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IRS Cries Uncle for the Fourth Time on the Section 871(m) Substantial Equivalence Test

On August 23, 2022, the IRS issued Notice 2022-37 (reproduced here), which once again extends the phase-in of withholding under Section 871(m). Broadly speaking, foreign persons may be subject to a 30% withholding tax under Section 871(m) on certain dividend equivalents paid or deemed paid to a foreign person with respect to a specified equity-linked instrument that references one or more dividend-paying U.S. equity securities. Specifically, Section 871(m) imposes withholding on (i) simple contracts with a delta of .8 or more, and (ii) complex contracts that fail to meet the substantial equivalence test. Under Notice 2022-37, Section 871(m), withholding on dividend equivalents applies only to delta-one transactions through 2024, and will not apply to other U.S. equity transactions until after 2024. Although “delta-one” has not been defined in IRS guidance, it is generally thought to mean a linear nearly one-to-one correlation. Accordingly, a delta-one transaction tracks the underlying security on a dollar-for-dollar basis.

Notice 2022-37 marks the fourth extension of the effective date for the regulations to apply, as most recently extended pursuant to Notice 2020-2 (discussed here). This latest extension of the implementation period for the final regulations, which were initially published in 2015, suggests that the regulations may never be finalized as currently drafted and may instead require substantial alterations. We read this extension as a tacit admission by the IRS that the substantial equivalence test may not be the best way forward due to its complexity and the high costs that market participants would have to incur to implement the test. Because of the uncertainty that these multiple extensions are causing to market participants, sooner rather than later the IRS should either (i) send strong signals of its intent to ultimately adopt the substantial equivalence test, or (ii) articulate its intention to adopt a more streamlined, simplified test.

In addition, the notice generally provides that:

  • When enforcing Section 871(m), the IRS will take into account the extent to which the taxpayer or withholding agent made a good faith effort to comply with Section 871(m) for delta-one transactions through 2024 and for non-delta-one transactions in 2025.
  • Until 2025, withholding agents will be required to combine transactions for purposes of determining whether the transactions are subject to withholding under Section 871(m) only if the transactions are over-the-counter transactions and are priced, marketed, or sold in connection with each other. Notably, this simplified standard applies only to withholding agents, and not to long parties. Thus, a long party may still owe substantive tax with respect to equity-linked derivatives that are entered into in connection with each other and, when combined, result in a delta-one transaction, even if the withholding agent does not withhold.  
  • Withholding agents can continue to use the qualified securities lending (“QSL”) rules for payments made until 2025.
  • A qualified derivatives dealer (“QDD”) will not be subject to tax on dividends and dividend equivalents received in its equity derivative dealer capacity until 2025. Beginning in 2025, a QDD must compute its Section 871(m) tax liability using a net delta exposure method and perform certain periodic reviews with respect to its QDD activities.  
 

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