Cadwalader: IRS Cries Uncle for the Fourth Time on the Section 871(m) Substantial Equivalence Test

On August 23, 2022, the IRS issued Notice 2022-37 (reproduced here), which once again extends the phase-in of withholding under Section 871(m). Broadly speaking, foreign persons may be subject to a 30% withholding tax under Section 871(m) on certain dividend equivalents paid or deemed paid to a foreign person with respect to a specified equity-linked instrument that references one or more dividend-paying U.S. equity securities. Specifically, Section 871(m) imposes withholding on (i) simple contracts with a delta of .8 or more, and (ii) complex contracts that fail to meet the substantial equivalence test. Under Notice 2022-37, Section 871(m), withholding on dividend equivalents applies only to delta-one transactions through 2024, and will not apply to other U.S. equity transactions until after 2024. Although “delta-one” has not been defined in IRS guidance, it is generally thought to mean a linear nearly one-to-one correlation. Accordingly, a delta-one transaction tracks the underlying security on a dollar-for-dollar basis.

Notice 2022-37 marks the fourth extension of the effective date for the regulations to apply, as most recently extended pursuant to Notice 2020-2 (discussed here). This latest extension of the implementation period for the final regulations, which were initially published in 2015, suggests that the regulations may never be finalized as currently drafted and may instead require substantial alterations. We read this extension as a tacit admission by the IRS that the substantial equivalence test may not be the best way forward due to its complexity and the high costs that market participants would have to incur to implement the test. Because of the uncertainty that these multiple extensions are causing to market participants, sooner rather than later the IRS should either (i) send strong signals of its intent to ultimately adopt the substantial equivalence test, or (ii) articulate its intention to adopt a more streamlined, simplified test.

The full article is available at

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