The IRS issued Notice 2026-61, extending the transition relief period for Section 871(m), provided for by Notice 2024-44, by two years.[1] Under this extension, the Section 871(m) rules will not apply to non-delta-one transaction payments until 2029. The anti-abuse rule under Treasury Regulation Section 1.871-15(o) will continue to apply during this period, and therefore certain transactions may still be characterized as 871(m) transactions despite this Notice.
Hedge funds should be aware of this extension in the phase-in period, as this extends the timeline for which they may engage in certain non-delta-one transactions without triggering withholding taxes due to the application of Section 871(m). Hedge funds engaged in such transactions should stay aware of any changes in the law or further delays in the application of the Section 871(m) rules to non-delta-one transactions to plan for compliance and to understand the tax treatment of their transactions.
Background
Section 871 imposes a 30% withholding tax on payments of U.S. source dividends to foreign persons.[2] Prior to 2010[3], income from equity swaps and other derivatives paid to foreign persons was generally exempt from this withholding tax. Income from such instruments was sourced to the jurisdiction of the recipient, and thus not subject to U.S. federal income taxation when received by a foreign person. In 2008, the Senate’s Permanent Subcommittee on Investigations made recommendations to eliminate the use of derivatives as a way to avoid imposition of the Section 871 withholding tax.[4] Section 871(m) was enacted into law, treating “dividend equivalent payments” as U.S. source dividends and thus subjecting them to the withholding tax.
A dividend equivalent, as described in Treasury Regulation Section 1.871-15(c)(1), includes, among others, payments that reference a dividend from an underlying security pursuant to either a specified notional principal contract (NPC) or a specified equity-linked instrument (ELI). Simple NPCs and ELIs with a specified delta with respect to an underlying security at the time of calculation for the NPC or ELI are specified NPCs or ELIs.[5] This delta threshold measures the ratio of change in fair market value of a contract to change in the fair market value of the property referenced by the contract.[6] Therefore, a contract that exactly tracks the referenced property would be considered a delta-one contract. The 2015 final regulations[7] adopted a delta threshold of 0.8, which was to become effective January 1, 2017. Simple NPCs and ELIs that had a delta of 0.8 or greater would be classified as specified NPCs or ELIs, and therefore dividend equivalent payments subject to the 871(m) rules.
Extension of the Transition Relief Period
On December 19, 2016, the IRS issued Notice 2016-76, which postponed the application of the 871(m) regulations to non-delta-one transactions by extending the transition relief period until January 1, 2018. The transition relief period has been further extended numerous times through IRS Notices, however, and non-delta-one transactions have not yet been subject to the 871(m) regulations.[8] The transition relief period, as extended through 2028 by the most recent IRS Notice, further delays the application of the Section 871(m) regulations to non-delta-one transactions. This extended relief period also applies to transactions that are combined transactions under Treasury Regulation Section 1.871-15(n).
The Section 871(m) regulations will continue to apply to delta-one transactions, as well as to certain transactions that fall under the anti-abuse rule under Treasury Regulation Section 1.871-15(o). As extended by Notice 2026-61, the IRS will follow a good faith effort standard in evaluating a taxpayer’s or withholding agent’s compliance with the Section 871(m) regulations with respect to any delta-one transactions in 2017 through 2028, and any non-delta-one transactions that are Section 871(m) transactions under Treasury Regulation Section 1.871-15(d)(2) or (e) in 2029.
Implications
With this extension of the transition relief period provided in Notice 2024-44, the 871(m) regulations are limited in application to delta-one instruments. If no extension or change to the law occurs by 2029, the application of the 871(m) regulations will extend to contracts entered into on or after January 1, 2029 with a delta of 0.8 or greater, subjecting significantly more instruments to the withholding tax. Hedge fund managers should consider whether a non-delta-one contract would accomplish their tax savings goals despite the differing economic results of such a contract. Taxpayers may reasonably have suspicion that withholding may never apply to non-delta-one transactions that are not otherwise abusive. The IRS will take into account a taxpayer’s or withholding agent’s good-faith attempt to comply with the Section 871(m) regulations in 2029 for transactions that fall under 871(m) pursuant to Treasury Regulation Section 1.871-15(d)(2) as specified NPCs, or Treasury Regulation Section 1.871-15(e) as specified ELIs.
Extensions in relief continue to allow hedge funds to use non-delta-one derivatives transactions without being subject to a 30% withholding tax under Section 871(m). Hedge funds and offshore feeders should stay aware of updates in IRS guidance in order to be best prepared for compliance with the 871(m) regulations and tax planning.
Our tax team is monitoring these developments closely and is available to assist clients in evaluating the impact of this updated IRS guidance on their existing and planned transactions.
Special thanks to Sara Mungo for her contributions on this article.
[1] “Section” references are to sections of the Internal Revenue Code of 1986, as amended.
[2] I.R.C. § 871(a).
[3] I.R.C. § 871(m) was passed as a part of the Hiring Incentives to Restore Employment Act in 2010. See Pub. L. No. 111-147.
[4] See U.S. Senate, Permanent Subcommittee on Investigations, Committee on Homeland Security and Governmental Affairs, Dividend Tax Abuse: How Offshore Entities Dodge Taxes on U.S. Stock Dividends, Staff Report (Sept. 11, 2008).
[5] Treasury Regulation § 1.871-15(d)(2)(ii) & (e)(1).
[6] TD 9734, 80 Fed. Reg. 56866 (Sept. 18, 2015).
[7] Id.
[8] See I.R.S. Notice 2017-42, 2018-72, 2020-2, 2022-37, 2024-44, 2026-61.
