Withholding Tax Policy & Legal History of Dividend Equivalent Payments Under IRC §871(m)
U.S. withholding tax raises concerns over sourcing, timing, and character. As a matter of policy, withholding tax balances the desire to attract foreign investment against the need to collect revenue from transactions involving foreign investors. For example, payments of U.S.-source “fixed or determinable annual or periodical” (FDAP) income to foreign persons are generally subject to U.S. withholding tax at a 30% rate under Internal Revenue Code (IRC) §871(a).
Before 2010, sourcing and character issues arose for U.S. withholding tax on certain FDAP-related income. On one hand, actual dividends paid by a domestic corporation were generally sourced to the U.S. and potentially subject to U.S. withholding tax when paid to foreign persons. On the other, substitute dividend payments made to transferors of stock in a securities lending transaction or a sale-repurchase transaction were sourced in the same manner as actual dividends. At the same time, payments under notional principal contracts were sourced to the residence of the income recipient. A notional principal contract is a financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts.
In 2010, the Hiring Incentives to Restore Employment Act enacted what is now IRC §871(m). In 2017, regulations under IRC §871(m) entered into force. According to the U.S. Joint Committee on Taxation, IRC §871(m) addressed concerns that securities lending and sale-repurchase transactions involving foreign investors were subject to excessive U.S. withholding tax and the confusing rules described above.
When Dividend Equivalent Payments Trigger U.S. Withholding Tax Under IRC §871(m)
To trigger IRC §871(m), the following two elements must exist: (1) there is a “dividend equivalent” payment, and (2) the recipient is a “nonresident alien individual.” A nonresident alien individual means an individual who is neither a U.S. citizen nor a U.S. resident.
A dividend equivalent means:
- any substitute dividend made pursuant to a securities lending or 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;
- any payment made under a “specified notional principal contract” that (directly or indirectly) is contingent upon, or determined by reference to, the payment of a dividend from sources within the U.S.; and
- any other payment that the U.S. Treasury secretary determines is substantially similar to a payment described in (1) or (2).
For example, under the third standard, the U.S. Treasury secretary may conclude that payments under certain forward contracts that reference stock of U.S. corporations are dividend equivalents.
A specified notional principal contract is any notional principal contract that has any of the following five characteristics:
- In connection with entering into the contract, any long party transfers the underlying security to any short party;
- In connection with terminating the contract, any short party transfers the underlying security to any long party;
- The underlying security is not readily tradeable on an established securities market;
- In connection with entering into the contract, any short party posts the underlying security as collateral with any long party; or
- The U.S. Treasury secretary identifies the contract as a specified notional principal contract, including all notional principal contracts that have the potential for U.S. withholding tax avoidance
For purposes of these five characteristics, a long party means any party to the notional principal contract that is entitled to receive any payment under the contract that is contingent upon—or determined by reference to—the payment of a U.S.-source dividend on the underlying security. A short party means any party to the notional principal contract that is not a long party in respect of the underlying security. An underlying security in a notional principal contract is the security with respect to which the dividend equivalent is paid. For purposes of IRC §871(m), any index or fixed basket of securities is treated as a single security.
Applying IRC §871(m) to Dividend Equivalent Payments – Rate & Total Return Swap Example
If (1) there is a dividend equivalent payment and (2) the recipient is a nonresident alien individual, then IRC §871(m) characterizes the payment as a dividend from U.S. sources and immediately subjects the payment to a 30% U.S. withholding tax, unless an exemption or lower treaty rate applies. The payments treated as U.S.-source dividends under IRC §871(m) are the gross amounts used in computing any net amounts transferred to or from the taxpayer.
One example of a dividend equivalent payment that IRC §871(m) applies to is a type of notional principal contract called a “total return swap” that references stock of a U.S. domestic corporation. Under a typical total return swap, a foreign investor enters into an agreement with a U.S. counterparty under which amounts due to each party are based on the returns generated by a notional investment in a specified dollar amount of the stock underlying the swap. The foreign investor agrees for a specified period to pay to the counterparty (1) an amount calculated by reference to a market interest rate on the notional amount of the underlying stock and (2) any depreciation in the stock’s value. In return, the U.S. counterparty agrees for the specified period to pay the investor (1) any dividends paid on the stock and (2) any appreciation in the value of the stock.
Amounts owed by each party under a total return swap are typically netted so that only one party makes an actual payment. However, under IRC §871(m), any dividend-based amount under the swap is treated as a payment. This is the withholding tax treatment even though any actual payment under the swap is a net amount determined in part by other amounts, such as the amount of interest and the amount of any appreciation or depreciation in the referenced stock’s value. Consequently, a U.S. counterparty to a total return swap may be obligated under IRC §871(m) to remit U.S. withholding tax on the gross amount of the dividend equivalent even though—as a result of netting payments due under the swap—the U.S. counterparty is not contractually required to make an actual payment to the foreign investor.
Reporting Dividend Equivalent Payments Under IRC §871(m) on IRS Schedules K-2 & K-3
For tax years beginning in 2021, new international information reporting for pass-throughs with international activity and operations is required. Pass-through entities traditionally attach various footnotes to Schedule K-1 to report relevant international tax items. However, these footnotes often vary in format, detail, and structure, making it difficult for the IRS to match the pass-through entity’s relevant international items to a partner’s, or shareholder’s, income tax return. In the absence of a standard footnote template to use, the IRS released Schedules K-2 and K-3 in August 2021 to standardize this process. Schedules K-2 and K-3 allow the IRS to better match entity income tax returns to a partner’s income tax return as it relates to relevant international items. A pass-through entity must file Schedule K-2 (partners’ total international distributive share items) and Schedule K-3 (partner’s share of international income, deductions, credits, etc.) if it has relevant international tax items.
For U.S. partnerships that file Form 1065, U.S. Return of Partnership Income, with international activity, Schedules K-2 and K-3 are (generally) required. This activity spans over many parts.
- Part XI of these Schedules requires certain partners that enter §871(m) transactions, referencing units in the partnership, to determine their U.S. withholding tax and reporting obligations with respect to those transactions. Per the instructions to these Schedules: Part XI, must be completed if you are a publicly traded partnership as defined in [IRC] section 7704(b) (a “PTP”) that is a covered partnership as defined in Regulations section 1.871-15(m)(1) (a “covered partnership”) or directly or indirectly holds an interest in a lower-tier partnership that is a covered partnership, regardless of whether the partners are domestic or foreign.
A covered partnership means a partnership that carries on a trade or business of dealing or trading in securities or holding significant investments in securities. A partnership holds a significant investment in securities for this purpose if either (A) 25% or more of the value of the partnership’s assets consist of underlying securities or potential §871(m) transactions, or (B) the value of the underlying securities or potential §871(m) transactions equals or exceeds $25 million.
Part XI consists of three lines. Line 1’s box must be checked if applicable. Line 2 requires disclosing the number of partnership units issued and outstanding. Line 3 provides information regarding the allocation period, dividends, and dividend equivalents for each specified unit.
Conclusion
Although one of the smaller parts to complete, certain partners will use this IRC §871(m) information to determine their U.S. withholding tax obligation. Those partners will then calculate and report any U.S. tax liability on Forms 1042 and 1042-S. Along with other parts of Schedules K-2 and K-3, due diligence by preparers is required to determine whether these parts apply. For private equity groups with alternative investments or fund of fund investments, this could prove difficult and time-consuming. Preparers need to have processes in place now to handle compliance burdens for this new reporting requirement.
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