[Federal Register Volume 77, Number 14 (Monday, January 23, 2012)]
[Proposed Rules]
[Pages 3202-3210]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2012-1231]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-120282-10]
RIN 1545-BJ56


Dividend Equivalents From Sources Within the United States

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking by cross-reference to temporary 
regulations and notice of public hearing.

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SUMMARY: In the Rules and Regulations section of this issue of the 
Federal Register, the IRS is issuing temporary regulations that provide 
guidance on the definition of the term ``specified notional principal 
contract'' for purposes of section 871(m) of the Internal Revenue Code 
(Code) beginning after March 18, 2012 through December 31, 2012. The 
text of those regulations also serves as the text of the proposed 
regulations. The preamble to the temporary regulations explains the 
amendments added by the temporary regulations. The preamble to this 
notice of proposed rulemaking explains the proposed regulations, which 
provide guidance to nonresident aliens and foreign corporations that 
hold certain financial products providing for payments that are 
contingent upon or determined by reference to payments of dividends 
from sources within the United States. This document also provides a 
notice of a public hearing on these proposed regulations.

DATES: Written or electronic comments must be received by April 6, 
2012. Outlines of topics to be discussed at the public hearing 
scheduled for April 27, 2012, at 10 a.m., must be received by April 6, 
2012.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-120282-10), room 
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
120282-10), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue NW., Washington, DC, or sent electronically, via the Federal 
eRulemaking Portal at http://www.regulations.gov (IRS REG-120282-10). 
The public hearing will be held in the auditorium, Internal Revenue 
Service Building, 1111 Constitution Avenue NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Mark E. Erwin or D. Peter Merkel at (202) 622-3870; concerning 
submission of comments, the hearing, and/or to be placed on the 
building access list to attend the hearing, Oluwafunmilayo (Funmi) 
Taylor, Publications and Regulations Branch Specialist, at (202) 622-
7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Background

    Temporary regulations in the Rules and Regulations section of this 
issue of the Federal Register amend the Income Tax Regulations (26 CFR 
part 1) relating to section 871. The temporary regulations extend the 
section 871(m)(3)(A) statutory definition of the term specified 
notional principal contract (specified NPC) through December 31, 2012. 
This document contains proposed regulations under section 871(m) of the 
Code that will be applicable as of January 1, 2013. The preamble to the 
temporary regulations provides a discussion of the background of 
section 871(m) and explains the provisions contained in the temporary

[[Page 3203]]

regulations and Sec.  1.871-16(b) of these proposed regulations.

1. In General

    Section 1.871-15(a) of these proposed regulations treats a dividend 
equivalent as a dividend from sources within the United States for 
purposes of sections 871(a), 881, and 4948(a), and chapters 3 and 4 of 
subtitle A of the Code. As prescribed by section 871(m)(2), Sec.  
1.871-15(b)(1) defines a dividend equivalent as (1) any substitute 
dividend made pursuant to a securities lending or a sale-repurchase 
transaction that is contingent upon or determined by reference to the 
payment of a dividend from sources within the United States, (2) any 
payment made pursuant to a specified NPC that is contingent upon or 
determined by reference to the payment of a dividend from sources 
within the United States, or (3) any other payment substantially 
similar to such payments. The proposed regulations specify that a 
payment is not a dividend equivalent if it is determined by reference 
to an estimate of an expected (but not yet announced) dividend without 
reference to or adjustment for the amount of any actual dividend.
    For purposes of determining a dividend equivalent, the term payment 
includes any gross amount used in computing any net amount transferred 
to or from the taxpayer. For example, the terms of a notional principal 
contract (NPC) may provide for periodic payments by each of the 
counterparties that occur at quarterly intervals. Because these 
payments may offset each other, in whole or in part, the terms of such 
contracts generally provide for payment of only the net amount owed 
between the counterparties (that is, the difference between the amounts 
owed between the counterparties). A dividend equivalent is equal to the 
gross amount that is contingent upon or determined by reference to a 
dividend used to determine a net amount, even if no net payment is made 
or the party entitled to a gross amount determined by reference to a 
dividend is required to make a net payment to the other contracting 
party.
    Section 1.871-15(d) describes payments that are considered 
substantially similar to substitute dividends made pursuant to 
securities lending and sale-repurchase transactions and to payments 
made pursuant to specified NPCs. Substantially similar payments are (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 sources within the 
United States that are made pursuant to an equity-linked instrument 
other than an NPC. The Treasury Department and the IRS will continue to 
monitor equity-linked transactions, and may identify in separate 
guidance other payments that are substantially similar to a substitute 
dividend payment or a payment made pursuant to a specified NPC.

2. Definition of Specified Notional Principal Contract

    Section 1.871-16 defines the term specified NPC for payments made 
after March 18, 2012. Comments requested that rules promulgated under 
section 871(m) rely on objective factors for determining whether an NPC 
is a specified NPC. The Treasury Department and the IRS believe that 
the proposed regulations address these requests by providing objective 
rules that will be administrable and that identify NPCs entered into 
with the potential for tax avoidance.

A. Transition Period

    To provide taxpayers with the time needed to implement withholding 
on specified NPCs, temporary regulations issued together with these 
proposed regulations provide that the term specified NPC will have the 
same meaning as provided in section 871(m)(3)(A) for payments made 
prior to January 1, 2013. Section 1.871-16(b) is the same as the 
temporary regulations accompanying this notice of proposed rulemaking. 
Thus, Sec.  1.871-16T(b) applies to payments made on or after March 18, 
2012 and before January 1, 2013.

B. Definition Applicable to Payments Made on or After January 1, 2013

    Beginning on January 1, 2013, an NPC generally will be a specified 
NPC for purposes of section 871(m) 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 long party is considered to be ``in the market'' if the long 
party sells the underlying security on the same day that the parties 
price an NPC or purchases the underlying security on the day that the 
parties terminate an NPC. An NPC is sometimes entered into in tranches 
that spread the execution over more than one day; in that case, the 
proposed regulations consider each day that a tranche is executed or 
settled as a testing date. Similarly, if the long party to an NPC sells 
or purchases an underlying security on a day other than the pricing 
date or the settlement date of an NPC, but sets the price to align with 
the price of the NPC (such as with a forward contract), the long party 
will be treated as in the market on that day.
    The Code and regulations define ``readily tradable on an 
established securities market'' (and similar phrases) differently 
depending on the context. The Treasury Department and the IRS believe 
that ``readily tradable on an established securities market,'' as used 
in section 871(m), is intended to ensure that the underlying securities 
trade in sufficient volume to provide ample liquidity in the position. 
The proposed regulations provide that if the underlying security is not 
regularly traded on a qualified exchange, an NPC referencing that 
security is a specified NPC. An underlying security is ``regularly 
traded'' for this purpose if it is traded on a qualified exchange and 
it was traded on at least 15 out of the 30 trading days prior to the 
date that the parties entered into an NPC.
    Section 871(m)(3)(A)(iv) provides that prior to March 18, 2012, an 
NPC will be a specified NPC if the short party to the contract posts 
the underlying security as collateral with any long party to the 
contract. The Treasury Department and the IRS believe that when a short 
party posts the underlying security as collateral with the long party 
the related NPC should be a specified NPC. In the event of default by 
the short party, the fact that the underlying security is posted as 
collateral guarantees that the value of the collateral moves in tandem 
with the contract. This concern is less applicable when the value of 
the underlying securities posted as collateral is a small portion of 
the total amount of cash or other property posted as collateral for the 
NPC. The proposed regulations treat an NPC as a specified NPC only if 
the underlying security is posted as collateral and the underlying 
security represents more than ten percent of the total fair market 
value

[[Page 3204]]

posted as collateral on any day that the NPC is in effect.
    The proposed regulations treat an NPC as a specified NPC if the 
term of the contract has fewer than 90 days. As the market for equity-
linked NPCs grew and evolved, taxpayers began to purchase and sell NPCs 
in lieu of trading the underlying equities. Many transactions entered 
into to avoid U.S. withholding tax on dividends involved short-term 
equity swaps around an ex-dividend date. In many cases, the taxpayer 
entered into an NPC with a financial institution that acquired the 
underlying security as a hedge of a contract; the parties then settled 
or terminated that contract within days or weeks of the date it was 
entered into. When an NPC has a short duration and is in effect over an 
ex-dividend date, the source rule of section 871(m) should take 
precedence over the general source rule for NPC income in Sec.  1.863-
7.
    In some situations, the long party controls the acquisition of 
stock that the short party uses to hedge its position under the 
contract or has directed the short party to sell the short party's 
hedge to a particular purchaser at a specific price and date. The long 
party in these situations may exercise such control over the short 
party's hedge pursuant to terms of a written agreement or through 
course of conduct. The Treasury Department and the IRS believe that the 
source rule of section 871(m) should apply to an NPC when a long party 
exercises control over the short party's hedge. Accordingly, the 
proposed regulations treat an NPC as a specified NPC when a foreign 
investor controls the short party's hedge or participates in an 
underlying equity control program. An underlying equity control program 
is any system, whether carried out electronically or otherwise, that 
allows a long party to direct its counterparty's hedge of an NPC or 
that allows a long party to acquire economic exposure to an underlying 
security and to determine the form of the transaction later. An 
underlying equity control program, however, does not include an 
electronic trading platform that allows a customer to place an order to 
enter into an NPC with a dealer, provided that the dealer independently 
determines whether and how to hedge its position without customer 
direction.
    The proposed regulations treat an equity swap as a specified NPC 
when the notional principal amount of an NPC is a significant 
percentage of the trading volume. Specifically, when the notional 
principal amount of the NPC is greater than five percent of the total 
public float or 20 percent of the 30-day average daily trading volume 
such contract is treated as a specified NPC. If a long party has 
multiple NPCs that reference the same underlying security, the notional 
principal amounts of those contracts must be aggregated when 
determining whether the notional principal amount represents a 
significant percentage of the trading volume.
    A special dividend is a nonrecurring payment to shareholders that 
is in addition to any recurring dividend payment. The proposed 
regulations provide that any NPC is a specified NPC when the parties 
enter into the NPC after the announcement of a special dividend on the 
underlying stock. The Treasury Department and the IRS believe that an 
NPC entered into after the announcement of a special dividend and 
before the ex-dividend date is more likely to be entered into for the 
purpose of avoiding U.S. tax than an NPC referencing a stock that pays 
only a recurring dividend.
    To prevent taxpayers from avoiding these rules through related 
parties, the proposed regulations provide that each 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 provide that an 
NPC entered into between two related dealers is not a specified NPC if 
the NPC hedges risk associated with another NPC entered into with a 
third party. This rule is intended to avoid excessive withholding tax 
on transactions commonly employed by dealers to transfer risk from one 
entity to another within their affiliated group.
    Notwithstanding these rules defining the term specified NPC, the 
Commissioner may challenge transactions that are designed to avoid the 
application of these rules under applicable judicial doctrines. Nothing 
in these rules precludes the Commissioner from asserting that a 
contract labeled as an NPC or other equity derivative is in fact an 
ownership interest in the equity referenced in the contract.

3. Underlying Security

    The term underlying security means any security that pays a U.S. 
source dividend. If an NPC references more than one security, each 
reference security is treated as an underlying security of a separate 
NPC. If an NPC references a customized index, each component security 
of that index is treated as an underlying security in a separate NPC 
for purposes of this section. An index is treated as a customized index 
if it is (1) a narrow-based index or (2) any other index unless futures 
contracts or options contracts referencing the index trade on a 
qualified board or exchange. The definition of the ``narrow-based 
index'' is generally based on the definition of that term in the 
Securities Exchange Act of 1934, Section 3(a)(55)(B).

4. Specified NPC Status Arising During Term of Contract; Liability of 
Withholding Agent; and Other Conforming Amendments

    These proposed regulations amend several regulations under section 
1441 to require a withholding agent to withhold tax owed with respect 
to a dividend equivalent. If an NPC that is not a specified NPC on the 
date it is entered into becomes a specified NPC during the term of the 
contract, it will be treated as though it had been a specified NPC 
during the entire term of the contract. Payments made under the NPC by 
reference to the payment of a dividend from sources within the United 
States will be re-characterized as dividend equivalents and all tax 
owed with respect to such dividend equivalents will be due at the time 
of the next payment made under the NPC, including a termination 
payment. In cases where the tax owed is greater than the next payment 
made under the specified NPC, the withholding agent is responsible for 
reporting and depositing the total amount due with the IRS. The 
mechanism by which a withholding agent collects the amount due from the 
taxpayer is left to the discretion of the withholding agent and the 
taxpayer, and is not specified in these proposed regulations. The 
withholding agent must deposit the total amount due even if it cannot 
collect the amount from the counterparty.
    The proposed regulations provide that dividend equivalents are 
treated as income from investments in stock for purposes of section 
892; taxpayers may rely on Sec.  1.892-3(a)(6) until final regulations 
are issued. Finally, the proposed regulations provide that a reduced 
rate of withholding tax provided by an income tax convention for 
dividends paid or derived by a foreign person applies to a dividend 
equivalent.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It also has 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations. Because the 
regulation does not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C.

[[Page 3205]]

chapter 6) does not apply. Pursuant to section 7805(f) of the Code, 
these regulations have been submitted to the Chief Counsel for Advocacy 
of the Small Business Administration for comment on its impact on small 
business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) or electronic comments that are submitted timely 
to the IRS. The IRS and the Treasury Department request comments on the 
clarity of the proposed rules and how they can be made easier to 
understand. All comments will be available for public inspection and 
copying.
    A public hearing has been scheduled for April 27, 2012, beginning 
at 10 a.m. in the auditorium of the Internal Revenue Service Building, 
1111 Constitution Avenue NW., Washington, DC. Due to building security 
procedures, visitors must enter at the Constitution Avenue entrance. 
All visitors must present photo identification to enter the building. 
Because of access restrictions, visitors will not be admitted beyond 
the immediate entrance area more than 30 minutes before the hearing 
starts. For information about having your name placed on the building 
access list to attend the hearing, see the FOR FURTHER INFORMATION 
CONTACT section of this preamble. The rules of 26 CFR 601.601(a)(3) 
apply to the hearing. Persons who wish to present oral comments at the 
hearing must submit electronic or written comments and an outline of 
the topics to be discussed and the time to be devoted to each topic by 
April 6, 2012. A period of 10 minutes will be allotted to each person 
for making comments. An agenda showing the scheduling of the speakers 
will be prepared after the deadline for receiving outlines has passed. 
Copies of the agenda will be available free of charge at the hearing.

Drafting Information

    The principal author of these regulations is D. Peter Merkel, the 
Office of Associate Chief Counsel (International). Other personnel from 
the Treasury Department and the IRS participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1-- INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority:  26 U.S.C. 871(m) and 7805 * * *

    Par. 2. In Sec.  1.863-7, paragraph (a) is revised to read as 
follows:


Sec.  1.863-7  Allocation of income attributable to certain notional 
principal contracts under section 863(a).

    (a) Scope--(1) Introduction. [The text of the proposed amendments 
to Sec.  1.863-7(a)(1) is the same as the text for Sec.  1.863-7T(a)(1) 
published elsewhere in this issue of the Federal Register].
* * * * *
    Par. 3. Section 1.871-15 is added to read as follows:


Sec.  1.871-15  Treatment of dividend equivalents.

    (a) In general. A dividend equivalent as defined in paragraph (b) 
of this section shall be treated as a dividend from sources within the 
United States for purposes of sections 871(a), 881, and 4948(a), and 
chapters 3 and 4 of subtitle A of the Code and the regulations 
thereunder.
    (b) Dividend equivalent--(1) Definition. The term dividend 
equivalent means--
    (i) Any substitute dividend made pursuant to a securities lending 
transaction, a sale-repurchase transaction, or a substantially similar 
transaction that (directly or indirectly) is contingent upon or 
determined by reference to the payment of a dividend (including 
payments pursuant to a redemption of stock that gives rise to a 
dividend under section 301) from sources within the United States;
    (ii) Any payment made pursuant to a specified notional principal 
contract (specified NPC) described in section 871(m) or Sec.  1.871-16 
that (directly or indirectly) is contingent upon or determined by 
reference to the payment of a dividend (including payments pursuant to 
a redemption of stock that gives rise to a dividend under section 301) 
from sources within the United States; and
    (iii) Any substantially similar payment as defined in paragraph (d) 
of this section.
    (2) Exception--(i) In general. The term dividend equivalent does 
not include any payment made pursuant to a specified NPC, or any 
substantially similar payment as defined in Sec.  1.871-15(d), if such 
payment is contingent upon or determined by reference to an estimate of 
expected dividends and the estimate of an expected dividend is not 
adjusted in any way for the amount of an actual dividend.
    (ii) Expected dividends. For purposes of this section, an expected 
dividend is not considered an estimate of expected dividends on or 
after the date that the corporate issuer announces a dividend. A 
dividend announcement occurs on the earliest date on which the 
corporation declares, announces, or agrees to the amount or payment of 
such dividend.
    (c) Payments determined on gross basis. A payment includes any 
gross amount that is used in computing any net amount that is 
transferred to or from the taxpayer under the terms of the contract. 
For example, a dividend equivalent includes a gross amount determined 
by reference to a dividend that is used in computing a net payment even 
if the taxpayer makes a net payment or no payment is made because the 
net amount is zero.
    (d) Substantially similar payments--(1) In general. For purposes of 
section 871(m), the following payments are considered payments 
substantially similar to payments described in paragraph (b)(1)(i) or 
(b)(1)(ii) of this section and are therefore dividend equivalents:
    (i) Any payment of a beneficial owner's tax liability with respect 
to a dividend equivalent made by a withholding agent is a dividend 
equivalent received by the beneficial owner in an amount determined 
under the gross-up formula provided in Sec.  1.1441-3(f)(1).
    (ii) Any payment, including the payment of the purchase price or an 
adjustment to the purchase price, is a dividend equivalent if made 
pursuant to an equity-linked instrument that is contingent upon or 
determined by reference to a dividend (including payments pursuant to a 
redemption of stock that gives rise to a dividend under section 301) 
from sources within the United States.
    (2) Rules regarding equity-linked instruments--(i) In general. An 
equity-linked instrument is a financial instrument or combination of 
financial instruments that references one or more underlying securities 
to determine its value, including a futures contract, forward contract, 
option, or other contractual arrangement.
    (ii) Equity-linked instruments treated as a notional principal 
contract. An equity-linked instrument that provides for a payment that 
is a substantially

[[Page 3206]]

similar payment within the meaning of paragraph (d) of this section is 
treated as a notional principal contract for purposes of section 
871(m)(3), this section, and Sec.  1.871-16.
    (e) Anti-abuse rule. If a taxpayer enters into a transaction or 
transactions with a principal purpose of avoiding the application of 
this section or Sec.  1.871-16, payments made with respect to such 
transaction or transactions may be treated as a dividend equivalent to 
extent necessary to prevent the avoidance of these rules.
    (f) Effective/applicability date. The rules of this section apply 
to payments made on or after the date of publication of the Treasury 
decision adopting these rules as final regulations in the Federal 
Register.
    Par. 4. Section 1.871-16 is added to read as follows:


Sec.  1.871-16  Specified notional principal contracts.

    (a) Purpose and scope. This section provides guidance with respect 
to the definition of a ``specified notional principal contract'' 
(specified NPC). Paragraph (b) of this section provides the definition 
of a specified NPC for payments made after March 18, 2012, through 
December 31, 2012. Paragraph (c) of this section provides the 
definition of a specified NPC for payments made after December 31, 
2012. Paragraph (d) of this section provides rules with respect to a 
notional principal contract that becomes a specified NPC during the 
term of the contract. Paragraph (e) of this section provides rules with 
respect to the treatment of a specified NPC entered into by related 
parties. For purposes of section 871(m) and this section, the term 
notional principal contract (NPC) means an NPC as defined in Sec.  
1.446-3(c)(1) and an equity-linked instrument as provided in Sec.  
1.871-15(d).
    (b) [The text of the proposed amendment to Sec.  1.871-16(b) is the 
same as the text for Sec.  1.871-16T(b) found elsewhere in this issue 
of the Federal Register].
    (c) Specified NPCs after December 31, 2012. With respect to 
payments made after December 31, 2012, the term specified NPC means any 
NPC described in any of the paragraphs (c)(1) through (7) of this 
section.
    (1) Contemporaneous transfers of the underlying securities. An NPC 
is described in this paragraph (c)(1) if the long party to the NPC is 
``in the market'' with respect to the underlying security on the same 
day or days that the parties price the NPC or on the same day or days 
that the NPC terminates.
    (i) Determining when a long party is in the market. The long party 
is ``in the market'' with respect to the underlying security if the 
long party--
    (A) Sells or otherwise disposes of the underlying security on the 
same day or days that the parties price the NPC;
    (B) Purchases or otherwise acquires the underlying security on the 
same day or days that the NPC terminates; or
    (C) Either purchases or disposes of the underlying security at a 
price that is set or calculated in such a way as to be substantially 
identical to or determined by reference to an amount used to price or 
terminate the NPC.
    (ii) De minimis exception. The long party will not be deemed to be 
in the market with respect to the underlying security if the amount of 
the underlying securities disposed of on a pricing date or acquired on 
a termination date is less than ten percent of the notional principal 
amount of the NPC.
    (2) Underlying security is not regularly traded. An NPC is 
described in this paragraph (c)(2) if the underlying security in the 
NPC is not regularly traded.
    (i) Definition of regularly traded--(A) In general. For purposes of 
this paragraph (c)(2), an underlying security is regularly traded if 
such security is listed on one or more qualified exchanges at the time 
the NPC is priced and the underlying security was traded on at least 15 
trading days during the 30 trading days prior to the date the parties 
price the NPC.
    (B) Special rule for first 30 days following a public offering. 
When a corporation initiates a public offering of a security, such 
security is regularly traded if such security is traded during at least 
15 trading days on one or more qualified exchanges during the 30 
trading days subsequent to the initial offering.
    (C) Days on which a security is considered traded. The underlying 
securities will be considered traded only on those days in which the 
underlying securities are traded in quantities that exceed ten percent 
of the 30-day average daily trading volume.
    (ii) Qualified exchange. For purposes of paragraph (c)(2)(i) of 
this section, the term qualified exchange means a national securities 
exchange that is registered with the Securities and Exchange Commission 
or the national market system established pursuant to section 11A of 
the Securities Exchange Act of 1934 (15 U.S.C. 78f).
    (3) Underlying security posted as collateral. An NPC is described 
in this paragraph (c)(3) if the short party to the NPC posts the 
underlying security with the long party as collateral and the 
underlying security posted as collateral represents more than ten 
percent of the total fair market value of all the collateral posted by 
the short party on any date that the NPC is outstanding.
    (4) The NPC has a term of fewer than 90 days--(i) In general. An 
NPC is described in this paragraph (c)(4) if the NPC has a term of 
fewer than 90 days.
    (ii) Term of an NPC. For purposes of this section, the term of any 
NPC is the number of days that the contract is actually outstanding, 
including the date on which the NPC is terminated, but not the date 
that the NPC was entered into. For purposes of determining whether a 
contract is a specified NPC, an NPC is treated as terminated, in whole 
or in part, on the date that a long party enters into any position 
within the meaning of Sec.  1.246-5(b)(3) to the extent that the 
position offsets a portion of the long party's position with respect to 
an underlying security in the NPC.
    (5) Long party controls short party's hedge. An NPC is described in 
this paragraph (c)(5) if--
    (i) The long party controls contractually or by conduct the short 
party's hedge of the short position; or
    (ii) The long party enters into an NPC using an underlying equity 
control program (as defined in paragraph (f)(2) of this section).
    (6) Notional principal amount represents a significant percentage 
of trading volume--(i) In general. An NPC is described in this 
paragraph (c)(6) if the notional principal amount of the underlying 
security in the NPC is greater than--
    (A) Five percent of the total public float of that class of 
security; or
    (B) Twenty percent of the 30-day average daily trading volume 
determined as of the close of the business day immediately preceding 
the first day in the term of an NPC.
    (ii) Aggregating certain NPCs. When determining whether the 
notional principal amount of an NPC represents a significant percentage 
of the trading volume, a taxpayer must aggregate the notional principal 
amounts of all NPCs for which the taxpayer is the long party that 
reference the same underlying security.
    (7) NPC provides for the payment of a special dividend. An NPC is 
described in this paragraph (c)(7) if the NPC is entered into on or 
after the announcement of a special dividend and prior to the ex-
dividend date. An announcement of a special dividend occurs on the 
earliest date on which the corporation declares, announces, or agrees 
to the amount or payment of such special dividend.

[[Page 3207]]

    (d) Specified NPC status arising during the term of the contract--
(1) In general. This section provides rules for determining the timing 
and amount of a dividend equivalent when an NPC is not a specified NPC 
on the date the parties enter into the NPC and subsequently becomes a 
specified NPC during the term of the transaction. If an NPC that is not 
a specified NPC on the date the parties enter into the contract 
subsequently becomes a specified NPC, any payment made during the term 
of the contract (including any payment during the period between the 
date the contract is entered into and the date the contract becomes a 
specified NPC) that is contingent upon or determined by reference to 
the payment of a dividend from sources within the United States is a 
dividend equivalent.
    (2) Determination of dividend equivalent--(i) In general. For 
purposes of sections 871(a), 881, 4948(a), and chapters 3 and 4 of 
subtitle A of the Code, when an NPC becomes a specified NPC during the 
term of the contract, any tax owed with respect to a dividend 
equivalent made prior to the NPC becoming a specified NPC is payable 
when the next payment as described in Sec.  1.1871-15(c), including a 
termination payment, is made pursuant to the contract.
    (ii) Payment to include amount equal to dividend equivalent with 
respect to current and prior payments. In computing the amount of tax 
owed with respect to the termination of the specified NPC or the first 
payment that occurs after the NPC becomes a specified NPC, the dividend 
equivalent equals the sum of all the dividend equivalents with respect 
to the NPC arising before the date the NPC became a specified NPC and 
the amount of any dividend equivalent arising upon the termination or 
payment.
    (3) Example. The rules of this paragraph (d) are illustrated by the 
following example:

    Example. (i) Facts. Party A is a foreign corporation organized 
in a jurisdiction that does not have an income tax treaty with the 
United States. Party B is a domestic corporation and a dealer in 
NPCs. Party A and Party B enter into an NPC on Day 1 whereby Party A 
will pay Party B an amount equal to LIBOR multiplied by the notional 
value of a specified number of shares of Corporation X, a domestic 
corporation, plus any depreciation on the same number of shares of 
Corporation X upon settlement of the contract. In return, Party B 
will pay Party A an amount equal to any dividends paid on the same 
specified number of shares of Corporation X, plus any appreciation 
on those shares upon settlement of the contract. On Day 1, the NPC 
is not a specified NPC. On Day 30, Party B determines that it owes 
Party A $25 based on a dividend paid on the underlying security and 
that Party A owes Party B $125 on the LIBOR leg of the contract. 
Party A therefore makes a net payment of $100 to Party B. On Day 
120, the NPC becomes a specified NPC within the meaning of section 
871(m), Sec. Sec.  1.871-15, and 1.871-16. On Day 120, Party A 
terminates the contract and makes a net termination payment to Party 
B. In calculating the net payment, Party B determined that it owes 
Party A $25 based on a dividend paid with respect to the shares of 
Corporation X and that Party A owes it $125 attributable to interest 
and the decrease in the value of the shares of Corporation X.
    (ii) Analysis. On Day 120, Party A is treated as having received 
a dividend equivalent of $50. This dividend equivalent consists of 
the $25 payment made on Day 120 that is based on a dividend payment 
made with respect to the shares of Corporation X and the $25 
dividend equivalent made prior to the contract being considered a 
specified NPC.

    (e) Related persons and parties to an NPC--(1) In general. For 
purposes of this section, a related person is considered a party to an 
NPC. A related person is a person that is related within the meaning of 
section 267(b) or 707(b)(1) to one of the parties to the NPC.
    (2) NPC entered into between related dealers. An NPC entered into 
between related persons is not a specified NPC when the NPC hedges 
another NPC (whether or not a specified NPC) entered into with an 
unrelated party and both NPCs were entered into by the related persons 
in the ordinary course of their business as a dealer in securities or 
commodities derivatives.
    (f) Definitions--(1) Underlying security. For purposes of this 
section, the term underlying security means, for any NPC, the security 
with respect to which the dividend referred to in Sec.  1.871-
15(b)(1)(ii) is paid. If an NPC references more than one security or a 
customized index, each security or component of such customized index 
is treated as an underlying security in a separate NPC for purposes of 
section 871(m), Sec.  1.871-15, and this section.
    (2) Underlying equity control program--(i) In general. The term 
underlying equity control program means any system or procedure that 
permits--
    (A) A long party to an NPC to direct how a short party hedges its 
risk under such NPC; or
    (B) A long party to acquire, or cause the short party to acquire, 
an underlying security in a transaction with a short party and to 
instruct the short party to execute such acquisition in the form of an 
NPC after acquiring such underlying security.
    (ii) Electronic trading--(A) In general. The term underlying equity 
control program does not include an electronic trading platform that 
allows customers electronically to place an order to enter into an NPC 
with a dealer and through which the dealer determines whether and how 
to hedge its position.

    (B) Example. Customer, a foreign corporation, and Dealer have 
entered into a master agreement that governs NPCs entered into 
between Customer and Dealer. Customer places an order with Dealer 
via Dealer's electronic trading platform to enter into an NPC with a 
long position in 100 shares of Corporation ABC, a domestic 
corporation. Dealer's electronic trading platform allows Customer to 
place an order using Dealer's computer program. Dealer's computer 
system confirms that Corporation ABC is not on its restricted list 
upon receipt of the order. Dealer's computer system automatically 
determines whether it has an internal hedge available to offset the 
risk of a short position in 100 shares of Corporation ABC. To the 
extent that an internal hedge is unavailable, Dealer's computer 
program automatically seeks to acquire the stock as a hedge in a 
market transaction. After obtaining its hedge, Dealer sends a 
confirmation that memorializes the NPC. The notional amount on the 
confirmation reflects the price of Dealer's hedge plus a market 
standard spread. Customer did not enter into the NPC using an 
underlying equity control program solely by placing the order 
through Dealer's electronic trading platform because Customer did 
not direct how Dealer hedged its position under the NPC.

    (3) Customized index--(i) In general. For purposes of this section, 
the term customized index means any index, as determined on the date 
that the long party and short party enter into an NPC, that is--
    (A) A narrow-based index; or
    (B) Any other index unless futures contracts or option contracts on 
such index trade on a qualified board or exchange, as defined in 
section 1256(g)(7).
    (ii) Narrow-based index. The term narrow-based index means an 
index--
    (A) That has nine or fewer component securities;
    (B) In which a component security comprises more than 30 percent of 
the index's weighting;
    (C) In which the five highest weighted component securities in the 
aggregate comprise more than 60 percent of the index's weighting; or
    (D) In which the lowest weighted component securities comprising, 
in the aggregate, 25 percent of the index's weighting have an aggregate 
dollar value of average daily trading volume of less than $50,000,000 
(or in the case of an index with 15 or more component securities, 
$30,000,000), except that if there are two or more securities with 
equal weighting that could be included in the calculation of the lowest

[[Page 3208]]

weighted component securities comprising, in the aggregate, 25 percent 
of the index's weighting, such securities shall be ranked from lowest 
to highest dollar value of average daily trading volume and shall be 
included in the calculation based on their ranking starting with the 
lowest ranked security.
    (iii) Aggregate dollar value of average daily trading volume. For 
purposes of determining whether an index is a narrow-based index, the 
method for determining the aggregate dollar value of average daily 
trading volume is the method described in Rule 3a55-1(b)(1), 17 CFR 
240.3a55-1(b)(1), under the Securities Exchange Act of 1934, as in 
effect on January 23, 2012.
    (4) Long party. The long party is the party with respect to an NPC 
entitled to receive any payment pursuant to such contract that is 
contingent upon or determined by reference to the payment of a dividend 
from sources within the United States on an underlying security.
    (5) Short party. The short party is any party to an NPC who is not 
a long party.
    (6) Special dividend. For purposes of this section, the term 
special dividend means a nonrecurring payment to shareholders of 
corporate assets that is in addition to a recurring dividend payment, 
if any (even if paid in conjunction with a recurring dividend).
    (g) Effective/applicability date. The rules of this section apply 
to payments made on or after the date of publication of the Treasury 
decision adopting these rules as final regulations in the Federal 
Register.
    Par. 5. In Sec.  1.881-2, paragraph (b)(3) is added and paragraph 
(e) is revised to read as follows:


Sec.  1.881-2  Taxation of foreign corporations not engaged in U.S. 
business.

* * * * *
    (b) * * *
    (3) [The text of the proposed amendments to Sec.  1.881-2(b)(3) is 
the same as the text for Sec.  1.881-2T(b)(3) published elsewhere in 
this issue of the Federal Register].
* * * * *
    (e) Effective/applicability date. Except as otherwise provided in 
this paragraph (e), this section applies for taxable years beginning 
after December 31, 1966. Paragraph (b)(2) of this section is applicable 
to payments made after November 13, 1997. Paragraph (b)(3) of this 
section applies to payments made on or after the date of publication of 
the Treasury decision adopting these rules as final regulation in the 
Federal Register. For corresponding rules applicable to taxable years 
beginning before January 1, 1967, see 26 CFR 1.881-2 (Revised as of 
January 1, 1971).
    Par. 6. Section 1.892-3 is added to read as follows:


Sec.  1.892-3  Income of foreign governments.

    (a)(1) through (a)(5) [Reserved]. For further information, see 
Sec.  1.892-3T(a)(1) through (a)(5).
    (6) Dividend Equivalents. Income from investments in stocks 
includes the payment of a dividend equivalent described in section 
871(m) and Sec.  1.871-15.
    (b) [Reserved]. For further information, see Sec.  1.892-3T(b).
    (c) Effective/applicability date. Paragraph (a)(6) of this section 
applies to payments made on or after the date of publication of the 
Treasury decision adopting these rules as final regulation in the 
Federal Register. See Sec.  1.892-3T(a) for the rules that apply before 
the date the regulations are published as final regulations in the 
Federal Register.
    Par. 7. Section 1.894-1 is amended by redesignating paragraph (c) 
as (c)(1), adding paragraph (c)(2), and revising paragraph (e) to read 
as follows:


Sec.  1.894-1  Income affected by treaty.

* * * * *
    (c) * * *
    (2) Dividend equivalents. The provisions of an income tax 
convention relating to dividends paid to or derived by a foreign person 
apply to a dividend equivalent under section 871(m) and Sec.  1.871-15.
* * * * *
    (e) Effective/applicability date. Paragraphs (a) and (b) of this 
section apply for taxable years beginning after December 31, 1966. For 
corresponding rules applicable to taxable years beginning before 
January 1, 1967, (see 26 CFR part 1 revised April 1, 1971). Except as 
otherwise provided in this paragraph, paragraph (c) of this section is 
applicable to payments made after November 1, 1997. Paragraph (c)(2) of 
this section applies to payments made on or after the date of 
publication of the Treasury decision adopting these rules as final 
regulation in the Federal Register. See paragraph (d)(6) of this 
section for applicability dates for paragraph (d) of this section.
    Par. 8. Section 1.1441-2 is amended by adding paragraphs (b)(6) and 
(e)(7), and revising paragraph (f) to read as follows:


Sec.  1.1441-2  Amounts subject to withholding.

* * * * *
    (b) * * *
    (6) [The text of the proposed amendments to Sec.  1.1441-2(b)(6) is 
the same as the text for Sec.  1.1441-2T(b)(6) published elsewhere in 
this issue of the Federal Register].
* * * * *
    (e) * * *
    (7) [The text of the proposed amendments to Sec.  1.1441-2(e)(7) is 
the same as the text for Sec.  1.1441-2T(e)(7) published elsewhere in 
this issue of the Federal Register].
    (f) Effective/applicability date. Except as otherwise provided in 
this paragraph (f), this section applies to payments made after 
December 31, 2000. Paragraphs (b)(5) and (d)(4) of this section apply 
to payments made after August 1, 2006. Paragraphs (b)(6) and (e)(7) of 
this section apply to payments made on or after the date of publication 
of the Treasury decision adopting these rules as final regulation in 
the Federal Register.
    Par. 9. Section 1.1441-3 is amended by:
    1. Redesignating paragraph (h) as paragraph (j), and revising newly 
designated paragraph (j).
    2. Adding new paragraphs (h) and (i).
    The revision and addition read as follows:


Sec.  1.1441-3  Determination of amounts to be withheld.

* * * * *
    (h) Dividend equivalents--(1) In general. [The text of the proposed 
amendments to Sec.  1.1441-3(h)(1) is the same as the text for Sec.  
1.1441-3T(h)(1) published elsewhere in this issue of the Federal 
Register].
    (2) Procedures for withholding with respect to a dividend 
equivalent paid prior to a notional principal contract (NPC) becoming a 
specified NPC. In the event that an NPC becomes a specified NPC (as 
defined in Sec.  1.871-16) after the date that the parties enter into 
the NPC, the term dividend equivalent includes any payment that is made 
prior to the date the NPC becomes a specified NPC and that was 
(directly or indirectly) contingent upon or determined by reference to 
the payment of a dividend (including payments pursuant to a redemption 
of stock that gives rise to a dividend under section 301) from sources 
within the United States. The withholding agent is required to withhold 
with respect to a dividend equivalent made prior to the NPC becoming a 
specified NPC when the next payment as described in Sec.  1.871-15(c), 
including a termination payment, is made pursuant to the contract. For 
purposes of section 6601 and the regulations thereunder, the last date 
prescribed for payment of tax imposed with respect to a dividend 
equivalent made prior to an NPC becoming a specified NPC is determined 
based on

[[Page 3209]]

the date of the next payment as described in Sec.  1.871-15(c), 
including a termination payment, made pursuant to the contract. For 
further guidance regarding liability for penalties and interest, see 
Sec. Sec.  1.1441-1(b)(7)(iii) and 1.1461-1(a)(2).
    (3) Effective/applicability date. The rules of this paragraph 
(h)(2) apply to payments made on or after the date of publication of 
the Treasury decision adopting these rules as final regulation in the 
Federal Register.
    (i) [The text of the proposed amendments to Sec.  1.1441-3(i)(1) is 
the same as the text for Sec.  1.1441-3T(i)(1) published elsewhere in 
this issue of the Federal Register].
    (j) Effective/applicability date. Except as otherwise provided in 
paragraphs (g), (h), and (i) of this section, this section applies to 
payments made after December 31, 2000.
    Par. 10. Section 1.1441-4 is amended by:
    1. Revising paragraph (a)(3)(i).
    2. Adding paragraph (a)(3)(iii).
    3. Revising paragraph (g)(1).
    The revisions and addition read as follows:


Sec.  1.1441-4  Exemptions from withholding for certain effectively 
connected income and other amounts.

    (a) * * *
    (3)(i) [The text of the proposed amendments to Sec.  1.1441-
4(a)(3)(i) is the same as the text for Sec.  1.1441-4T(a)(3)(i) 
published elsewhere in this issue of the Federal Register].
    (ii) * * *
    (iii) [The text of the proposed amendments to Sec.  1.1441-
4(a)(3)(iii) is the same as the text for Sec.  1.1441-4T(a)(3)(iii) 
published elsewhere in this issue of the Federal Register].
* * * * *
    (g) Effective/applicability date--(1) General rule. Except as 
otherwise provided in this paragraph (g)(1), this section applies to 
payments made after December 31, 2000. The rules of paragraph 
(a)(3)(iii) of this section apply to payments made on or after the date 
of publication of the Treasury decision adopting these rules as final 
regulation in the Federal Register.
* * * * *
    Par. 11. Section 1.1441-6 is amended by:
    1. Revising paragraph (c)(2).
    2. Redesignating paragraph (h) as paragraph (i) and revising newly 
designated paragraph (i).
    3. Adding a new paragraph (h).
    The revision and addition read as follows:


Sec.  1.1441-6  Claim of reduced withholding under an income tax 
treaty.

* * * * *
    (c) * * *
    (2) Income to which special rules apply. The income to which 
paragraph (c)(1) of this section applies is dividends and interest from 
stocks and debt obligations that are actively traded, dividends from 
any redeemable security issued by an investment company registered 
under the Investment Company Act of 1940 (15 U.S.C. 80a-1), dividends, 
interest, or royalties from units of beneficial interest in a unit 
investment trust that are (or were upon issuance) publicly offered and 
are registered with the Securities and Exchange Commission under the 
Securities Act of 1933 (15 U.S.C. 77a), and amounts paid with respect 
to loans of securities described in this paragraph (c)(2). With respect 
to a dividend equivalent as defined in section 871(m) and Sec.  1.871-
15, this paragraph (c)(2) applies to the extent that the underlying 
security as defined in Sec.  1.871-16(f)(1) satisfies the requirements 
of this paragraph (c)(2). For purposes of this paragraph (c)(2), a 
stock or debt obligation is actively traded if it is actively traded 
within the meaning of section 1092(d) and Sec.  1.1092(d)-1 when 
documentation is provided.
* * * * *
    (h) Dividend equivalents. The rate of withholding on a dividend 
equivalent may be reduced to the extent provided under an income tax 
treaty in effect between the United States and a foreign country. For 
this purpose, a dividend equivalent is treated as a dividend from 
sources within the United States. To receive a reduced rate of 
withholding with respect to a dividend equivalent, a foreign person 
must satisfy the other requirements described in this section.
    (i) Effective/applicability dates--(1) General rule. This section 
applies to payments made after December 31, 2000, except for paragraph 
(g) of this section which applies to payments made after December 31, 
2001, and paragraph (h) of this section which applies to payments made 
on or after the date of publication of the Treasury decision adopting 
these rules as final regulation in the Federal Register.
    (2) [Reserved]
    Par. 12. Section 1.1441-7 is amended by:
    1. Redesignating paragraph (a)(2) as paragraph (a)(3) and revising 
newly designated paragraph (a)(3).
    2. Adding a new paragraph (a)(2).
    3. Adding an entry for Example 6 in paragraph (a)(3).
    4. Revising paragraph (g).
    The revision and addition read as follows:


Sec.  1.1441-7  General provisions relating to withholding agents.

    (a) * * *
    (2) [The text of the proposed amendments to Sec.  1.1441-7(a)(2) is 
the same as the text for Sec.  1.1441-7T(a)(2) published elsewhere in 
this issue of the Federal Register].
    (3) [The text of the proposed amendments to Sec.  1.1441-7(a)(3) is 
the same as the text for Sec.  1.1441-7T(a)(3) published elsewhere in 
this issue of the Federal Register].
* * * * *
    Example 6. [The text of the proposed amendments to Sec.  1.1441-
7(a)(3), Example 6 is the same as the text for Sec.  1.1441-
7T(a)(3), Example 6 published elsewhere in this issue of the Federal 
Register].
* * * * *
    (g) Effective/applicability date. Except as otherwise provided in 
paragraph (f)(3) of this section and as otherwise provided in this 
paragraph (g), this section applies to payments made after December 31, 
2000. Paragraph (a)(2) applies to payments made on or after the date of 
publication of the Treasury decision adopting these rules as final 
regulation in the Federal Register.
    Par. 13. Section 1.1461-1 is amended by:
    1. Redesignating paragraph (c)(2)(i)(L) and (M) as paragraphs 
(c)(2)(i)(M) and (N) respectively.
    2. Adding a new paragraph (c)(2)(i)(L).
    3. Revising paragraph (i).
    The addition reads as follows:


Sec.  1.1461-1  Payment and returns of tax withheld.

* * * * *
    (c) * * *
    (2) * * *
    (i) * * *
    (L) [The text of the proposed amendments to Sec.  1.1461-
1(c)(2)(i)(L) is the same as the text for Sec.  1.1461-1T(c)(2)(i)(L) 
published elsewhere in this issue of the Federal Register].
* * * * *
    (i) Effective/applicability date. Unless otherwise provided in this 
section and as otherwise provided in this paragraph (i), this section 
shall apply to returns required for payments made after December 31, 
2000. The rules of paragraph (c)(2)(i)(L) of this section apply to 
returns for payments made on or after the date of publication of the 
Treasury decision adopting these rules

[[Page 3210]]

as final regulation in the Federal Register.

Steven T. Miller,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2012-1231 Filed 1-19-12; 11:15 am]
BILLING CODE 4830-01-P