On Friday, Oct. 21, a senior official from the Internal Revenue Service said that new transition rules for the regulations for withholding on dividend equivalent payments on equity-linked derivatives under Section 871(m) will be issued in November.

At a symposium sponsored by the Securities Industry and Financial Markets Association (SIFMA) in New York, Peter Merkel, Branch 5 Senior Technical Reviewer, IRS Office of Associate Chief Counsel (International) announced that the IRS will issue transition rules for the implementation of regulations promulgated last year under Code section 871(m) shortly.  Merkel said that this guidance should contain the following rules:

• The rules regarding withholding on dividend equivalent payments on delta one contracts will be effective as of Jan. 1, 2017, per the existing regulations.  However, withholding on dividend-equivalent payments on non-delta one contracts will be delayed until Jan. 1, 2018.  No guidance is expected regarding the distinction between a delta one contract and a non delta one contract;

• A more relaxed “combination rule” is expected.  Under the current regulations, positions below the 0.8 delta threshold may be combined with each other to constitute a synthetic derivative position with a delta greater than 0.8 if the positions are entered into in connection with each other.  The current regulations include a set of presumptions to be used in determining whether positions should be combined that are rebuttable for the government and for the short party, but not for the long party.  Merkel acknowledged that the current rules may constitute a procrustean bed, and that some flexibility may be introduced in the new guidance.

• The guidance is also expected to address certain issues regarding the treatment of qualified derivative dealers (QDDs) as qualified intermediaries (QIs).  Although practitioners gave comments regarding these issues, Merkel did not say what position the government expected to take thereon.

The proposed guidance is being drafted in response to industry comments to the existing regulations.  Because of the significant burden involved in operationalizing the existing regulations, banks, securities dealers, and other “sell-side” participants should welcome the push-back of the effective date for non-delta one contracts to 2018, as well as increased flexibility in the combination rules.  Banks and broker-dealers who have signed up as QIs should also welcome any rules disambiguating QDD compliance.  Buy-side participants, such as funds, insurance companies and high net worth individuals, should welcome the deferral of withholding on non-delta one contracts prior to 2018, and they should also welcome increased flexibility in the combination rule.