The Treasury Department just released temporary regulations for Section 871(m), governing nonresident aliens and foreign corporations holding notional principal contracts which provide for payments determined by reference to the payment of US sourced dividends.

These rules treat as “dividend equivalents” arrangements that provide for a payment contingent upon or determined by reference to a U.S. source dividend.  These Section 871(m) regulations aim to apply the dividend withholding regime of sections 1441, 1442, and 1461 to these types of dividend substitutes.    

For payments made after March 18, 2012, any NPC will be a “specified NPC” unless Treasury and the IRS determined that the contract is of a type which does not have the potential for tax avoidance.

The new regulations do not adopt a safe harbor.  Indeed, the preamble notes that, notwithstanding the temporary regulations, the IRS may challenge transactions that are designed to avoid these rules under applicable judicial doctrines and may assert that an NPC other derivative is, in fact, an equity ownership interest.

 In sum, the proposed regulations:

• Define which payments are US sourced dividend equivalents;
• Define a “specified NPC” and allow a transition period for pre-1/1/2013 payments;
• Set forth rules for what constitutes a “specified NPC” for post 1/1/2013 periods;
• Define the term “underlying security”;
• Amend the 1441 regulations to require a withholding agent to withhold tax owed on a dividend equivalent;
• Treat dividend equivalents as income from investments in stock under section 892; and
• Treat dividend equivalents as a “dividends” to determine the appropriate rate of withholding tax under a tax treaty. 

If your US business has any non-US participants in any arrangements like a phantom stock or stock appreciation right plan, I would highly recommend reviewing such terms before payment to determine if 871(m) applies.