(a) Scope—(1) Introduction. This section provides rules relating to the source and, in certain cases, the character of notional principal contract income. However, this section does not apply to income from a section 988 transaction within the meaning of section 988 and the regulations thereunder, relating to the treatment of certain nonfunctional currency transactions. Further, this section does not apply to a dividend equivalent described in section 871(m) and the regulations thereunder. Notional principal contract income is income attributable to a notional principal contract as defined in §1.446–3(c). An agreement between a taxpayer and a qualified business unit (as defined in section 989(a)) of the taxpayer, or among qualified business units of the same taxpayer, is not a notional principal contract, because a taxpayer cannot enter into a contract with itself.

(2) Effective/applicability date. * * * With respect to a dividend equivalent described in section 871(m) and the regulations thereunder, this section applies to payments made on or after January 23, 2012.

* * * * *

(a) through (c) [Reserved].

(d) Specified NPCs—(1) Specified NPCs before January 1, 2016. For payments made after March 18, 2012, and before January 1, 2016, a specified NPC is any NPC if—

(i) In connection with entering into the contract, any long party to the contract transfers the underlying security to any short party to the contract;

(ii) In connection with the termination of the contract, any short party to the contract transfers the underlying security to any long party to the contract;

(iii) The underlying security is not readily tradable on an established securities market; or

(iv) In connection with entering into the contract, the underlying security is posted as collateral by any short party to the contract with any long party to the contract.

(d)(2) through (n) [Reserved].

(o) Effective/applicability date. This section applies to payments made on or after January 23, 2012.

* * * * *

(b) * * *

(3) Dividend Equivalents. For rules applicable to a foreign corporation’s receipt of a dividend equivalent, see section 871(m) and the regulations thereunder.

* * * * *

(e) Effective/applicability date. * * * Paragraph (b)(3) of this section applies to payments made on or after January 23, 2012. * * *

(a)(1) through (a)(5) [Reserved]. For further information, see §1.892–3T(a)(1) through (a)(5).

(6) Dividend equivalents. Income from investments in stocks includes the payment of a dividend equivalent described in section 871(m) and the regulations thereunder.

(b) [Reserved]. For further information, see §1.892–3T(b).

(c) Effective/applicability date. Paragraph (a)(6) of this section applies to payments made on or after December 5, 2013.

Par. 10. Section 1.894–1 is amended by:

1. Redesignating paragraph (c) as (c)(1) and adding paragraph (c)(2).

2. In paragraph (e):

a. Revising the heading,

b. Revising the third sentence, and

c. Adding a new fourth sentence.

The addition and revisions read as follows:

* * * * *

(c) * * *

(2) Dividend equivalents. The provisions of an income tax convention relating to dividends paid to or derived by a foreign person apply to the payment of a dividend equivalent described in section 871(m) and the regulations thereunder.

* * * * *

(e) Effective/applicability date. * * * Paragraph (c)(1) of this section applies to payments made after November 13, 1997. Paragraph (c)(2) of this section applies to payments made on or after December 5, 2013. * * *

Par. 11. Section 1.1441–2 is amended by:

1. Revising paragraph (b)(6).

2. Adding a sentence to the end of paragraph (f).

The revision and addition read as follows:

* * * * *

(b) * * *

(6) Dividend equivalents. Amounts subject to withholding include a dividend equivalent described in section 871(m) and the regulations thereunder. For this purpose, the amount of a dividend equivalent includes any gross amount that is used in computing any net amount that is transferred to or from the taxpayer under the terms of the transaction or any other payment described in section 871(m) and the regulations thereunder.

* * * * *

(f) Effective/applicability date. * * * Paragraph (b)(6) of this section applies to payments made on or after January 23, 2012.

* * * * *

(h) Dividend equivalents—(1) Withholding on gross amount. The gross amount of a dividend equivalent described in section 871(m) and the regulations thereunder is subject to withholding in an amount equal to the gross amount of the dividend equivalent used in computing any net amount that is transferred to or from the taxpayer.

(2) Effective/applicability date. This paragraph (h) applies to payments made on or after January 23, 2012.

* * * * *

(a) * * *

(3) Income on notional principal contracts—(i) General rule. Except as otherwise provided in paragraph (a)(3)(iii) of this section, a withholding agent that pays amounts attributable to a notional principal contract described in §1.863–7(a) or §1.988–2(e) shall have no obligation to withhold on the amounts paid under the terms of the notional principal contract regardless of whether a withholding certificate is provided. However, a withholding agent must file returns under §1.1461–1(b) and (c) reporting the income that it must treat as effectively connected with the conduct of a trade or business in the United States under the provisions of this paragraph (a)(3). Except as otherwise provided in paragraph (a)(3)(ii) of this section, a withholding agent must treat the income as effectively connected with the conduct of a U.S. trade or business if the income is paid to, or to the account of, a qualified business unit of a foreign person located in the United States or, if the payment is paid to, or to the account of, a qualified business unit of a foreign person located outside the United States, the withholding agent knows, or has reason to know, the payment is effectively connected with the conduct of a trade or business within the United States. Income on a notional principal contract does not include the amount characterized as interest under the provisions of §1.446–3(g)(4).

* * * * *

(iii) Exception for specified notional principal contracts. A withholding agent that makes a payment attributable to a specified notional principal contract described in section 871(m) and the regulations thereunder that is not treated as effectively connected with the conduct of a trade or business within the United States is obligated to withhold on the amount of the payment that is a dividend equivalent.

* * * * *

(g) Effective/applicability date—* * *

* * * * *

* * * * *

(c) * * *

(2) Income to which special rules apply. The income to which paragraph (c)(1) of this section applies is dividends and interest from stocks and debt obligations that are actively traded, dividends from any redeemable security issued by an investment company registered under the Investment Company Act of 1940 (15 U.S.C. 80a–1), dividends, interest, or royalties from units of beneficial interest in a unit investment trust that are (or were upon issuance) publicly offered and are registered with the Securities and Exchange Commission under the Securities Act of 1933 (15 U.S.C. 77a), and amounts paid with respect to loans of securities described in this paragraph (c)(2). With respect to a dividend equivalent described in section 871(m) and the regulations thereunder, this paragraph (c)(2) applies to the extent that the underlying security described in section 871(m) and the regulations thereunder satisfies the requirements of this paragraph (c)(2). For purposes of this paragraph (c)(2), a stock or debt obligation is actively traded if it is actively traded within the meaning of section 1092(d) and §1.1092(d)–1 when documentation is provided.

* * * * *

(h) Dividend equivalents. The rate of withholding on a dividend equivalent may be reduced to the extent provided under an income tax treaty in effect between the United States and a foreign country. For this purpose, a dividend equivalent as described in section 871(m) and the regulations thereunder is treated as a dividend from sources within the United States. To receive a reduced rate of withholding with respect to a dividend equivalent, a foreign person must satisfy the other requirements described in this section.

(i) Effective/applicability dates—(1) General rule. This section applies to payments made after December 31, 2000, except that—

(i) Paragraph (g) of this section applies to payments made after December 31, 2001, and

(ii) Paragraph (h) of this section applies to payments made on or after December 5, 2013.

* * * * *

Par. 18. Section 1.1441–7 is amended by:

1. Removing paragraph (a)(3).

2. Redesignating paragraph (a)(2) as paragraph (a)(3) and revising newly-redesignated paragraph (a)(3).

3. Adding a new paragraph (a)(2).

4. Adding a new paragraph (a)(4).

5. Revising paragraph (g).

The revisions and additions read as follows:

(a) * * *

(2) Withholding agent with respect to dividend equivalents. Each person that is a party to any contract or arrangement that provides for the payment of a dividend equivalent, as described in section 871(m) and the regulations thereunder, is treated as having control and custody of the payment.

(3) Examples. The following examples illustrate the rules of paragraphs (a)(1) and (a)(2) of this section:

Example 1. USB is a broker organized in the United States. USB pays U.S. source dividends and interest, which are amounts subject to withholding under § 1.1441–2(a), to FC, a foreign corporation that has an investment account with USB. USB is a withholding agent as defined in paragraph (a)(1) of this section.

Example 2. USB is a bank organized in the United States. FB is a bank organized in country X. FB has an omnibus account with USB through which FB invests in debt and equity instruments that pay amounts subject to withholding as defined in § 1.1441–2(a). FB is a nonqualified intermediary, as defined in § 1.1441–1(c)(14). Both USB and FB are withholding agents as defined in paragraph (a)(1) of this section.

Example 3. The facts are the same as in Example 2, except that FB is a qualified intermediary. Both USB and FB are withholding agents as defined in paragraph (a)(1) of this section.

Example 4. FB is a bank organized in country X. FB has a branch in the United States. FB’s branch has customers that are foreign persons who receive amounts subject to withholding, as defined in §1.1441–2(a). FB is a withholding agent under paragraph (a)(1) of this section and is required to withhold and report payments of amounts subject to withholding in accordance with chapter 3 of the Internal Revenue Code.

Example 5. X is a foreign corporation. X pays dividends to shareholders who are foreign persons. Under section 861(a)(2)(B), a portion of the dividends are from sources within the United States and constitute amounts subject to withholding within the meaning of §1.1441–2(a). The dividends are not subject to tax under section 884(a). See section 884(e)(3). X is a withholding agent under paragraph (a)(1) of this section.

Example 6. FC, a foreign corporation, enters into a notional principal contract (NPC) with Bank X, a bank organized in the United States. The NPC is a specified NPC for purposes of section 871(m) and the regulations thereunder. FC is the long party to the contract and Bank X is the short party. The NPC references a specified number of shares of dividend-paying common stock issued by a domestic corporation. As the long party, FC receives payments from Bank X based on any appreciation in the value of the common stock and dividends paid with respect to the common stock. As the short party, Bank X receives payment from FC based on any depreciation in the value of the common stock and a payment based on LIBOR. Bank X is a withholding agent because Bank X is deemed to have control and custody of a dividend equivalent as a party to the NPC. If FC’s tax liability under section 881 has not been satisfied in full by Bank X as withholding agent, FC is required to file a return on Form 1120-F (U.S. Income Tax Return of a Foreign Corporation).

(4) Effective/applicability date. Paragraph (a)(2) of this section and Example 6 apply on or after January 23, 2012.

* * * * *

(g) Effective/applicability date. Except as otherwise provided in paragraphs (a)(4) and (f)(3) of this section, this section applies to payments made after December 31, 2000.

* * * * *

(c) * * *

(2) * * *

(i) * * *

(L) Dividend equivalents as described in section 871(m) and the regulations thereunder;

* * * * *

(iii) Effective/applicability date. Paragraph (c)(2)(i)(L) of this section applies on or after January 23, 2012.

* * * * *

* * * * *

(b) Fee. The fee for entering into an installment agreement before January 1, 2014, is $105. The fee for entering into an installment agreement on or after January 1, 2014, is $120. A reduced fee applies in the following situations:

* * * * *

(d) Effective/applicability date. This section is applicable beginning January 1, 2014.

Par. 3. In § 300.2, paragraphs (b) and (d) are revised to read as follows:

* * * * *

(b) Fee. The fee for restructuring or reinstating an installment agreement before January 1, 2014, is $45. The fee for restructuring or reinstating an installment agreement on or after January 1, 2014, is $50.

* * * * *

(d) Effective/applicability date. This section is applicable beginning January 1, 2014.

Par. 4. In § 300.3, paragraphs (b)(1) introductory text and (d) are revised to read as follows:

* * * * *

(b) Fee. (1) The fee for processing an offer to compromise before January 1, 2014, is $150. The fee for processing an offer to compromise on or after January 1, 2014, is $186. No fee will be charged if an offer is—

* * * * *

(d) Effective/applicability date. This section is applicable beginning January 1, 2014.

John Dalrymple,
Deputy Commissioner for Services and Enforcement.

Approved November 22, 2013

Mark J. Mazur,
Assistant Secretary of the Treasury (Tax Policy).

Congress enacted section 871(m) (originally designated as section 871(l)) on March 18, 2010, in section 541 of the Hiring Incentives to Restore Employment Act (HIRE Act), Public Law 111–147 (124 Stat. 71). Section 871(m) treats a dividend equivalent as a dividend from sources within the United States for purposes of sections 871(a), 881, and 4948(a), and chapters 3 and 4 of subtitle A of the Code. Section 871(m) applies to any dividend equivalent paid on or after September 14, 2010. Section 871(m)(5) provides that the term payment includes any gross amount that is used in computing any net payment that is transferred to or from the taxpayer.

Section 871(m)(2) defines a dividend equivalent as (1) any substitute dividend made pursuant to a securities lending or a 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, (2) any payment made pursuant to a specified NPC that (directly or indirectly) is contingent upon or determined by reference to the payment of a dividend from sources within the United States, or (3) any other payment that the Secretary determines is “substantially similar” to a specified NPC payment or substitute dividend payment.

Section 871(m)(3) defines the term specified NPC. For payments made on or after September 14, 2010, and on or before March 18, 2012, section 871(m)(3)(A) defines a specified NPC as any NPC if (1) the long party transferred the underlying security to the short party in connection with entering into the NPC, (2) the short party transferred the underlying security to the long party in connection with the termination of the NPC, (3) the underlying security is not readily tradable on an established securities market, (4) the short party posted the underlying security as collateral with the long party, or (5) the NPC is identified by the Secretary as a specified NPC. For payments made after March 18, 2012, section 871(m)(3)(B) provides that any NPC is a specified NPC unless the Secretary determines that the NPC is of a type that does not have the potential for tax avoidance.

The 2012 section 871(m) regulations provided guidance regarding dividend equivalents under section 871(m). Generally, the 2012 section 871(m) regulations defined the terms specified NPC and substantially similar payment, addressed certain issues regarding withholding of tax with respect to the payment of a dividend equivalent, and provided other rules relating to dividend equivalents.

Section 1.871–15(c) of the 2012 proposed regulations provided that a dividend equivalent included any gross amount used to compute any net amount transferred to or from the taxpayer, even if the taxpayer made a net payment or no payment was made because the net amount was zero. A dividend equivalent, however, did not include any amount determined by reference to an estimate of an expected (but not yet announced) dividend. This exception did not apply if the estimate adjusted to reflect the amount of the actual dividend.

Section 1.871–16 of the 2012 section 871(m) regulations defined the term specified NPC with respect to payments made after March 18, 2012. For payments made prior to January 1, 2014, the 2012 temporary regulations (as amended by the correcting amendment published at 77 FR 53141) defined a specified NPC using substantially the same definition as provided in section 871(m)(3)(A). For payments made on or after January 1, 2014, the 2012 proposed regulations defined a specified NPC as an NPC that meets one or more of the following factors: (1) the long party is “in the market” on the same day that the parties priced or terminated the NPC; (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 ten percent of the collateral posted by the short party; (4) the actual term of the NPC is fewer than 90 days; (5) the long party controls the short party’s hedge; (6) the notional principal amount is greater than five percent of the total public float of the underlying security or greater than 20 percent of the 30-day daily average trading volume; or (7) the NPC is entered into on or after the announcement of a special dividend and prior to the ex-dividend date.

Section 1.871–15(d) of the 2012 proposed regulations described payments that are substantially similar to substitute dividends made pursuant to securities lending and sale-repurchase transactions and to payments made pursuant to specified NPCs. A substantially similar payment was any (1) gross-up amount paid by a short party in satisfaction of the long party’s tax liability with respect to a dividend equivalent, or (2) payment made pursuant to an equity-linked instrument (ELI) that was calculated by reference to a dividend from sources within the United States if the ELI satisfied one or more of the specified NPC factors.

The 2012 proposed regulations provided that certain indices referenced by an NPC or ELI would not be underlying securities, and therefore, would not be subject to section 871(m). Section 1.871–16(f)(1) of the 2012 proposed regulations provided that each component security of a customized index would be treated as an underlying security in a separate NPC. Section 1.871–16(f)(3) of the 2012 proposed regulations defined a customized index as (1) a “narrow-based index,” which was generally defined based on the Securities Exchange Act of 1934, section 3(a)(55)(B); or (2) any other index unless futures contracts or options contracts referencing the index trade on a qualified board or exchange.

The 2012 section 871(m) regulations provided rules under section 1441 to require a withholding agent to withhold tax owed with respect to a dividend equivalent. Many of these amendments and proposals simply coordinated the rules in §1.871–16T of the 2012 temporary regulations and §§1.871–15 and 1.871–16 of the 2012 proposed regulations with the withholding rules in chapter 3 of the Code. Section 1.1441–3(h)(2) of the 2012 proposed regulations explained the procedures for withholding when an NPC became a specified NPC after the date that the parties entered into the NPC. The proposed regulations provided that the term dividend equivalent included any payment that was made prior to the date the NPC became a specified NPC and that was (directly or indirectly) contingent upon or determined by reference to the payment of a dividend from sources within the United States.

The Treasury Department and the IRS received numerous comments regarding the 2012 section 871(m) regulations. The major concerns raised in the comments related to (1) the definition of a specified NPC, (2) the definition of an ELI, (3) withholding issues that arise regarding the payment of a dividend equivalent, (4) the potential for over-withholding in a chain of transactions, (5) the treatment of indices, and (6) the effective date of the 2012 proposed regulations.

Several comments on the 2012 proposed regulations stated that the seven-factor approach to defining a specified NPC would not accurately identify tax avoidance transactions. These comments asserted that the factors could treat a contract as a specified NPC even when the contract was not entered into primarily to avoid withholding. Similarly, comments noted that some tax-motivated transactions would not be subject to tax under section 871(m) because the transaction would not meet any of the seven factors. These comments generally recommended substantial modification to the factors used in the 2012 proposed regulations.

Comments stated that the term of a contract does not indicate the potential for tax avoidance. Comments noted that the term rule could result in retroactive withholding obligations and that it would be difficult for withholding agents to design systems to monitor withholding obligations that may arise after a payment has been made. Other comments asserted that 90 days was not the appropriate threshold for a minimum term and suggested eliminating the 90-day term factor or reducing the minimum term. Another comment acknowledged that the length of the term may indicate that a contract has a tax avoidance motive; however, this comment recommended adding an exception for termination events that are beyond the control of the parties to the transaction.

Comments asserted that withholding agents and taxpayers would have difficulty applying the “in the market” factor. Those comments recommended that a long party should be treated as being “in the market” only when the long party sold or purchased the underlying security “in connection with” entering into or terminating an NPC. In addition, several comments indicated that withholding agents would have difficulty determining whether a long party was “in the market” and would have to rely on representations from the long party to the withholding agent.

Comments stated that the definition of a specified ELI in the 2012 proposed regulations was overly broad because numerous types of ELIs do not give rise to the policy concerns underlying section 871(m). The comments requested that the final regulations limit the scope of the term ELI to contracts that provide delta-one or near-delta-one exposure to the underlying equity. One comment explained that the delta of an instrument reflects the change in the value of the instrument relative to a change in the value of the underlying security. These comments asserted that non-delta-one derivatives do not provide investors with a substitute for physical ownership of the underlying security. One comment, however, disagreed that a delta-based standard is the appropriate criteria for ELIs. This comment stated that a delta-based standard would provide non-delta-one financial instruments with a competitive advantage over delta-one products because non-delta-one financial instruments would be subject to more favorable tax treatment.

Another comment suggested that the term ELI should not include single stock futures contracts (SSFs) unless the SSF is an “exchange future for physical” (EFP). That comment described an EFP as a transaction in which an investor (1) sold stock and purchased an SSF for future delivery of the same stock or (2) purchased stock and sold an SSF to deliver the same stock in the future. The comment maintained that an SSF, other than an EFP, should not be treated as an ELI because SSFs trade on a regulated exchange, unlike bilateral over-the-counter contracts. The comment also asserted that an adjustment to the settlement price of an SSF is not a payment upon which withholding may be applied.

Similarly, several comments recommended that the final regulations provide an exception to the term ELI for exchange-traded options because many of these options do not provide close economic substitutes for owning stock. These comments explained that two of the seven specified NPC factors will apply to many standard exchange-traded options. First, the majority of exchange-traded options have an initial term of less than 90 days. Second, when an investor exercises an exchange-traded call option, the investor acquires the underlying securities because the terms of the transaction require physical settlement. If exchange-traded options continue to be treated as ELIs, these comments recommended that the final regulations account for the differences between over-the-counter and exchange-traded options.

Comments requested clarification on how the 2012 proposed regulations would interact with the withholding rules of chapter 3. Comments asserted that the 2012 proposed regulations did not clearly address whether intermediaries, custodians, clearing organizations, and members of clearing organizations are withholding agents. Due to the large volume of transactions cleared by exchanges on a daily basis, one comment noted that it would be impractical to treat an exchange as a withholding agent. Other comments stated that the 2012 proposed regulations would impose an undue burden on broker-dealers with non-U.S. customers because the broker-dealers would have to develop complicated systems to determine whether an instrument is an ELI and the amount of any dividend equivalent.

Other comments suggested limiting a withholding agent’s liability for withholding tax with respect to dividend equivalents. Comments stated that a withholding agent should not be liable for U.S. tax when the withholding agent lacks the information necessary to determine whether a transaction constitutes a specified NPC. For instance, comments noted that a withholding agent may not know whether a long party is selling or purchasing underlying securities on the same day that a specified NPC or ELI is entered into or terminated. A comment asserted that withholding for U.S. tax would be complicated and impractical if the final regulations do not limit a withholding agent’s knowledge to the information available to the withholding agent at the trading unit level.

Comments also questioned the rule in §1.1441–3(h)(2) of the 2012 proposed regulations treating all payments as dividend equivalents if a contract became a specified NPC only as a result of the long party acquiring physical shares upon termination (“crossing out”). Comments stated that the 2012 proposed regulations unfairly would have required a withholding agent to withhold for U.S. tax on all payments made pursuant to a contract that would be treated as dividend equivalents when the contract only became a specified NPC because of a “cross out” at the end of the contract. Other comments recommended that this rule prescribing retroactive treatment of a payment as a dividend equivalent should apply only to NPCs that are specified NPCs because they meet the “in the market” or the 90-day factor.

Several comments stated that a chain of equity derivatives could result in the collection of cascading U.S. tax, for example, when each transaction in a chain of back-to-back equity derivatives referencing the same underlying security is subject to U.S. withholding tax. Some comments recommended that the final regulations incorporate specified NPCs into the qualified securities lender and credit forward regimes described in Notice 2010–46, 2010–24 I.R.B. 757, which outlines a framework for limiting the amount of U.S. tax withheld in a chain of securities lending or sale-repurchase transactions. See §601.601(d)(2)(ii)(b). Other comments recommended that certain transactions be exempt from section 871(m), such as transactions entered into by a non-U.S. dealer as a long party in the ordinary course of business with customers. Comments explained that these transactions should be exempt from section 871(m) because the non-U.S. dealer does not enter into the transaction to avoid U.S. tax and U.S. tax would be paid on any dividend equivalent paid to the customers of the non-U.S. dealer.

Comments recommended several changes to the definition of the terms “narrow-based index” and “customized index”. One comment questioned the definition of narrow-based index and suggested that the final regulations incorporate the exceptions to that term provided in section 3(a)(55) of the Securities Exchange Act of 1934.

Several comments suggested changes that would narrow the scope of the term customized index. For example, comments suggested that the term customized index be revised to apply only to a narrow-based index or any index offered by a publisher that is not a “recognized independent index publisher.” Another comment recommended that the definition of a customized index exclude an index if an exchange-traded fund, exchanged-traded note, or other exchange-traded derivative tracked that index. One comment suggested that the final regulations provide that a customized index does not include any index with respect to which U.S. equity securities comprise less than 20 percent of the notional value.

Other comments suggested that the final regulations broaden the definition of customized index because the definition in the 2012 proposed regulation may have permitted certain transactions designed to avoid U.S. tax. For example, one comment suggested that a customized index should include any index that uses dividend yield as the primary criteria for inclusion in the index. Another comment noted that a partnership may function in the same manner as a customized index if the partnership was formed to hold a small basket of U.S. securities.

The 2012 proposed regulations provided that the rules would apply to payments made on or after the date of publication of the Treasury decision adopting those rules as final regulations. Comments expressed concern about the potentially retroactive effect of the regulations. With respect to ELIs, comments recommended that the final regulations should apply only to those transactions entered into after the effective date (rather than payments made after the effective date) because taxpayers and withholding agents did not foresee that these contracts would be subject to U.S. tax. Comments also recommended that the effective date of the final regulations be delayed because market participants will be required to make systems modifications and operational adjustments to comply with the final regulations.

After consideration of the comments, the Treasury Department and the IRS agree that the proposed seven-factor approach to identify a specified NPC does not provide the best framework for evaluating whether an NPC “is of a type which does not have the potential for tax avoidance” and that the seven-factor approach would be difficult to administer, both for the IRS and withholding agents. Accordingly, the Treasury Department and the IRS are withdrawing the 2012 proposed regulations and proposing new regulations based on the objective measurement of a derivative’s delta to determine whether a contract is subject to tax under section 871(m). The delta of an NPC or ELI is the ratio of the change in the fair market value of the contract to the change in the fair market value of the property referenced by the contract. This approach is consistent with comments suggesting that the delta of an option be used to determine whether the option is a specified ELI.

The Treasury Department and the IRS believe that this delta-based standard will prevent taxpayers from avoiding withholding tax by electing derivative exposure to U.S. equities rather than physical ownership.

A transaction has the “potential for tax avoidance” if it approximates the economics of owning an underlying security without incurring the tax liability associated with owning that security. In many cases, a long party is indifferent as to whether to invest in a derivative or a physical position because the derivative and the physical position provide comparable economic returns. Furthermore, the short party will often hedge an NPC or ELI by acquiring physical securities in proportion to the delta of the derivative to which it is exposed. When dividends paid on physical securities are subject to tax while dividend equivalents with respect to economically comparable derivatives are not, those derivatives have a potential for tax avoidance regardless of whether a long party is using the derivative in a particular case to avoid tax. Accordingly, the Treasury Department and the IRS favor a delta approach that objectively identifies transactions in which the long party is able to sufficiently approximate the economic returns associated with an underlying security.

In addition, the Treasury Department and the IRS believe that the delta-based standard of the 2013 proposed regulations provides a simpler and more administrable framework than the seven-factor test of the 2012 proposed regulations. Using the delta of an NPC or ELI to determine the application of section 871(m) employs a single standard for NPCs and ELIs, although the regulations have different applicability dates for specified NPCs and specified ELIs. Therefore, for both equity swaps and other equity derivatives, the determination of whether a transaction may give rise to a dividend equivalent will generally depend only on the determination of a single objective measurement at the time the transaction is acquired.

This notice of proposed rulemaking should not be construed as providing guidance with respect to any other section of the Code. For example, this notice should not be used as a basis for applying the delta standard to interpret other Code sections.

Section 1.871–15(b) of the 2013 proposed regulations treats a dividend equivalent as a dividend from sources within the United States for purposes of sections 871(a), 881, 892, 894, and 4948(a), and chapters 3 and 4 of subtitle A of the Code. Section 1.871–15(c) provides that a dividend equivalent is (1) any payment of a substitute dividend made pursuant to a securities lending or sale-repurchase transaction that references a U.S. source dividend payment, (2) any payment made pursuant to a specified NPC that references a U.S. source dividend payment, (3) any payment made pursuant to a specified ELI that references a U.S. source dividend payment, or (4) any other substantially similar payment. A payment references a U.S. source dividend payment if the payment is directly or indirectly contingent upon or determined by reference to the payment of a dividend from sources within the United States.

Certain transactions typically provide for dividend equivalents to be paid at the time a dividend is paid, and in an amount equal to that dividend payment, on a referenced stock. Stock loans, equity sale-repurchase transactions, and total return swaps referencing stock are the most common types of equity-linked transactions that provide the long party with either a dividend or a dividend equivalent equal to the dividend paid on the referenced stock.

Other transactions that are linked to U.S. equities may also provide for dividend equivalents. The Treasury Department and the IRS believe that an ELI that has economic terms that are substantially similar to a payment made pursuant to a securities lending or sale-repurchase transaction, or a specified NPC, creates the same potential for avoidance of U.S. withholding tax as those transactions. Section 1.871–15(a)(4) of the 2013 proposed regulations defines an ELI as any financial transaction (other than a securities lending or sale-repurchase transaction or an NPC) that references the value of one or more underlying securities. The term ELI includes instruments such as forward contracts, futures contracts, options, debt instruments convertible into underlying securities, and debt instruments with payments linked to underlying securities. The long party with respect to an ELI is the counterparty that holds a long position with respect to an underlying security, such as the purchaser of a call option or the writer of a put option.

Section 1.871–15(f) of the 2013 proposed regulations provides that another substantially similar payment is a gross-up amount paid by a short party in satisfaction of the long party’s tax liability with respect to a dividend equivalent. The Treasury Department and the IRS request comments regarding whether other payments should be treated as substantially similar payments, such as a payment made by a seller of stock to the purchaser of the stock pursuant to an agreement to deliver a pending U.S. source dividend after the record date (for example, a due bill).

The definition of an underlying security has also been revised. The 2013 proposed regulations define an underlying security as any interest in an entity taxable as a corporation for Federal tax purposes if a payment with respect to that interest may give rise to a U.S. source dividend. If a transaction references more than one such entity (including a reference to an index that is not a qualified index), each interest is treated as a separate underlying security. If a transaction references a qualified index, the qualified index is treated as a single security that is not an underlying security.

The 2013 proposed regulations also revise the rules pertaining to indices. In general, a qualified index is any index that (1) references 25 or more underlying securities; (2) references only long positions in underlying securities; (3) contains no underlying security that represents more than 10 percent of the index’s weighting; (4) rebalances based on objective rules at set intervals; (5) does not provide for a high dividend yield; and (6) is referenced by futures or option contracts that trade on a national securities exchange or a domestic board of trade.

The 2013 proposed regulations define a section 871(m) transaction as any securities lending or sale-repurchase transaction, specified NPC, or specified ELI. Section 1.871–15(a)(10) of the 2013 proposed regulations defines a securities lending transaction and sale-repurchase transaction by reference to §1.861–3(a)(6) and includes substantially similar transactions.

As noted above, to determine whether a transaction is a specified NPC or specified ELI, the 2013 proposed regulations replace the seven-factor test in the 2012 proposed regulations with a single-factor test. Section 1.871–15(d)(2) provides that, with respect to payments made on or after January 1, 2016, a specified NPC is any NPC that has a delta of 0.70 or greater when the long party acquires the transaction. Similarly, §1.871–15(e) provides that a specified ELI is any ELI that has a delta of 0.70 or greater when the long party acquires the transaction. If a transaction references more than one underlying security, the taxpayer must determine whether the transaction is a section 871(m) transaction with respect to each underlying security. A transaction, therefore, may be a section 871(m) transaction with respect to one or more underlying securities referenced in the transaction, but may not be treated as a section 871(m) transaction with respect to other underlying securities referenced by that same transaction.

Section 1.871–15(g)(1) of the 2013 proposed regulations provides that the delta of an NPC or an ELI is the ratio of the change in the fair market value of the NPC or ELI to the change in the fair market value of the property referenced by the NPC or ELI. For purposes of the 2013 proposed regulations, the delta of a transaction must be determined in a commercially reasonable manner. If a taxpayer calculates delta for non-tax business purposes, that delta ordinarily is treated as the delta for purposes of this section. For example, to determine whether an option is a specified ELI, a dealer may use the delta that it calculates to determine the number of shares needed to balance its position on the option (even though that number of shares may not correspond to the dealer’s actual hedge). If an NPC or ELI contains more than one reference to a single underlying security, all references to that underlying security are taken into account in determining the delta. If an NPC or an ELI references more than one underlying security or other property or liability, a separate delta must be determined with respect to each underlying security without taking into account any other underlying security or other property or liability referenced in the transaction. Section 1.871–15(g)(2) provides that if the delta of an NPC or ELI is not reasonably expected to vary during the term of the transaction, the NPC or ELI has a constant delta and the delta is treated as 1.0. If a transaction would not have a delta of 1.0 but for the rule in §1.871–15(g)(2), the number of shares of the underlying security is adjusted to reflect the constant delta of 1.0. This rule is intended to prevent taxpayers from avoiding the application of the 2013 proposed regulations by using transactions that reduce delta while retaining the economics of owning a set amount of shares. For example, a transaction that provides 50 percent of the appreciation, dividends, and depreciation on 200 shares of stock X throughout the term of the transaction (and therefore has a delta of 0.5) will be treated as a contract that provides 100 percent of the same exposure on 100 shares of stock X (and therefore has a delta of 1.0). The Treasury Department and the IRS request comments regarding whether taxpayers could avoid the constant delta rule by structuring transactions with the potential for de minimis delta variability and whether such transactions should be deemed to have a constant delta.

The Treasury Department and the IRS understand that a long party may enter into multiple transactions referencing the same underlying security to substantially replicate the economics of owning the underlying security. For example, a taxpayer may purchase a call option and sell a put option referencing the same underlying security that individually have a delta below 0.70 but together have a delta that exceeds 0.70. If section 871(m) were to apply to each transaction separately, neither transaction would be a section 871(m) transaction even though the economics of the positions when considered together are the same as another transaction that would be a section 871(m) transaction. Therefore, §1.871–15(l) of the 2013 proposed regulations treats multiple transactions as a single transaction for purposes of determining if the transactions are a section 871(m) transaction with respect to an underlying security when a long party (or a related person) enters into two or more transactions that reference the same underlying security and the transactions were entered into in connection with each other. These rules apply only to combine transactions in which the taxpayer is the long party. Section 1.871–15(l) does not combine transactions when a taxpayer is the long party with respect to an underlying security in one transaction and the short party with respect to the same underlying security in another transaction. Transactions that are combined for purposes of determining whether there is a section 871(m) transaction are treated as separate transactions for all other purposes of this section, including for purposes of determining the amount of a dividend equivalent with respect to each transaction. A withholding agent, however, is not required to withhold on a dividend equivalent paid pursuant to a transaction that has been combined with one or more other transactions unless the withholding agent knows that the long party (or a related person) entered into the potential section 871(m) transactions in connection with each other.

The Treasury Department and the IRS request comments regarding whether (and, if applicable, how) the rules for combining separate transactions to determine whether the transactions are section 871(m) transactions should apply in other situations, such as when a taxpayer holds both long and short positions with respect to the same underlying security. Comments also are requested regarding whether (and, if applicable, how) the remaining transaction (or transactions) should be retested when a long party terminates one or more, but not all, of the transactions that make up a combined position.

Section 1.871–15(h) of the 2013 proposed regulations provides rules for identifying a payment of a dividend equivalent. A payment includes any gross amount that references a U.S. source dividend and that is used to compute any net amount transferred to or from the long party even if the long party makes a net payment to the short party or the net payment is zero. For purposes of section 871(m), a payment is treated as made on the date the amount of the dividend equivalent is fixed even if it is paid or otherwise taken into account on a later date.

The 2012 proposed regulations provided that estimates of expected dividends were not dividend equivalents unless the estimate was adjusted to reflect actual dividend payments. The 2013 proposed regulations eliminate this exception and explicitly treat estimated dividend payments as dividend equivalents because the economic benefit of a dividend is present in contracts that use estimated dividends in much the same way as a contract that adjusts for actual dividends. Moreover, the Treasury Department and the IRS are concerned that taxpayers may inappropriately avoid section 871(m) if estimated dividends are not treated as dividend equivalents.

In the 2013 proposed regulations, a dividend equivalent includes any amount that references the payment of a U.S. source dividend. In addition to an actual payment of dividends and an estimated payment of dividends, a dividend equivalent includes any other contractual term of a potential section 871(m) transaction that is calculated based on an actual or estimated dividend. For example, when a long party enters into an NPC that provides for payments based on the appreciation in the value of an underlying security but does not explicitly entitle the long party to receive payments based on regular dividends (a price return swap), the 2013 proposed regulations treat the price return swap as a transaction that provides for the payment of a dividend equivalent because the anticipated dividend payments are presumed to be taken into account in determining other terms of the NPC, such as in the payments that the long party is required to make to the short party or in setting the price of the underlying securities referenced in the price return swap.

The 2013 proposed regulations also provide rules for calculating the amount of a dividend equivalent. For a securities lending or sale-repurchase transaction, §1.871–15(i) provides that the amount of a dividend equivalent for each underlying security equals the actual per share dividend amount paid on the underlying security multiplied by the number of shares of the underlying security transferred pursuant to the transaction. For a specified NPC or specified ELI, the amount of a dividend equivalent equals the per share dividend amount with respect to the underlying security multiplied by the number of shares of the underlying security referenced in the transaction (subject to adjustment) multiplied by the delta of the transaction with respect to the underlying security at the time that the amount of the dividend equivalent is determined.

If a transaction provides for a payment based on an estimated dividend (including an implicit estimated dividend), §1.871–15(h)(2)(i) and (iii) of the 2013 proposed regulations require that the actual amount of the dividend payment is used to calculate the amount of the dividend equivalent unless the short party identifies a reasonable estimated dividend amount in writing at the inception of the transaction. Prop. Treas. Reg. §1.871–15(h)(2)(i) and (iii). If a transaction that provides for payment based on estimated dividends is supported by the required documentation, the per share dividend amount used to compute the amount of a dividend equivalent is the lesser of the amount of the estimated dividend and the amount of the actual dividend paid.

The delta used to determine whether a potential section 871(m) transaction is a section 871(m) transaction may differ from the delta used to determine the amount of the dividend equivalent of a section 871(m) transaction. Whereas the delta of a transaction at the time the long party acquires a potential section 871(m) transaction is used to determine whether the transaction is a section 871(m) transaction, the delta of the section 871(m) transaction at the time that the amount of the dividend equivalent is determined is used to calculate the amount of the dividend equivalent. Because the delta of a transaction may vary over time, the delta of the transaction at the time of acquisition may differ from the delta of the transaction at the time the amount of the dividend equivalent is determined. Under §1.871–15(i)(1)(ii)(C)(1) of the 2013 proposed regulations, the delta used to calculate the amount of a dividend equivalent is not used to re-test whether a transaction is a section 871(m) transaction; a long party’s section 871(m) transaction continues to be subject to tax even if the delta of the section 871(m) transaction is below 0.70 at the time the amount of the dividend equivalent is determined. Similarly, a long party that acquires a potential section 871(m) transaction that has a delta below 0.70 at the time of acquisition will not have a section 871(m) transaction even if the delta increases to be above 0.70 during the time the long party holds the transaction.

Under the 2013 proposed regulations, the amount of the dividend equivalent generally is determined on the earlier of the ex-dividend date or the record date for the dividend. However, if a section 871(m) transaction has a term of one year or less, the amount of the dividend equivalent is determined when the long party disposes of the transaction. Therefore, a long party that acquires an option with a term of one year or less that is a specified ELI will not incur a withholding tax if the option lapses.

In response to comments, §1.871–15(j) of the 2013 proposed regulations provides exceptions to the definition of a section 871(m) transaction for two types of potential section 871(m) transactions that have little potential for tax avoidance. The first exception applies when a qualified dealer enters into a transaction as the long party in its capacity as a dealer. A qualified dealer is any dealer in securities within the meaning of section 475 that is subject to regulatory supervision by a governmental authority in the jurisdiction in which it was created or organized. In addition, the dealer must certify to the short party that it is a qualified dealer acting in its capacity as a dealer in securities and that it will withhold and deposit any tax imposed by section 871(m) with respect to a section 871(m) transaction that it enters into as a short party in its capacity as a dealer. The second exception applies when a taxpayer enters into a transaction as part of a plan pursuant to which one or more persons (including the taxpayer) are obligated to acquire 50 percent or more of the entity issuing the underlying securities.

A comment to the 2012 proposed regulations stated that an NPC may reference a partnership interest and that the partnership could be formed to hold a small basket of U.S. equity securities. Noting that a partnership may function like a customized index, the comment recommended that regulations treat an NPC that references a partnership interest as a separate NPC with respect to each underlying security held by the partnership. To address the concern noted in the comment, §1.871–15(m) of the 2013 proposed regulations treats a transaction that references an interest in an entity that is not a C corporation for Federal tax purposes as referencing the allocable portion of any underlying securities and potential section 871(m) contracts held directly or indirectly by that entity. The 2013 proposed regulations provide an exception for a transaction that references an interest in an entity that is not a C corporation if underlying securities and potential section 871(m) transactions represent, in the aggregate, 10 percent or less of the value of the interest in the referenced entity at the time the transaction is entered into.

Section 1.871–15(n) of the 2013 proposed regulations provides that the Commissioner may treat any payment made with respect to a transaction as a dividend equivalent if the taxpayer acquires a transaction with a principal purpose of avoiding the application of these rules. The Treasury Department and the IRS will continue to closely scrutinize other transactions that are not covered by section 871(m) and that may be used to avoid U.S. taxation and U.S. withholding. In addition, the IRS may challenge the U.S. tax results claimed in connection with transactions that are designed to avoid the application of section 871(m) using all available statutory provisions and judicial doctrines (including the substance over form doctrine, the economic substance doctrine under section 7701(o), the step transaction doctrine, and tax ownership principles) as appropriate. For example, nothing in section 871(m) precludes the IRS from asserting that a contract labeled as an NPC or other equity derivative is in fact an ownership interest in the equity referenced in the contract.

The 2013 proposed regulations also make a number of conforming changes to reporting and withholding requirements. Most equity-linked transactions involve a financial institution acting as a broker, dealer, or intermediary. A financial institution is usually in the best position to undertake the responsibility to report the tax consequences of a potential section 871(m) transaction. Accordingly, §1.871–15(o) of the 2013 proposed regulations provides that when a broker or dealer is a party to a potential section 871(m) transaction, the broker or dealer is required to determine whether the transaction is a section 871(m) transaction, and if so, the amounts of the dividend equivalents. If a broker or dealer is not a party to the transaction or both parties are brokers or dealers, the short party must determine whether the transaction is a section 871(m) transaction and the amounts of the dividend equivalents. Determinations made by the broker, dealer, or short party are binding on the parties to the section 871(m) transaction unless the other person knows or has reason to know that the information is incorrect; the determinations are not binding on the IRS. In addition, certain persons described in §1.871–15(o)(3)(ii) of the 2013 proposed regulations are permitted to request information from certain parties to a potential section 871(m) transaction who are described in §1.871–15(o)(1) when the information is necessary to satisfy their withholding or information reporting obligations, or to determine their tax liability. If a withholding agent reasonably relies on information received, it will not be liable for underwithholding; however, the party to the transaction who failed to properly determine the amount will be liable for the underwithholding. The Treasury Department and the IRS solicit comments with respect to these reporting rules, including comments regarding the parties that should be required to report and the extent of information that is appropriate.

The 2013 proposed regulations include amendments to chapter 3 specifically addressing dividend equivalents. The 2013 proposed regulations describe how the exception to withholding where no money or property is paid applies to a dividend equivalent. Section 1.1441–2(d)(5) of the 2013 proposed regulations provides that a withholding agent is not obligated to withhold on a dividend equivalent until the later of: (1) the time that the amount of the dividend equivalent is determined and (2) the time at which any of the following has occurred: (a) money or other property is paid pursuant to a section 871(m) transaction, (b) the withholding agent has custody or control of money or other property of the long party at any time on or after the amount of the dividend equivalent is determined, or (c) there is an upfront payment or a prepayment of the purchase price. Although §1.1441–2(d)(5) of the 2013 proposed regulations relieves a withholding agent of liability to withhold when the withholding agent does not have control of money or other property of the long party, the long party remains liable for U.S. tax on the dividend equivalent pursuant to section 871(m) and Prop. Treas. Reg. §1.871–15.

Generally, section 871(h)(4) provides that U.S. source portfolio interest received by a nonresident alien individual is not subject to the 30-percent U.S. tax imposed under section 871(a)(1). Certain contingent interest payments, however, are excluded from the definition of portfolio interest. Section 871(h)(4)(A)(ii) grants the Secretary authority to impose tax on contingent interest when necessary to prevent the avoidance of Federal income tax. Most contingent debt instruments are either referenced to a qualified index, have an embedded option with a delta below 0.70 or both. A debt obligation that is a specified ELI and provides for a contingent interest payment determined by reference to a U.S. source dividend payment has the potential to be used by a nonresident alien individual or foreign corporation to avoid section 871(m). Therefore, §1.871–14(h) of the 2013 proposed regulations provide that any contingent interest will not qualify for the portfolio interest exemption to the extent that the contingent interest payment is a dividend equivalent.

The 2013 proposed regulations generally will apply to payments made on or after the date of publication of the Treasury decision adopting these rules as final regulations. Certain provisions in the 2013 proposed regulations, however, apply at different dates. For example, the definition of a specified NPC in the 2013 proposed regulations will apply to payments made pursuant to a specified NPC on or after January 1, 2016. For payments made before January 1, 2016, the definition of a specified NPC is provided in section 871(m)(3)(A), §1.871–16T(b) of the 2012 temporary regulations, and §1.871–15(d)(1) of the final regulations in the Rules and Regulations section of this issue of the Federal Register. For specified ELIs, the rules of the 2013 proposed regulations will apply to payments made on or after January 1, 2016, but only with respect to an ELI that was acquired by the long party on or after March 5, 2014.

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(h) Portfolio interest not to include certain contingent interest—(1) Dividend equivalents. Contingent interest does not qualify as portfolio interest to the extent that the interest is a dividend equivalent within the meaning of section 871(m).

(2) Amount of dividend equivalent that is not portfolio interest. The amount that does not qualify as portfolio interest because it is a dividend equivalent equals the amount of the dividend equivalent determined pursuant to §1.871–15(i). Unless otherwise excluded pursuant to section 871(h), any other interest paid on an obligation that is not a dividend equivalent may qualify as portfolio interest.

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(j) * * *

(3) Effective/applicability date. The rules of paragraph (h) of this section apply to payments made on or after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register.

Par. 3. Section 1.871–15 is added to read as follows:

(a) Definitions. For purposes of this section, the following terms have the meanings described in this paragraph (a).

(1) Acquire. To acquire means to enter into, purchase, accept by transfer, by exchange, or by conversion, or otherwise acquire a potential section 871(m) transaction.

(2) Dealer. A dealer is a dealer in securities within the meaning of section 475(c)(1).

(3) Dividend. A dividend means a dividend as described in section 316.

(4) Equity-linked instrument. An equity-linked instrument (ELI) is a financial transaction, other than a securities lending or sale-repurchase transaction or an NPC, that references the value of one or more underlying securities. For example, a futures contract, forward contract, option, debt instrument, or other contractual arrangement that references the value of one or more underlying securities is an ELI.

(5) Notional principal contract. A notional principal contract (NPC) is a notional principal contract as defined in §1.446–3(c).

(6) Option. An option includes an option embedded in any debt instrument, forward contract, NPC, or other potential section 871(m) transaction.

(7) Parties to a transaction—(i) Long party. A long party is the party to a potential section 871(m) transaction with respect to an underlying security that is entitled to a dividend equivalent described in paragraph (c) of this section.

(ii) Short party. A short party is the party to a potential section 871(m) transaction with respect to an underlying security that is liable for a dividend equivalent described in paragraph (c) of this section.

(iii) Party to a transaction. A party to a transaction is any person that is a long party or a short party to a potential section 871(m) transaction.

(iv) Party to a transaction that is both a long party and a short party—(A) In general. If a potential section 871(m) transaction references more than one underlying security, the long party and short party are determined separately with respect to each underlying security. A party to a potential section 871(m) transaction is both a long party and a short party when the potential section 871(m) transaction entitles the party to receive a payment that references a dividend payment on an underlying security and obligates the same party to make a payment that references a dividend payment on another underlying security.

(B) Example. The following example illustrates the definitions in paragraph (a)(7) of this section:

Example. (i) Stock X and Stock Y are underlying securities within the meaning of paragraph (a)(11) of this section. Corporations A and B enter into an NPC. The NPC entitles A to receive payments from B based on any appreciation in the value of Stock X and dividends paid on Stock X during the term of the contract and obligates A to make payments to B based on any depreciation in the value of Stock X during the term of the contract. In return, the NPC entitles B to receive payments from A based on any appreciation in the value of Stock Y and dividends paid on Stock Y during the term of the contract and obligates B to make payments to A based on any depreciation in the value of Stock Y during the term of the contract.

(ii) A is the long party with respect to dividend equivalents it receives based on Stock X. A is the short party with respect to dividend equivalents it makes based on Stock Y. B is the long party with respect to divided equivalents it receives based on Stock Y. B is the short party with respect to dividend equivalents it makes based on Stock X.

(8) Reference. Reference means to be contingent upon or determined by reference to, directly or indirectly, whether in whole or in part.

(9) Section 871(m) transaction. A section 871(m) transaction is any securities lending or sale-repurchase transaction, specified NPC, or specified ELI. A potential section 871(m) transaction is any securities lending or sale-repurchase transaction, NPC, or ELI that references one or more underlying securities.

(10) Securities lending or sale-repurchase transaction. A securities lending or sale-repurchase transaction is any securities lending transaction, sale-repurchase transaction, or substantially similar transaction. Securities lending transaction and sale-repurchase transaction have the same meaning as provided in §1.861–3(a)(6).

(11) Underlying security. An underlying security is any interest in an entity taxable as a C corporation (within the meaning of section 1361(a)(2)) if a payment with respect to that interest could give rise to a U.S. source dividend pursuant to §1.861–3. If a potential section 871(m) transaction references an interest in more than one entity described in the preceding sentence (including a reference to an index that is not a qualified index described in paragraph (k) of this section) or different interests in the same entity, each referenced interest is a separate underlying security for purposes of applying the rules of this section.

(b) Source of a dividend equivalent. A dividend equivalent is treated as a dividend from sources within the United States for purposes of sections 871(a), 881, 892, 894, and 4948(a), and chapters 3 and 4 of subtitle A of the Code.

(c) Dividend equivalent—(1) In general. Except as provided in paragraph (2), dividend equivalent means—

(i) Any payment (as described in paragraph (h) of this section) pursuant to a securities lending or sale-repurchase transaction that references the payment of a dividend from an underlying security;

(ii) Any payment (as described in paragraph (h) of this section) pursuant to a specified NPC described in paragraph (d) of this section (specified NPC) that references the payment of a dividend from an underlying security;

(iii) Any payment (as described in paragraph (h) of this section) pursuant to a specified ELI described in paragraph (e) of this section (specified ELI) that references the payment of a dividend from an underlying security; and

(iv) Any other substantially similar payment as described in paragraph (f) of this section.

(2) Exceptions—(i) Not a dividend. A payment pursuant to a section 871(m) transaction that references a distribution with respect to an underlying security is not a dividend equivalent to the extent that the distribution would not be subject to tax pursuant to section 871 or 881, or withholding under chapter 3 or 4, if the long party owned the underlying security referenced by the section 871(m) transaction. For example, if a specified NPC references stock in a regulated investment company that pays a capital gains dividend described in section 852(b)(3)(C) that would not be subject to withholding tax if paid directly to the long party, then an NPC payment determined by reference to the capital gains dividend is not a dividend equivalent.

(ii) Section 305 coordination. A payment pursuant to a section 871(m) transaction is not a dividend equivalent to the extent that the payment is treated as a distribution taxable as a dividend pursuant to section 305.

(d) Specified NPCs—(1) [Reserved].

(2) Specified NPC on or after January 1, 2016. With respect to payments made on or after January 1, 2016, a specified NPC is any NPC that has a delta of 0.70 or greater with respect to an underlying security at the time that the long party acquires the NPC. If an NPC references more than one underlying security, the NPC is a specified NPC only with respect to underlying securities for which the NPC has a delta of 0.70 or greater at the time that the long party acquires the NPC. For example, if an NPC references underlying security A and underlying security B, and it has a delta of 1.0 with respect to A and 1.0 with respect to B, the NPC is a specified NPC with respect to A and B.

(e) Specified ELIs. With respect to payments made on or after January 1, 2016, a specified ELI is any ELI acquired by the long party on or after March 5, 2014, that has a delta of 0.70 or greater with respect to an underlying security at the time that the long party acquires the ELI. If an ELI references more than one underlying security, the ELI is a specified ELI only with respect to underlying securities for which the ELI has a delta of 0.70 or greater at the time that the long party acquires the ELI. For example, if an ELI references underlying security A and underlying security B, and it has a delta of 0.90 with respect to A and 0.30 with respect to B, the ELI is a specified ELI with respect to A and is not a specified ELI with respect to B.

(f) Other substantially similar payments. For purposes of this section, the following payments are substantially similar payments:

(1) Payment of a tax liability. Any payment (as described in paragraph (h) of this section) in satisfaction of a tax liability with respect to a dividend equivalent made by a withholding agent is a dividend equivalent received by the long party in an amount determined under the gross-up formula provided in §1.1441–3(f)(1); and

(2) Due bill. [Reserved].

(g) Delta—(1) Determination of delta. Delta is the ratio of the change in the fair market value of an NPC or ELI to the change in the fair market value of the property referenced by the NPC or ELI. If an NPC or ELI contains more than one reference to a single underlying security, all references to that underlying security are taken into account in determining the delta with respect to that underlying security. If an NPC or ELI references more than one underlying security, a separate delta must be determined with respect to each underlying security without taking into account any other underlying security or other property or liability. For purposes of this section, the delta of an NPC or ELI must be determined in a commercially reasonable manner. If a taxpayer calculates delta for non-tax business purposes, that delta ordinarily is the delta used for purposes of this section.

(2) Constant delta. An NPC or ELI is treated as having a delta of one (1.0) with respect to an underlying security when it has a constant delta with respect to the underlying security at the time it is acquired by the long party. An NPC or ELI has a constant delta with respect to an underlying security if the NPC or ELI has a delta that is not reasonably expected to vary during the term of the transaction with respect to that underlying security. If a transaction would not have a delta of one with respect to an underlying security without this paragraph, the number of shares of the underlying security of an NPC or ELI that has a constant delta is adjusted as described in paragraph (i)(1)(ii)(B)(2) of this section.

(3) Examples. The following examples illustrate the rules of paragraph (g) of this section. For purposes of these examples, Stock X and Stock Y are common stock of domestic corporations X and Y. LP is the long party to the transaction.

Example 1. The terms of an NPC require LP to pay the short party an amount equal to all of the depreciation in the value of 100 shares of Stock X and an interest-rate based return. In return, the NPC requires the short party to pay LP an amount equal to all of the appreciation in the value of 100 shares of Stock X and any dividends paid by X on those shares. The value of the NPC will change by $1 for each $0.01 change in the price of a share of Stock X. The NPC therefore has a delta of 1.0 ($1.00 / ($0.01 × 100)).

Example 2. LP acquires a call option that references 100 shares of Stock X. At the time LP purchases the call option, the value of the option is expected to change by $0.30 for a $0.01 change in the price of a share of Stock X. The call option has a delta of 0.3 ($0.30 / ($0.01 × 100)) when LP acquired it.

Example 3. (i) LP acquires an NPC that entitles LP to receive 50 percent of the appreciation and dividends on 100 shares of Stock X in return for the obligation to pay the short party 50 percent of the depreciation on 100 shares of Stock X and an interest based return. The value of the NPC is expected to change by $0.50 for each $0.01 change in the price of a share of Stock X. The delta is expected to remain constant during the term of the transaction.

(ii) Pursuant to the terms of the NPC and the amount of referenced underlying securities, the NPC has a delta of 0.5 ($0.50 / ($0.01 × 100)) on the date that LP acquired the transaction. The delta of the NPC, however, is not expected to vary during the term of the transaction. Therefore, the NPC has a constant delta and is treated as having a delta equal to 1.0 on 50 shares of Stock X after the adjustments described in §1.871–15(i)(1)(ii)(B)(2).

(h) Payment of a dividend equivalent—(1) Payments determined on gross basis. For purposes of this section, a payment includes any gross amount that references the payment of a dividend and that is used in computing any net amount transferred to or from the long party even if the long party makes a net payment to the short party or no payment is made because the net amount is zero.

(2) Actual and estimated dividends—(i) In general. A payment includes any amount that references an actual or estimated payment of dividends, whether the reference is explicit or implicit. If a potential section 871(m) transaction provides for a payment based on an estimated dividend that adjusts to account for the amount of an actual dividend paid, the payment is treated as referencing the actual dividend amount and not an estimated dividend amount.

(ii) Implicit dividends. A payment includes an actual or estimated dividend payment that is implicitly taken into account in computing one or more of the terms of a potential section 871(m) transaction, including interest rate, notional amount, purchase price, premium, upfront payment, strike price, or any other amount paid or received pursuant to the potential section 871(m) transaction.

(iii) Actual dividend presumption. A section 871(m) transaction is treated as paying a per share dividend amount equal to the actual dividend amount unless the short party to the section 871(m) transaction identifies a reasonable estimated dividend amount in writing at the inception of the transaction. For this purpose, a reasonable estimated dividend amount stated in an offering document or the documents governing the terms of the transaction will establish the estimated dividend amount in writing at the inception of the transaction. To qualify as an estimated dividend amount, the written estimated dividend amount must separately state the amount estimated for each anticipated dividend or state a formula that allows each dividend to be determined. If a stock is not expected to pay a dividend, a reasonable estimate of the dividend amount may be zero.

(iv) Limitation on estimated payments. When a section 871(m) transaction provides for one or more payments based on estimated dividends supported by documentation described in paragraph (h)(2)(iii) of this section, the per share dividend amount used to calculate the amount of the dividend equivalent is the lesser of the estimated dividend amount and the actual dividend amount paid on the stock while the long party was a party to the section 871(m) transaction. If a section 871(m) transaction provides for any payment determined by reference to a dividend in addition to the estimated dividends (for example, a special dividend), the actual dividend amount paid on the stock is used for the additional dividend payment.

(3) Deferred payments. A payment occurs when the amount of a dividend equivalent is fixed pursuant to the terms of the transaction, even if paid or otherwise taken into account on a later date. For example, if a specified NPC provides for a payment at settlement that takes into account an earlier dividend payment, the dividend equivalent is treated as paid on the date that the amount of the dividend equivalent is fixed pursuant to the terms of the contract.

(4) Examples. The following examples illustrate the rules of paragraph (h) of this section. For purposes of these examples, Stock X is common stock of Corporation X, a domestic corporation, that historically pays quarterly dividends on Stock X. The parties anticipate that Corporation X will continue to pay the quarterly dividends.

Example 1. Forward contract to purchase domestic stock. (i) When Stock X is trading at $50 per share, Foreign Investor enters into a forward contract to purchase 100 shares of Stock X in one year. Reasonable estimates of the quarterly dividend are specified in the transaction documents. The price in the forward contract is determined by multiplying the number of shares referenced in the contract by the current price of the shares and an interest rate, and subtracting the future value of any dividends expected to be paid during the term of the contract. Assuming that the forward contract is priced using an interest rate of 4 percent and estimated dividends with a future value of $1 per share during the term of the forward contract, the purchase price set in the forward contract is $5,100 (100 shares × $50 per share × 1.04 − ($1 × 100)).

(ii) Subject to paragraph (h)(2)(iv), the estimated dividend amount is the per share dividend amount because the estimate is reasonable and specified in accordance with paragraph (h)(2)(iii) of this section. Those estimated per share dividend amounts are dividend equivalents for purposes of this section.

Example 2. Price return only swap contract. (i) Foreign Investor enters into a price return swap contract that entitles Foreign Investor to receive payments based on the appreciation in the value of 100 shares of Stock X and requires Foreign Investor to pay an amount based on LIBOR plus any depreciation in the value of Stock X. The swap contract does not explicitly entitle Foreign Investor to payments based on dividends paid on Stock X during the term of the contract and the swap contract does not contain any reference to an estimated dividend amount. The LIBOR rate on the swap contract, however, is reduced to reflect expected annual dividends on Stock X.

(ii) Because the LIBOR leg of the swap contract is reduced to reflect estimated dividends and the estimated dividend amount is not specified, Foreign Investor is treated as receiving the actual dividend amount in accordance with paragraph (h)(2) of this section. Those actual per share dividend amounts are dividend equivalents for purposes of this section.

(i) Amount of dividend equivalent—(1) Calculation of the amount of a dividend equivalent—(i) Securities lending or sale-repurchase transactions. For a securities lending or sale-repurchase transaction, the amount of the dividend equivalent for each underlying security equals the amount of the actual per share dividend paid on the underlying security multiplied by the number of shares of the underlying security transferred pursuant to the securities lending or sale-repurchase transaction.

(ii) Specified NPCs and specified ELIs—(A) In general. For a specified NPC or a specified ELI, the amount of the dividend equivalent for each underlying security equals:

(1) The amount of the per share dividend (as determined under paragraph (h) of this section) with respect to the underlying security multiplied by;

(2) The number of shares of the underlying security as calculated pursuant to paragraph (i)(1)(ii)(B) of this section multiplied by;

(3) The delta of the section 871(m) transaction with respect to the underlying security at the time that the amount of the dividend equivalent is determined.

(B) Calculation of the number of shares—(1) In general. Except as provided in paragraph (i)(1)(ii)(B)(2) of this section, the number of shares of an underlying security for purposes of this section is the number of shares of the underlying security referenced in the section 871(m) transaction.

(2) Adjustments. When a section 871(m) transaction multiplies the number of shares of an underlying security by a factor or fraction, or otherwise alters the amount of a payment, the number of shares of a section 871(m) transaction is adjusted to take into account the factor, fraction, or other alteration provided by the section 871(m) transaction. For example, if a total return swap entitles a long party to receive a payment based on the appreciation and dividend amount on 100 shares of an underlying security multiplied by a factor of 1.50, the number of shares of the underlying security is 150 shares.

(C) Delta at the time the amount of the dividend equivalent is determined—(1) In general. The delta of a section 871(m) transaction at the time that the amount of the dividend equivalent is determined is the delta of the section 871(m) transaction determined at the time specified in paragraph (i)(2) of this section. This delta is used solely for purposes of determining the amount of the dividend equivalent at that time, and the transaction is not retested to determine if it is a section 871(m) transaction. For example, if a transaction had a delta of 0.80 when acquired by the long party and was a section 871(m) transaction, the transaction remains a section 871(m) transaction even if the delta is below 0.70 at the time the amount of the dividend equivalent is determined.

(2) Delta of an option at lapse. The delta of an option when it lapses is treated as zero.

(3) Delta of an option at exercise. The delta of an option when it is exercised is treated as one (1.0).

(iii) Other substantially similar payments. In addition to any amount determined pursuant to paragraph (i)(1)(i) or (ii), the amount of a dividend equivalent includes the amount of any payment described in paragraph (f) of this section.

(2) Time for determining the amount of a dividend equivalent—(i) In general. Except as provided in paragraph (i)(2)(ii) of this section, the amount of a dividend equivalent is determined on the earlier of the date that the underlying security becomes ex-dividend with respect to the dividend and the record date of the dividend. For example, if a specified NPC provides for a payment at settlement that takes into account an earlier dividend payment, the amount of a dividend equivalent is determined on the earlier of the ex-dividend date or the record date for that dividend.

(ii) Specified NPCs and specified ELIs with a term of one year or less. For a specified NPC or specified ELI with a term of one year or less when acquired by the long party, the amount of a dividend equivalent is determined when the long party disposes of the section 871(m) transaction. For purposes of this paragraph, to dispose of means to sell, exercise, terminate, allow to lapse or expire, transfer, settle (whether in cash or otherwise), cancel, exchange, convert, surrender, forfeit, or otherwise dispose of or allow to expire.

(iii) Term. For purposes of this section, if a transaction does not specify a term, the transaction is treated as having a term of more than one year. If a transaction permits extensions, the term of the transaction is the maximum term permitted by the transaction.

(j) Limitation on the treatment of certain transactions as section 871(m) transactions—(1) Dealers—(i) In general. A potential section 871(m) transaction is not a section 871(m) transaction if the potential section 871(m) transaction is entered into by a qualified dealer in its capacity as a dealer in securities and the dealer is the long party with respect to the underlying security. This paragraph does not apply with respect to any proprietary position held by a dealer in securities.

(ii) Qualified dealer. A qualified dealer is any dealer that:

(A) Is subject to regulatory supervision by a governmental authority in the jurisdiction in which it was created or organized; and

(B) furnishes a written certification to the short party confirming that the dealer is a qualified dealer acting in its capacity as a dealer in securities and that the dealer will withhold and deposit any tax imposed by section 871(m) with respect to any section 871(m) transactions that the dealer enters into as a short party in its capacity as a dealer in securities.

(2) Corporate acquisitions. A potential section 871(m) transaction is not a section 871(m) transaction with respect to an underlying security if the transaction obligates the long party to acquire ownership of the underlying security as part of a plan pursuant to which one or more persons (including the long party) are obligated to acquire underlying securities representing more than 50 percent of the value of the entity issuing the underlying securities. To qualify for the exception provided in this paragraph, the long party must furnish a written certification, provided under penalties of perjury, to the short party that it satisfies the requirements of this paragraph (j)(2).

(k) Rules relating to indices—(1) Qualified index not treated as an underlying security. For purposes of this section, a qualified index is treated as a single security that is not an underlying security. The determination of whether an index is a qualified index is made at the time that a long party acquires a potential section 871(m) transaction and is determinative only with respect to that transaction. Therefore, an index can be a qualified index with respect to a transaction entered into on one day and not be a qualified index with respect to a transaction entered into on another day.

(2) Qualified index. A qualified index means an index that:

(i) References 25 or more component underlying securities;

(ii) References only long positions in component underlying securities;

(iii) Contains no component underlying security that represents more than 10 percent of the weighting of the underlying securities in the index;

(iv) Is modified or rebalanced only according to predefined objective rules at set dates or intervals;

(v) Does not provide a dividend yield from component underlying securities that is greater than 1.5 times the current dividend yield of the S&P 500 Index as reported for the month immediately preceding the date the long party acquires the potential section 871(m) transaction; and

(vi) Futures contracts or option contracts on the index (whether the contracts provide price only or total return exposure to the index) trade on a national securities exchange that is registered with the Securities and Exchange Commission or a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission.

(3) Safe harbor for indices that primarily reference assets other than underlying securities. Notwithstanding paragraph (k)(2) of this section, an index is a qualified index if the index is comprised solely of long positions in assets and the referenced component underlying securities in the aggregate comprise 10 percent or less of the index’s weighting.

(4) Weighting of component underlying securities. For purposes of paragraph (k) of this section, the weighting of a component underlying security of an index is the percentage of the index’s value represented, or accounted for, by the component underlying security.

(5) Indices with components other than underlying securities. Any component of an index that is not an underlying security is not taken into account for purposes of determining whether an index is a qualified index, except for purposes of paragraph (k)(3) of this section.

(6) Transactions that reference a qualified index and one or more underlying securities or indices. If a potential section 871(m) transaction references a qualified index and one or more underlying securities or indices, the qualified index will remain a qualified index only if the potential section 871(m) transaction does not reference a short position in any referenced component underlying security of the qualified index, other than a short position with respect to the entire qualified index (for example, a cap or floor). If, in connection with a potential section 871(m) transaction that references a qualified index, a taxpayer (or a related person within the meaning of section 267(b) or 707(b)) enters into one or more transactions that reduce exposure to any referenced component underlying security of the index, other than transactions that reduce exposure to the entire index, then the potential section 871(m) transaction is not treated as referencing a qualified index.

(l) Combined transactions—(1) In general. For purposes of determining whether a potential section 871(m) transaction is a section 871(m) transaction, two or more potential section 871(m) transactions are treated as a single transaction with respect to an underlying security when:

(i) A person (or a related person within the meaning of section 267(b) or 707(b)) is the long party with respect to the underlying security for each potential section 871(m) transaction;

(ii) The potential section 871(m) transactions reference the same underlying security; and

(iii) The potential section 871(m) transactions are entered into in connection with each other (regardless of whether the transactions are entered into simultaneously or with the same counterparty).

(2) Time and delta for testing. Combined transactions are tested each time the long party (or a related person) acquires a potential section 871(m) transaction to which paragraph (l)(1) of this section applies. The deltas used to determine whether the combined transactions are section 871(m) transactions pursuant to paragraph (l)(1) of this section are the deltas of each of the combined transactions at that time. For example, if a taxpayer buys a call option on day 1 and sells a put option on day 10 on the same underlying security and the two transactions are entered into in connection with each other, the call option is tested on day 1 to determine whether it is a section 871(m) transaction, and the combined single transaction is tested on day 10 based on the deltas of the call option and put option at that time.

(3) Section 871(m) transactions. If a potential section 871(m) transaction is a section 871(m) transaction, either by itself or as a result of a combination, it does not cease to be a section 871(m) transaction as a result of applying paragraph (l) of this section.

(4) More than one underlying security referenced. If potential section 871(m) transactions reference more than one underlying security, paragraph (l)(1) of this section applies separately with respect to each underlying security.

(5) Separate transactions for all other purposes. Potential section 871(m) transactions that are combined for purposes of determining whether there is a section 871(m) transaction with respect to an underlying security are treated as separate transactions for all other purposes of this section, including separately determining the amount of a dividend equivalent with respect to each transaction. For withholding obligations with respect to combined transactions, see §1.1441–1(b)(4)(xxiii).

(6) Example. The following examples illustrate the rules of paragraph (l) of this section. For purposes of this paragraph (l)(6), Foreign Investor (FI) is a nonresident alien individual and Stock X is common stock of Corporation X, a domestic corporation.

Example 1. (i) FI purchases a call option with a term of six months that references 100 shares of Stock X, and simultaneously sells a six month put option on 100 shares of Stock X. The delta of the call option is 0.45 and the delta of the put option is 0.40 at the time FI acquired each option.

(ii) Because the purchased call option and the sold put option are entered into simultaneously by FI and reference the same underlying security, the facts and circumstances indicate that the call option and the put option are entered into in connection with each other and are treated as a combined transaction under paragraph (l)(1) of this section. Accordingly, the call option and the put option are treated as a combined transaction to compute delta for purposes of paragraph (e) of this section. The delta of the combined purchased call option and written put option is 0.85 (0.45 + 0.40). The combined transaction is therefore a specified ELI.

Example 2. (i) FI purchases a call option with a term of six months that references 100 shares of Stock X. At the time, the delta of the call option is 0.45. Three months later, FI re-evaluates FI’s position in Stock X and writes a three month put option on 100 shares of Stock X. At the time FI writes the put option, the delta of the call option is 0.65 and the delta of the put is 0.25.

(ii) FI’s purchased call option and sold put option reference the same underlying security. Because FI wrote the put option referencing Stock X to adjust FI’s economic position associated with the call option referencing Stock X, these options are entered into in connection with each other and treated as a combined transaction under paragraph (l)(1) of this section. Because the delta of the combined transaction is tested on the date that FI entered into the additional transaction, the delta of the combined purchased call option and sold put option is 0.90 (0.65 + 0.25). The combined transaction is a specified ELI.

Example 3. (i) FI purchases a call option with a term of one month that references 100 shares of Stock X. At the time, the delta of the call option is 0.75. Two weeks later, FI re-evaluates FI’s position in Stock X and writes a two week put option on 100 shares of Stock X. At the time FI writes the put option, the delta of the call option is 0.35 and the delta of the put is 0.25.

(ii) FI’s purchased call option has an initial delta of 0.75 and therefore is a specified ELI and a section 871(m) transaction. FI’s purchased call option and sold put option reference the same underlying security. Because FI sold the put option referencing Stock X to adjust FI’s economic position associated with the call option referencing Stock X, these options are entered into in connection with each other and treated as a combined transaction under paragraph (l)(1) of this section. Because the delta of the combined transaction is tested on the date that FI entered into the additional transaction, the delta of the combined purchased call option and sold put option is 0.60 (0.35 + 0.25). The combined transaction is not a specified ELI; however, the purchased call option remains a specified ELI.

(m) Rules relating to interests in entities that are not taxable as corporations—(1) In general. Except as provided in paragraph (m)(2) of this section, if a transaction references an interest in an entity that is not a C corporation (within the meaning of section 1361(a)(2)), the transaction references the allocable portion of any underlying security or potential section 871(m) transaction held, directly or indirectly (including through one or more other entities that are not C corporations), by the referenced entity. When a transaction references any underlying security as a result of the application of this paragraph, the transaction also references the payment of any dividends from those underlying securities and has a dividend equivalent equal to the allocable portion of any dividend or dividend equivalent received, directly or indirectly (including through one or more other entities that are not C corporations), by the referenced entity.

(2) Exception. A transaction is not treated as referencing underlying securities as a result of applying paragraph (m)(1) of this section if the underlying securities held directly or indirectly by the referenced entity and the underlying securities referenced by any potential section 871(m) transaction held directly or indirectly by the referenced entity represent, in the aggregate, 10 percent or less of the value of the referenced interest in the entity at the time the long party acquires the transaction and there is no plan or intention for acquisitions or dispositions (within the meaning of paragraph (i)(2)(ii) of this section) that would cause underlying securities to represent more than 10 percent of the value of the referenced interest. For example, if actively-traded Partnership A owns a pro rata interest in Partnership B that represents 10 percent of the value of an interest in Partnership A, and Partnership B owns an interest in Underlying Security X that represents 20 percent of the value of an interest in Partnership B, then Underlying Security X represents two percent of the value of a pro rata interest in Partnership A. Accordingly, a pro rata interest in Partnership A qualifies for the exception in paragraph (m)(2) of this section and Underlying Security X is not treated as referenced by a transaction that references a pro rata interest in Partnership A pursuant to paragraph (m)(1) of this section.

(n) Anti-abuse rule. If a taxpayer (directly or through the use of a related person) acquires a transaction or transactions with a principal purpose of avoiding the application of this section, the Commissioner may treat any payment (as described in paragraph (h) of this section) made with respect to any transaction as a dividend equivalent to the extent necessary to prevent the avoidance of this section. Therefore, notwithstanding any other provision of this section, the Commissioner may adjust the delta of a transaction, change the number of shares, adjust an estimated dividend amount, adjust the timing of payments, combine, separate, or disregard transactions, indices, or components of indices to reflect the substance of the transaction or transactions, or otherwise depart from the rules of this section as necessary to determine whether the transaction includes a dividend equivalent or the amount or timing of a dividend equivalent.

(o) Information required to be reported regarding a potential section 871(m) transaction—(1) In general. If a broker or dealer is a party to a potential section 871(m) transaction with a counterparty or customer that is not a broker or dealer, the broker or dealer is required to determine whether the potential section 871(m) transaction is a section 871(m) transaction. If both parties to the potential section 871(m) transaction are brokers or dealers, or neither party to the potential section 871(m) transaction is a broker or dealer, the short party must determine whether the potential section 871(m) transaction is a section 871(m) transaction. The party to the transaction that is required to determine whether a transaction is a section 871(m) transaction must also determine and report to the counterparty or customer the timing and amount of any dividend equivalent (as described in paragraphs (h) and (i) of this section). The party required to make the determinations described in this paragraph is required to exercise reasonable diligence to determine whether a transaction is a section 871(m) transaction, any dividend equivalents, and any other information necessary to apply the rules of this section. The information must be provided in the manner prescribed in paragraphs (o)(2) and (o)(3) of this section. The determinations required by paragraph (o) of this section are binding on the parties to the potential section 871(m) transaction and on any person who is a withholding agent with respect to the potential section 871(m) transaction, unless the person has actual knowledge or reason to know that the information received is incorrect, but are not binding on the IRS.

(2) Reporting requirements. For rules regarding reporting requirements with respect to dividend equivalents described in this section, see §§1.1461–1(b) and (c), and 1.1474–1(c) and (d).

(3) Additional information on potential section 871(m) transactions—(i) In general. Upon request by any person described in paragraph (o)(3)(ii) of this section, the party required to provide information pursuant to paragraph (o)(1) must provide the requester with information regarding the amount of each dividend equivalent, the delta of the potential section 871(m) transaction, the amount of any tax withheld and deposited, the estimated dividend amount if specified in accordance with paragraph (h)(2)(iii), and any other information necessary to apply the rules of this section. With respect to the delta, the party must provide the delta when the transaction is acquired, at the time the amount of each dividend equivalent is determined, and at any other time delta information is necessary to apply the rules of this section. The information requested must be provided within a reasonable time, not to exceed 14 calendar days, and communicated in one or more of the following ways:

(A) By telephone, and confirmed in writing;

(B) By written statement sent by first class mail to the address provided by the requesting party;

(C) By electronic publication available to all persons entitled to request information; or

(D) By any other method agreed to by the parties, and confirmed in writing.

(ii) Persons entitled to request information. The following persons may request the information specified in paragraph (o) of this section with respect to a potential section 871(m) transaction from the party required by paragraph (o)(3)(i) of this section to provide the information—

(A) A broker who holds the potential section 871(m) transaction as an agent or nominee to any party to the transaction as described in paragraph (a)(7) of this section;

(B) A person who is required to make an information return under §1.1461–1(c) and paragraph (o)(2) of this section and who acts as an agent or nominee to any party to the transaction as described in paragraph (a)(7) of this section; or

(C) Any party to the transaction as described in paragraph (a)(7) of this section.

(iii) Reliance on information received. A person described in paragraph (o)(1) or (o)(3)(ii) of this section that receives information described in paragraph (o)(1) or (o)(3)(i) of this section (first recipient) may rely on that information to provide information to any other person unless the first recipient has actual knowledge or reason to know that the information received is incorrect. When the first recipient has actual knowledge or reason to know that the information received is incorrect, the first recipient must make a reasonable effort to determine and provide the information described in paragraph (o)(1) or (o)(3)(i) of this section to any person described in paragraph (o)(1) or (o)(3)(ii) of this section that requests information from the first recipient.

(4) Recordkeeping rules. For rules regarding recordkeeping requirements sufficient to establish the amount of gross income treated as a dividend equivalent, see §1.6001–1.

(p) Effective/applicability date. This section applies to payments made on or after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register, except for paragraph (d)(1) of this section, which applies to payments made on or after January 23, 2012.

Par. 4. Section 1.1441–1 is amended by:* * * *

1. Adding paragraphs (b)(4)(xxii) and (xxiii).

2. Adding paragraph (f)(3).

The additions read as follows:

* * * * *

(b) * * *

(4) * * *

(xxii) Amounts paid with respect to a notional principal contract described in §1.871–15(a)(5), an equity-linked instrument described in §1.871–15(a)(4), or a securities lending or sale-repurchase transaction described in §1.871–15(a)(10) are exempt from withholding under section 1441(a) as dividend equivalents under section 871(m) if the transaction is not a section 871(m) transaction within the meaning of §1.871–15(a)(9) or is subject to an exception described in §1.871–15(j). However, the amounts may be subject to withholding under section 1441(a) if they are subject to tax under any section other than section 871(m). For purposes of this withholding exemption, it is not necessary to provide documentation establishing that a notional principal contract or equity-linked instrument has a delta that is less than 0.70 at the time it was acquired by the long party. For purposes of the withholding exemption for qualified dealers described in this paragraph, §1.871–15(j)(1) applies only if the long party furnishes to the withholding agent the documentation described in §1.871–15(j)(1). For purposes of the withholding exemption regarding corporate acquisitions described in this paragraph, the exemption only applies if the long party furnishes to the withholding agent the documentation described in §1.871–15(j)(2).

(xxiii) If a potential section 871(m) transaction is only a section 871(m) transaction as a result of applying §1.871–15(l) (combined transactions) and the withholding agent did not know that the long party (or a related person) entered into the potential section 871(m) transaction in connection with any other potential section 871(m) transaction, the potential section 871(m) transaction is exempt from withholding under section 1441(a).

* * * * *

(f) * * *

(3) Effective/applicability date. Paragraphs (b)(xxii) and (xxiii) of this section apply to payments made on or after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register.

Par. 5. Section 1.1441–2 is amended by adding paragraph (d)(5) and adding a sentence to the end of paragraph (f) to read as follows:

* * * * *

(d) * * *

(5) Payments of dividend equivalents. A withholding agent is not obligated to withhold until the later of—

(i) The time that the amount of a dividend equivalent is determined as provided in §1.871–15(i)(2), and

(ii) The time that the withholding agent is deemed to have control over money or other property of the long party because—

(A) Money or other property is paid to or from the long party,

(B) The withholding agent has custody or control over money or other property of the long party at any time on or after the amount of a dividend equivalent is determined as provided in §1.871–15(i)(2), or

(C) The section 871(m) transaction provides for an upfront payment or pre-payment of the purchase price even though an actual payment has not been made at the time the amount of a dividend equivalent is determined as provided in §1.871–15(i)(2).

* * * * *

(f) Effective/applicability date. * * * Paragraph (d)(5) of this section applies to payments made on or after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register.

Par. 6. Section 1.1441–3 is amended by:

1. Adding a second sentence to paragraph (h)(1).

2. Redesignating paragraph (h)(2) as (h)(3) and revising paragraph (h)(3).

3. Adding new paragraph (h)(2).

The additions and revisions read as follows:

* * * * *

(h) * * * (1) * * * Withholding is required on the amount of the dividend equivalent calculated under §1.871–15(i).

(2) Reliance by withholding agent on reasonable determinations. For purposes of determining whether a payment is a dividend equivalent and the amount of a dividend equivalent described in §1.871–15, a withholding agent may rely on the information received from the party to the transaction that is required to determine whether a transaction is a section 871(m) transaction as provided in §1.871–15(o), unless the withholding agent has actual knowledge or reason to know that the information received is incorrect. When a withholding agent fails to withhold the required amount because the party described in §1.871–15(o) fails to reasonably determine or timely provide whether a transaction is a section 871(m) transaction, the amount of any dividend equivalent, or any other information required to be provided pursuant to §1.871–15(o) and the withholding agent reasonably relied on that party’s determination, then the failure to withhold is imputed to the party required to make the determinations described in §1.871–15(o). In that case, the IRS may collect any underwithheld amount from the party to the transaction that is required to make the determinations described in §1.871–15(o) and subject that party to applicable interest and penalties as a withholding agent.

(3) Effective/applicability date. Except for the first sentence of paragraph (h)(1), this paragraph (h) applies to payments made on or after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register. The first sentence of paragraph (h)(1) applies to payments made on or after January 23, 2012.

* * * * *

Par. 7. Section 1.1441–7 is amended by:

1. Adding entry for Example 7 in paragraph (a)(3).

2. Adding a second sentence to paragraph (a)(4).

The additions read as follows:

(a) * * *

(3) * * *

Example 7. CO is a domestic clearing organization. CO serves as a central counterparty clearing and settlement service provider for derivatives exchanges in the U.S. CB is a broker organized in Foreign Country X and a clearing member of CO. CB is a nonqualified intermediary, as defined in §1.1441–1(c)(14). FC is a foreign corporation that has an investment account with CB. FC instructs CB to purchase a call option that is a specified ELI (as described in §1.871–15(e)). CB effects the trade for FC. The exchange matches FC’s order with an order for a written call option with the same terms. The exchange then sends the matched trade to CO, which clears the trade. CB and the clearing member representing the call option seller settle the trade with CO. Upon receiving the matched trade, the option contracts are novated and CO becomes the counterparty to CB and the counterparty to the clearing member representing the call option seller. To the extent that there is a dividend equivalent with respect to the call option, both CO and CB are withholding agents as described in paragraph (a)(1) of this section.

(4) Effective/applicability date. Example 7 of paragraph (a)(3) of this section applies to payments made on or after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register.

* * * * *

John Dalrymple,
Deputy Commissioner for Services and Enforcement.

Section 708(a) generally provides that, for purposes of subchapter K of chapter 1 of subtitle A of Title 26, an existing partnership shall be considered as continuing if it is not terminated.

Section 708(b)(1) provides that, for purposes of section 708(a), a partnership shall be considered as terminated only if (A) no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership, or (B) within a 12-month period there is a sale or exchange of 50 percent or more of the total interest in partnership capital and profits.

Section 1.708–1(b)(4) of the Income Tax Regulations provides that if a partnership is terminated by a sale or exchange of an interest, the following is deemed to occur: the partnership contributes all of its assets and liabilities to a new partnership in exchange for an interest in the new partnership; immediately thereafter, the terminated partnership distributes interests in the new partnership to the purchasing partner and the other remaining partners in proportion to their respective interests in the terminated partnership in liquidation of the terminated partnership, either for the continuation of the business by the new partnership or for its dissolution and winding up.

Section 195(a) provides that, except as otherwise provided in section 195, no deduction shall be allowed for start-up expenditures (as defined in section 195(c)(1)). Section 195(b)(1) provides that a taxpayer may elect to deduct start-up expenditures as provided in section 195(b)(1)(A) and (B).

Section 195(b)(1)(A) allows an electing taxpayer to deduct start-up expenditures in the taxable year in which the active trade or business begins. The amount that may be deducted under section 195(b)(1)(A) in that year is the lesser of (i) the amount of start-up expenditures with respect to the active trade or business, or (ii) $5,000, reduced (but not below zero) by the amount by which the start-up expenditures exceed $50,000.

Section 195(b)(1)(B) provides that any start-up expenditures that are not deductible under section 195(b)(1)(A) shall be allowed as a deduction ratably over the 180-month period beginning with the month in which the active trade or business begins. All start-up expenditures that relate to the active trade or business are considered in determining whether the start-up expenditures exceed $50,000, including expenditures incurred on or before October 22, 2004. Section 902(a) of the American Jobs Creation Act of 2004, Pub. L. No. 108–357, 118 Stat. 1418 (“AJCA”), amended section 195(b)(1) for start-up expenditures paid or incurred after October 22, 2004. Prior to the AJCA amendment, section 195(b)(1) (former section 195(b)(1)) allowed taxpayers to elect to treat such expenditures as deferred expenses deductible ratably over a period of at least 60 months.

Section 1.195–1(b) provides that, for start-up expenditures paid or incurred after August 16, 2011(the effective date of §1.195–1(b)), a taxpayer is deemed to make an election under section 195(b) to amortize start-up expenditures for the taxable year in which the active trade or business to which the expenditures relate begins. However, taxpayers may apply all provisions of §1.195–1 to start-up expenditures paid or incurred after October 22, 2004, provided that the period of limitations on assessment of tax for the year the election under §1.195–1(b) is deemed made has not expired.

Section 195(b)(2) provides that in any case in which a trade or business is completely disposed of by the taxpayer before the end of the amortization period, any deferred expenses attributable to such trade or business that were not allowed as a deduction by reason of section 195 may be deducted to the extent allowable under section 165.

Section 709(a) provides that, except as otherwise provided in section 709(b), no deduction shall be allowed for any amounts paid or incurred to organize a partnership or to promote the sale of (or to sell) an interest in the partnership. Section 709(b) provides that a partnership may elect to deduct organizational expenses, within the meaning of section 709(b)(3), as provided in section 709(b)(1)(A) and (B).

Section 709(b)(1)(A) allows an electing partnership to deduct organizational expenses in the year in which the partnership begins business. The amount that may be deducted under section 709(b)(1)(A) in that year is the lesser of (i) the amount of the organizational expenses of the partnership, or (ii) $5,000, reduced (but not below zero) by the amount by which the organizational expenses exceed $50,000.

Section 709(b)(1)(B) provides that any organizational expenses that are not deductible under section 709(b)(1)(A) shall be allowed as a deduction ratably over the 180-month period beginning with the month in which the partnership begins business. All organizational expenses incurred by the partnership are considered in determining whether the organizational expenses exceed $50,000, including expenses incurred on or before October 22, 2004. Prior to October 22, 2004, section 709(b) contained a rule similar to former section 195(b)(1).

Section 1.709–1(b)(2) provides that, for organizational expenses as defined in section 709(b)(3) and §1.709–2(a) paid or incurred after August 16, 2011 (the effective date of §1.709–1(b)(2)), a partnership is deemed to make an election under section 709(b) to amortize organizational expenses for the taxable year in which the partnership begins business. However, taxpayers may apply all provisions of §1.709–1 to organizational expenses paid or incurred after October 22, 2004, provided that the period of limitations on assessment of tax for the year the election under §1.709–1(b)(2) is deemed made has not expired.

Section 709(b)(2) provides that in any case in which a partnership is liquidated before the end of the amortization period, any deferred expenses attributable to the partnership that were not allowed as a deduction by reason of section 709 may be deducted to the extent allowable under section 165. See also §1.709–1(b)(3). However, there is no partnership deduction with respect to its capitalized syndication expenses. Id.

(a) In general. If a partnership that has elected to amortize start-up expenditures under section 195(b) and §1.195–1 terminates in a transaction (or a series of transactions) described in section 708(b)(1)(B) or §1.708–1(b)(2), the termination shall not be treated as resulting in a disposition of the partnership’s trade or business for purposes of section 195(b)(2). See §1.708–1(b)(6) for rules concerning the treatment of these start-up expenditures by the new partnership.

(b) Effective/applicability date. This section applies to a technical termination of a partnership under section 708(b)(1)(B) that occurs on or after December 9, 2013.

Par. 3. Section 1.708–1 is amended by adding paragraph (b)(6) to read as follows:

* * * * *

(b) * * *

(6) Treatment of certain start-up or organizational expenses following a technical termination—(i) In general. If a partnership that has elected to amortize start-up expenditures under section 195(b) or organizational expenses under section 709(b)(1) terminates in a transaction (or a series of transactions) described in section 708(b)(1)(B) or paragraph (b)(2) of this section, the new partnership must continue to amortize those expenditures using the same amortization period adopted by the terminating partnership. See section 195 and §1.195–1 for rules concerning the amortization of start-up expenditures and section 709 and §1.709–1 for rules concerning the amortization of organizational expenses.

(ii) Effective/applicability date. This paragraph (b)(6) applies to a technical termination of a partnership under section 708(b)(1)(B) that occurs on or after December 9, 2013.

* * * * *

Par. 4. Section 1.709–1 is amended by:

1. Designating the text in paragraph (b)(3) as paragraph (b)(3)(i) , adding a heading to newly designated paragraph (b)(3)(i) and adding paragraph (b)(3)(ii);

Adding a sentence at the end of paragraph (b)(5).

The additions read as follows:

* * * * *

(b) * * *

(3) Liquidation of partnership—(i) In general. * * *

(ii) Technical termination of a partnership. If a partnership that has elected to amortize organizational costs under section 709(b) terminates in a transaction (or a series of transactions) described in section 708(b)(1)(B) or §1.708–1(b)(2), the termination shall not be treated as resulting in a liquidation of the partnership for purposes of section 709(b)(2). See §1.708–1(b)(6) for rules concerning the treatment of these organizational costs by the new partnership.

* * *

(5) * * * Paragraph (b)(3)(ii) of this section applies to a technical termination of a partnership under section 708(b)(1)(B) that occurs on or after December 9, 2013.

Heather C. Maloy,
Deputy Commissioner for Operations Support.

The Treasury Department and the IRS recognize that more definitive rules with respect to political activities related to candidates – rather than the existing, fact-intensive analysis – would be helpful in applying the rules regarding qualification for tax-exempt status under section 501(c)(4). Although more definitive rules might fail to capture (or might sweep in) activities that would (or would not) be captured under the IRS’ traditional facts and circumstances approach, adopting rules with sharper distinctions in this area would provide greater certainty and reduce the need for detailed factual analysis in determining whether an organization is described in section 501(c)(4). Accordingly, the Treasury Department and the IRS propose to amend Treas. Reg. §1.501(c)(4)–1(a)(2) to identify specific political activities that would be considered candidate-related political activities that do not promote social welfare.

To distinguish the proposed rules under section 501(c)(4) from the section 501(c)(3) standard and the similar standard currently applied under section 501(c)(4), the proposed regulations would amend Treas. Reg. §1.501(c)(4)–1(a)(2)(ii) to delete the current reference to “direct or indirect participation or intervention in political campaigns on behalf of or in opposition to any candidate for public office,” which is similar to language in the section 501(c)(3) statute and regulations. Instead the proposed regulations would revise Treas. Reg. §1.501(c)(4)–1(a)(2)(ii) to state that “[t]he promotion of social welfare does not include direct or indirect candidate-related political activity.” As explained in more detail in section 2 of this preamble, the proposed rules draw upon existing definitions of political campaign activity, both in the Code and in federal election law, to define candidate-related political activity that would not be considered to promote social welfare. The proposed rules draw in particular from certain statutory provisions of section 527, which specifically deals with political organizations and taxes section 501(c) organizations, including section 501(c)(4) organizations, on certain types of political campaign activities. Recognizing that it may be beneficial to have a more uniform set of rules relating to political campaign activity for tax-exempt organizations, the Treasury Department and the IRS request comments in subparagraphs a through c of this section of the preamble regarding whether the same or a similar approach should be adopted in addressing political campaign activities of other section 501(c) organizations, as well as whether the regulations under section 527 should be revised to adopt the same or a similar approach in defining section 527 exempt function activity.

These proposed regulations do not address the definition of political campaign intervention under section 501(c)(3). The Treasury Department and the IRS recognize that, because such intervention is absolutely prohibited under section 501(c)(3), a more nuanced consideration of the totality of facts and circumstances may be appropriate in that context. The Treasury Department and the IRS request comments on the advisability of adopting an approach to defining political campaign intervention under section 501(c)(3) similar to the approach set forth in these regulations, either in lieu of the facts and circumstances approach reflected in Rev. Rul. 2007–41 or in addition to that approach (for example, by creating a clearly defined presumption or safe harbor). The Treasury Department and the IRS also request comments on whether any modifications or exceptions would be needed in the section 501(c)(3) context and, if so, how to ensure that any such modifications or exceptions are clearly defined and administrable. Any such change would be introduced in the form of proposed regulations to allow an additional opportunity for public comment.

As noted in the “Background” section of this preamble, a section 501(c)(4) organization is subject to tax under section 527(f) if it makes expenditures for a section 527 exempt function. Consistent with section 527, the proposed regulations provide that “candidate-related political activity” for purposes of section 501(c)(4) includes activities relating to selection, nomination, election, or appointment of individuals to serve as public officials, officers in a political organization, or Presidential or Vice Presidential electors. These proposed regulations do not, however, address the definition of “exempt function” activity under section 527 or the application of section 527(f). The Treasury Department and the IRS request comments on the advisability of adopting rules that are the same as or similar to these proposed regulations for purposes of defining section 527 exempt function activity in lieu of the facts and circumstances approach reflected in Rev. Rul. 2004–6. Any such change would be introduced in the form of proposed regulations to allow an additional opportunity for public comment.

The proposed regulations define candidate-related political activity for social welfare organizations described in section 501(c)(4). The Treasury Department and the IRS are considering whether to amend the current regulations under sections 501(c)(5) and 501(c)(6) to provide that exempt purposes under those regulations (which include “the betterment of the conditions of those engaged in [labor, agricultural, or horticultural] pursuits” in the case of a section 501(c)(5) organization and promoting a “common business interest” in the case of a section 501(c)(6) organization) do not include candidate-related political activity as defined in these proposed regulations. The Treasury Department and the IRS request comments on the advisability of adopting this approach in defining activities that do not further exempt purposes under sections 501(c)(5) and 501(c)(6). Any such change would be introduced in the form of proposed regulations to allow an additional opportunity for public comment.

The Treasury Department and the IRS have received requests for guidance on the meaning of “primarily” as used in the current regulations under section 501(c)(4). The current regulations provide, in part, that an organization is operated exclusively for the promotion of social welfare within the meaning of section 501(c)(4) if it is “primarily engaged” in promoting in some way the common good and general welfare of the people of the community. Treas. Reg. §1.501(c)(4)–1(a)(2)(i). As part of the same 1959 Treasury decision promulgating the current section 501(c)(4) regulations, regulations under section 501(c)(3) were adopted containing similar language: “[a]n organization will be regarded as ‘operated exclusively’ for one or more exempt purposes only if it engages primarily in activities which accomplish one or more of such exempt purposes specified in section 501(c)(3).” Treas. Reg. §1.501(c)(3)–1(c)(1). Unlike the section 501(c)(4) regulations, however, the section 501(c)(3) regulations also provide that “[a]n organization will not be so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose.” Id.

Some have questioned the use of the “primarily” standard in the section 501(c)(4) regulations and suggested that this standard should be changed. The Treasury Department and the IRS are considering whether the current section 501(c)(4) regulations should be modified in this regard and, if the “primarily” standard is retained, whether the standard should be defined with more precision or revised to mirror the standard under the section 501(c)(3) regulations. Given the potential impact on organizations currently recognized as described in section 501(c)(4) of any change in the “primarily” standard, the Treasury Department and the IRS wish to receive comments from a broad range of organizations before deciding how to proceed. Accordingly, the Treasury Department and the IRS invite comments from the public on what proportion of an organization’s activities must promote social welfare for an organization to qualify under section 501(c)(4) and whether additional limits should be imposed on any or all activities that do not further social welfare. The Treasury Department and the IRS also request comments on how to measure the activities of organizations seeking to qualify as section 501(c)(4) social welfare organizations for these purposes.

These proposed regulations provide guidance on which activities will be considered candidate-related political activity for purposes of the regulations under section 501(c)(4). These proposed regulations would replace the language in the existing final regulation under section 501(c)(4) – “participation or intervention in political campaigns on behalf of or in opposition to any candidate for public office” – with a new term – “candidate-related political activity” – to differentiate the proposed section 501(c)(4) rule from the standard employed under section 501(c)(3) (and currently employed under section 501(c)(4)). The proposed rule is intended to help organizations and the IRS more readily identify activities that constitute candidate-related political activity and, therefore, do not promote social welfare within the meaning of section 501(c)(4). These proposed regulations do not otherwise define the promotion of social welfare under section 501(c)(4). The Treasury Department and the IRS note that the fact that an activity is not candidate-related political activity under these proposed regulations does not mean that the activity promotes social welfare. Whether such an activity promotes social welfare is an independent determination.

In defining candidate-related political activity for purposes of section 501(c)(4), these proposed regulations draw key concepts from the federal election campaign laws, with appropriate modifications reflecting the purpose of these regulations to define which organizations may receive the benefits of section 501(c)(4) tax-exempt status and to promote tax compliance (as opposed to campaign finance regulation). In addition, the concepts drawn from the federal election campaign laws have been modified to reflect that section 501(c)(4) organizations may be involved in activities related to local or state elections (in addition to federal elections), as well as the broader scope of the proposed definition of candidate (which is not limited to candidates for federal elective office).

The proposed regulations provide that candidate-related political activity includes activities that the IRS has traditionally considered to be political campaign activity per se, such as contributions to candidates and communications that expressly advocate for the election or defeat of a candidate. The proposed regulations also would treat as candidate-related political activity certain activities that, because they occur close in time to an election or are election-related, have a greater potential to affect the outcome of an election. Currently, such activities are subject to a facts and circumstances analysis before a determination can be made as to whether the activity furthers social welfare within the meaning of section 501(c)(4). Under the approach in these proposed regulations, such activities instead would be subject to a more definitive rule. In addition, consistent with the goal of providing greater clarity, the proposed regulations would identify certain specific activities as candidate-related political activity. The Treasury Department and the IRS acknowledge that the approach taken in these proposed regulations, while clearer, may be both more restrictive and more permissive than the current approach, but believe the proposed approach is justified by the need to provide greater certainty to section 501(c)(4) organizations regarding their activities and reduce the need for fact-intensive determinations.

The Treasury Department and the IRS note that a particular activity may fit within one or more categories of candidate-related political activity described in subsections b through e of this section 2 of the preamble; the categories are not mutually exclusive. For example, the category of express advocacy communications may overlap with the category of certain communications close in time to an election.

These proposed regulations provide that, consistent with the scope of section 527, “candidate” means an individual who identifies himself or is proposed by another for selection, nomination, election, or appointment to any public office or office in a political organization, or to be a Presidential or Vice-Presidential elector, whether or not the individual is ultimately selected, nominated, elected, or appointed. In addition, the proposed regulations clarify that for these purposes the term “candidate” also includes any officeholder who is the subject of a recall election. The Treasury Department and the IRS note that defining “candidate-related political activity” in these proposed regulations to include activities related to candidates for a broader range of offices (such as activities relating to the appointment or confirmation of executive branch officials and judicial nominees) is a change from the historical application in the section 501(c)(4) context of the section 501(c)(3) standard of political campaign intervention, which focuses on candidates for elective public office only. See Treas. Reg. §1.501(c)(3)–1(c)(3)(iii). These proposed regulations instead would apply a definition that reflects the broader scope of section 527 and that is already applied to a section 501(c)(4) organization engaged in section 527 exempt function activity through section 527(f).

These proposed regulations provide that candidate-related political activity includes communications that expressly advocate for or against a candidate. These proposed regulations draw from Federal Election Commission rules in defining “expressly advocate,” but expand the concept to include communications expressing a view on the selection, nomination, or appointment of individuals, or on the election or defeat of one or more candidates or of candidates of a political party. These proposed regulations make clear that all communications – including written, printed, electronic (including Internet), video, and oral communications – that express a view, whether for or against, on a clearly identified candidate (or on candidates of a political party) would constitute candidate-related political activity. A candidate can be “clearly identified” in a communication by name, photograph, or reference (such as “the incumbent” or a reference to a particular issue or characteristic distinguishing the candidate from others). The proposed regulations also provide that candidate-related political activity includes any express advocacy communication the expenditures for which an organization reports to the Federal Election Commission under the Federal Election Campaign Act as an independent expenditure.

Under current guidance, the timing of a communication about a candidate that is made shortly before an election is a factor tending to indicate a greater risk of political campaign intervention or section 527 exempt function activity. In the interest of greater clarity, these proposed regulations would move away from the facts and circumstances approach that the IRS has traditionally applied in analyzing certain activities conducted close in time to an election. These proposed regulations draw from provisions of federal election campaign laws that treat certain communications that are close in time to an election and that refer to a clearly identified candidate as electioneering communications, but make certain modifications. The proposed regulations expand the types of candidates and communications that are covered to reflect the types of activities an organization might conduct related to local and state, as well as federal, contests, including any election or ballot measure to recall an individual who holds state or local elective public office. In addition, the expansion of the types of communications covered in the proposed regulations reflects the fact that an organization’s tax exempt status is determined based on all of its activities, even low cost and volunteer activities, not just its large expenditures.

Under the proposed definition, any public communication that is made within 60 days before a general election or 30 days before a primary election and that clearly identifies a candidate for public office (or, in the case of a general election, refers to a political party represented in that election) would be considered candidate-related political activity. These timeframes are the same as those appearing in the Federal Election Campaign Act definition of electioneering communications. The definition of “election,” including what would be treated as a primary or a general election, is consistent with section 527(j) and the federal election campaign laws.

A communication is “public” if it is made using certain mass media (specifically, by broadcast, in a newspaper, or on the Internet), constitutes paid advertising, or reaches or is intended to reach at least 500 people (including mass mailings or telephone banks). The Treasury Department and the IRS intend that content previously posted by an organization on its Web site that clearly identifies a candidate and remains on the Web site during the specified pre-election period would be treated as candidate-related political activity.

The proposed regulations also provide that candidate-related political activity includes any communication the expenditures for which an organization reports to the Federal Election Commission under the Federal Election Campaign Act, including electioneering communications.

The approach taken in the proposed definition of candidate-related political activity would avoid the need to consider potential mitigating or aggravating circumstances in particular cases (such as whether an issue-oriented communication is “neutral” or “biased” with respect to a candidate). Thus, this definition would apply without regard to whether a public communication is intended to influence the election or some other, non-electoral action (such as a vote on pending legislation) and without regard to whether such communication was part of a series of similar communications. Moreover, a public communication made outside the 60-day or 30-day period would not be candidate-related political activity if it does not fall within the ambit of express advocacy communications or another specific provision of the definition. The Treasury Department and the IRS request comments on whether the length of the period should be longer (or shorter) and whether there are particular communications that (regardless of timing) should be excluded from the definition because they can be presumed to neither influence nor constitute an attempt to influence the outcome of an election. Any comments should specifically address how the proposed exclusion is consistent with the goal of providing clear rules that avoid fact-intensive determinations.

The Treasury Department and the IRS also note that this rule regarding public communications close in time to an election would not apply to public communications identifying a candidate for a state or federal appointive office that are made within a specified number of days before a scheduled appointment, confirmation hearing or vote, or other selection event. The Treasury Department and the IRS request comments on whether a similar rule should apply with respect to communications within a specified period of time before such a scheduled appointment, confirmation hearing or vote, or other selection event.

The proposed definition of candidate-related political activity would include contributions of money or anything of value to or the solicitation of contributions on behalf of (1) any person if such contribution is recognized under applicable federal, state, or local campaign finance law as a reportable contribution; (2) any political party, political committee, or other section 527 organization; or (3) any organization described in section 501(c) that engages in candidate-related political activity within the meaning of this proposed rule. This definition of contribution is similar to the definition of contribution that applies for purposes of section 527. The Treasury Department and the IRS intend that the term “anything of value” would include both in-kind donations and other support (for example, volunteer hours and free or discounted rentals of facilities or mailing lists). The Treasury Department and the IRS request comments on whether other transfers, such as indirect contributions described in section 276 to political parties or political candidates, should be treated as candidate-related political activity.

The Treasury Department and the IRS recognize that a section 501(c)(4) organization making a contribution may not know whether a recipient section 501(c) organization engages in candidate-related political activity. The proposed regulations provide that, for purposes of this definition, a recipient organization would not be treated as a section 501(c) organization engaged in candidate-related political activity if the contributor organization obtains a written representation from an authorized officer of the recipient organization stating that the recipient organization does not engage in any such activity and the contribution is subject to a written restriction that it not be used for candidate-related political activity. This special provision would apply only if the contributor organization does not know or have reason to know that the representation is inaccurate or unreliable.

The proposed definition of candidate-related political activity would include certain specified election-related activities, including the conduct of voter registration and get-out-the-vote drives, distribution of material prepared by or on behalf of a candidate or section 527 organization, and preparation or distribution of a voter guide and accompanying material that refers to a candidate or a political party. In addition, an organization that hosts an event on its premises or conducts an event off-site within 30 days of a primary election or 60 days of a general election at which one or more candidates in such election appear as part of the program (whether or not such appearance was previously scheduled) would be engaged in candidate-related political activity under the proposed definition.

The Treasury Department and the IRS acknowledge that under the facts and circumstances analysis currently used for section 501(c)(4) organizations as well as for section 501(c)(3) organizations, these election-related activities may not be considered political campaign intervention if conducted in a non-partisan and unbiased manner. However, these determinations are highly fact-intensive. The Treasury Department and the IRS request comments on whether any particular activities conducted by section 501(c)(4) organizations should be excepted from the definition of candidate-related political activity as voter education activity and, if so, a description of how the proposed exception will both ensure that excepted activities are conducted in a non-partisan and unbiased manner and avoid a fact-intensive analysis.

These proposed regulations provide that activities conducted by an organization include, but are not limited to, (1) activities paid for by the organization or conducted by the organization’s officers, directors, or employees acting in that capacity, or by volunteers acting under the organization’s direction or supervision; (2) communications made (whether or not such communications were previously scheduled) as part of the program at an official function of the organization or in an official publication of the organization; and (3) other communications (such as television advertisements) the creation or distribution of which is paid for by the organization. These proposed regulations also provide that an organization’s Web site is an official publication of the organization, so that material posted by the organization on its Web site may constitute candidate-related political activity. The proposed regulations do not specifically address material posted by third parties on an organization’s Web site. The Treasury Department and the IRS request comments on whether, and under what circumstances, material posted by a third party on an interactive part of the organization’s Web site should be attributed to the organization for purposes of this rule. In addition, the Treasury Department and the IRS have stated in guidance under section 501(c)(3) regarding political campaign intervention that when a charitable organization chooses to establish a link to another Web site, the organization is responsible for the consequences of establishing and maintaining that link, even if it does not have control over the content of the linked site. See Rev. Rul. 2007–41. The Treasury Department and the IRS request comments on whether the consequences of establishing and maintaining a link to another Web site should be the same or different for purposes of the proposed definition of candidate-related political activity.

(a) * * *

(2) * * *

(ii) * * * The promotion of social welfare does not include direct or indirect candidate-related political activity, as defined in paragraph (a)(2)(iii) of this section. * * *

(iii) Definition of candidate-related political activity—(A) In general. For purposes of this section, candidate-related political activity means:

(1) Any communication (as defined in paragraph (a)(2)(iii)(B)(3) of this section) expressing a view on, whether for or against, the selection, nomination, election, or appointment of one or more clearly identified candidates or of candidates of a political party that—

(i) Contains words that expressly advocate, such as “vote,” “oppose,” “support,” “elect,” “defeat,” or “reject;” or

(ii) Is susceptible of no reasonable interpretation other than a call for or against the selection, nomination, election, or appointment of one or more candidates or of candidates of a political party;

(2) Any public communication (defined in paragraph (a)(2)(iii)(B)(5) of this section) within 30 days of a primary election or 60 days of a general election that refers to one or more clearly identified candidates in that election or, in the case of a general election, refers to one or more political parties represented in that election;

(3) Any communication the expenditures for which are reported to the Federal Election Commission, including independent expenditures and electioneering communications;

(4) A contribution (including a gift, grant, subscription, loan, advance, or deposit) of money or anything of value to or the solicitation of contributions on behalf of—

(i) Any person, if the transfer is recognized under applicable federal, state, or local campaign finance law as a reportable contribution to a candidate for elective office;

(ii) Any section 527 organization; or

(iii) Any organization described in section 501(c) that engages in candidate-related political activity within the meaning of this paragraph (a)(2)(iii) (see special rule in paragraph (a)(2)(iii)(D) of this section);

(5) Conduct of a voter registration drive or “get-out-the-vote” drive;

(6) Distribution of any material prepared by or on behalf of a candidate or by a section 527 organization including, without limitation, written materials, and audio and video recordings;

(7) Preparation or distribution of a voter guide that refers to one or more clearly identified candidates or, in the case of a general election, to one or more political parties (including material accompanying the voter guide); or

(8) Hosting or conducting an event within 30 days of a primary election or 60 days of a general election at which one or more candidates in such election appear as part of the program.

(B) Related definitions. The following terms are defined for purposes of this paragraph (a)(2)(iii) only:

(1) “Candidate” means an individual who publicly offers himself, or is proposed by another, for selection, nomination, election, or appointment to any federal, state, or local public office or office in a political organization, or to be a Presidential or Vice-Presidential elector, whether or not such individual is ultimately selected, nominated, elected, or appointed. Any officeholder who is the subject of a recall election shall be treated as a candidate in the recall election.

(2) “Clearly identified” means the name of the candidate involved appears, a photograph or drawing of the candidate appears, or the identity of the candidate is apparent by reference, such as by use of the candidate’s recorded voice or of terms such as “the Mayor,” “your Congressman,” “the incumbent,” “the Democratic nominee,” or “the Republican candidate for County Supervisor.” In addition, a candidate may be “clearly identified” by reference to an issue or characteristic used to distinguish the candidate from other candidates.

(3) “Communication” means any communication by whatever means, including written, printed, electronic (including Internet), video, or oral communications.

(4) “Election” means a general, special, primary, or runoff election for federal, state, or local office; a convention or caucus of a political party that has authority to nominate a candidate for federal, state or local office; a primary election held for the selection of delegates to a national nominating convention of a political party; or a primary election held for the expression of a preference for the nomination of individuals for election to the office of President. A special election or a runoff election is treated as a primary election if held to nominate a candidate. A convention or caucus of a political party that has authority to nominate a candidate is also treated as a primary election. A special election or a runoff election is treated as a general election if held to elect a candidate. Any election or ballot measure to recall an individual who holds state or local elective public office is also treated as a general election.

(5) “Public communication” means any communication (as defined in paragraph (a)(2)(iii)(B)(3) of this section)—

(i) By broadcast, cable, or satellite;

(ii) On an Internet Web site;

(iii) In a newspaper, magazine, or other periodical;

(iv) In the form of paid advertising; or

(v) That otherwise reaches, or is intended to reach, more than 500 persons.

(6) “Section 527 organization” means an organization described in section 527(e)(1) (including a separate segregated fund described in section 527(f)(3)), whether or not the organization has filed notice under section 527(i).

(C) Attribution. For purposes of this section, activities conducted by an organization include activities paid for by the organization or conducted by an officer, director, or employee acting in that capacity or by volunteers acting under the organization’s direction or supervision. Communications made by an organization include communications the creation or distribution of which is paid for by the organization or that are made in an official publication of the organization (including statements or material posted by the organization on its Web site), as part of the program at an official function of the organization, by an officer or director acting in that capacity, or by an employee, volunteer, or other representative authorized to communicate on behalf of the organization and acting in that capacity.

(D) Special rule regarding contributions to section 501(c) organizations. For purposes of paragraph (a)(2)(iii)(A)(4) of this section, a contribution to an organization described in section 501(c) will not be treated as a contribution to an organization engaged in candidate-related political activity if—

(1) The contributor organization obtains a written representation from an authorized officer of the recipient organization stating that the recipient organization does not engage in such activity (and the contributor organization does not know or have reason to know that the representation is inaccurate or unreliable); and

(2) The contribution is subject to a written restriction that it not be used for candidate-related political activity within the meaning of this paragraph (a)(2)(iii).

(c) Effective/applicability date. Paragraphs (a)(2)(ii) and (iii) of this section apply on and after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register.

John Dalrymple,
Deputy Commissioner for Services and Enforcement.