Daily Tax Update - January 19, 2012: Treasury, IRS Issue Regulations on Dividend Equivalent Source Rules

TREASURY, IRS ISSUE REGULATIONS ON DIVIDEND EQUIVALENT SOURCE RULES.  Today, Treasury and the IRS issued temporary and proposed regulations relating to the treatment of dividend equivalent payments under section 871(m).  The temporary regulations extend the applicability of a narrower statutory definition of "specified notional principal contract" ("specified NPC") until December 31, 2012, while the proposed regulations provide guidance on the definition of specified NPC and the treatment of dividend equivalents beginning January 1, 2013.

  • Background.  Enacted March 18, 2010 in the Hiring Incentives to Restore Employment Act (i.e., the legislation containing the FATCA provisions), section 871(m) provides that a "dividend equivalent" is treated as a US-source dividend. 
    • A "dividend equivalent" is defined in section 871(m)(2) as (1) any substitute dividend made pursuant to a securities lending or a sale-repurchase transaction that (directly or indirectly) is contingent upon, or determined by reference to, the payment of a US-source dividend, (2) any payment made pursuant to a specified NPC that (directly or indirectly) is contingent upon, or determined by reference to, the payment of a US-source dividend, and (3) "any other payment determined by the Secretary to be substantially similar" to the first two types of payments.
    • A "specified NPC" is defined in section 871(m)(3)(A) as a NPC with one of four stated characteristics or any contract "identified by the Secretary as a specified notional principal contract."  However, section 871(m)(3)(B) provides that, in the case of payments made after March 18, 2012, any NPC is a specified NPC "unless the Secretary determines that such contract is of a type which does not have the potential for tax avoidance."
  • "Dividend Equivalent" Definition.  Consistent with the statute, the proposed regulations define a dividend equivalent as including substitute dividends made pursuant to securities lending and sale-repurchase transactions and payments made pursuant to specified NPCs.  The proposed regulations also state that the following payments are "substantially similar" and are thus dividend equivalents: (1) gross-up amounts paid by a short party in satisfaction of the long party’s tax liability with respect to a dividend equivalent and (2) payments calculated by reference to a dividend from US sources that are made pursuant to an equity-linked instrument other than a NPC.  The preamble to the proposed regulations states that Treasury and the IRS continue to monitor equity-linked transactions and may identify in separate guidance other types of substantially similar payments.
    • The proposed regulations also provide that the term "payment" includes any gross amount used in computing any net amount transferred to or from the taxpayer.
  • "Specified NPC" Definition. 
    • The temporary regulations extend the applicability of the section 871(m)(3)(A) definition through December 31, 2012.  According to the preamble of the temporary regulations, Treasury and the IRS "believe that an extension of the statutory definition of the term specified NPC is necessary to allow taxpayers and withholding agents to modify their systems and other operating procedures to comply with the rules described in the notice of proposed rulemaking."  The preamble also notes, however, that the IRS may use judicial doctrines to challenge transactions designed to avoid the application of the regulations and that nothing in the rules precludes the IRS "from asserting that a contract labeled as an NPC or other equity derivative is in fact an ownership interest in the equity reference in the contract."
    • The proposed regulations define "specified NPC" for payments made after January 1, 2013.  Beginning that date, an NPC generally will be a specified NPC if: (1) the long party is "in the market" on the same day that the parties price the NPC or when the NPC terminates; (2) the underlying security is not regularly traded on a qualified exchange; (3) the short party posts the underlying security as collateral and the underlying security represents more than ten percent of the collateral posted by the short party; (4) the term of the NPC has fewer than 90 days; (5) the long party controls the short party’s hedge; (6) the notional principal amount is greater than five percent of the total public float of the underlying security or greater than 20 percent of the 30-day daily average trading volume, as determined at the close of business on the day immediately preceding the first day of the term of the NPC; or (7) the NPC is entered into on or after the announcement of a special dividend and prior to the ex-dividend date.  A related person (within the meaning of section 267(b) or 707(b)(1)) is treated as a party to the contract.
  • The proposed regulations also amend several rules under section 1441 to require withholding agents to withhold tax on dividend equivalents and further provide that a reduced rate of withholding provided by an income tax treaty for dividends paid or derived by a foreign person applies to a dividend equivalent.
  • The regulations can be accessed here and here.
  • For additional information, contact Philip R. West - pwest@steptoe.com or Amanda Varma - avarma@steptoe.com

MISCELLANEOUS GUIDANCE RELEASED:

Revenue Ruling 2012-7 provides various prescribed rates for federal income tax purposes including the applicable federal interest rates, the adjusted applicable federal interest rates, the adjusted federal long-term rate, the adjusted federal long-term tax-exempt rate. These rates are determined as prescribed by § 1274. The rates are published monthly for purposes of sections 42, 382, 412, 1288, 1274, 7520, 7872, and various other sections of the Internal Revenue Code.

Notice 2012-12 advises taxpayers that mandatory restitution payments awarded under 18 U.S.C. § 1593 are excluded from gross income for federal income tax purposes. This law requires a defendant convicted of a human trafficking offense to make these payments to the victim to compensate for costs for medical services, physical and occupational therapy or rehabilitation, transportation, temporary housing, child care expenses, lost income, attorneys’ fees and other costs, and other losses the victim suffers as a proximate result of the offense.

INTERNAL REVENUE SERVICE - CIRCULAR 230 DISCLOSURE:
As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained in this communication (including attachments) is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or arrangement addressed herein.

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