On 17 September 2015, the U.S. Treasury Department and the Internal Revenue Service (IRS) released a combined set of final and temporary §871(m) regulations (hereafter, the “New §871(m) Regulations”). The law aims to regulate derivative contracts referencing a U.S. equity as an underlying asset, regardless of the location of the issuer. The U.S. government is concerned that some of these contracts enable non-U.S. Persons to enjoy the economic benefits of holding the underlying U.S. equities, while avoiding any withholding on U.S. dividend payments. Therefore, the IRS introduced deemed dividend payments of U.S. underlying equities, so called dividend equivalent payments, which will be treated by the IRS as U.S.-source income, hence, subject to withholding and reporting.
The New §871(m) Regulations will fully enter into force on 1 January 2017. Thus, only derivative contracts issued on or after that date will be subject to its full range of terms. Nonetheless, prior to 2017 derivative contracts may be in scope of 871(m) if they are issued from 1 January 2016 onwards and if they contemplate a dividend equivalent payment in 2018 or afterwards.
As a result of the staggered implementation of the regulations, for any contracts issued in 2016 with a payment contemplated in 2018 or beyond, designated financial institutions (generally derivative brokers and dealers) will be required to provide the 871(m)-related information within 10 business days upon request from a counterparty. Furthermore, there is a requirement under the New §871(m) Regulations to keep 871(m)-related records of any derivative contract within 10 business days of issuance. Few designated financial institutions will be prepared with the processes and systems necessary to determine a contract’s status by 1 January 2016. Many had presumed a longer implementation period in light of the delays in the release of the regulations. Many, thus, will need to assess the risks attendant to issuing any products that could potentially be captured by the notification rule and record-keeping obligation.
The route to full compliance with the New §871(m) Regulations is long but time is pressing. In addition to the various testing methods needed to assess whether a contract is in-scope for §871(m), payments must be identified, payees documented and withholding potentially applied. In order to overcome such obstacles, careful planning and informed decision-making are critical.
Authors: Paul Millen, Dr Martin Widmer, Kevin Radon.