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May 30, 2024

IRS provides further transitional relief under IRC Section 871(m) for treatment of dividend equivalents

  • Notice 2024-44 allows withholding agents to continue applying the transition rules from Notice 2022-37 through 2026 for delta one transactions and non-delta one contracts.

In Notice 2024-44, the IRS extends, for two more years, the additional time provided by Notice 2022-37 for broker/dealers to comply with the IRC Section 871(m) regulations and the Qualified Derivatives Dealer (QDD) provisions in the Qualified Intermediary (QI) Agreement, generally through the end of 2026. Notice 2024-44 also includes additional references to the anti-abuse rule and a statement that Treasury and IRS “will consider” a QDD to satisfy its obligations under the QI Agreement for years preceding 2027 where the QDD makes a good faith effort to comply with the 2023 QI Agreement. Notice 2024-44 is nearly identical to Notice 2022-37.

EY observes: It is noteworthy and indicative of the complexity of the rules that this is the fifth time that Treasury and the IRS have delayed the implementation of various aspects of IRC Section 871(m). This provision was first enacted as part of the Hiring Incentives to Restore Employment (HIRE) Act of 2010. Final regulations were first published in September 2015, and then again in January 2017 and December 2019. Treasury and the IRS provided transition relief for certain aspects of IRC Section 871(m) in Notice 2017-42, Notice 2018-72, Notice 2020-2 and Notice 2022-37. While some of the prior Notices were released close in time to the upcoming effective date of the regulations, Treasury and the IRS have helpfully issued Notice 2024-44 more than six months before the regulations were scheduled to be effective. As in Notice 2022-37, the delay of two years (as opposed to one year in certain prior Notices) is crucial given that it typically takes withholding agents at least 18 months to build new withholding systems, especially one as complex as will be required for IRC Section 871(m).

Extension of the phase-in years for delta-one and non-delta-one transactions

Notice 2024-44 states that Treasury and the IRS intend to revise the effective date for withholding under IRC Section 871(m) so that any payment made with respect to non-delta one notional principal contracts (NPCs) or equity-linked instruments (ELIs) issued before January 1, 2027, will not be subject to IRC Section 871(m).

EY observes: While Treasury and the IRS deemed it appropriate to delay the effective date for withholding on non-delta one contracts, in a similar manner to Notice 2022-37, Notice 2024-44 does not clarify how to identify, or withhold on, non-delta one contracts or give any additional guidance on the combination rule, complex contracts or the substantial equivalent test. Before enhancing systems, financial institutions may consider waiting for additional clarity and guidance on these matters.

Anti-abuse rule will continue to apply during phase-in years

According to Notice 2024-44, the anti-abuse rule will continue to apply during the extension and good-faith periods. The anti-abuse rule allows the IRS to treat a payment as a dividend equivalent if the taxpayer acquires or disposes of one or more transactions with a principal purpose of avoiding IRC Section 871(m).

EY observes: It appears that the IRS wants to emphasize that the anti-abuse rule trumps any relief provided by Notice 2024-44 and prior notices. Financial institutions should use the additional time to review their internal processes and procedures to confirm compliance with the anti-abuse provisions.

Good-faith-effort standard extended

Notice 2024-44 also extends the good-faith-effort standard, under which the IRS pledges to “take into account the extent to which the taxpayer or withholding agent made a good faith effort to comply” with the IRC Section 871(m) regulations. The good-faith-effort standard now applies to any delta-one transaction from 2017 through 2026 and to any non-delta one transaction that is entered in 2027.

Notice 2024-44 also includes an extension of the good-faith-effort standard for QDDs to comply with the IRC Section 871(m) regulations. The IRS will consider a QDD to have satisfied the obligations of the QI Agreement as long as the QDD made a good faith effort to comply with the 2023 QI Agreements.

EY observes: In Notice 2022-37, the IRS commented that it is “considering providing guidance" to extend the good faith standard to comply with the 2017 and 2023 QI Agreements, while the same passage in Notice 2024-44 was revised to state that the IRS “will consider a QDD to satisfy the obligations that apply specifically to a QDD under its 2023 QI Agreement for years before 2027 provided that the QDD makes a good faith effort to comply with the relevant provisions of the 2023 QI Agreement, to the extent applicable to the QDD.” The language change regarding the QDD good-faith-effort standard is notable because Notice 2024-44 is otherwise largely a word-for-word reissuance of Notice 2022-37 (other than discussion of the 2023 QI Agreement).

Extension of simplified standard for determining combined transactions

The previously announced “priced, marketed, and sold” standard for combined transactions has been extended to transactions entered through the end of 2026. During the transition relief period, transactions that are combined will not stop being combined transactions by disposing of less than all the potential IRC Section 871(m) transactions that are combined under this rule.

Conversely, transactions that were entered in 2017 through 2026 and are not treated as combined under the simplified standard will not become combined transactions in future years, when the standards in the regulations will apply. For a reissuance or other such event, these transactions must be retested to determine whether they are IRC Section 871(m) transactions.

Tax exemption for QDDs acting in capacity of equity-derivatives dealer

According to Notice 2024-44, Treasury and the IRS plan to amend the regulations so that a QDD will not be subject to tax or withholding on dividends or dividend equivalents received during 2017 through 2026 when acting in its equity-derivatives-dealer capacity. A QDD remains responsible for IRC Section 871(m) withholding on dividend equivalents paid to foreign persons.

EY observes: Beginning in 2027, financial institutions may need to determine whether payments on internal hedging transactions and payments from other broker/dealers are received in a QDD capacity or in a non-QDD capacity. This bifurcation of payments is required for a QDD to calculate its net delta exposure and corresponding IRC Section 871(m) amount. Payments of both dividends and dividend equivalents to QDDs acting in a proprietary capacity continue to be subject to withholding under IRC Section 871(m).

Notice 2024-44 states that a QDD will be required to start computing its IRC Section 871(m) exposure using the net delta approach as of 2027. A QDD will, however, remain liable for tax on dividends and dividend equivalent amounts it receives in any capacity other than as an equities derivatives dealer.

EY observes: The use of the net delta approach by QDDs likely depends on the IRC Section 871(m) guidance going forward for non-delta one contracts. If additional guidance indicates non-delta one contracts are not subject to IRC Section 871(m), Treasury and the IRS may revisit the net delta approach for a QDD to compute its QDD tax liability. Currently, financial institutions’ risk systems are built to provide a view of the overall exposure to an underlying security; removing non-delta one transactions from the risk calculation would be extremely difficult. As such, financial institutions may want to wait for additional guidance before enhancing systems to calculate a QDD tax liability.

Phase-in relief for QDDs extended

Notice 2024-44 extends the period for which a QI is not required to perform a periodic review or provide factual information in Appendix I about its QDD activities until 2027. Treasury and the IRS will consider incorporating the waiver of the QDD periodic review for 2025 and 2026 into the 2023 QI Agreement. Currently, Part V (Qualified Derivatives Dealers) of Appendix I in the 2023 QI Agreement states that it is “RESERVED.”

EY observes: While Notice 2022-37 also extended for two years the period for which a QI is not required to perform a periodic review of its QDD activities, Notice 2024-44 adds that the two-year extension applies to providing factual information in Appendix I as well. While Notice 2022-37 stated that Treasury and the IRS “anticipate” incorporating the two-year waiver of the QDD periodic review into the 2023 QI Agreement, Notice 2024-44 states that Treasury and the IRS “will consider” incorporating the two-year waiver of the QDD periodic review into the 2023 QI Agreement. While the extension of the period during which a QDD does not have to perform a periodic review is welcome, entities that act as both a QI and a QDD should consider how to segregate the activity. This will enable the QI to perform its periodic review while excluding the QDD activity.

Like Notice 2022-37, Notice 2024-44 does not provide any extension for a QDD to fulfill its Form 1042 and Form 1120-F reporting obligations. A QDD must attach Schedule Q to its Form 1042 showing its calculation of QDD tax liability under the QI Agreement (but omitting the net delta calculation of tax on the IRC Section 871(m) amount until the net delta approach becomes effective). A QDD that is as corporation must file Form 1120-F, which also has an attached Schedule Q. Reporting by QDD partnerships was further clarified in the 2023 QI Agreement, which generally includes a statement attached to Form 1065.

Transition rules for QSL and credit forward extended

Notice 2024-44 extends through calendar year 2026 the period during which withholding agents may apply the qualified securities lender (QSL) and credit forward transition rules from Notice 2010-46.

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Contact Information

For additional information concerning this Alert, please contact:

Financial Services Organization

Published by NTD’s Tax Technical Knowledge Services group; Andrea Ben-Yosef, legal editor