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IRS Kicks Substantial Equivalence Test Down the Road Again

On May 22, 2024, the IRS issued Notice 2024-44 (reproduced here), which once again extends the phase-in for Section 871(m) withholding.  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 2024-44, Section 871(m), withholding on dividend equivalents applies only to delta-one transactions through 2026 and will not apply to other U.S. equity transactions until after 2026.  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.

The repeated extensions of the effective dates for the Section 871(m) regulations, which were originally published in 2015, raise concerns about their future.  As previously discussed here, we view the IRS’s reluctance to finalize these regulations as an acknowledgment of the regulations’ inherent flaws, namely the substantial equivalence test’s complexity and implementation cost.  Ultimately, this lack of clear guidance leaves market participants in a state of uncertainty, unsure when, if ever, these regulations will become effective.

In addition to the above, the notice further provides that:

  • When enforcing Section 871(m), the IRS will take into account the extent to which the taxpayer or withholding agent makes a good faith effort to comply with Section 871(m) for delta-one transactions through 2026 and for non-delta-one transactions in 2027.                        
  • Until 2027, 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 rules for payments made until 2027.                                                                                                                       
  • A qualified derivatives dealer (“QDD”) will not be subject to tax on dividends and dividend equivalents received in its equity derivatives dealer capacity until 2027. Beginning in 2027, 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.  

Key Contacts

Linda Z. Swartz
T. +1 212 504 6062


Adam Blakemore
T. +44 (0) 20 7170 8697

Jon Brose
T. +1 212 504 6376

Andrew Carlon
T. +1 212 504 6378

Mark P. Howe
T. +1 202 862 2236

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