Code Section 871
| Code Section | Effective Date | Name of Act | Name of Provision | 10yr Revenue Estimate ($millions) |
|---|---|---|---|---|
| 871(k) | 12/31/2011 | The American Taxpayer Relief Act of 2012 | Treatment of certain dividends of regulated investment companies | -151 |
| 861(a)(1)(A) and 871(i) | **12/31/2010 | The Air Traffic Control Act | Termination of Special Rules for Interest and Dividends Received from Persons Meeting the 80-Percent Foreign Business Requirements | 153 |
| 871 | 3/18/2010 | The Hiring Incentives to Restore Employment Act | Substitute dividends and dividend equivalent payments received by foreign persons treated as dividends | ***See sec. 1471 |
| 149, 163, 165, 871, 881, 1287, and 4701 | *3/18/2010 | The Hiring Incentives to Restore Employment Act | Repeal of the foreign targeted obligation exception to the registration requirement | ***See sec. 1471 |
| 871(k) | 12/31/2009 | The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 | Treatment of certain dividends of regulated investment companies | -174 |
* Notes on Effective Date
The provision applies to debt obligations issued after the date which is two years after the date of enactment (March 18, 2010).
** Notes on Effective Date
The provision is effective for taxable years beginning after December 31, 2010.
The repeal of the 80/20 company provisions relating to the payment of interest does not apply to payments of interest to persons not related to the 80/20 company (applying rules similar to those of section 954(d)(3)) on obligations issued before the date of enactment. 1278 For this purpose, a significant modification of the terms of any obligation (including any extension of the term of such obligation) is treated as the issuance of a new obligation.
***Note on Revenue Estimate
See section 1471, provision: Reporting on certain foreign accounts.
Treatment of certain dividends of regulated investment companies
Explanation of Provision
The provision extends the rules exempting from gross basis tax and from withholding tax the interest-related dividends and short-term capital gain dividends received from a RIC, to dividends with respect to taxable years of a RIC beginning before January 1, 2014.
Termination of Special Rules for Interest and Dividends Received from Persons Meeting the 80-Percent Foreign Business Requirements
Explanation of Provision
The provision repeals the present-law rule that treats as foreignsource all or a portion of any interest paid by a resident alien individual or domestic corporation that meets the 80/20 test. The provision also repeals the present-law rule that exempts from U.S. withholding tax all or a portion of any dividends paid by a domestic corporation that meets the 80/20 test.
The provision provides a grandfather rule for any domestic corporation that (1) meets the 80/20 test (as in effect before the enactment of this provision) (hereinafter ‘‘the present law 80/20 test’’) for its last taxable year beginning before January 1, 2011 (‘‘an existing 80/20 company’’), (2) meets a new 80/20 test with respect to each taxable year beginning after December 31, 2010, and (3) has not added a substantial line of business with respect to such corporation after the date of enactment of this provision. Any payment of dividend or interest after December 31, 2010 by an existing 80/20 company that meets the grandfather rule is exempt from withholding tax to the extent of the existing 80/20 company’s active foreign business percentage. Nonetheless, any payment of interest will be treated as U.S.-source income.
As with the present law 80/20 test, a corporation meets the 80- percent foreign business requirements of the 80/20 test under the grandfather rule if it is shown to the satisfaction of the Secretary that at least 80-percent of the gross income from all sources of such corporation for the testing period is active foreign business income. This percentage—active foreign business income of the company for the testing period as a percentage of total gross income of the company for the testing period—is also the company’s active foreign business percentage for purposes of determining the portion of any dividend or interest paid by an existing 80/20 company that is exempt from withholding tax. However, except as modified by the transition rule below, the existing 80/20 company and all of its subsidiaries are aggregated and treated as one corporation. For this purpose, a subsidiary means any corporation in which the existing 80/20 company owns (directly or indirectly) stock meeting the requirements of section 1504(a)(2), determined by substituting 50 percent for 80 percent and without regard to section 1504(b)(3). As a result, an existing 80/20 company must take into account the gross income of any domestic or foreign subsidiary. The Secretary may issue guidance as is necessary or appropriate to carry out the purpose of this provision, including guidance providing for the proper application of the aggregation rules.
Under the 80/20 test provided by the grandfather rule, the testing period is the three-year period ending with the close of the taxable year of the corporation preceding the payment (or such part of such period as may be applicable). If the corporation has no gross income for such three-year period (or part thereof), the testing period is the taxable year in which the payment is made.
The grandfather rule includes a transition rule that applies in the case of any taxable year for which the testing period includes one or more taxable years beginning before January 1, 2011. Under this transition rule, a corporation meets the 80-percent foreign business requirements if, and only if, the weighted average of (1) the percentage of the corporation’s gross income from all sources that is active foreign business income (as defined in subparagraph (B) of section 861(c)(1) (as in effect before the date of enactment of this provision)) for the portion of the testing period that includes taxable years beginning before January 1, 2011,1277 and (2) the percentage of the corporation’s gross income from all sources that is active foreign business income for the portion of the testing period, if any, that includes taxable years beginning on or after January 1, 2011, is at least 80 percent. Accordingly, this transition rule applies instead of the new 80/20 test for the relevant tax years. This weighted average percentage is also treated as the active foreign business percentage for purposes of determining the amount of withholding for such taxable years.
The following example illustrates the operation of this transition rule. Assume a domestic corporation has $100 of active foreign business income and no other income on a separate company basis (i.e., without regard to the income of any affiliate) for each of the 2008, 2009, and 2010 tax years. For the 2011, 2012, and 2013 tax years, the domestic company has $700 of active foreign business income and $300 of other income on an aggregate basis (including the income of its 50-percent owned domestic and foreign subsidiaries). Under the provision, the domestic company’s weighted average percentage for the 2011 tax year is 100 percent, determined by considering the 2008, 2009, and 2010 tax years on a separate company basis (($100 + $100 + $100)/($100 + $100 + $100)). Therefore, for the 2011 tax year, the domestic company meets the 80-percent active foreign business requirements, and its active foreign business percentage is 100 percent for the 2011 tax year.
For the 2012 tax year, the weighted average percentage is 90 percent, determined by considering the 2009 and 2010 tax years on a separate company basis ((($100 + $100)/($100 + $100) × 2⁄3)) or 66.7 percent) and the 2011 tax year on an aggregate basis ((($700/ $1,000) × 1⁄3) or 23.3 percent). As a result, the domestic company meets the 80-percent active foreign business requirements, and its active foreign business percentage is 90 percent for the 2012 tax year.
For the 2013 tax year, the weighted average percentage is 80 percent, determined by considering the 2010 tax year on a separate company basis ((($100/$100) × 1⁄3) or 33.3 percent) and the 2011 and 2012 tax years on an aggregate basis ((($700 + $700)/($1,000 + $1,000) × 2⁄3) or 46.7 percent). Therefore, for the 2013 tax year, the domestic company meets the 80-percent active foreign business requirements, and its active foreign business percentage is 80 percent.
For the 2014 tax year, the transition rule does not apply since none of the years within the three-year testing period begin before January 1, 2011. As a result, the domestic company does not meet the 80-percent foreign business requirements for the 2014 tax year since only 70 percent (($700 + $700 + $700)/($1,000 + $1,000 + $1,000)) of its gross income from all sources for the testing period is active foreign business income.
An existing 80/20 company does not meet the grandfather rule if there has been an addition of a substantial line of business with respect to such corporation after the date of enactment of this provision. For purposes of determining whether a substantial line of business has been added, rules similar to those of section 7704(g) and the Treasury regulations there under (relating to certain publicly- traded partnerships treated as corporations and including specifically Treas. Reg. section 1.7704–2(c) to (e)) apply. It is anticipated that the Secretary will issue guidance providing that the acquisition of foreign operating assets or stock of a foreign corporation by the existing 80/20 company for the purpose of increasing its active foreign business percentage will be treated as the addition of a substantial line of business.
Substitute dividends and dividend equivalent payments received by foreign persons treated as dividends
Explanation of Provision
The provision treats a dividend equivalent as a dividend from U.S. sources for certain purposes, including the U.S. withholding tax rules applicable to foreign persons.
A dividend equivalent is any substitute dividend made pursuant to a securities lending or a sale-repurchase transaction that (directly or indirectly) is contingent upon, or determined by reference to, the payment of a dividend from sources within the United States or any payment made under a specified notional principal contract that directly or indirectly is contingent upon, or determined by reference to, the payment of a dividend from sources within the United States. A dividend equivalent also includes any other payment that the Secretary determines is substantially similar to a payment described in the immediately preceding sentence. Under this rule, for example, the Secretary may conclude that payments under certain forward contracts or other financial contracts that reference stock of U.S. corporations are dividend equivalents.
A specified notional principal contract is any notional principal contract that has any one of the following five characteristics: (1) in connection with entering into the contract, any long party to the contract transfers the underlying security to any short party to the contract; (2) in connection with the termination of the contract, any short party to the contract transfers the underlying security to any long party to the contract; (3) the underlying security is not readily tradable on an established securities market; (4) in connection with entering into the contract, any short party to the contract posts the underlying security as collateral with any long party to the contract; or (5) the Secretary identifies the contract as a specified notional principal contract.670 For purposes of these characteristics, for any underlying security of any notional principal contract (1) a long party is any party to the contract that is entitled to receive any payment under the contract that is contingent upon or determined by reference to the payment of a U.S.-source dividend on the underlying security, and (2) a short party is any party to the contract that is not a long party in respect of the underlying security. An underlying security in a notional principal contract is the security with respect to which the dividend equivalent is paid. For these purposes, any index or fixed basket of securities is treated as a single security. In applying this rule, it is intended that such a security will be deemed to be regularly traded on an established securities market if every component of such index or fixed basket is a security that is readily tradable on an established securities market.
For payments made more than two years after the provision’s date of enactment (March 18, 2010), a specified notional principal contract also includes any notional principal contract unless the Secretary determines that the contract is of a type that does not have the potential for tax avoidance.
No inference is intended as to whether the definition of specified notional principal contract, or any determination under this provision that a transaction does not have the potential for the avoidance of taxes on U.S.-source dividends (or, in the case of a debt instrument, U.S.-source interest), is relevant in determining whether an agency relationship exists under general tax principles or whether a foreign party to a contract should be treated as having beneficial tax ownership of the stock giving rise to U.S.-source dividends.
The payments that are treated as U.S.-source dividends under the provision are the gross amounts that are used in computing any net amounts transferred to or from the taxpayer. The example of a ‘‘total return swap’’ referencing stock of a domestic corporation (an example of a notional principal contract to which the provision generally applies), illustrates the consequences of this rule. Under a typical total return swap, a foreign investor enters into an agreement with a counterparty under which amounts due to each party are based on the returns generated by a notional investment in a specified dollar amount of the stock underlying the swap. The investor agrees for a specified period to pay to the counterparty (1) an amount calculated by reference to a market interest rate (such as the London Interbank Offered Rate (‘‘LIBOR’’)) on the notional amount of the underlying stock and (2) any depreciation in the value of the stock. In return, the counterparty agrees for the specified period to pay the investor (1) any dividends paid on the stock and (2) any appreciation in the value of the stock. Amounts owed by each party under this swap typically are netted so that only one party makes an actual payment. The provision treats any dividend-based amount under the swap as a payment even though any actual payment under the swap is a net amount determined in part by other amounts (for example, the interest amount and the amount of any appreciation or depreciation in value of the referenced stock). Accordingly, a counterparty to a total return swap may be obligated to withhold and remit tax on the gross amount of a dividend equivalent even though, as a result of a netting of payments due under the swap, the counterparty is not required to make an actual payment to the foreign investor.
If there is a chain of dividend equivalents (under, for example, transactions similar to those described in Notice 97–66), and one or more of the dividend equivalents is subject to tax under the provision or under section 881, the Secretary may reduce that tax, but only to the extent that the taxpayer either establishes that the tax has been paid on another dividend equivalent in the chain, or that such tax is not otherwise due, or as the Secretary determines is appropriate to address the role of financial intermediaries in such chain. An actual dividend is treated as a dividend equivalent for purposes of this rule.
For purposes of chapter 3 (withholding of tax on nonresident aliens and foreign corporations) and chapter 4 (taxes to enforce reporting on certain foreign accounts), each person that is a party to a contract or other arrangement that provides for the payment of a dividend equivalent is treated as having control of the payment. Accordingly, Treasury may provide guidance requiring either party to withhold tax on dividend equivalents.
The rule treating dividend equivalents as U.S.-source dividends is not intended to limit the authority of the Secretary (1) to determine the appropriate source of income from financial arrangements (including notional principal contracts) under present law section 863 or 865 or (2) to provide additional guidance addressing the source and characterization of substitute payments made in securities lending and similar transactions.
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Repeal of the foreign targeted obligation exception to the registration requirement
Explanation of Provision
- Repeal of the foreign targeted obligation exception to the registration requirement
- Preservation of exception to the registration requirement for excise tax purposes
- Repeal of treatment as portfolio interest
- Dematerialized book-entry systems treated as registered form
- Repeal of exception to requirement that Treasury obligations be in registered form
1. Repeal of the foreign targeted obligation exception to the registration requirement
The provision repeals the foreign targeted obligation exception to the denial of a deduction for interest on bonds not issued in registered form. Thus, under the provision, a deduction for interest is disallowed with respect to any obligation not issued in registered form, unless that obligation (1) is issued by a natural person, (2) matures in one year or less, or (3) is not of a type offered to the public.
Also, the provision repeals the foreign targeted obligation exception to the denial of the tax exemption on interest on State and local bonds not issued in registered form. Therefore, under the provision, interest paid on State and local bonds not issued in registered form will not qualify for tax exemption unless that obligation (1) is not of a type offered to the public, or (2) matures in one year or less.
The Act preserves the ordinary income treatment under present law of any gain realized by the beneficial owner from the sale or other disposition of a registration-required obligation that is not in registered form. Similarly, the Act does not change the present law rule disallowing deductions for losses realized by a beneficial owner of a registration-required obligation that is not in a registered form.
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2. Preservation of exception to the registration requirement for excise tax purposes
Under the provision, the foreign targeted obligation exception is available with respect to the excise tax applicable to issuers of registration- required obligations that are not in registered form. Thus, the excise tax applies with respect to any obligation that is not in registered form unless the obligation (1) is issued by a natural person, (2) matures in one year or less, (3) is not of a type offered to the public, or (4) is a foreign targeted obligation.
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3. Repeal of treatment as portfolio interest
The provision repeals the treatment as portfolio interest of interest paid on bonds that are not issued in registered form but meet the foreign targeting requirements of section 163(f)(2)(B). Under the provision, interest qualifies as portfolio interest only if it is paid on an obligation that is issued in registered form and either (1) the beneficial owner has provided the withholding agent with a statement certifying that the beneficial owner is not a United States person (on IRS Form W–8), or (2) the Secretary has determined that such statement is not required in order to carry out the purposes of the subsection. It is anticipated that the Secretary may exercise its authority under this rule to waive the requirement of collecting Forms W–8 in circumstances in which the Secretary has determined there is a low risk of tax evasion and there are adequate documentation standards within the country of tax residency of the beneficial owner of the obligations in question or in the country where the book-entry system exists. Generally, however, as a result of the provision, interest paid to a foreign person on an obligation that is not issued in registered form is subject to U.S. withholding tax at a 30-percent rate, unless the withholding agent can establish that the beneficial owner of the amount is eligible for an exemption from withholding other than the portfolio interest exemption or for a reduced rate of withholding under an income tax treaty.
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4. Dematerialized book-entry systems treated as registered form
The provision provides that a debt obligation held through a dematerialized book entry system, or other book entry system specified by the Secretary, is treated, for purposes of section 163(f), as held through a book entry system for the purpose of treating the obligation as in registered form.553 A debt obligation that is formally in bearer form is treated, for the purposes of section 163(f), as held in a book-entry system as long as the debt obligation may be transferred only through a dematerialized book entry system or other book entry system specified by the Secretary.
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5. Repeal of exception to requirement that Treasury obligations be in registered form
The provision includes a conforming change to title 31 of the United States Code that repeals the foreign targeted exception to the definition of a registration-required obligation. Thus, a foreign targeted obligation of the Treasury must be in registered form.
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Treatment of certain dividends of regulated investment companies
Explanation of Provision
The provision extends the rules exempting from gross basis tax and from withholding tax the interest-related dividends and short term capital gain dividends received from a RIC, to dividends with respect to taxable years of a RIC beginning before January 1, 2012.
553- By reason of cross references, this rule will also apply to sections 165(j), 312(m), 871(h), 881(c), 1287 and 4701.
-Return to Explanation of Provision
670- Any notional principal contract identified by the Secretary as a specified notional principal contract will be subject to the provision’s general effective date described below.
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1277- Hence, this percentage is determined without application of the new aggregation rule.
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1278- A person will be treated as a related person with respect to a controlled foreigh corporation if (A) such person is an individual, corporation, partnership, trust, or estate which controls, or is controlled by, the controlled foreign corporation, or (B) such person is a corporation, partnership, trust or estate which is controlled by the same person or persons which control the resident controlled foreign corporation. For purposes of the preceding sentence, control means, with respect to a corporation, the ownership, directly or indirectly, of stock possessing more than 50 percent of the total voting power of all classes of stock entitled to vote or of the total value of stock of such corporation. In the case of a partnership, trust, or estate, control means the ownership, directly or indirectly, of more than 50 percent (by value) of the beneficial interests in such partnership, trust, or estate. For purposes of this paragraph, rules similar to the rules of section 958 shall apply. Sec. 954(d)(3).
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