Tax Matters
Vol. 5, No. 2

 

Each edition of Tax Matters consists of free-flowing responses by three tax practitioners to a question regarding a current issue in tax law and policy. Tax Matters commentaries provide insightful perspectives on a broad range of topics, making important contributions to the dialogue within the tax bar about cutting-edge issues. Although the commentaries are certainly of interest to the academic community, they are primarily directed toward tax professionals and their clients.

Dawn of the Delta: Taming International Derivatives Tax Abuse

In 2008, Senator Carl Levin chaired congressional hearings on “Dividend Tax Abuse: How Offshore Entities Dodge Taxes on U.S. Stock Dividends.” The abuse in question arose from techniques used by foreign recipients to avoid dividend withholding tax. In brief, foreign holders owning U.S. stock directly would face dividend withholding of as much as 30 percent (lower under a treaty), but economically equivalent payments made to foreign counterparties in equity derivatives transactions escaped this tax.

The hearings gave rise to IRC § 871(m), ultimately added to the Code in 2010 as part of the Hiring Incentives to Restore Employment (“HIRE”) Act (which also featured the sweeping anti-evasion provisions known as the Foreign Account Tax Compliance Act). Section 871(m) imposes a withholding rate on “dividend equivalents.” These include substitute dividends made through securities lending or through a sale-repurchase transaction, and to specified notional principle contracts (“NPCs”). The statute, affirmed by temporary regulations released in 2012, deemed an NPC to be specified when there is a transfer or “crossing” of the underlying security, when the underlying security is not traded on an established securities market, or when the underlying security acts as collateral. Later proposed regulations, also issued in 2012, broadened the scope of NPCs to include “equity linked instruments” and replaced the statutory definition of specified NPCs with a list of seven types of prohibited derivatives (sometimes referred to as the “seven deadly sins”). In December 2013, however, the seven deadly sins were abandoned via final regulations, so the statutory definition of specified NPCs is again in place until the end of 2015.

Concurrent with the release of the 2013 final regulations, the Treasury released new proposed regulations that move away from a factor-based definition of specified NPCs all together, in favor of a test based on the economic similarity between the equity linked instrument and the underlying security. Starting in 2016, the deeming of specified NPCs will be based on the “delta” or change between the equity linked instrument and the underlying security. For example, a delta of “1”—that is, 100%—would indicate exact correspondence between the two instruments. The proposed regulations indicate that a change that tracks the underlying equity more than 0.7 or 70% will be assessed withholding tax.

The main criticism prompted by the 2013 proposed regulations is that the delta test is overbroad. They would impose withholding on a broad range of equity derivatives, like the original 2012 regulations. But they would also include many more derivatives than the statute as enacted in 2010 would cover. Observers will no doubt note that the delta test will impede legitimate business transactions. If this is true, what do these legitimate transactions look like, and what purpose do they serve? Is a test focused on economic similarity via a delta test inherently flawed? If so, what would be an appropriate way to mitigate abusive transactions while leaving unimpaired those transactions that do not have tax avoidance as their primary function?

 

Allison Christians, Associate Professor at McGill University Faculty of Law


5 Colum. J. Tax L. Tax Matters 12
Section 871(M) and Delta: When Should a Dividend Equivalent be Treated like a Dividend?
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5 Colum. J. Tax L. Tax Matters 15
Taxation Without Authorization: The Proposed “Dividend Equivalent” Withholding Regulations Under Section 871(M)
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5 Colum. J. Tax L. Tax Matters 19
The Most Recent Proposed Regulations Under Section 871(M): The Perfect is the Enemy of the Good
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Please visit the Archive for Tax Matters from previous issues.