Press Room: Tax Release

February 01, 2012

Dividend Related Swap Payments Now Subject to Withholding

New temporary regulations implement law that subjects dividend related swap payments to withholding tax for the first time.

This month IRS published temporary and proposed regulations that require taxpayers to treat dividend related payments due under swaps and other financial derivative contracts as U.S. source income subject to the 30% gross basis withholding tax. The temporary regulations apply to payments made to foreign persons before January 1, 2013, and only with respect to payments made under certain types of contracts. The proposed regulations would cover a broader class of instruments and would apply beginning on January 1, 2013. Affected taxpayers may be subject to U.S. withholding tax on swap payments and may be required to file a U.S. income tax return. Moreover, U.S. withholding agents must withhold tax from, and report payment of, such amounts even if no cash is actually paid to a foreign person.

For the remainder of 2012, the temporary regulations would apply: (1) to substitute payments made in lieu of dividends under securities lending or sale-repurchase transactions involving U.S. stock; or (2) to swap payments if such payments are contingent on payment of U.S. source dividends on U.S. stock and certain other requirements are met. In particular, a swap contract is covered if: (a) the equity security on which it is based (reference security) is transferred at the inception or termination of the contract; (b) the reference security is not traded on a public market; or (c) the reference security is posted as collateral by the person who makes the dividend related payments. The proposed regulations would expand the scope of payments covered to include: (a) gross-up payments made to cover taxes (such as the withholding tax); and (b) payments made under an “equity-linked instrument” including sales contracts, forwards, options, and other derivative contracts based on U.S. stock. Under these proposed rules, financial contracts based on an index of stocks would be covered unless that index is traded in the futures markets. 

Some exceptions to U.S. source treatment may apply. First, the rules would not apply to payments that are based on estimates of dividends on U.S. stock if no adjustment for actual dividends paid occurs. In addition, no withholding is required for payments that are effectively connected with the U.S. trade or business of a foreign person. Of course, the amount of any withholding tax may be reduced under a relevant Tax Treaty.

These rules affect non-U.S. taxpayers who have entered into derivative contracts based on U.S. stock and U.S. persons who make payments of, or who have custody over, amounts related to U.S. source dividends. The impact of these rules can be onerous since U.S. withholding agents must withhold each time the amount of a dividend related payment is calculated under the terms of the swap agreement even if no net amount is paid to the foreign person. This is contrary to the general rule that withholding tax liability arises only upon actual payments of cash.

For more information, please contact your WTAS advisor or Ramon Camacho at ramon.camacho@wtas.com or 571.382.0049.