Recent guidance on enforcement of Section 871(m) withholding

December 28, 2016

In anticipation of the regulations under Internal Revenue Code Section 871(m)1 coming into partial effect in 2017, the IRS published Notice 2016-76 on December 2, 2016, providing transition rules for taxpayers affected by these regulations.

Background.  Generally, U.S.-source dividends are subject to 30% U.S. withholding tax, subject to reduction under a tax treaty. In 2010, Congress enacted Section 871(m), which provided that dividend-equivalent payments in respect of swaps and other similar arrangements referencing U.S. equity securities would be subject to U.S. withholding tax. Since 2012, the IRS has issued several iterations of proposed and final regulations interpreting Section 871(m). These rules will partially come into effect in 2017.2

These rules will impose withholding and reporting obligations on short parties, including non-U.S. persons who are parties to certain swaps, derivative arrangements, securities lending and repurchase transactions, and other equity-linked instruments which reference U.S. equity securities. Under the final and temporary rules, if a covered transaction or instrument has a “delta” (i.e., the ratio of the value of the contract to the market value of the reference asset) greater than 0.8 at the time the long party enters into or acquires the covered transaction or instrument, dividend equivalent payments are subject to withholding tax.

Phase-In Period.  Beginning on January 1, 2017, only delta-one transactions, including combined transactions,3 will be subject to 30% withholding tax under section 871(m). Non-delta-one transaction will be subject to this withholding tax beginning on January 1, 2018. Noting potential challenges in compliance and developing withholding and reporting systems, the IRS will take into account whether a withholding agent has made a good faith effort to comply with these regulations during this phase-in period.

Combined Transactions.  0Notice 2016-76 provides a simplified rule for determining whether transactions are combined transactions. Multiple transactions are treated as one transaction when the long party enters into multiple transactions referencing the same asset, the combined transactions replicate the economics of a section 871(m) transaction, and the transactions were entered into in connection with another transaction. While this test appears subjective, the IRS allows a short party to presume that transactions are not entered into in connection with another transaction when the long party holds the transactions in separate accounts or entered into the transactions more than two business days apart, unless the party has actual knowledge that the transactions should be treated as a single combined transaction.

Qualified Derivative Dealer (“QDD”) Status Phase-In. For 2017, the IRS will take into account whether the QDD has made a good faith effort to comply with the QDD rules and with the terms of the Qualified Intermediary (“QI”) agreement. An equity derivatives dealer can seek QI and QDD status by entering into the QI agreement with the IRS by March 31, 2017. Prior to timely filing the QI application and obtaining QI and QDD status, the QDD may represent that it is a QDD on Form W-8IMY if it intends to file the QI application by March 31, 2017. Where the prospective QDD’s application is denied or it no longer intends or does not timely file the QI application, the entity should notify any withholding agent that it should not be treated as a QDD.

Once the QI application is approved, the QDD is issued a QI-EIN (i.e., a special employer identification number issued to QIs), which is included on the Form W-8IMY. Prior to approval, the QI can state it is “awaiting QI-EIN.” Within 3 days of receiving the QI-EIN, the QDD must deposit any amounts it withheld, and it may enroll in the Election Federal Tax Payment Systems to deposit these funds.

Guidance on Exchange Traded Notes (“ETNs”). The IRS has provided a list of ETNs to which the 871(m) rules will not apply until January 1, 2020. This list can be found under section III.D of the Notice. Additional ETNs may be added to this list.

For additional guidance on potential withholding and reporting obligations, please contact Ronald P. Cima (212-574-1471), Jonathan P. Brose (212-574-1615), James C. Cofer (212-574-1688), Peter E. Pront (212-574-1221), Daniel C. Murphy (212-574-1210) or Brett Cotler (212-574-1269).


1 All “Section” references are to the United States Internal Revenue Code of 1986, as amended.

2 See our previous client alerts on Section 871(m) from February 2012, December 2013 and October 2015.

3 Delta-one transactions have a delta of one. A transaction’s delta is the ratio of the value of the contract to value of the reference asset(s). Where a delta is greater than 0.80, the transaction will be subject to 871(m) withholding.


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