[Federal Register Volume 78, Number 234 (Thursday, December 5, 2013)]
[Proposed Rules]
[Pages 73128-73143]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2013-28932]


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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: Withdrawal of notice of proposed rulemaking, notice of proposed 
rulemaking and notice of public hearing.

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[[Page 73129]]

SUMMARY: This document provides guidance to nonresident alien 
individuals and foreign corporations that hold certain financial 
products providing for payments that are contingent upon or determined 
by reference to U.S. source dividend payments and to withholding 
agents. It withdraws proposed regulations under section 871(m) that 
were published in the Federal Register on January 23, 2012 (77 FR 
3202). This document also provides a notice of a public hearing on 
these proposed regulations.

DATES: Written or electronic comments must be received by March 5, 
2014. Requests to speak and outlines of topics to be discussed at the 
public hearing scheduled for April, 11, 2014, at 10 a.m., must be 
received by March 5, 2014.

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, beginning at 10 
a.m., at the Internal Revenue Service Building, 1111 Constitution 
Avenue NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
D. Peter Merkel or Karen Walny at (202) 317-6938 (not a toll-free 
number); concerning submission of comments, the hearing, or to be 
placed on the building access list to attend the hearing, 
Oluwafunmilayo (Funmi) Taylor, Publications and Regulations Branch 
Specialist, at (202) 317-6901 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in this notice of proposed 
rulemaking have been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collections of information should be 
sent to the Office of Management and Budget, Attn: Desk Office for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, 
Washington, DC 20224. Comments on the collection of information should 
be received by February 3, 2014. Comments are specifically requested 
concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the Internal Revenue Service, 
including whether the information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information;
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collections of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    The collections of information in this notice of proposed 
rulemaking are in Sec. Sec.  1.871-15(j) and (o), and are an increase 
in the total annual burden in the current regulations under Sec. Sec.  
1.1441-1 through 1.1441-9, 1.1461-1 and 1.1474-1. Under Sec.  1.871-
15(o), a broker, dealer, or short party is required to provide 
information relating to a potential section 871(m) transaction in a 
commercially reasonable fashion. The information may include whether 
the transaction is a section 871(m) transaction, the delta of the 
transaction, estimates of dividends, and the amount of the dividend 
equivalents. This information is required to establish whether a 
payment is treated as a U.S. source dividend for purposes of section 
871(m). This information will be used for audit and examination 
purposes. The likely respondents are businesses and other for-profit 
institutions.
    Estimated total annual reporting burden is 240,000 hours.
    Estimated average annual burden per respondent is 8 hours.
    Estimated average burden per response is 4 minutes.
    Estimated number of respondents is 30,000.
    Estimated total annual frequency of responses is 4,000,000.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
return information are confidential, as required by 26 U.S.C. 6103.

Background

    On January 23, 2012, the Federal Register published temporary 
regulations (TD 9572) at 77 FR 3108 (2012 temporary regulations) and a 
notice of proposed rulemaking by cross-reference to temporary 
regulations and notice of public hearing at 77 FR 3202 (2012 proposed 
regulations, and together with the 2012 temporary regulations, 2012 
section 871(m) regulations) under section 871(m) of the Internal 
Revenue Code (Code). The 2012 section 871(m) regulations related to 
dividend equivalents from sources within the United States paid to 
nonresident alien individuals and foreign corporations. Corrections to 
the 2012 temporary regulations were published on February 6, 2012, and 
March 8, 2012, in the Federal Register at 77 FR 5700 and 77 FR 13969, 
respectively. A correcting amendment to the 2012 temporary regulations 
was also published on August 31, 2012, in the Federal Register at 77 FR 
53141. The Treasury Department and the IRS received written comments on 
the 2012 proposed regulations, which are available at 
www.regulations.gov. A public hearing was held on April 27, 2012.
    This document withdraws the 2012 proposed regulations and provides 
new proposed regulations (2013 proposed regulations). Based on comments 
received on the 2012 proposed regulations, the Treasury Department and 
the IRS believe that the 2013 proposed regulations better identify (1) 
when a notional principal contract (NPC) ``is of a type which does not 
have the potential for tax avoidance'' and (2) other payments that are 
dividend equivalents because they are substantially similar to 
specified NPC payments and substitute dividend payments.
    This preamble discusses section 871(m), describes the 2012 section 
871(m) regulations, summarizes the comments received on the 2012 
section 871(m) regulations, and explains the 2013 proposed regulations.

1. Section 871(m)

    Congress enacted section 871(m) (originally designated as section 
871(l)) on March 18, 2010, in section 541 of the Hiring Incentives to 
Restore Employment Act (HIRE Act), Public Law 111-147 (124 Stat. 71). 
Section 871(m) treats a dividend equivalent as a

[[Page 73130]]

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. Section 871(m) applies to any dividend equivalent paid on or 
after September 14, 2010. Section 871(m)(5) provides that the term 
payment includes any gross amount that is used in computing any net 
payment that is transferred to or from the taxpayer.
    Section 871(m)(2) defines a dividend equivalent 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 dividend from sources 
within the United States, (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 dividend from sources within the United 
States, or (3) any other payment that the Secretary determines is 
``substantially similar'' to a specified NPC payment or substitute 
dividend payment.
    Section 871(m)(3) defines the term specified NPC. For payments made 
on or after September 14, 2010, and on or before March 18, 2012, 
section 871(m)(3)(A) defines a specified NPC as any NPC if (1) the long 
party transferred the underlying security to the short party in 
connection with entering into the NPC, (2) the short party transferred 
the underlying security to the long party in connection with the 
termination of the NPC, (3) the underlying security is not readily 
tradable on an established securities market, (4) the short party 
posted the underlying security as collateral with the long party, or 
(5) the NPC is identified by the Secretary as a specified NPC. For 
payments made after March 18, 2012, section 871(m)(3)(B) provides that 
any NPC is a specified NPC unless the Secretary determines that the NPC 
is of a type that does not have the potential for tax avoidance.

2. 2012 Section 871(m) Regulations

    The 2012 section 871(m) regulations provided guidance regarding 
dividend equivalents under section 871(m). Generally, the 2012 section 
871(m) regulations defined the terms specified NPC and substantially 
similar payment, addressed certain issues regarding withholding of tax 
with respect to the payment of a dividend equivalent, and provided 
other rules relating to dividend equivalents.
    Section 1.871-15(c) of the 2012 proposed regulations provided that 
a dividend equivalent included any gross amount used to compute any net 
amount transferred to or from the taxpayer, even if the taxpayer made a 
net payment or no payment was made because the net amount was zero. A 
dividend equivalent, however, did not include any amount determined by 
reference to an estimate of an expected (but not yet announced) 
dividend. This exception did not apply if the estimate adjusted to 
reflect the amount of the actual dividend.
    Section 1.871-16 of the 2012 section 871(m) regulations defined the 
term specified NPC with respect to payments made after March 18, 2012. 
For payments made prior to January 1, 2014, the 2012 temporary 
regulations (as amended by the correcting amendment published at 77 FR 
53141) defined a specified NPC using substantially the same definition 
as provided in section 871(m)(3)(A). For payments made on or after 
January 1, 2014, the 2012 proposed regulations defined a specified NPC 
as an NPC that meets one or more of the following factors: (1) The long 
party is ``in the market'' on the same day that the parties priced or 
terminated the NPC; (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 actual 
term of the NPC is 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; or 
(7) the NPC is entered into on or after the announcement of a special 
dividend and prior to the ex-dividend date.
    Section 1.871-15(d) of the 2012 proposed regulations described 
payments that are substantially similar to substitute dividends made 
pursuant to securities lending and sale-repurchase transactions and to 
payments made pursuant to specified NPCs. A substantially similar 
payment was any (1) gross-up amount paid by a short party in 
satisfaction of the long party's tax liability with respect to a 
dividend equivalent, or (2) payment made pursuant to an equity-linked 
instrument (ELI) that was calculated by reference to a dividend from 
sources within the United States if the ELI satisfied one or more of 
the specified NPC factors.
    The 2012 proposed regulations provided that certain indices 
referenced by an NPC or ELI would not be underlying securities, and 
therefore, would not be subject to section 871(m). Section 1.871-
16(f)(1) of the 2012 proposed regulations provided that each component 
security of a customized index would be treated as an underlying 
security in a separate NPC. Section 1.871-16(f)(3) of the 2012 proposed 
regulations defined a customized index as (1) a ``narrow-based index,'' 
which was generally defined based on the Securities Exchange Act of 
1934, section 3(a)(55)(B); or (2) any other index unless futures 
contracts or options contracts referencing the index trade on a 
qualified board or exchange.
    The 2012 section 871(m) regulations provided rules under section 
1441 to require a withholding agent to withhold tax owed with respect 
to a dividend equivalent. Many of these amendments and proposals simply 
coordinated the rules in Sec.  1.871-16T of the 2012 temporary 
regulations and Sec. Sec.  1.871-15 and 1.871-16 of the 2012 proposed 
regulations with the withholding rules in chapter 3 of the Code. 
Section 1.1441-3(h)(2) of the 2012 proposed regulations explained the 
procedures for withholding when an NPC became a specified NPC after the 
date that the parties entered into the NPC. The proposed regulations 
provided that the term dividend equivalent included any payment that 
was made prior to the date the NPC became a specified NPC and that was 
(directly or indirectly) contingent upon or determined by reference to 
the payment of a dividend from sources within the United States.

3. Summary of Comments on the 2012 Section 871(m) Regulations

    The Treasury Department and the IRS received numerous comments 
regarding the 2012 section 871(m) regulations. The major concerns 
raised in the comments related to (1) the definition of a specified 
NPC, (2) the definition of an ELI, (3) withholding issues that arise 
regarding the payment of a dividend equivalent, (4) the potential for 
over-withholding in a chain of transactions, (5) the treatment of 
indices, and (6) the effective date of the 2012 proposed regulations.
A. Definition of Specified NPC
    Several comments on the 2012 proposed regulations stated that the 
seven-factor approach to defining a specified NPC would not accurately 
identify tax avoidance transactions. These comments asserted that the 
factors could treat a contract as a specified NPC even when the 
contract was not entered into primarily to avoid withholding. 
Similarly, comments noted that some tax-motivated transactions would 
not be subject to tax under section 871(m) because the transaction 
would not meet any of the seven factors. These comments generally

[[Page 73131]]

recommended substantial modification to the factors used in the 2012 
proposed regulations.
    Comments stated that the term of a contract does not indicate the 
potential for tax avoidance. Comments noted that the term rule could 
result in retroactive withholding obligations and that it would be 
difficult for withholding agents to design systems to monitor 
withholding obligations that may arise after a payment has been made. 
Other comments asserted that 90 days was not the appropriate threshold 
for a minimum term and suggested eliminating the 90-day term factor or 
reducing the minimum term. Another comment acknowledged that the length 
of the term may indicate that a contract has a tax avoidance motive; 
however, this comment recommended adding an exception for termination 
events that are beyond the control of the parties to the transaction.
    Comments asserted that withholding agents and taxpayers would have 
difficulty applying the ``in the market'' factor. Those comments 
recommended that a long party should be treated as being ``in the 
market'' only when the long party sold or purchased the underlying 
security ``in connection with'' entering into or terminating an NPC. In 
addition, several comments indicated that withholding agents would have 
difficulty determining whether a long party was ``in the market'' and 
would have to rely on representations from the long party to the 
withholding agent.
B. Definition of ELI
    Comments stated that the definition of specified ELI in the 2012 
proposed regulations was overly broad because numerous types of ELIs do 
not give rise to the policy concerns underlying section 871(m). The 
comments requested that the final regulations limit the scope of the 
term ELI to contracts that provide delta-one or near-delta-one exposure 
to the underlying equity. One comment explained that the delta of an 
instrument reflects the change in the value of the instrument relative 
to a change in the value of the underlying security. These comments 
asserted that non-delta-one derivatives do not provide investors with a 
substitute for physical ownership of the underlying security. One 
comment, however, disagreed that a delta-based standard is the 
appropriate criteria for ELIs. This comment stated that a delta-based 
standard would provide non-delta-one financial instruments with a 
competitive advantage over delta-one products because non-delta-one 
financial instruments would be subject to more favorable tax treatment.
    Another comment suggested that the term ELI should not include 
single stock futures contracts (SSFs) unless the SSF is an ``exchange 
future for physical'' (EFP). That comment described an EFP as a 
transaction in which an investor (1) sold stock and purchased an SSF 
for future delivery of the same stock or (2) purchased stock and sold 
an SSF to deliver the same stock in the future. The comment maintained 
that an SSF, other than an EFP, should not be treated as an ELI because 
SSFs trade on a regulated exchange, unlike bilateral over-the-counter 
contracts. The comment also asserted that an adjustment to the 
settlement price of an SSF is not a payment upon which withholding may 
be applied.
    Similarly, several comments recommended that the final regulations 
provide an exception to the term ELI for exchange-traded options 
because many of these options do not provide close economic substitutes 
for owning stock. These comments explained that two of the seven 
specified NPC factors will apply to many standard exchange-traded 
options. First, the majority of exchange-traded options have an initial 
term of less than 90 days. Second, when an investor exercises an 
exchange-traded call option, the investor acquires the underlying 
securities because the terms of the transaction require physical 
settlement. If exchange-traded options continue to be treated as ELIs, 
these comments recommended that the final regulations account for the 
differences between over-the-counter and exchange-traded options.
C. Withholding Issues
    Comments requested clarification on how the 2012 proposed 
regulations would interact with the withholding rules of chapter 3. 
Comments asserted that the 2012 proposed regulations did not clearly 
address whether intermediaries, custodians, clearing organizations, and 
members of clearing organizations are withholding agents. Due to the 
large volume of transactions cleared by exchanges on a daily basis, one 
comment noted that it would be impractical to treat an exchange as a 
withholding agent. Other comments stated that the 2012 proposed 
regulations would impose an undue burden on broker-dealers with non-
U.S. customers because the broker-dealers would have to develop 
complicated systems to determine whether an instrument is an ELI and 
the amount of any dividend equivalent.
    Other comments suggested limiting a withholding agent's liability 
for withholding tax with respect to dividend equivalents. Comments 
stated that a withholding agent should not be liable for U.S. tax when 
the withholding agent lacks the information necessary to determine 
whether a transaction constitutes a specified NPC. For instance, 
comments noted that a withholding agent may not know whether a long 
party is selling or purchasing underlying securities on the same day 
that a specified NPC or ELI is entered into or terminated. A comment 
asserted that withholding for U.S. tax would be complicated and 
impractical if the final regulations do not limit a withholding agent's 
knowledge to the information available to the withholding agent at the 
trading unit level.
    Comments also questioned the rule in Sec.  1.1441-3(h)(2) of the 
2012 proposed regulations treating all payments as dividend equivalents 
if a contract became a specified NPC only as a result of the long party 
acquiring physical shares upon termination (``crossing out''). Comments 
stated that the 2012 proposed regulations unfairly would have required 
a withholding agent to withhold for U.S. tax on all payments made 
pursuant to a contract that would be treated as dividend equivalents 
when the contract only became a specified NPC because of a ``cross 
out'' at the end of the contract. Other comments recommended that this 
rule prescribing retroactive treatment of a payment as a dividend 
equivalent should apply only to NPCs that are specified NPCs because 
they meet the ``in the market'' or the 90-day factor.
D. Chain of Transactions
    Several comments stated that a chain of equity derivatives could 
result in the collection of cascading U.S. tax, for example, when each 
transaction in a chain of back-to-back equity derivatives referencing 
the same underlying security is subject to U.S. withholding tax. Some 
comments recommended that the final regulations incorporate specified 
NPCs into the qualified securities lender and credit forward regimes 
described in Notice 2010-46, 2010-24 I.R.B. 757, which outlines a 
framework for limiting the amount of U.S. tax withheld in a chain of 
securities lending or sale-repurchase transactions. See Sec.  
601.601(d)(2)(ii)(b). Other comments recommended that certain 
transactions be exempt from section 871(m), such as transactions 
entered into by a non-U.S. dealer as a long party in the ordinary 
course of business with customers. Comments explained that these 
transactions should be exempt from section 871(m) because the non-U.S. 
dealer does not enter into

[[Page 73132]]

the transaction to avoid U.S. tax and U.S. tax would be paid on any 
dividend equivalent paid to the customers of the non-U.S. dealer.
E. Indices
    Comments recommended several changes to the definition of the terms 
narrow-based index and customized index. One comment questioned the 
definition of narrow-based index and suggested that the final 
regulations incorporate the exceptions to that term provided in section 
3(a)(55) of the Securities Exchange Act of 1934.
    Several comments suggested changes that would narrow the scope of 
the term customized index. For example, comments suggested that the 
term customized index be revised to apply only to a narrow-based index 
or any index offered by a publisher that is not a ``recognized 
independent index publisher.'' Another comment recommended that the 
definition of a customized index exclude an index if an exchange-traded 
fund, exchanged-traded note, or other exchange-traded derivative 
tracked that index. One comment suggested that the final regulations 
provide that a customized index does not include any index with respect 
to which U.S. equity securities comprise less than 20 percent of the 
notional value.
    Other comments suggested that the final regulations broaden the 
definition of customized index because the definition in the 2012 
proposed regulation may have permitted certain transactions designed to 
avoid U.S. tax. For example, one comment suggested that a customized 
index should include any index that uses dividend yield as the primary 
criteria for inclusion in the index. Another comment noted that a 
partnership may function in the same manner as a customized index if 
the partnership was formed to hold a small basket of U.S. securities.
F. Effective Dates
    The 2012 proposed regulations provided that the rules would apply 
to payments made on or after the date of publication of the Treasury 
decision adopting those rules as final regulations. Comments expressed 
concern about the potentially retroactive effect of the regulations. 
With respect to ELIs, comments recommended that the final regulations 
should apply only to those transactions entered into after the 
effective date (rather than payments made after the effective date) 
because taxpayers and withholding agents did not foresee that these 
contracts would be subject to U.S. tax. Comments also recommended that 
the effective date of the final regulations be delayed because market 
participants will be required to make systems modifications and 
operational adjustments to comply with the final regulations.

4. Explanation of Provisions

    After consideration of the comments, the Treasury Department and 
the IRS agree that the proposed seven-factor approach to identify a 
specified NPC does not provide the best framework for evaluating 
whether an NPC ``is of a type which does not have the potential for tax 
avoidance'' and that the seven-factor approach would be difficult to 
administer, both for the IRS and withholding agents. Accordingly, the 
Treasury Department and the IRS are withdrawing the 2012 proposed 
regulations and proposing new regulations based on the objective 
measurement of a derivative's delta to determine whether a contract is 
subject to tax under section 871(m). The delta of an NPC or ELI is the 
ratio of the change in the fair market value of the contract to the 
change in the fair market value of the property referenced by the 
contract. This approach is consistent with comments suggesting that the 
delta of an option be used to determine whether the option is a 
specified ELI.
    The Treasury Department and the IRS believe that this delta-based 
standard will prevent taxpayers from avoiding withholding tax by 
electing derivative exposure to U.S. equities rather than physical 
ownership.
    A transaction has the ``potential for tax avoidance'' if it 
approximates the economics of owning an underlying security without 
incurring the tax liability associated with owning that security. In 
many cases, a long party is indifferent as to whether to invest in a 
derivative or a physical position because the derivative and the 
physical position provide comparable economic returns. Furthermore, the 
short party will often hedge an NPC or ELI by acquiring physical 
securities in proportion to the delta of the derivative to which it is 
exposed. When dividends paid on physical securities are subject to tax 
while dividend equivalents with respect to economically comparable 
derivatives are not, those derivatives have a potential for tax 
avoidance regardless of whether a long party is using the derivative in 
a particular case to avoid tax. Accordingly, the Treasury Department 
and the IRS favor a delta approach that objectively identifies 
transactions in which the long party is able to sufficiently 
approximate the economic returns associated with an underlying 
security.
    In addition, the Treasury Department and the IRS believe that the 
delta-based standard of the 2013 proposed regulations provides a 
simpler and more administrable framework than the seven-factor test of 
the 2012 proposed regulations. Using the delta of an NPC or ELI to 
determine the application of section 871(m) employs a single standard 
for NPCs and ELIs, although the regulations have different 
applicability dates for specified NPCs and specified ELIs. Therefore, 
for both equity swaps and other equity derivatives, the determination 
of whether a transaction may give rise to a dividend equivalent will 
generally depend only on the determination of a single objective 
measurement at the time the transaction is acquired.
    This notice of proposed rulemaking should not be construed as 
providing guidance with respect to any other section of the Code. For 
example, this notice should not be used as a basis for applying the 
delta standard to interpret other Code sections.
A. In General
    Section 1.871-15(b) of the 2013 proposed regulations treats a 
dividend equivalent as a dividend from sources within the United States 
for purposes of sections 871(a), 881, 892, 894, and 4948(a), and 
chapters 3 and 4 of subtitle A of the Code. Section 1.871-15(c) 
provides that a dividend equivalent is (1) any payment of a substitute 
dividend made pursuant to a securities lending or sale-repurchase 
transaction that references a U.S. source dividend payment, (2) any 
payment made pursuant to a specified NPC that references a U.S. source 
dividend payment, (3) any payment made pursuant to a specified ELI that 
references a U.S. source dividend payment, or (4) any other 
substantially similar payment. A payment references a U.S. source 
dividend payment if the payment is directly or indirectly contingent 
upon or determined by reference to the payment of a dividend from 
sources within the United States.
    Certain transactions typically provide for dividend equivalents to 
be paid at the time a dividend is paid, and in an amount equal to that 
dividend payment, on a referenced stock. Stock loans, equity sale-
repurchase transactions, and total return swaps referencing stock are 
the most common types of equity-linked transactions that provide the 
long party with either a dividend or a dividend equivalent equal to the 
dividend paid on the referenced stock.
    Other transactions that are linked to U.S. equities may also 
provide for dividend equivalents. The Treasury

[[Page 73133]]

Department and the IRS believe that an ELI that has economic terms that 
are substantially similar to a payment made pursuant to a securities 
lending or sale-repurchase transaction, or a specified NPC, creates the 
same potential for avoidance of U.S. withholding tax as those 
transactions. Section 1.871-15(a)(4) of the 2013 proposed regulations 
defines an ELI as any financial transaction (other than a securities 
lending or sale-repurchase transaction or an NPC) that references the 
value of one or more underlying securities. The term ELI includes 
instruments such as forward contracts, futures contracts, options, debt 
instruments convertible into underlying securities, and debt 
instruments with payments linked to underlying securities. The long 
party with respect to an ELI is the counterparty that holds a long 
position with respect to an underlying security, such as the purchaser 
of a call option or the writer of a put option.
    Section 1.871-15(f) of the 2013 proposed regulations provides that 
another substantially similar payment is a gross-up amount paid by a 
short party in satisfaction of the long party's tax liability with 
respect to a dividend equivalent. The Treasury Department and the IRS 
request comments regarding whether other payments should be treated as 
substantially similar payments, such as a payment made by a seller of 
stock to the purchaser of the stock pursuant to an agreement to deliver 
a pending U.S. source dividend after the record date (for example, a 
due bill).
    The definition of an underlying security has also been revised. The 
2013 proposed regulations define an underlying security as any interest 
in an entity taxable as a corporation for Federal tax purposes if a 
payment with respect to that interest may give rise to a U.S. source 
dividend. If a transaction references more than one such entity 
(including a reference to an index that is not a qualified index), each 
interest is treated as a separate underlying security. If a transaction 
references a qualified index, the qualified index is treated as a 
single security that is not an underlying security.
    The 2013 proposed regulations also revise the rules pertaining to 
indices. In general, a qualified index is any index that (1) references 
25 or more underlying securities; (2) references only long positions in 
underlying securities; (3) contains no underlying security that 
represents more than 10 percent of the index's weighting; (4) 
rebalances based on objective rules at set intervals; (5) does not 
provide for a high dividend yield; and (6) is referenced by futures or 
option contracts that trade on a national securities exchange or a 
domestic board of trade.
B. Section 871(m) Transactions and Delta
    The 2013 proposed regulations define a section 871(m) transaction 
as any securities lending or sale-repurchase transaction, specified 
NPC, or specified ELI. Section 1.871-15(a)(10) of the 2013 proposed 
regulations defines a securities lending transaction and sale-
repurchase transaction by reference to Sec.  1.861-3(a)(6) and includes 
substantially similar transactions.
    As noted above, to determine whether a transaction is a specified 
NPC or specified ELI, the 2013 proposed regulations replace the seven-
factor test in the 2012 proposed regulations with a single-factor test. 
Section 1.871-15(d)(2) provides that, with respect to payments made on 
or after January 1, 2016, a specified NPC is any NPC that has a delta 
of 0.70 or greater when the long party acquires the transaction. 
Similarly, Sec.  1.871-15(e) provides that a specified ELI is any ELI 
that has a delta of 0.70 or greater when the long party acquires the 
transaction. If a transaction references more than one underlying 
security, the taxpayer must determine whether the transaction is a 
section 871(m) transaction with respect to each underlying security. A 
transaction, therefore, may be a section 871(m) transaction with 
respect to one or more underlying securities referenced in the 
transaction, but may not be treated as a section 871(m) transaction 
with respect to other underlying securities referenced by that same 
transaction.
    Section 1.871-15(g)(1) of the 2013 proposed regulations provides 
that the delta of an NPC or an ELI is the ratio of the change in the 
fair market value of the NPC or ELI to the change in the fair market 
value of the property referenced by the NPC or ELI. For purposes of the 
2013 proposed regulations, the delta of a transaction must be 
determined in a commercially reasonable manner. If a taxpayer 
calculates delta for non-tax business purposes, that delta ordinarily 
is treated as the delta for purposes of this section. For example, to 
determine whether an option is a specified ELI, a dealer may use the 
delta that it calculates to determine the number of shares needed to 
balance its position on the option (even though that number of shares 
may not correspond to the dealer's actual hedge). If an NPC or ELI 
contains more than one reference to a single underlying security, all 
references to that underlying security are taken into account in 
determining the delta. If an NPC or an ELI references more than one 
underlying security or other property or liability, a separate delta 
must be determined with respect to each underlying security without 
taking into account any other underlying security or other property or 
liability referenced in the transaction. Section 1.871-15(g)(2) 
provides that if the delta of an NPC or ELI is not reasonably expected 
to vary during the term of the transaction, the NPC or ELI has a 
constant delta and the delta is treated as 1.0. If a transaction would 
not have a delta of 1.0 but for the rule in Sec.  1.871-15(g)(2), the 
number of shares of the underlying security is adjusted to reflect the 
constant delta of 1.0. This rule is intended to prevent taxpayers from 
avoiding the application of the 2013 proposed regulations by using 
transactions that reduce delta while retaining the economics of owning 
a set amount of shares. For example, a transaction that provides 50 
percent of the appreciation, dividends, and depreciation on 200 shares 
of stock X throughout the term of the transaction (and therefore has a 
delta of 0.5) will be treated as a contract that provides 100 percent 
of the same exposure on 100 shares of stock X (and therefore has a 
delta of 1.0). The Treasury Department and the IRS request comments 
regarding whether taxpayers could avoid the constant delta rule by 
structuring transactions with the potential for de minimis delta 
variability and whether such transactions should be deemed to have a 
constant delta.
    The Treasury Department and the IRS understand that a long party 
may enter into multiple transactions referencing the same underlying 
security to substantially replicate the economics of owning the 
underlying security. For example, a taxpayer may purchase a call option 
and sell a put option referencing the same underlying security that 
individually have a delta below 0.70 but together have a delta that 
exceeds 0.70. If section 871(m) were to apply to each transaction 
separately, neither transaction would be a section 871(m) transaction 
even though the economics of the positions when considered together are 
the same as another transaction that would be a section 871(m) 
transaction. Therefore, Sec.  1.871-15(l) of the 2013 proposed 
regulations treats multiple transactions as a single transaction for 
purposes of determining if the transactions are a section 871(m) 
transaction with respect to an underlying security when a long party 
(or a related person) enters into two or more transactions that 
reference the same underlying security and the

[[Page 73134]]

transactions were entered into in connection with each other. These 
rules apply only to combine transactions in which the taxpayer is the 
long party. Section 1.871-15(l) does not combine transactions when a 
taxpayer is the long party with respect to an underlying security in 
one transaction and the short party with respect to the same underlying 
security in another transaction. Transactions that are combined for 
purposes of determining whether there is a section 871(m) transaction 
are treated as separate transactions for all other purposes of this 
section, including for purposes of determining the amount of a dividend 
equivalent with respect to each transaction. A withholding agent, 
however, is not required to withhold on a dividend equivalent paid 
pursuant to a transaction that has been combined with one or more other 
transactions unless the withholding agent knows that the long party (or 
a related person) entered into the potential section 871(m) 
transactions in connection with each other.
    The Treasury Department and the IRS request comments regarding 
whether (and, if applicable, how) the rules for combining separate 
transactions to determine whether the transactions are section 871(m) 
transactions should apply in other situations, such as when a taxpayer 
holds both long and short positions with respect to the same underlying 
security. Comments also are requested regarding whether (and, if 
applicable, how) the remaining transaction (or transactions) should be 
retested when a long party terminates one or more, but not all, of the 
transactions that make up a combined position.
C. Amount of Dividend Equivalent
    Section 1.871-15(h) of the 2013 proposed regulations provides rules 
for identifying a payment of a dividend equivalent. A payment includes 
any gross amount that references a U.S. source dividend and that is 
used to compute any net amount transferred to or from the long party 
even if the long party makes a net payment to the short party or the 
net payment is zero. For purposes of section 871(m), a payment is 
treated as made on the date the amount of the dividend equivalent is 
fixed even if it is paid or otherwise taken into account on a later 
date.
    The 2012 proposed regulations provided that estimates of expected 
dividends were not dividend equivalents unless the estimate was 
adjusted to reflect actual dividend payments. The 2013 proposed 
regulations eliminate this exception and explicitly treat estimated 
dividend payments as dividend equivalents because the economic benefit 
of a dividend is present in contracts that use estimated dividends in 
much the same way as a contract that adjusts for actual dividends. 
Moreover, the Treasury Department and the IRS are concerned that 
taxpayers may inappropriately avoid section 871(m) if estimated 
dividends are not treated as dividend equivalents.
    In the 2013 proposed regulations, a dividend equivalent includes 
any amount that references the payment of a U.S. source dividend. In 
addition to an actual payment of dividends and an estimated payment of 
dividends, a dividend equivalent includes any other contractual term of 
a potential section 871(m) transaction that is calculated based on an 
actual or estimated dividend. For example, when a long party enters 
into an NPC that provides for payments based on the appreciation in the 
value of an underlying security but does not explicitly entitle the 
long party to receive payments based on regular dividends (a price 
return swap), the 2013 proposed regulations treat the price return swap 
as a transaction that provides for the payment of a dividend equivalent 
because the anticipated dividend payments are presumed to be taken into 
account in determining other terms of the NPC, such as in the payments 
that the long party is required to make to the short party or in 
setting the price of the underlying securities referenced in the price 
return swap.
    The 2013 proposed regulations also provide rules for calculating 
the amount of a dividend equivalent. For a securities lending or sale-
repurchase transaction, Sec.  1.871-15(i) provides that the amount of a 
dividend equivalent for each underlying security equals the actual per 
share dividend amount paid on the underlying security multiplied by the 
number of shares of the underlying security transferred pursuant to the 
transaction. For a specified NPC or specified ELI, the amount of a 
dividend equivalent equals the per share dividend amount with respect 
to the underlying security multiplied by the number of shares of the 
underlying security referenced in the contract (subject to adjustment) 
multiplied by the delta of the transaction with respect to the 
underlying security at the time that the amount of the dividend 
equivalent is determined.
    If a transaction provides for a payment based on an estimated 
dividend (including an implicit estimated dividend), Sec.  1.871-
15(h)(2)(i) and (iii) of the 2013 proposed regulations require that the 
actual amount of the dividend payment is used to calculate the amount 
of the dividend equivalent unless the short party identifies a 
reasonable estimated dividend amount in writing at the inception of the 
transaction. Prop. Treas. Reg. Sec.  1.871-15(h)(2)(i) and (iii). If a 
transaction that provides for payment based on estimated dividends is 
supported by the required documentation, the per share dividend amount 
used to compute the amount of a dividend equivalent is the lesser of 
the amount of the estimated dividend and the amount of the actual 
dividend paid.
    The delta used to determine whether a potential section 871(m) 
transaction is a section 871(m) transaction may differ from the delta 
used to determine the amount of the dividend equivalent of a section 
871(m) transaction. Whereas the delta of a transaction at the time the 
long party acquires a potential section 871(m) transaction is used to 
determine whether the transaction is a section 871(m) transaction, the 
delta of the section 871(m) transaction at the time that the amount of 
the dividend equivalent is determined is used to calculate the amount 
of the dividend equivalent. Because the delta of a transaction may vary 
over time, the delta of the transaction at the time of acquisition may 
differ from the delta of the transaction at the time the amount of the 
dividend equivalent is determined. Under Sec.  1.871-15(i)(1)(ii)(C)(1) 
of the 2013 proposed regulations, the delta used to calculate the 
amount of a dividend equivalent is not used to re-test whether a 
transaction is a section 871(m) transaction; a long party's section 
871(m) transaction continues to be subject to tax even if the delta of 
the section 871(m) transaction is below 0.70 at the time the amount of 
the dividend equivalent is determined. Similarly, a long party that 
acquires a potential section 871(m) transaction that has a delta below 
0.70 at the time of acquisition will not have a section 871(m) 
transaction even if the delta increases to be above 0.70 during the 
time the long party holds the transaction.
    Under the 2013 proposed regulations, the amount of the dividend 
equivalent generally is determined on the earlier of the ex-dividend 
date or the record date for the dividend. However, if a section 871(m) 
transaction has a term of one year or less, the amount of the dividend 
equivalent is determined when the long party disposes of the 
transaction. Therefore, a long party that acquires an option with a 
term of one year or less that is a specified ELI will not incur a 
withholding tax if the option lapses.

[[Page 73135]]

D. Other Rules
    In response to comments, Sec.  1.871-15(j) of the 2013 proposed 
regulations provides exceptions to the definition of a section 871(m) 
transaction for two types of potential section 871(m) transactions that 
have little potential for tax avoidance. The first exception applies 
when a qualified dealer enters into a transaction as the long party in 
its capacity as a dealer. A qualified dealer is any dealer in 
securities within the meaning of section 475 that is subject to 
regulatory supervision by a governmental authority in the jurisdiction 
in which it was created or organized. In addition, the dealer must 
certify to the short party that it is a qualified dealer acting in its 
capacity as a dealer in securities and that it will withhold and 
deposit any tax imposed by section 871(m) with respect to a section 
871(m) transaction that it enters into as a short party in its capacity 
as a dealer. The second exception applies when a taxpayer enters into a 
transaction as part of a plan pursuant to which one or more persons 
(including the taxpayer) are obligated to acquire 50 percent or more of 
the entity issuing the underlying securities.
    A comment to the 2012 proposed regulations stated that an NPC may 
reference a partnership interest and that the partnership could be 
formed to hold a small basket of U.S. equity securities. Noting that a 
partnership may function like a customized index, the comment 
recommended that regulations treat an NPC that references a partnership 
interest as a separate NPC with respect to each underlying security 
held by the partnership. To address the concern noted in the comment, 
Sec.  1.871-15(m) of the 2013 proposed regulations treats a transaction 
that references an interest in an entity that is not a C corporation 
for Federal tax purposes as referencing the allocable portion of any 
underlying securities and potential section 871(m) contracts held 
directly or indirectly by that entity. The 2013 proposed regulations 
provide an exception for a transaction that references an interest in 
an entity that is not a C corporation if underlying securities and 
potential section 871(m) transactions represent, in the aggregate, 10 
percent or less of the value of the interest in the referenced entity 
at the time the transaction is entered into.
    Section 1.871-15(n) of the 2013 proposed regulations provides that 
the Commissioner may treat any payment made with respect to a 
transaction as a dividend equivalent if the taxpayer acquires a 
transaction with a principal purpose of avoiding the application of 
these rules. The Treasury Department and the IRS will continue to 
closely scrutinize other transactions that are not covered by section 
871(m) and that may be used to avoid U.S. taxation and U.S. 
withholding. In addition, the IRS may challenge the U.S. tax results 
claimed in connection with transactions that are designed to avoid the 
application of section 871(m) using all available statutory provisions 
and judicial doctrines (including the substance over form doctrine, the 
economic substance doctrine under section 7701(o), the step transaction 
doctrine, and tax ownership principles) as appropriate. For example, 
nothing in section 871(m) 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 referenced in the contract.
    The 2013 proposed regulations also make a number of conforming 
changes to reporting and withholding requirements. Most equity-linked 
transactions involve a financial institution acting as a broker, 
dealer, or intermediary. A financial institution is usually in the best 
position to undertake the responsibility to report the tax consequences 
of a potential section 871(m) transaction. Accordingly, Sec.  1.871-
15(o) of the 2013 proposed regulations provides that when a broker or 
dealer is a party to a potential section 871(m) transaction, the broker 
or dealer is required to determine whether the transaction is a section 
871(m) transaction, and if so, the amounts of the dividend equivalents. 
If a broker or dealer is not a party to the transaction or both parties 
are brokers or dealers, the short party must determine whether the 
transaction is a section 871(m) transaction and the amounts of the 
dividend equivalents. Determinations made by the broker, dealer, or 
short party are binding on the parties to the section 871(m) 
transaction unless the other person knows or has reason to know that 
the information is incorrect; the determinations are not binding on the 
IRS. In addition, certain persons described in Sec.  1.871-15(o)(3)(ii) 
of the 2013 proposed regulations are permitted to request information 
from certain parties to a potential section 871(m) transaction who are 
described in Sec.  1.871-15(o)(1) when the information is necessary to 
satisfy their withholding or information reporting obligations, or to 
determine their tax liability. If a withholding agent reasonably relies 
on information received, it will not be liable for underwithholding; 
however, the party to the transaction who failed to properly determine 
the amount will be liable for the underwithholding. The Treasury 
Department and the IRS solicit comments with respect to these reporting 
rules, including comments regarding the parties that should be required 
to report and the extent of information that is appropriate.
    The 2013 proposed regulations include amendments to chapter 3 
specifically addressing dividend equivalents. The 2013 proposed 
regulations describe how the exception to withholding where no money or 
property is paid applies to a dividend equivalent. Section 1.1441-
2(d)(5) of the 2013 proposed regulations provides that a withholding 
agent is not obligated to withhold on a dividend equivalent until the 
later of: (1) The time that the amount of the dividend equivalent is 
determined and (2) the time at which any of the following to has 
occurred: (a) Money or other property is paid pursuant to a section 
871(m) transaction, (b) the withholding agent has custody or control of 
money or other property of the long party at any time on or after the 
amount of the dividend equivalent is determined, or (c) there is an 
upfront payment or a prepayment of the purchase price. Although Sec.  
1.1441-2(d)(5) of the 2013 proposed regulations relieves a withholding 
agent of liability to withhold when the withholding agent does not have 
control of money or other property of the long party, the long party 
remains liable for U.S. tax on the dividend equivalent pursuant to 
section 871(m) and Prop. Treas. Reg. Sec.  1.871-15.
E. Certain Contingent Interest
    Generally, section 871(h)(4) provides that U.S. source portfolio 
interest received by a nonresident alien individual is not subject to 
the 30-percent U.S. tax imposed under section 871(a)(1). Certain 
contingent interest payments, however, are excluded from the definition 
of portfolio interest. Section 871(h)(4)(A)(ii) grants the Secretary 
authority to impose tax on contingent interest when necessary to 
prevent the avoidance of Federal income tax. Most contingent debt 
instruments are either referenced to a qualified index, have an 
embedded option with a delta below 0.7, or both. A debt obligation that 
is a specified ELI and provides for a contingent interest payment 
determined by reference to a U.S. source dividend payment has the 
potential to be used by a nonresident alien individual or foreign 
corporation to avoid section 871(m). Therefore, Sec.  1.871-14(h) of 
the 2013 proposed regulations provide that any contingent interest will 
not qualify for the portfolio interest exemption to the extent that the

[[Page 73136]]

contingent interest payment is a dividend equivalent.
F. Effective/Applicability Date
    The 2013 proposed regulations generally will apply to payments made 
on or after the date of publication of the Treasury decision adopting 
these rules as final regulations. Certain provisions in the 2013 
proposed regulations, however, apply at different dates. For example, 
the definition of a specified NPC in the 2013 proposed regulations will 
apply to payments made pursuant to a specified NPC on or after January 
1, 2016. For payments made before January 1, 2016, the definition of a 
specified NPC is provided in section 871(m)(3)(A), Sec.  1.871-16T(b) 
of the 2012 temporary regulations, and Sec.  1.871-15(d)(1) of the 
final regulations in the Rules and Regulations section of this issue of 
the Federal Register. For specified ELIs, the rules of the 2013 
proposed regulations will apply to payments made on or after January 1, 
2016, but only with respect to an ELI that was acquired by the long 
party on or after March 5, 2014.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866, as supplemented by Executive Order 13563. 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. It is hereby certified that these 
regulations will not have a significant economic impact on a 
substantial number of small entities. This certification is based on 
the fact that these regulations will primarily affect multinational 
financial institutions, which tend to be larger businesses, and foreign 
entities. Moreover the number of taxpayers affected and the average 
burden are minimal. Therefore, a Regulatory Flexibility Analysis is not 
required. 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 Treasury Department and the IRS 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 11, 2013, 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 Sec.  601.601(a)(3) 
apply to the hearing. Persons who wish to present oral comments at the 
hearing must submit electronic or written comments by March 5, 2014 and 
an outline of the topics to be discussed and the time to be devoted to 
each topic by March 5, 2014. A period of 10 minutes will be allotted to 
each person for making comments. An agenda showing the schedule 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 authors of these regulations are D. Peter Merkel and 
Karen Walny of the Office of Associate Chief Counsel (International). 
Other personnel from the Treasury Department and the IRS also 
participated in the development of these regulations.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Withdrawal of Proposed Regulations

    Accordingly, under the authority of 26 U.S.C. 7805, the notice of 
proposed rulemaking (REG-120282-10) that was published in the Federal 
Register on Monday, January 23, 2012, (77 FR 3202) is withdrawn.

Proposed Amendments to the Regulations

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

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Sec.  1.871-14(h) also issued under 26 U.S.C. 871(h) and 871(m). 
* * *
    Sec.  1.871-15 also issued under 26 U.S.C. 871(m). * * *

0
Par. 2. Section 1.871-14 is amended by:
0
1. Redesignating paragraphs (h) and (i) as paragraphs (i) and (j), 
respectively.
0
2. Adding new paragraphs (h) and (j)(3).
    The additions read as follows:


Sec.  1.871-14  Rules relating to repeal of tax on interest of 
nonresident alien individuals and foreign corporations received from 
certain portfolio debt investments.

* * * * *
    (h) Portfolio interest not to include certain contingent interest--
(1) Dividend equivalents. Contingent interest does not qualify as 
portfolio interest to the extent that the interest is a dividend 
equivalent within the meaning of section 871(m).
    (2) Amount of dividend equivalent that is not portfolio interest. 
The amount that does not qualify as portfolio interest because it is a 
dividend equivalent equals the amount of the dividend equivalent 
determined pursuant to Sec.  1.871-15(i). Unless otherwise excluded 
pursuant to section 871(h), any other interest paid on an obligation 
that is not a dividend equivalent may qualify as portfolio interest.
* * * * *
    (j) * * *
    (3) Effective/applicability date. The rules of paragraph (h) 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.

0
Par. 3. Section 1.871-15 is added to read as follows:


Sec.  1.871-15  Treatment of dividend equivalents.

    (a) Definitions. For purposes of this section, the following terms 
have the meanings described in this paragraph (a).
    (1) Acquire. To acquire means to enter into, purchase, accept by 
transfer, by exchange, or by conversion, or otherwise acquire a 
potential section 871(m) transaction.
    (2) Dealer. A dealer is a dealer in securities within the meaning 
of section 475(c)(1).
    (3) Dividend. A dividend means a dividend as described in section 
316.

[[Page 73137]]

    (4) Equity-linked instrument. An equity-linked instrument (ELI) is 
a financial transaction, other than a securities lending or sale-
repurchase transaction or an NPC, that references the value of one or 
more underlying securities. For example, a futures contract, forward 
contract, option, debt instrument, or other contractual arrangement 
that references the value of one or more underlying securities is an 
ELI.
    (5) Notional principal contract. A notional principal contract 
(NPC) is a notional principal contract as defined in Sec.  1.446-3(c).
    (6) Option. An option includes an option embedded in any debt 
instrument, forward contract, NPC, or other potential section 871(m) 
transaction.
    (7) Parties to a transaction--(i) Long party. A long party is the 
party to a potential section 871(m) transaction with respect to an 
underlying security that is entitled to a dividend equivalent described 
in paragraph (c) of this section.
    (ii) Short party. A short party is the party to a potential section 
871(m) transaction with respect to an underlying security that is 
liable for a dividend equivalent described in paragraph (c) of this 
section.
    (iii) Party to a transaction. A party to a transaction is any 
person that is a long party or a short party to a potential section 
871(m) transaction.
    (iv) Party to a transaction that is both a long party and a short 
party--(A) In general. If a potential section 871(m) transaction 
references more than one underlying security, the long party and short 
party are determined separately with respect to each underlying 
security. A party to a potential section 871(m) transaction is both a 
long party and a short party when the potential section 871(m) 
transaction entitles the party to receive a payment that references a 
dividend payment on an underlying security and obligates the same party 
to make a payment that references a dividend payment on another 
underlying security.
    (B) Example. The following example illustrates the definitions in 
paragraph (a)(7) of this section:

    Example. (i) Stock X and stock Y are underlying securities 
within the meaning of paragraph (a)(11) of this section. 
Corporations A and B enter into an NPC. The NPC entitles A to 
receive payments from B based on any appreciation in the value of 
Stock X and dividends paid on Stock X during the term of the 
contract and obligates A to make payments to B based on any 
depreciation in the value of Stock X during the term of the 
contract. In return, the NPC entitles B to receive payments from A 
based on any appreciation in the value of Stock Y and dividends paid 
on Stock Y during the term of the contract and obligates B to make 
payments to A based on any depreciation in the value of Stock Y 
during the term of the contract.
    (ii) A is the long party with respect to dividend equivalents it 
receives based on Stock X. A is the short party with respect to 
dividend equivalents it makes based on Stock Y. B is the long party 
with respect to divided equivalents it receives based on Stock Y. B 
is the short party with respect to dividend equivalents it makes 
based on Stock X.

    (8) Reference. Reference means to be contingent upon or determined 
by reference to, directly or indirectly, whether in whole or in part.
    (9) Section 871(m) transaction. A section 871(m) transaction is any 
securities lending or sale-repurchase transaction, specified NPC, or 
specified ELI. A potential section 871(m) transaction is any securities 
lending or sale-repurchase transaction, NPC, or ELI that references one 
or more underlying securities.
    (10) Securities lending or sale-repurchase transaction. A 
securities lending or sale-repurchase transaction is any securities 
lending transaction, sale-repurchase transaction, or substantially 
similar transaction. Securities lending transaction and sale-repurchase 
transaction have the same meaning as provided in Sec.  1.861-3(a)(6).
    (11) Underlying security. An underlying security is any interest in 
an entity taxable as a C corporation (within the meaning of section 
1361(a)(2)) if a payment with respect to that interest could give rise 
to a U.S. source dividend pursuant to Sec.  1.861-3. If a potential 
section 871(m) transaction references an interest in more than one 
entity described in the preceding sentence (including a reference to an 
index that is not a qualified index described in paragraph (k) of this 
section) or different interests in the same entity, each referenced 
interest is a separate underlying security for purposes of applying the 
rules of this section.
    (b) Source of a dividend equivalent. A dividend equivalent is 
treated as a dividend from sources within the United States for 
purposes of sections 871(a), 881, 892, 894, and 4948(a), and chapters 3 
and 4 of subtitle A of the Code.
    (c) Dividend equivalent--(1) In general. Except as provided in 
paragraph (2), dividend equivalent means--
    (i) Any payment (as described in paragraph (h) of this section) 
pursuant to a securities lending or sale-repurchase transaction that 
references the payment of a dividend from an underlying security;
    (ii) Any payment (as described in paragraph (h) of this section) 
pursuant to a specified NPC described in paragraph (d) of this section 
(specified NPC) that references the payment of a dividend from an 
underlying security;
    (iii) Any payment (as described in paragraph (h) of this section) 
pursuant to a specified ELI described in paragraph (e) of this section 
(specified ELI) that references the payment of a dividend from an 
underlying security; and
    (iv) Any other substantially similar payment as described in 
paragraph (f) of this section.
    (2) Exceptions--(i) Not a dividend. A payment pursuant to a section 
871(m) transaction that references a distribution with respect to an 
underlying security is not a dividend equivalent to the extent that the 
distribution would not be subject to tax pursuant to sections 871 or 
881, or withholding under chapters 3 or 4, if the long party owned the 
underlying security referenced by the section 871(m) transaction. For 
example, if a specified NPC references stock in a regulated investment 
company that pays a capital gains dividend described in section 
852(b)(3)(C) that would not be subject to withholding tax if paid 
directly to the long party, then an NPC payment determined by reference 
to the capital gains dividend is not a dividend equivalent.
    (ii) Section 305 coordination. A payment pursuant to a section 
871(m) transaction is not a dividend equivalent to the extent that the 
payment is treated as a distribution taxable as a dividend pursuant to 
section 305.
    (d) Specified NPCs--(1) [Reserved]
    (2) Specified NPC on or after January 1, 2016. With respect to 
payments made on or after January 1, 2016, a specified NPC is any NPC 
that has a delta of 0.70 or greater with respect to an underlying 
security at the time that the long party acquires the NPC. If an NPC 
references more than one underlying security, the NPC is a specified 
NPC only with respect to underlying securities for which the NPC has a 
delta of 0.70 or greater at the time that the long party acquires the 
NPC. For example, if an NPC references underlying security A and 
underlying security B, and it has a delta of 1.0 with respect to A and 
1.0 with respect to B, the NPC is a specified NPC with respect to A and 
B.
    (e) Specified ELIs. With respect to payments made on or after 
January 1, 2016, a specified ELI is any ELI acquired by the long party 
on or after March 5, 2014 that has a delta of 0.70 or greater

[[Page 73138]]

with respect to an underlying security at the time that the long party 
acquires the ELI. If an ELI references more than one underlying 
security, the ELI is a specified ELI only with respect to underlying 
securities for which the ELI has a delta of 0.70 or greater at the time 
that the long party acquires the ELI. For example, if an ELI references 
underlying security A and underlying security B, and it has a delta of 
0.90 with respect to A and 0.30 with respect to B, the ELI is a 
specified ELI with respect to A and is not a specified ELI with respect 
to B.
    (f) Other substantially similar payments. For purposes of this 
section, the following payments are substantially similar payments:
    (1) Payment of a tax liability. Any payment (as described in 
paragraph (h) of this section) in satisfaction of a tax liability with 
respect to a dividend equivalent made by a withholding agent is a 
dividend equivalent received by the long party in an amount determined 
under the gross-up formula provided in Sec.  1.1441-3(f)(1); and
    (2) Due bill. [Reserved].
    (g) Delta--(1) Determination of delta. Delta is the ratio of the 
change in the fair market value of an NPC or ELI to the change in the 
fair market value of the property referenced by the NPC or ELI. If an 
NPC or ELI contains more than one reference to a single underlying 
security, all references to that underlying security are taken into 
account in determining the delta with respect to that underlying 
security. If an NPC or ELI references more than one underlying 
security, a separate delta must be determined with respect to each 
underlying security without taking into account any other underlying 
security or other property or liability. For purposes of this section, 
the delta of an NPC or ELI must be determined in a commercially 
reasonable manner. If a taxpayer calculates delta for non-tax business 
purposes, that delta ordinarily is the delta used for purposes of this 
section.
    (2) Constant delta. An NPC or ELI is treated as having a delta of 
one (1.0) with respect to an underlying security when it has a constant 
delta with respect to the underlying security at the time it is 
acquired by the long party. An NPC or ELI has a constant delta with 
respect to an underlying security if the NPC or ELI has a delta that is 
not reasonably expected to vary during the term of the transaction with 
respect to that underlying security. If a transaction would not have a 
delta of one with respect to an underlying security without this 
paragraph, the number of shares of the underlying security of an NPC or 
ELI that has a constant delta is adjusted as described in paragraph 
(i)(1)(ii)(B)(2) of this section.
    (3) Examples. The following examples illustrate the rules of 
paragraph (g) of this section. For purposes of these examples, Stock X 
and Stock Y are common stock of domestic corporations X and Y. LP is 
the long party to the transaction.

    Example 1.  The terms of an NPC require LP to pay the short 
party an amount equal to all of the depreciation in the value of 100 
shares of Stock X and an interest-rate based return. In return, the 
NPC requires the short party to pay LP an amount equal to all of the 
appreciation in the value of 100 shares of Stock X and any dividends 
paid by X on those shares. The value of the NPC will change by $1 
for each $0.01 change in the price of a share of Stock X. The NPC 
therefore has a delta of 1.0 ($1.00/($0.01 x 100)).
    Example 2. LP acquires a call option that references 100 shares 
of Stock X. At the time LP purchases the call option, the value of 
the option is expected to change by $0.30 for a $0.01 change in the 
price of a share of Stock X. The call option has a delta of 0.3 
($0.30/($0.01 x 100)) when LP acquired it.
    Example 3.  (i) LP acquires an NPC that entitles LP to receive 
50 percent of the appreciation and dividends on 100 shares of Stock 
X in return for the obligation to pay the short party 50 percent of 
the depreciation on 100 shares of Stock X and an interest based 
return. The value of the NPC is expected to change by $0.50 for each 
$0.01 change in the price of a share of Stock X. The delta is 
expected to remain constant during the term of the transaction.
    (ii) Pursuant to the terms of the NPC and the amount of 
referenced underlying securities, the NPC has a delta of 0.5 ($0.50/
($0.01 x 100)) on the date that LP acquired the transaction. The 
delta of the NPC, however, is not expected to vary during the term 
of the transaction. Therefore, the NPC has a constant delta and is 
treated as having a delta equal to 1.0 on 50 shares of Stock X after 
the adjustments described in Sec.  1.871-15(i)(1)(ii)(B)(2).

    (h) Payment of a dividend equivalent--(1) Payments determined on 
gross basis. For purposes of this section, a payment includes any gross 
amount that references the payment of a dividend and that is used in 
computing any net amount transferred to or from the long party even if 
the long party makes a net payment to the short party or no payment is 
made because the net amount is zero.
    (2) Actual and estimated dividends--(i) In general. A payment 
includes any amount that references an actual or estimated payment of 
dividends, whether the reference is explicit or implicit. If a 
potential section 871(m) transaction provides for a payment based on an 
estimated dividend that adjusts to account for the amount of an actual 
dividend paid, the payment is treated as referencing the actual 
dividend amount and not an estimated dividend amount.
    (ii) Implicit dividends. A payment includes an actual or estimated 
dividend payment that is implicitly taken into account in computing one 
or more of the terms of a potential section 871(m) transaction, 
including interest rate, notional amount, purchase price, premium, 
upfront payment, strike price, or any other amount paid or received 
pursuant to the potential section 871(m) transaction.
    (iii) Actual dividend presumption. A section 871(m) transaction is 
treated as paying a per share dividend amount equal to the actual 
dividend amount unless the short party to the section 871(m) 
transaction identifies a reasonable estimated dividend amount in 
writing at the inception of the transaction. For this purpose, a 
reasonable estimated dividend amount stated in an offering document or 
the documents governing the terms of the transaction will establish the 
estimated dividend amount in writing at the inception of the 
transaction. To qualify as an estimated dividend amount, the written 
estimated dividend amount must separately state the amount estimated 
for each anticipated dividend or state a formula that allows each 
dividend to be determined. If a stock is not expected to pay a 
dividend, a reasonable estimate of the dividend amount may be zero.
    (iv) Limitation on estimated payments. When a section 871(m) 
transaction provides for one or more payments based on estimated 
dividends supported by documentation described in paragraph (h)(2)(iii) 
of this section, the per share dividend amount used to calculate the 
amount of the dividend equivalent is the lesser of the estimated 
dividend amount and the actual dividend amount paid on the stock while 
the long party was a party to the section 871(m) transaction. If a 
section 871(m) transaction provides for any payment determined by 
reference to a dividend in addition to the estimated dividends (for 
example, a special dividend), the actual dividend amount paid on the 
stock is used for the additional dividend payment.
    (3) Deferred payments. A payment occurs when the amount of a 
dividend equivalent is fixed pursuant to the terms of the transaction, 
even if paid or otherwise taken into account on a later date. For 
example, if a specified NPC provides for a payment at settlement that 
takes into account an earlier dividend payment, the dividend equivalent 
is treated as paid on the date that the amount of the dividend

[[Page 73139]]

equivalent is fixed pursuant to the terms of the contract.
    (4) Examples. The following examples illustrate the rules of 
paragraph (h) of this section. For purposes of these examples, Stock X 
is common stock of Corporation X, a domestic corporation, that 
historically pays quarterly dividends on Stock X. The parties 
anticipate that Corporation X will continue to pay the quarterly 
dividends.

    Example 1. Forward contract to purchase domestic stock. (i) When 
Stock X is trading at $50 per share, Foreign Investor enters into a 
forward contract to purchase 100 shares of Stock X in one year. 
Reasonable estimates of the quarterly dividend are specified in the 
transaction documents. The price in the forward contract is 
determined by multiplying the number of shares referenced in the 
contract by the current price of the shares and an interest rate, 
and subtracting the future value of any dividends expected to be 
paid during the term of the contract. Assuming that the forward 
contract is priced using an interest rate of 4 percent and estimated 
dividends with a future value of $1 per share during the term of the 
forward contract, the purchase price set in the forward contract is 
$5,100 (100 shares x $50 per share x 1.04-($1 x 100)).
    (ii) Subject to paragraph (h)(2)(iv), the estimated dividend 
amount is the per share dividend amount because the estimate is 
reasonable and specified in accordance with paragraph (h)(2)(iii) of 
this section. Those estimated per share dividend amounts are 
dividend equivalents for purposes of this section.
    Example 2. Price return only swap contract. (i) Foreign Investor 
enters into a price return swap contract that entitles Foreign 
Investor to receive payments based on the appreciation in the value 
of 100 shares of Stock X and requires Foreign Investor to pay an 
amount based on LIBOR plus any depreciation in the value of Stock X. 
The swap contract does not explicitly entitle Foreign Investor to 
payments based on dividends paid on Stock X during the term of the 
contract and the swap contract does not contain any reference to an 
estimated dividend amount. The LIBOR rate on the swap contract, 
however, is reduced to reflect expected annual dividends on Stock X.
    (ii) Because the LIBOR leg of the swap contract is reduced to 
reflect estimated dividends and the estimated dividend amount is not 
specified, Foreign Investor is treated as receiving the actual 
dividend amount in accordance with paragraph (h)(2) of this section. 
Those actual per share dividend amounts are dividend equivalents for 
purposes of this section.

    (i) Amount of dividend equivalent--(1) Calculation of the amount of 
a dividend equivalent--(i) Securities lending or sale-repurchase 
transactions. For a securities lending or sale-repurchase transaction, 
the amount of the dividend equivalent for each underlying security 
equals the amount of the actual per share dividend paid on the 
underlying security multiplied by the number of shares of the 
underlying security transferred pursuant to the securities lending or 
sale-repurchase transaction.
    (ii) Specified NPCs and specified ELIs--(A) In general. For a 
specified NPC or a specified ELI, the amount of the dividend equivalent 
for each underlying security equals:
    (1) The amount of the per share dividend (as determined under 
paragraph (h) of this section) with respect to the underlying security 
multiplied by;
    (2) The number of shares of the underlying security as calculated 
pursuant to paragraph (i)(1)(ii)(B) of this section multiplied by;
    (3) The delta of the section 871(m) transaction with respect to the 
underlying security at the time that the amount of the dividend 
equivalent is determined.
    (B) Calculation of the number of shares--(1) In general. Except as 
provided in paragraph (i)(1)(ii)(B)(2) of this section, the number of 
shares of an underlying security for purposes of this section is the 
number of shares of the underlying security referenced in the section 
871(m) transaction.
    (2) Adjustments. When a section 871(m) transaction multiplies the 
number of shares of an underlying security by a factor or fraction, or 
otherwise alters the amount of a payment, the number of shares of a 
section 871(m) transaction is adjusted to take into account the factor, 
fraction, or other alteration provided by the section 871(m) 
transaction. For example, if a total return swap entitles a long party 
to receive a payment based on the appreciation and dividend amount on 
100 shares of an underlying security multiplied by a factor of 1.50, 
the number of shares of the underlying security is 150 shares.
    (C) Delta at the time the amount of the dividend equivalent is 
determined--(1) In general. The delta of a section 871(m) transaction 
at the time that the amount of the dividend equivalent is determined is 
the delta of the section 871(m) transaction determined at the time 
specified in paragraph (i)(2) of this section. This delta is used 
solely for purposes of determining the amount of the dividend 
equivalent at that time, and the transaction is not retested to 
determine if it is a section 871(m) transaction. For example, if a 
transaction had a delta of 0.80 when acquired by the long party and was 
a section 871(m) transaction, the transaction remains a section 871(m) 
transaction even if the delta is below 0.70 at the time the amount of 
the dividend equivalent is determined.
    (2) Delta of an option at lapse. The delta of an option when it 
lapses is treated as zero.
    (3) Delta of an option at exercise. The delta of an option when it 
is exercised is treated as one (1.0).
    (iii) Other substantially similar payments. In addition to any 
amount determined pursuant to paragraph (i)(1)(i) or (ii), the amount 
of a dividend equivalent includes the amount of any payment described 
in paragraph (f) of this section.
    (2) Time for determining the amount of a dividend equivalent--(i) 
In general. Except as provided in paragraph (i)(2)(ii) of this section, 
the amount of a dividend equivalent is determined on the earlier of the 
date that the underlying security becomes ex-dividend with respect to 
the dividend and the record date of the dividend. For example, if a 
specified NPC provides for a payment at settlement that takes into 
account an earlier dividend payment, the amount of a dividend 
equivalent is determined on the earlier of the ex-dividend date or the 
record date for that dividend.
    (ii) Specified NPCs and specified ELIs with a term of one year or 
less. For a specified NPC or specified ELI with a term of one year or 
less when acquired by the long party, the amount of a dividend 
equivalent is determined when the long party disposes of the section 
871(m) transaction. For purposes of this paragraph, to dispose of means 
to sell, exercise, terminate, allow to lapse or expire, transfer, 
settle (whether in cash or otherwise), cancel, exchange, convert, 
surrender, forfeit, or otherwise dispose of or allow to expire.
    (iii) Term. For purposes of this section, if a transaction does not 
specify a term, the transaction is treated as having a term of more 
than one year. If a transaction permits extensions, the term of the 
transaction is the maximum term permitted by the transaction.
    (j) Limitation on the treatment of certain transactions as section 
871(m) transactions--(1) Dealers--(i) In general. A potential section 
871(m) transaction is not a section 871(m) transaction if the potential 
section 871(m) transaction is entered into by a qualified dealer in its 
capacity as a dealer in securities and the dealer is the long party 
with respect to the underlying security. This paragraph does not apply 
with respect to any proprietary position held by a dealer in 
securities.
    (ii) Qualified dealer. A qualified dealer is any dealer that:

[[Page 73140]]

    (A) Is subject to regulatory supervision by a governmental 
authority in the jurisdiction in which it was created or organized; and
    (B) furnishes a written certification to the short party confirming 
that the dealer is a qualified dealer acting in its capacity as a 
dealer in securities and that the dealer will withhold and deposit any 
tax imposed by section 871(m) with respect to any section 871(m) 
transactions that the dealer enters into as a short party in its 
capacity as a dealer in securities.
    (2) Corporate acquisitions. A potential section 871(m) transaction 
is not a section 871(m) transaction with respect to an underlying 
security if the transaction obligates the long party to acquire 
ownership of the underlying security as part of a plan pursuant to 
which one or more persons (including the long party) are obligated to 
acquire underlying securities representing more than 50 percent of the 
value of the entity issuing the underlying securities. To qualify for 
the exception provided in this paragraph, the long party must furnish a 
written certification, provided under penalties of perjury, to the 
short party that it satisfies the requirements of this paragraph 
(j)(2).
    (k) Rules relating to indices--(1) Qualified index not treated as 
an underlying security. For purposes of this section, a qualified index 
is treated as a single security that is not an underlying security. The 
determination of whether an index is a qualified index is made at the 
time that a long party acquires a potential section 871(m) transaction 
and is determinative only with respect to that transaction. Therefore, 
an index can be a qualified index with respect to a transaction entered 
into on one day and not be a qualified index with respect to a 
transaction entered into on another day.
    (2) Qualified index. A qualified index means an index that:
    (i) References 25 or more component underlying securities;
    (ii) References only long positions in component underlying 
securities;
    (iii) Contains no component underlying security that represents 
more than 10 percent of the weighting of the underlying securities in 
the index;
    (iv) Is modified or rebalanced only according to predefined 
objective rules at set dates or intervals;
    (v) Does not provide a dividend yield from component underlying 
securities that is greater than 1.5 times the current dividend yield of 
the S&P 500 Index as reported for the month immediately preceding the 
date the long party acquires the potential section 871(m) transaction; 
and
    (vi) Futures contracts or option contracts on the index (whether 
the contracts provide price only or total return exposure to the index) 
trade on a national securities exchange that is registered with the 
Securities and Exchange Commission or a domestic board of trade 
designated as a contract market by the Commodity Futures Trading 
Commission.
    (3) Safe harbor for indices that primarily reference assets other 
than underlying securities. Notwithstanding paragraph (k)(2) of this 
section, an index is a qualified index if the index is comprised solely 
of long positions in assets and the referenced component underlying 
securities in the aggregate comprise 10 percent or less of the index's 
weighting.
    (4) Weighting of component underlying securities. For purposes of 
paragraph (k) of this section, the weighting of a component underlying 
security of an index is the percentage of the index's value 
represented, or accounted for, by the component underlying security.
    (5) Indices with components other than underlying securities. Any 
component of an index that is not an underlying security is not taken 
into account for purposes of determining whether an index is a 
qualified index, except for purposes of paragraph (k)(3) of this 
section.
    (6) Transactions that reference a qualified index and one or more 
underlying securities or indices. If a potential section 871(m) 
transaction references a qualified index and one or more underlying 
securities or indices, the qualified index will remain a qualified 
index only if the potential section 871(m) transaction does not 
reference a short position in any referenced component underlying 
security of the qualified index, other than a short position with 
respect to the entire qualified index (for example, a cap or floor). 
If, in connection with a potential section 871(m) transaction that 
references a qualified index, a taxpayer (or a related person within 
the meaning of section 267(b) or 707(b)) enters into one or more 
transactions that reduce exposure to any referenced component 
underlying security of the index, other than transactions that reduce 
exposure to the entire index, then the potential section 871(m) 
transaction is not treated as referencing a qualified index.
    (l) Combined transactions--(1) In general. For purposes of 
determining whether a potential section 871(m) transaction is a section 
871(m) transaction, two or more potential section 871(m) transactions 
are treated as a single transaction with respect to an underlying 
security when:
    (i) A person (or a related person within the meaning of section 
267(b) or 707(b)) is the long party with respect to the underlying 
security for each potential section 871(m) transaction;
    (ii) The potential section 871(m) transactions reference the same 
underlying security; and
    (iii) The potential section 871(m) transactions are entered into in 
connection with each other (regardless of whether the transactions are 
entered into simultaneously or with the same counterparty).
    (2) Time and delta for testing. Combined transactions are tested 
each time the long party (or a related person) acquires a potential 
section 871(m) transaction to which paragraph (l)(1) of this section 
applies. The deltas used to determine whether the combined transactions 
are section 871(m) transactions pursuant to paragraph (l)(1) of this 
section are the deltas of each of the combined transactions at that 
time. For example, if a taxpayer buys a call option on day 1 and sells 
a put option on day 10 on the same underlying security and the two 
transactions are entered into in connection with each other, the call 
option is tested on day 1 to determine whether it is a section 871(m) 
transaction, and the combined single transaction is tested on day 10 
based on the deltas of the call option and put option at that time.
    (3) Section 871(m) transactions. If a potential section 871(m) 
transaction is a section 871(m) transaction, either by itself or as a 
result of a combination, it does not cease to be a section 871(m) 
transaction as a result of applying paragraph (l) of this section.
    (4) More than one underlying security referenced. If potential 
section 871(m) transactions reference more than one underlying 
security, paragraph (l)(1) of this section applies separately with 
respect to each underlying security.
    (5) Separate transactions for all other purposes. Potential section 
871(m) transactions that are combined for purposes of determining 
whether there is a section 871(m) transaction with respect to an 
underlying security are treated as separate transactions for all other 
purposes of this section, including separately determining the amount 
of a dividend equivalent with respect to each transaction. For 
withholding obligations with respect to combined transactions, see 
Sec.  1.1441-1(b)(4)(xxiii).
    (6) Example. The following examples illustrate the rules of 
paragraph (l) of this section. For purposes of this paragraph (l)(6), 
Foreign Investor (FI) is a nonresident alien individual and

[[Page 73141]]

Stock X is common stock of Corporation X, a domestic corporation.

    Example 1. (i) FI purchases a call option with a term of six 
months that references 100 shares of Stock X, and simultaneously 
sells a six month put option on 100 shares of Stock X. The delta of 
the call option is 0.45 and the delta of the put option is 0.40 at 
the time FI acquired each option.
    (ii) Because the purchased call option and the sold put option 
are entered into simultaneously by FI and reference the same 
underlying security, the facts and circumstances indicate that the 
call option and the put option are entered into in connection with 
each other and are treated as a combined transaction under paragraph 
(l)(1) of this section. Accordingly, the call option and the put 
option are treated as a combined transaction to compute delta for 
purposes of paragraph (e) of this section. The delta of the combined 
purchased call option and written put option is 0.85 (0.45 + 0.40). 
The combined transaction is therefore a specified ELI.

    Example 2. (i) FI purchases a call option with a term of six 
months that references 100 shares of Stock X. At the time, the delta 
of the call option is 0.45. Three months later, FI re-evaluates FI's 
position in Stock X and writes a three month put option on 100 
shares of Stock X. At the time FI writes the put option, the delta 
of the call option is 0.65 and the delta of the put is 0.25.
    (ii) FI's purchased call option and sold put option reference 
the same underlying security. Because FI wrote the put option 
referencing Stock X to adjust FI's economic position associated with 
the call option referencing Stock X, these options are entered into 
in connection with each other and treated as a combined transaction 
under paragraph (l)(1) of this section. Because the delta of the 
combined transaction is tested on the date that FI entered into the 
additional transaction, the delta of the combined purchased call 
option and sold put option is 0.90 (0.65 + 0.25). The combined 
transaction is a specified ELI.
    Example 3. (i) FI purchases a call option with a term of one 
month that references 100 shares of Stock X. At the time, the delta 
of the call option is 0.75. Two weeks later, FI re-evaluates FI's 
position in Stock X and writes a two week put option on 100 shares 
of Stock X. At the time FI writes the put option, the delta of the 
call option is 0.35 and the delta of the put is 0.25.
    (ii) FI's purchased call option has an initial delta of .75 and 
therefore is a specified ELI and a section 871(m) transaction. FI's 
purchased call option and sold put option reference the same 
underlying security. Because FI sold the put option referencing 
Stock X to adjust FI's economic position associated with the call 
option referencing Stock X, these options are entered into in 
connection with each other and treated as a combined transaction 
under paragraph (l)(1) of this section. Because the delta of the 
combined transaction is tested on the date that FI entered into the 
additional transaction, the delta of the combined purchased call 
option and sold put option is 0.6 (0.35 + 0.25). The combined 
transaction is not a specified ELI; however, the purchased call 
option remains a specified ELI.
    (m) Rules relating to interests in entities that are not taxable as 
corporations--(1) In general. Except as provided in paragraph (m)(2) of 
this section, if a transaction references an interest in an entity that 
is not a C corporation (within the meaning of section 1361(a)(2)), the 
transaction references the allocable portion of any underlying security 
or potential section 871(m) transaction held, directly or indirectly 
(including through one or more other entities that are not C 
corporations), by the referenced entity. When a transaction references 
any underlying security as a result of the application of this 
paragraph, the transaction also references the payment of any dividends 
from those underlying securities and has a dividend equivalent equal to 
the allocable portion of any dividend or dividend equivalent received, 
directly or indirectly (including through one or more other entities 
that are not C corporations), by the referenced entity.
    (2) Exception. A transaction is not treated as referencing 
underlying securities as a result of applying paragraph (m)(1) of this 
section if the underlying securities held directly or indirectly by the 
referenced entity and the underlying securities referenced by any 
potential section 871(m) transaction held directly or indirectly by the 
referenced entity represent, in the aggregate, 10 percent or less of 
the value of the referenced interest in the entity at the time the long 
party acquires the transaction and there is no plan or intention for 
acquisitions or dispositions (within the meaning of paragraph 
(i)(2)(ii) of this section) that would cause underlying securities to 
represent more than 10 percent of the value of the referenced interest. 
For example, if actively-traded Partnership A owns a pro rata interest 
in Partnership B that represents 10 percent of the value of an interest 
in Partnership A, and Partnership B owns an interest in Underlying 
Security X that represents 20 percent of the value of an interest in 
Partnership B, then Underlying Security X represents two percent of the 
value of a pro rata interest in Partnership A. Accordingly, a pro rata 
interest in Partnership A qualifies for the exception in paragraph 
(m)(2) of this section and Underlying Security X is not treated as 
referenced by a transaction that references a pro rata interest in 
Partnership A pursuant to paragraph (m)(1) of this section.
    (n) Anti-abuse rule. If a taxpayer (directly or through the use of 
a related person) acquires a transaction or transactions with a 
principal purpose of avoiding the application of this section, the 
Commissioner may treat any payment (as described in paragraph (h) of 
this section) made with respect to any transaction as a dividend 
equivalent to the extent necessary to prevent the avoidance of this 
section. Therefore, notwithstanding any other provision of this 
section, the Commissioner may adjust the delta of a transaction, change 
the number of shares, adjust an estimated dividend amount, adjust the 
timing of payments, combine, separate, or disregard transactions, 
indices, or components of indices to reflect the substance of the 
transaction or transactions, or otherwise depart from the rules of this 
section as necessary to determine whether the transaction includes a 
dividend equivalent or the amount or timing of a dividend equivalent.
    (o) Information required to be reported regarding a potential 
section 871(m) transaction--(1) In general. If a broker or dealer is a 
party to a potential section 871(m) transaction with a counterparty or 
customer that is not a broker or dealer, the broker or dealer is 
required to determine whether the potential section 871(m) transaction 
is a section 871(m) transaction. If both parties to the potential 
section 871(m) transaction are brokers or dealers, or neither party to 
the potential section 871(m) transaction is a broker or dealer, the 
short party must determine whether the potential section 871(m) 
transaction is a section 871(m) transaction. The party to the 
transaction that is required to determine whether a transaction is a 
section 871(m) transaction must also determine and report to the 
counterparty or customer the timing and amount of any dividend 
equivalent (as described in paragraphs (h) and (i) of this section). 
The party required to make the determinations described in this 
paragraph is required to exercise reasonable diligence to determine 
whether a transaction is a section 871(m) transaction, any dividend 
equivalents, and any other information necessary to apply the rules of 
this section. The information must be provided in the manner prescribed 
in paragraphs (o)(2) and (o)(3) of this section. The determinations 
required by paragraph (o) of this section are binding on the parties to 
the potential section 871(m) transaction and on any person who is a 
withholding agent with respect to the potential section 871(m) 
transaction, unless the person has actual knowledge or reason to know 
that the

[[Page 73142]]

information received is incorrect, but are not binding on the IRS.
    (2) Reporting requirements. For rules regarding reporting 
requirements with respect to dividend equivalents described in this 
section, see Sec. Sec.  1.1461-1(b) and (c), and 1.1474-1(c) and (d).
    (3) Additional information on potential section 871(m) 
transactions--(i) In general. Upon request by any person described in 
paragraph (o)(3)(ii) of this section, the party required to provide 
information pursuant to paragraph (o)(1) must provide the requester 
with information regarding the amount of each dividend equivalent, the 
delta of the potential section 871(m) transaction, the amount of any 
tax withheld and deposited, the estimated dividend amount if specified 
in accordance with paragraph (h)(2)(iii), and any other information 
necessary to apply the rules of this section. With respect to the 
delta, the party must provide the delta when the transaction is 
acquired, at the time the amount of each dividend equivalent is 
determined, and at any other time delta information is necessary to 
apply the rules of this section. The information requested must be 
provided within a reasonable time, not to exceed 14 calendar days, and 
communicated in one or more of the following ways:
    (A) By telephone, and confirmed in writing;
    (B) By written statement sent by first class mail to the address 
provided by the requesting party;
    (C) By electronic publication available to all persons entitled to 
request information; or
    (D) By any other method agreed to by the parties, and confirmed in 
writing.
    (ii) Persons entitled to request information. The following persons 
may request the information specified in paragraph (o) of this section 
with respect to a potential section 871(m) transaction from the party 
required by paragraph (o)(3)(i) of this section to provide the 
information--
    (A) A broker who holds the potential section 871(m) transaction as 
an agent or nominee to any party to the transaction as described in 
paragraph (a)(7) of this section;
    (B) A person who is required to make an information return under 
Sec.  1.1461-1(c) and paragraph (o)(2) of this section and who acts as 
an agent or nominee to any party to the transaction as described in 
paragraph (a)(7) of this section; or
    (C) Any party to the transaction as described in paragraph (a)(7) 
of this section.
    (iii) Reliance on information received. A person described in 
paragraph (o)(1) or (o)(3)(ii) of this section that receives 
information described in paragraph (o)(1) or (o)(3)(i) of this section 
(first recipient) may rely on that information to provide information 
to any other person unless the first recipient has actual knowledge or 
reason to know that the information received is incorrect. When the 
first recipient has actual knowledge or reason to know that the 
information received is incorrect, the first recipient must make a 
reasonable effort to determine and provide the information described in 
paragraph (o)(1) or (o)(3)(i) of this section to any person described 
in paragraph (o)(1) or (o)(3)(ii) of this section that requests 
information from the first recipient.
    (4) Recordkeeping rules. For rules regarding recordkeeping 
requirements sufficient to establish the amount of gross income treated 
as a dividend equivalent, see Sec.  1.6001-1.
    (p) Effective/applicability date. This section applies to payments 
made on or after the date of publication of the Treasury decision 
adopting these rules as final regulations in the Federal Register, 
except for paragraph (d)(1) of this section, which applies to payments 
made on or after January 23, 2012.
0
Par. 4. Section 1.1441-1 is amended by:
0
1. Adding paragraphs (b)(4)(xxii) and (xxiii).
0
2. Adding paragraph (f)(3).
    The additions read as follows:


Sec.  1.1441-1  Requirement for the deduction and withholding of tax on 
payments to foreign persons.

* * * * *
    (b) * * *
    (4) * * *
    (xxii) Amounts paid with respect to a notional principal contract 
described in Sec.  1.871-15(a)(5), an equity-linked instrument 
described in Sec.  1.871-15(a)(4), or a securities lending or sale-
repurchase transaction described in Sec.  1.871-15(a)(10) are exempt 
from withholding under section 1441(a) as dividend equivalents under 
section 871(m) if the transaction is not a section 871(m) transaction 
within the meaning of Sec.  1.871-15(a)(9) or is subject to an 
exception described in Sec.  1.871-15(j). However, the amounts may be 
subject to withholding under section 1441(a) if they are subject to tax 
under any section other than section 871(m). For purposes of this 
withholding exemption, it is not necessary to provide documentation 
establishing that a notional principal contract or equity-linked 
instrument has a delta that is less than 0.70 at the time it was 
acquired by the long party. For purposes of the withholding exemption 
for qualified dealers described in this paragraph, Sec.  1.871-15(j)(1) 
applies only if the long party furnishes to the withholding agent the 
documentation described in Sec.  1.871-15(j)(1). For purposes of the 
withholding exemption regarding corporate acquisitions described in 
this paragraph, the exemption only applies if the long party furnishes 
to the withholding agent the documentation described in Sec.  1.871-
15(j)(2).
    (xxiii) If a potential section 871(m) transaction is only a section 
871(m) transaction as a result of applying Sec.  1.871-15(l) (combined 
transactions) and the withholding agent did not know that the long 
party (or a related person) entered into the potential section 871(m) 
transaction in connection with any other potential section 871(m) 
transactions, the potential section 871(m) transaction is exempt from 
withholding under section 1441(a).
* * * * *
    (f) * * *
    (3) Effective/applicability date. Paragraphs (b)(xxii) and (xxiii) 
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.
0
Par. 5. Section 1.1441-2 is amended by adding paragraph (d)(5) and 
adding a sentence to the end of paragraph (f) to read as follows:


Sec.  1.1441-2  Amounts subject to withholding.

* * * * *
    (d) * * *
    (5) Payments of dividend equivalents. A withholding agent is not 
obligated to withhold until the later of--
    (i) The time that the amount of a dividend equivalent is determined 
as provided in Sec.  1.871-15(i)(2), and
    (ii) The time that the withholding agent is deemed to have control 
over money or other property of the long party because--
    (A) Money or other property is paid to or from the long party,
    (B) The withholding agent has custody or control over money or 
other property of the long party at any time on or after the amount of 
a dividend equivalent is determined as provided in Sec.  1.871-
15(i)(2), or
    (C) The section 871(m) transaction provides for an upfront payment 
or pre-payment of the purchase price even though an actual payment has 
not been made at the time the amount of a dividend equivalent is 
determined as provided in Sec.  1.871-15(i)(2).
* * * * *
    (f) Effective/applicability date. * * * Paragraph (d)(5) of this 
section applies to payments made on or after the date

[[Page 73143]]

of publication of the Treasury decision adopting these rules as final 
regulations in the Federal Register.
0
Par. 6. Section 1.1441-3 is amended by:
0
1. Adding a second sentence to paragraph (h)(1).
0
2. Redesignating paragraph (h)(2) as (h)(3) and revising paragraph 
(h)(3).
0
3. Adding new paragraph (h)(2).
    The additions and revisions read as follows:


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

* * * * *
    (h) * * * (1) * * * Withholding is required on the amount of the 
dividend equivalent calculated under Sec.  1.871-15(i).
    (2) Reliance by withholding agent on reasonable determinations. For 
purposes of determining whether a payment is a dividend equivalent and 
the amount of a dividend equivalent described in Sec.  1.871-15, a 
withholding agent may rely on the information received from the party 
to the transaction that is required to determine whether a transaction 
is a section 871(m) transaction as provided in Sec.  1.871-15(o), 
unless the withholding agent has actual knowledge or reason to know 
that the information received is incorrect. When a withholding agent 
fails to withhold the required amount because the party described in 
Sec.  1.871-15(o) fails to reasonably determine or timely provide 
whether a transaction is a section 871(m) transaction, the amount of 
any dividend equivalent, or any other information required to be 
provided pursuant to Sec.  1.871-15(o) and the withholding agent 
reasonably relied on that party's determination, then the failure to 
withhold is imputed to the party required to make the determinations 
described in Sec.  1.871-15(o). In that case, the IRS may collect any 
underwithheld amount from the party to the transaction that is required 
to make the determinations described in Sec.  1.871-15(o) and subject 
that party to applicable interest and penalties as a withholding agent.
    (3) Effective/applicability date. Except for the first sentence of 
paragraph (h)(1), this paragraph (h) applies to payments made on or 
after the date of publication of the Treasury decision adopting these 
rules as final regulations in the Federal Register. The first sentence 
of paragraph (h)(1) applies to payments made on or after January 23, 
2012.
* * * * *
0
Par. 7. Section 1.1441-7 is amended by:
0
1. Adding entry for Example 7 in paragraph (a)(3).
0
2. Adding a second sentence to paragraph (a)(4).
    The additions read as follows:


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

    (a) * * *
    (3) * * *

    Example 7. CO is a domestic clearing organization. CO serves as 
a central counterparty clearing and settlement service provider for 
derivatives exchanges in the U.S. CB is a broker organized in 
Foreign Country X and a clearing member of CO. CB is a nonqualified 
intermediary, as defined in Sec.  1.1441-1(c)(14). FC is a foreign 
corporation that has an investment account with CB. FC instructs CB 
to purchase a call option that is a specified ELI (as described in 
Sec.  1.871-15(e)). CB effects the trade for FC. The exchange 
matches FC's order with an order for a written call option with the 
same terms. The exchange then sends the matched trade to CO, which 
clears the trade. CB and the clearing member representing the call 
option seller settle the trade with CO. Upon receiving the matched 
trade, the option contracts are novated and CO becomes the 
counterparty to CB and the counterparty to the clearing member 
representing the call option seller. To the extent that there is a 
dividend equivalent with respect to the call option, both CO and CB 
are withholding agents as described in paragraph (a)(1) of this 
section.

    (4) Effective/applicability date. Example 7 of paragraph (a)(3) of 
this section applies to payments made on or after the date of 
publication of the Treasury decision adopting these rules as final 
regulations in the Federal Register.
* * * * *

John Dalrymple,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2013-28932 Filed 12-4-13; 8:45 am]
BILLING CODE 4830-01-P