Derivatives and Tax

An Overview of the Substantial Equivalence Test under Internal Revenue Code Section 871(m)


Internal Revenue Code Section 871(m) and the regulations thereunder treat “dividend equivalent payments” on certain equity derivatives as dividends from sources within the United States.[1] [2]  That is, federal withholding tax applies to such payments made to non-U.S. parties.[3] READ MORE

IRS Proposes to Revise the Treatment of Nonperiodic Payments

On May 8, 2015, the Internal Revenue Service (“IRS”) and the Department of the Treasury (“Treasury”) issued proposed and temporary regulations (the “Regulations”) relating to the treatment of notional principal contracts (“NPCs”) with nonperiodic payments.[1] The Regulations are designed to resolve questions that have arisen with the enactment of Dodd-Frank. The Regulations are a fundamental change in the treatment of NPCs. The rules apply to NPCs entered into on or after November 4, 2015, but taxpayers may apply the rules to NPCs entered into before November 4, 2015. The Regulations package also includes regulations under section 956 of the Internal Revenue Code of 1986 (the “Code”).

While the Regulations are designed to resolve issues, many unanswered questions remain.


NYS Bar Association Tax Session Issues Report on Section 871(m) Regulations

On May 20, 2014, the New York State Bar Association Tax Session issued a Report on Proposed Regulations under Section 871(m) of the Internal Revenue Code of 1986.  The report addresses proposed regulations that the Internal Revenue Service issued in December 2013 concerning withholding on equity-linked financial instruments that reference U.S. stocks.[1]  The report, available here, was co-authored by Orrick partner Peter J. Connors.

[1] A past issue of Derivatives in Review (available here) also reported on those proposed regulations.


IRS Issues Final Regulations and New Proposed Regulations Regarding Withholding on Derivatives on U.S. Stocks

On December 5, 2013, the Internal Revenue Service issued final regulations and proposed regulations under section 871(m), which address withholding on certain equity-linked notional principal contracts and other financial instruments.  These regulations are targeted at derivatives referencing U.S. stocks in which non-U.S. persons receive a “dividend equivalent” while arguably avoiding U.S. withholding tax but will impact many common corporate transactions, including merger and acquisition transactions and equity based compensation arrangements.  Click here to read more about this recent development.

IRS Amends Temporary Treasury Regulations Under Section 871(m)

On August 31st, the U.S. Internal Revenue Service amended Temporary Treasury Regulations under Section 871(m) of the U.S. Internal Revenue Code of 1986, as amended, that were originally issued on January 23, 2012, postponing the effective date for the new regulatory scheme contemplated by Proposed Treasury Regulations also issued on January 23, 2012.  The Temporary Regulations now extend the definition of “specified notional principal contract” that is set forth in Section 871(m)(3)(A) to payments made before January 1, 2014.

Commentators on the Proposed Regulations have noted that they pose many challenges for the withholding tax system and expand the contexts in which a non-U.S. person may be required to act as a withholding agent.  It was further noted that Section 871(m) is principally aimed at arrangements that provide synthetic exposure to the full economic risk and reward of an underlying security (so-called total return or delta one transactions).  However, the Proposed Treasury Regulations could apply more broadly to other arrangements, including options and other instruments that are not economic substitutes for actual ownership.  In this regard, the amendment to the Temporary Treasury Regulations acknowledges that U.S. Department of the Treasury and the Internal Revenue Service received numerous comments that the proposed effective date of January 1, 2013, would not allow taxpayers enough time to build and test the systems required to implement the withholding rules for specified notional principal contracts.  In response to these comments, the amended Temporary Regulations effectively delay the applicability of the definition of “specified notional principal contract” that is set forth in the Proposed Treasury Regulations until January 1, 2014.  For additional information on this development, please click here.

IRS Issues Proposed Regulations Addressing CDS and Section 1256 Swap Exclusion

On  September 15th, the U.S. Treasury Department issued proposed regulations that would add credit default swaps and non-financial index derivatives to a revised definition of “notional principal contracts.”  The proposed regulations also provide guidance on the definition of swaps and similar agreements within the meaning of section 1256(b)(2)(B) of the Internal Revenue Code of 1986.  For a complete description of the proposed regulations in a recent Orrick Client Alert, please click here.

IRS Issues Temporary Regulations on Transfers of Derivative Contracts

On July 15th, the Department of the Treasury, Internal Revenue Service (“IRS”), issued temporary and proposed regulations (the “Temporary Regulations”)[1] addressing when a transfer of certain derivative contracts does not result in an “exchange” to the remaining party for purposes of Section 1.1001-1(a) of the Income Tax Regulations (the “Tax Regulations”) of the Internal Revenue Code (the “Code”). The significance of the Temporary Regulations is that they clarify that, subject to certain specified conditions, a transfer of a derivative contract by a counterparty does not, in and of itself, result in an event for which gain or loss must be calculated by a remaining party, irrespective of whether the terms of the derivative contract itself require the consent of the remaining party for the transfer.

Section 1001 of the Code provides rules for the calculation and recognition of gain or loss from a sale or other disposition of property. Section 1.1001-1(a) of the Tax Regulations requires that such a gain or loss be realized (i.e., that a taxable disposition exist) upon an exchange of properties that differ materially, whether in kind or in extent. This rule has applied to a remaining party to a “notional principal contract”[2] if the resulting contract (i.e., between the transferee and remaining party) differs materially from the original contract (i.e., between the transferor and the remaining party). However, Section 1.1001-4(a) of the Tax Regulations provides that the substitution of a new party to a notional principal contract does not constitute an exchange if: (i) the transfer occurs between dealers; and (ii) the terms of the contract permit the transfer. Significant uncertainty has existed in connection with the second prong of this test. Moreover, historically, this test has applied solely to derivatives contracts that qualify as notional principal contracts.

The standard boilerplate language of the various master agreements published by the International Swaps and Derivatives Association, Inc., the predominant forms of master agreement governing derivatives transactions in the marketplace, states that, with certain limited exceptions, the transfer of the master agreement or any interest in or under the agreement, requires the prior written consent of the other party. This provision is often modified by the contracting parties to provide for certain additional flexibility (e.g., that consent to transfer shall not be unreasonably withheld or to permit a party to transfer to its affiliate, so long as the credit profile remains the same), but it is quite exceptional for a master agreement to require no consent to transfer. As a result of the consent requirement, there has been uncertainty as to whether most derivatives contracts satisfy the requirement that they “permit” transfer. The impending implementation of the Dodd-Frank legislation has heightened the focus on this ambiguity, as it may compel market participants to effect certain transfers of transactions (and, in some cases, entire portfolios of transactions).

The Temporary Regulations expand the Section 1.1001-4 test to include derivative contracts (which is broadly defined) other than notional principal contracts. Moreover, the Temporary Regulations specifically state that there is no “exchange” to the remaining party solely because a dealer in securities (or a clearinghouse) transfers a derivative contract to another dealer in securities (or a clearinghouse), so long as: (i) the transfer is permitted by the terms of the contract; and (ii) the terms of the derivative contract are not otherwise modified in a manner that results in a taxable exchange under Section 1001. The Temporary Regulations further clarify that transfers are deemed to be “permitted” by the terms of a contract even when consent of the remaining party is required and that the treatment of the remaining party for purposes of Section 1.1001-4 is not affected by the exchange of consideration between the transferor and transferee in connection with a transfer.[3]

The IRS requested comment on the Temporary Regulations within 90 days of their effective date, which was July 22nd.

[1]The temporary regulations may be found at

[2]A “notional principal contract” is defined as a financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts, including interest rate swaps, currency swaps, basis swaps, interest rate caps, interest rate floors, commodity swaps, equity swaps, equity index swaps, and similar agreements. 26 C.F.R. §1.446-3.


[3]Note, however, that if any consideration is paid to or received by the remaining party, such a payment will need to be analyzed to determine its impact on the remaining party. Also, any changes to the terms of a derivative contract will require additional analysis to determine whether a taxable disposition has occurred.

Equity Swap Withholding

On May 11, 2009, the Obama Administration, responding to concerns about dividend withholding abuse, released legislative proposals that include a provision requiring withholding on certain equity swaps where the underlying position relates to a U.S. corporation. Our next issue will contain a detailed explanation of this provision and its implications.