The main purpose of Section 871(m) and the regulations is to apply a withholding tax on dividend equivalent payments associated with derivative contracts. Withholding generally applies with the derivative (or combinations of derivatives) has a delta that’s greater than 0.80. Delta measures how closely a derivative price will follow the stock price over a short range of prices. Essentially, once the delta of a derivative is deemed high enough, it is essentially deemed a stock equivalent and the dividend equivalent payment that is associated with the derivative is taxed in a similar manner.
While I may get into the background of Section 871(m) in later posts, I’m just going to dive into specific provisions of the Section 871(m) regulations first. I’ll just note that there are plenty of generic outlines of the new final regulations online (e.g., here, here, and everywhere).
The specific provision I want to deal with first addresses so-called combination transactions. Treasury obviously realized that if they looked at a single transaction, savvy taxpayers could simply avoid the withholding taxes imposed of Section 871(m) by entering into multiple transactions. For example, where the price of stock is 100, a taxpayer could simply acquire a call @100 and sell a put @100. This is effectively economically equivalent to owning stock (e.g., a delta of 1.00) and each of the separate derivatives likely qualify if examined separately because their delta is probably right around 0.50 or so. Therefore, Treasury has set forth a rule for combining transactions as well as a fairly interesting set of presumptions.
First, a combined transaction is, very generally, two or more transactions with respect to the same underlying security entered into in connection with each other that, when combined, replicate the economics of a transaction that would be a section 871(m) transaction if it had been done as a single transaction.
This seems relatively simple but there are a ton of issues packed into this and I’m only going to address certain issues that relate to (1) “in connection with” and (2) whether the combined transaction replicates the economics of an otherwise covered section 871(m) transaction.
In Connection With–Generally
The first thing a taxpayer (or withholding agent or IRS agent) must determine is whether a series of transactions are related enough to be treated as a combined transaction.
Here, the regulatory language requires, in the first instance, that the transactions must be entered into “in connection with” each other. “In connection with” is not separately defined by the regulations but it is a common enough English phrase that it’s probably not all that confusing.
Nevertheless, Treasury does provide some color on the meaning of “in connection with”. First, in the preamble to the regulations, Treasury states “…[a] long party…must treat two or more transactions as combined transactions if the transactions satisfy the requirements to be a combined transaction. The long parties affected by this rule consist primarily of securities traders, who are in a position to know their securities positions and trading strategies.” Clearly, Treasury’s position is that any derivatives that are acquired as part of a single trading strategy should be combined.
This seems to be consistent with their position taken in Example 2 of Prop. Reg. 1.871-15(l)(6). In the example, a taxpayer adjusted its position on a call by selling a put two weeks after the acquisition of the call. Treasury concluded that these two transactions should be deemed connected with each other.
It’s interesting to note here that the Treasury did not specifically target combination transactions that were done for avoidance purposes. One could argue that this is beyond the authority granted by the statute in Section 871(m) since it seems to be focused on the “potential for tax avoidance”; however, this is likely a very weak argument given the word “potential”. Potential is a very big modifier here because, even if the avoidance purpose was not present in any specific case, the potential for avoidance almost certainly exists.
In Connection With – The Presumptions
In any event, due to the potentially broad implication of the “in connection with” language, Treasury set forth some favorable presumptions that can be applied by certain parties. These parties are: (a) the long party (the “real” taxpayer), (b) the IRS, and (c) the long party (the “real” taxpayer) and (c) the short-party broker (generally the withholding agent). These are the three parties that are generally tasked with ensuring that withholding tax is paid and I’ll set forth the presumptions that are applied to each party.
(a) The Long Party (the “Real” Taxpayer)
None. The long party must simply treat transactions as combined if they meet the “in connection with” requirement. Treasury was not willing to provide any beneficial presumptions to long parties because long parties “…are in a position to know their securities positions and trading strategies and to monitor their compliance with section 871(m).”
This is actually quite interesting given the presumptions that the IRS is expected to apply.
(b) The IRS.
First, the IRS must make a positive presumption that the transactions were entered into in connection with each other if they were separated by less than two days and they were reflected in the same trading book. The Long Party can rebut this presumption with facts and circumstances showing that the transactions were not entered into in connection with each other.
This first presumption seems to make sense both in the context of the rule that applies to the Long Party in (a) and as a rule of convenience. That is, Treasury is providing a presumptive rule for combined transactions that shifts the burden of proof on the taxpayer in a scenario where it seems that, prima facie, the transactions are connected.
Second, the IRS must make a negative presumption that the transactions were not entered into in connection with each other if the long party properly reflected those transactions on separate trading books, or if the long party entered into the transactions at least two business days apart. The IRS may rebut these presumptions if the facts and circumstances show that the transactions were entered into in connection with each other.
I have to admit, I’m a bit confounded by this presumption and its consistency with (a) above as well as Its overall construction. It seems to be a conversation that the IRS is having with itself. It must make a presumption and then rebut itself? Moreover, the Long Party does not get this presumption (as set forth in (a)) but the IRS grants the presumption in the Long Party’s favor.
I think this is what Treasury really means here. If the trades are not in the same trading book or are separated by at least two business, the IRS has to make its case that the transactions are connected.
The fact that the presumptions do not, in fact, apply to the Long Party may have import for the Long Party’s own due diligence and as well as any review of potential tax liability in their audited financial statements. Because the presumptions don’t apply to the Long Party, I imagine that the Long Party’s auditors cannot take them into account for purposes of determining tax liability. I’m not sure if this is what Treasury was trying to accomplish but found it interesting.
(c) The Short-Party Broker (the Withholding Agent).
Generally, the first party to determine whether to collect the withholding tax is the withholding agent. However, Treasury acknowledged that a short party likely has limited information as to whether a series of transactions conducted by a Long Party are done “in connection with” each other. Therefore, the regulations provide a series of beneficial presumptions in favor of the Short-Party Broker.
First, the short-party broker may presume that transactions are not entered into in connection with each other if the transactions are held in separate accounts. Second, the short-party broker may presume the transactions are not entered into in connection with each other if the transactions are entered into at least two business days apart.
Neither of these presumptions apply if the short-party broker actually knew that the separate accounts were used to avoid Section 871(m) or that the transactions were entered into in connection with each other.*
These set of presumptions are obviously helpful to short-party brokers. However, there are a couple of things that will continue to make these rules difficult for brokers: (i) Angel taxpayers and (ii) “complex contracts”.
- Angel Taxpayers
Angel taxpayers are taxpayers that intend to pay the tax that they owe and calculate it correctly. Remember in (a) above that the presumptions simply do not apply to a Long Party. That is, the short-party broker can be off the hook for withholding based on the presumptions here but the Long Party still has to pay the actual tax. Therefore, the presumptions are effectively meaningless for the Angel taxpayer.
Moreover, since these calculations are likely to be difficult and require contemporaneous processing, an Angel taxpayer may not have any in-house capability of doing the actual payment. In my experience, even many recipients are incapable of even processing more simple withholding taxes because they simply rely on withholding agents to do it properly.
Therefore, the Angel taxpayer may simply tell the short-party broker that all trades in various accounts relate to the same trading strategy and tell the short-party broker to go ahead and implement the proper withholding. Because the short-party broker has actual knowledge of the connection, the various presumptions no longer apply and the IRS can sink its teeth into juicy withholding agent steak.
A short-party broker will thus have to consider (x) a systems build that can take into account a wide variety of transactions across several accounts, (y) telling clients that they should take their business elsewhere, and (z) just assuming that all trades are in those accounts are subject to withholding. A firm capable of (x) may be able to create some business opportunities for certain dealers that can implement such a scheme as (y) and (z) are not client friendly. However, this problem may be exacerbated by the next issue.
- Replicating the Economics and “Complex Contracts”.
While transactions may be combined, that fact alone does not doom them. Combined transactions will be subject to withholding if they replicate the economics of a transaction that would be a section 871(m) transaction if it had been done as a single transaction.
That seems pretty straightforward. For example, if someone enters into a put-call combo at the same strike price, sure, that replicates the economics of a delta 1 stock. However, the Treasury regulations also apply to “Complex Contracts”. I don’t intend to go into the definition of complex contracts here but they are derivatives that laymen don’t really deal with. They often do not reference a set number of shares over a range of values or time, they may be binary, etc. In addressing these, Treasury has set forth a “substantial equivalence test” in temporary regulations. Again, I don’t intend to discuss these in any depth in this post, but it’s complicated, and it’s complicated in how it applies to a single transaction.
However, a series of options don’t always combine in such a nice way as to avoid having economics that are not complex in nature. Even a simple call and put option can have overlapping strike prices and/or have different maturities. When combined, these would likely have economics that would be described as complex. In accounts with lots of trades, I can’t even begin to imagine how this calculation will be done.
This complexity is even further compounded by the ordering rule provided in the regulations that says, very generally, that combinations must be done in a way that results in the highest withholding tax. However, let’s say there are 10 options executed on the same day that relate to stock X (or alternatively, on different days but nevertheless executed in connection with each other). Even with only 10 options, there are 1,023 potential combinations for those options. I’m sure someone smarter than me can figure out how to program those calculations but that seems like a difficult task.
Anyway, it should be interesting to see if there is any further clarity on how combined transactions and complex transactions work together. Of course, maybe I’m already missing something.
*It appears that Treas. Reg. 1.871-15(p)(1) does not require the short-party broker exercise “reasonable diligence” in determining whether they should have had “actual knowledge”. However, some may be worried that the IRS can rebut the presumption by showing the lack of reasonable diligence. See Cadwalader Note 85. However, my “guess” is that this is simply a point of clarification and Treasury by using actual knowledge meant actual knowledge and not reason to know.