The regulations adopt a two-part test to determine if a derivative instrument is subject to the rules. First, the derivative instruments must reference the dividend on a U.S. equity security. Examples include:
- equity options
- regulated index futures and options on index futures
- structured and exchange traded notes
- CFD contracts
- convertible bonds
- securities lending transactions
- derivatives on custom baskets and
- warrants
If the underlying position is a U.S. equity, the exchange upon which the instrument is traded and the identity of the counter-party do not affect the application of the rules. That is, a derivative can be subject to the rules, whether it is exchange-listed or over-the-counter or trades in the United States or overseas.
Second, the derivative instrument must substantially replicate the economics of the underlying U.S. equity at the time of issuance. The rules look to delta (for simple contracts) and a substantial equivalency test (for complex contracts) to make this determination.
Delta is a correlation measurement that computes the ratio of the change in the fair market value of the derivative instrument to a change in the fair market value of the U.S. equity referenced by the derivative. In general, for purposes of this regulation, delta is only determined once over the life of the derivative instrument – at the time it is ‘issued’. It is not recomputed as the fair market value of the underlying security changes or when the derivative instrument is re-sold in the secondary market.
For most contracts, the rules are as follows:
- Pre-2017 – a derivative instrument issued prior to January 1, 2017 (i.e., anything held by a customer with us on December 31, 2016) is not subject to the new withholding tax rules.
- 2017 - a derivative instrument issued in 2017 is potentially subject to the new withholding tax regime if the delta at the time of issuance is 1.0.
- After 2017 – a derivative instrument issued after December 31, 2017 is potentially subject to the new withholding tax rules if the delta at the time of issuance is 0.8 or greater.
If the derivative is classified as “complex,” the delta test does not apply and instead the substantial equivalency test applies.