and 
• Withholding agents are permitted to apply the transition rules from Notice 2010-46.

These items are discussed in further detail below. 

Extension of the phase-in years for delta-one and non-delta-one transactions

Notice 2022-37 provides that the Section 871(m) Regulations will (1) continue to apply only to any delta-one transaction entered into through the end of 2024 (this limitation was due to expire at the end of 2022), and (2) begin to apply to any non-delta-one transaction that is a Section 871(m) transaction pursuant to Treas. Reg. sec. 1.871-15(d)(2) or (e) in 2025 (i.e., any derivative with a delta of 0.8 or greater or that fails the “substantial equivalent test”). A delta-one transaction is a transaction in which the value of the derivative moves in tandem with the underlying asset on which the derivative is based and the change in value is one-to-one.

Notice 2022-37 provides the anti-abuse rule in Treas. Reg. sec. 1.871-15(o) will continue to apply to the phased-in application of the Section 871(m) Regulations, including for the purpose of determining whether a transaction is a delta-one transaction. As a result of the anti-abuse rule, a transaction that otherwise would not be treated as a Section 871(m) transaction may be treated as one. 

For purposes of IRS enforcement and administration of the QDD rules in the Section 871(m) Regulations and the relevant provisions of the 2017 QI Agreement and of a revised QI Agreement that is anticipated to apply beginning January 1, 2023 (2023 QI Agreement), Notice 2022-37 extends through 2024 the period during which the IRS will take into account the extent to which the QDD made a good-faith effort to comply with the Section 871(m) Regulations and the relevant provisions of the 2017 QI Agreement and the 2023 QI Agreement. 

Observation: Notice 2022-37 generally is consistent with the substance of prior extensions and thus in effect extends the status quo for an additional two years. 

Extension of phase-in relief for qualified derivatives dealers

Under the Section 871(m) Regulations, a QDD may rely on the net delta exposure test to determine its residual exposure to underlying securities. That is, if it has a net delta of zero (i.e., no net economic exposure) in respect of an underlying security at the relevant time, then it generally would not have a Section 871(m) liability in respect of that position on such date. 

However, to address the concern that the exemption from withholding on dividends paid to a QDD, when combined with the net delta exposure method, could result in US source dividends escaping US tax completely in certain circumstances, a QDD remains liable for tax under Section 881(a)(1) and subject to withholding under chapters 3 and 4 on dividends. To allow taxpayers time to implement the net delta exposure method, dividends and deemed dividends received by a QDD in its equity derivatives dealer capacity in 2017 through 2022 were not subject to tax under Section 881(a)(1) or subject to withholding under chapters 3 and 4. Notice 2022-37 extends the period to include 2023 and 2024. 

Under current rules, a QDD would have been required to compute its net delta exposure beginning in 2023. Notice 2022-37 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 US source fixed, determinable, annual, or periodical income payments that it receives (whether or not in its equity derivatives dealer capacity). In addition, 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.