On August 23, 2022, the Internal Revenue Service (IRS) released Notice 2022-37 (the Notice), which again extends transition relief for certain regulations promulgated under Section 871(m) of the Code, published December 17, 2019 (the Section 871(m) Regulations).
Section 871(m) treats “dividend equivalent” payments on certain contracts as U.S.-source dividends potentially subject to U.S. withholding tax. The Notice is substantially identical earlier transition relief provided by a series of IRS notices.
Notably, the Notice in effect provides that the section 871(m) regulations will not apply to any payment made with respect to any “non-delta-one” transaction issued prior to January 1, 2025.
Weil Observations. The delayed application is particularly helpful to issuers of convertible debt, convertible preferred stock, warrants and similar instruments that want to ensure that such instruments can be deposited through The Depository Trust Company (DTC) to facilitate trading. DTC requires issuer certification as to whether an instrument is treated as a “section 871(m) transaction” in order for any security to qualify as DTC eligible. Under the Notice, for instruments issued prior to January 1, 2025, the ability to comply with the certification requirement turns on whether instrument is delta one with respect to the underlying stock. This can be a relatively straightforward determination in the case of a standard convertible bond because of the inherent optionality. Beginning in 2026, the certification requirement will turn on whether the instrument has delta of 0.8 or greater with respect to the underlying stock, which, in the least, is more difficult to support as a practical matter.
Consistent with prior IRS guidance, the Notice provides the following extensions of previous transition relief:
- Extension of the phase in year for delta-one and non-delta-one transactions. Under the Notice, the Section 871(m) Regulations will not apply to “non-delta-one” transactions issued before January 1, 2025. For both delta-one and non-delta-one transactions, the Notice provides that the IRS will take into account the extent to which a taxpayer or withholding agent made a good faith effort to comply with the Section 871(m) Regulations (i) for delta-one transactions, through 2024 and (ii) for non-delta-one transactions, through 2025. The Notice also provides that the IRS will consider the extent to which a “qualified derivatives dealer” (QDD) made a good faith effort to comply with the Section 871(m) Regulations when enforcing the QDD-specific rules for delta-one transactions through 2022 and non-delta-one transactions through 2023.
- Extension of the simplified standard for “combined transactions.” The Notice provides that transactions entered into before the end of 2024 will only be combined to determine whether transactions are subject to withholding under Section 871(m) using the “simplified” standard. Under this standard, a withholding agent is only required to combine over-the-counter transactions that are priced, marketed or sold in connection with each other.
- Extension of the phase-in relief for QDDs. Finally, the Notice provides that (i) a QDD will not be subject to tax or withholding on dividends and dividend equivalents received through 2024 in its capacity as an equity derivatives dealer; (ii) a QDD will not be required to compute its Section 871(m) amount using the “net delta exposure method” until 2025; and (iii) a QDD will not be required to perform a periodic review with respect to its QDD activities through 2024.