Section 871(m) is a set of US tax regulations designed to prevent non-US investors from avoiding US withholding tax on dividends by using equity derivatives instead of directly holding dividend-paying US stocks. They impact many non-US banks, brokers, and other financial institutions that issue, trade, and hold contracts over US equities.
Historically, instruments like swaps and certain options that reference US equities fell outside the scope of US withholding rules. To close this loophole, the IRS introduced Section 871(m), which treats dividend equivalent payments (DEPs), income that replicates the economic effect of a dividend, as if they were actual dividends. As a result, these payments are generally subject to a 30% US withholding tax, unless reduced by an applicable tax treaty.
The rules apply to derivative contracts linked to US equities, such as swaps, forwards, options, and securities lending arrangements, when they closely track the performance of the underlying stock.
Currently, the regulations are limited to 'delta-one' instruments (those with a delta of 1.0). However, from January 1, 2027, the scope will expand to include derivatives with a delta of 0.8 or higher, significantly widening the range of in-scope transactions.
Crucially, the combination rule will also come into effect. This means institutions must evaluate whether multiple offsetting positions, when viewed together, result in a combined delta of 0.8 or more, potentially bringing many previously excluded transactions into scope.
The upcoming 2027 expansion of Section 871(m) presents significant compliance and operational challenges, particularly for brokers, custodians, and investment funds.
Responsibility for withholding and reporting typically lies with the withholding agent, often the short party in a transaction. However, if they fail to meet their obligations, the burden can shift downstream to custodians or other intermediaries, increasing risk across the chain.
The anti-abuse rule allows the IRS to target transactions designed to skirt the rules, even if they appear compliant on the surface.
From a technology and operations perspective, many firms have relied on manual processes or tactical workarounds during the phase-in period. Some institutions may have even paused further preparations, assuming they aren't exposed to delta-one instruments. However, with full enforcement on the horizon, these stopgap measures are unlikely to be sustainable. Automation and robust controls are becoming a top priority, especially as the broader market moves toward compliance and seeks to minimise withholding tax exposures.
With the 2027 deadline approaching, early preparation is essential. Financial institutions should take proactive steps to ensure readiness for the expanded Section 871(m) rules:
Identify in-scope products following the expanded scope resulting from the reduction of the delta threshold to 0.8. Be sure to include instruments that may fall under the combination rule, which aggregates multiple positions to determine overall delta exposure.
Clarify your institutional role (whether as an issuer, broker, fund, or custodian) to assess whether you meet the definition of a dealer under US regulations. This determination is critical in understanding who holds responsibility for withholding and reporting obligations.
Engage with upstream and downstream counterparties to confirm roles and responsibilities. Ensure appropriate documentation is in place to minimise the impact on cashflows from in-scope products.
Evaluate current systems and processes. Given the expanded scope, manual compliance will be increasingly difficult. Prioritising automation and systems integration will be essential for sustainable compliance.
Consider applying for qualified derivatives dealer (QDD) status under a qualified intermediary (QI) agreement if your institution trades equity derivatives. While QDD status can help avoid double withholding, it introduces additional compliance obligations, particularly certification requirements to the IRS. Institutions must also assess which transactions fall within the QDD capacity, which can be complex.
During the transition period up to 1 January 2027, demonstrating ‘good faith compliance’ is essential, particularly for institutions that are QDDs. This involves assessing the impact of the expanded rules, investing in system upgrades, maintaining robust documentation, training staff, and showing sustained efforts to meet IRS expectations. Given that the start date for the expanded rules has already been deferred several times, it's important for institutions to stay closely aligned with regulatory developments and to establish processes that can adapt to further changes.
The expansion of 871(m) in 2027 marks a significant shift in the tax landscape for US-based equity derivatives. Institutions that prepare early by modernising systems, clarifying responsibilities, and embedding compliance into their operations will be well-positioned to navigate the changes smoothly and alleviate risk.
Those that delay could face administrative headaches, penalties, and reputational issues. Proactive planning today is the key to staying compliant tomorrow.
For more information contact Martin Killer.
