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Statutory definition of specified notional principal contract extended through 2012

 

By Alistair M. Nevius
January 20, 2012

The IRS issued temporary and identical proposed regulations on dividend equivalents for purposes of Sec. 871(m) (T.D. 9572; REG-120282-10). The regulations provide guidance to nonresident aliens and foreign corporations that hold notional principal contracts providing for payments determined by reference to payments of dividends from sources within the United States.

Sec. 871(m) was enacted by the Hiring Incentives to Restore Employment (HIRE) Act, P.L. 111-147, in 2010. It treats as U.S.-source dividends transactions that provide for a payment contingent upon or determined by reference to a U.S.-source dividend (dividend equivalent), such as securities loans, sale-repurchase transactions, and certain notional principal contracts called “specified notional principal contracts” (specified NPCs).

Dividend equivalents made after Sept. 14, 2010, are treated as dividends from sources within the United States for purposes of Secs. 871(a) (30% tax on nonresident aliens’ income not connected with a U.S. business), 881 (tax on income of foreign corporations not connected with the United States), and 4948(a) (tax on certain foreign private foundations), and chapters 3 and 4 of subtitle A of the Code (regarding withholding on nonresident aliens and foreign corporations, and reporting of certain foreign accounts).

The statutory definition of a specified NPC (found in Sec. 871(m)(3)(A)) is effective for only two years; and for payments after March 18, 2012, any notional principal contract will be a specified NPC unless the IRS determines it is of a type that does not have a potential for tax avoidance.

The temporary regulations extend the statutory definition of a specified NPC through Dec. 31, 2012, thus postponing the treatment of all notional principal contracts as specified NPCs unless the IRS determines they are of a type that does not have a potential for tax avoidance. The proposed regulations contain proposed treatment of dividend equivalents under Sec. 871(m), beginning Jan. 1, 2013.

Under the proposed regulations, beginning on Jan. 1, 2013, a notional principal contract generally will be a specified NPC for purposes of Sec. 871(m) if:

  1. The long party is “in the market” on the same day that the parties price the notional principal contract or when the notional principal contract terminates;
  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 10% of the collateral posted by the short party;
  4. The term of the notional principal contract has fewer than 90 days;
  5. The long party controls the short party’s hedge;
  6. The notional principal amount is greater than 5% of the total public float of the underlying security or greater than 20% of the 30-day daily average trading volume, as determined at the close of business on the day immediately preceding the first day of the term of the notional principal contract; or
  7. The notional principal contract is entered into on or after the announcement of a special dividend and prior to the ex-dividend date.

The IRS believes that it is necessary to extend the statutory definition of a specified NPC through the end of the year so taxpayers and withholding agents can modify their systems and other operating procedures to comply with the rules.

The temporary regulations also amend several regulations to clarify the application of Sec. 871(m). The IRS cautions, however, that notwithstanding the temporary regulations, the IRS can challenge transactions that are designed to avoid the application of these rules under applicable judicial doctrines.

The IRS has asked for comments on the proposed regulations; comments are due April 6.
 
The temporary regulations are effective upon their publication in the Federal Register and apply to payments made on or after that date. The proposed regulations would be effective upon their publication as final regulations in the Federal Register.

Alistair M. Nevius (anevius@aicpa.org) is editor-in-chief for tax.

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