Phase-In of Rules on “Dividend Equivalent” Payment Withholding Provided in IRS Notice

On December 2, 2016, the IRS issued Notice 2016-76 (the “Notice”)  in order to provide guidance for complying with the final and temporary regulations under Internal Revenue Code (“IRC”) Sections 871(m), 1441, 1461  and 1473 (collectively, the “Section 871(m) regulations”).  These Section 871(m) regulations address withholding on United States-source dividend equivalents.  (See the EisnerAmper Alert, dated October 13, 2015, entitled “IRS Issues New Final and Temporary Regulations on “Dividend Equivalent” Payment Withholding.”)  Due to the reported challenges that face taxpayers and withholding agents in complying with the Section 871(m) regulations, the Treasury and IRS intend to amend the applicability dates of Section 871(m) regulations, and phase in the application of these rules to certain transactions during calendar years 2017 and 2018 (“2017 phase-in year” and “2018 phase-in year”).

The Notice provides that during the 2017 phase-in year, the Section 871(m) regulations will apply to payments made with respect to any potential 871(m) transactions issued on or after January 1, 2017 that have a “delta” of one, including so-called “combined transactions.”  As noted in our October 23, 2015 alert, delta is the ratio of the change in the fair market value of a notional principal contract (“NPC”) or equity linked instrument (“ELI”) to a small change in the fair market value of the number of shares of the underlying security referenced by the NPC or ELI.  A “combined transaction” involves two or more potential section 871(m) transactions that are treated as a single transaction with respect to an underlying security under specified circumstances.

Payments made with respect to any non-delta-one transactions, including combined transactions, will be subject to the Section 871(m) regulations as of January 1, 2018.  All public indications by Treasury and IRS representatives are that this January 1, 2018 date is not likely to be further delayed.  2018 will be a phase-in year for any non-delta-one transaction that is a section 871(m) transaction.

During these phase-in years, the IRS will provide relief to taxpayers and withholding agents with respect to enforcement if they make a “good faith” effort to comply with the Section 871(m) regulations.  For example, the IRS will take into account whether a withholding agent made a good faith effort to:

1. build or update documentation and withholding systems to comply with the Section 871(m) regulations,
2. determine whether transactions are combined transactions,
3. report information to other parties to a transaction and
4. implement the “substantial equivalence” test for complex contracts for 2018.  

Any person that does not make a good faith effort to comply with the Section 871(m) regulations will not be given relief from IRS administration or enforcement, including penalties. 

During 2017, a withholding agent will be considered to have timely satisfied deposit requirements for Section 871(m) dividend equivalent payments if it makes deposits of amounts withheld for dividend equivalents during any calendar quarter on or before the last day of that calendar quarter. The withholding agent should write “Notice 2016-76” on the center, top portion of the 2017 Form 1042 tax return.

The Notice provides a “simplified standard” for withholding agents to determine whether transactions entered into in 2017 are combined transactions.  A withholding agent will only be required to combine transactions entered into in 2017 for determining whether the transactions are Section 871(m) transactions when the transactions are over-the-counter transactions that are priced, marketed, or sold in connection with each other.  Withholding agents will not be required to combine any transactions that are listed securities that are entered into in 2017.  Transactions that are entered into in 2017 that are combined under the simplified standard will continue to be treated as combined transactions for future years and will not cease to be combined transactions as a result of applying the Section 871(m) regulations or disposing of less than all of the potential section 871(m) transactions that are combined under this rule.  Transactions entered in 2017 that are not combined under this simplified standard will not become combined transactions as a result of applying the Section 871(m) regulations to these transactions in future years unless a reissuance or other event causes the transactions to be retested to determine whether they are section 871(m) transactions.  The simplified standard only applies to withholding agents and does not apply to taxpayers that are long parties to potential section 871(m) transactions. 

Certain exchange traded notes (“ETNs”) that reference underlying securities, are delta-one transactions and were issued prior to the issuance of the Section 871(m) regulations in 2015, get special attention in this Notice.  Certain of these ETNs have been in “continuous distribution,” i.e.,  issuers continually issue and sell new ETNs based on the same offering documents as the original ETN security, with the same ticker symbol and CUSIP number.  Thus, in the case of these particular continually distributed delta-one ETNs , those issued before January 1, 2017 would not be subject to section 871(m) withholding , while an identical newly created ETN issued on or after January 1, 2017 would be subject to that withholding.  Thus, otherwise identical ETNs for commercial and other legal purposes would not be fungible for tax purposes.  Accordingly, the Notice delays the application of the Section 871(m) regulations in the case of 25 specified ETNs until January 1, 2020.

Finally, the Notice provides that the anti-abuse rule contained in the Section 871(m) regulations will continue to apply during the 2017 and 2018 phase-in years.