What Is a Dividend Equivalent and How Is It Taxed?

Dividend equivalents are payments designed to capture the economic substance of a dividend, even when the underlying stock is not directly owned. They are a significant aspect of financial transactions involving U.S. equities. Understanding dividend equivalents is important for investors and financial institutions navigating U.S. tax regulations. The rules primarily aim to ensure equitable tax treatment and prevent certain forms of tax avoidance.

Understanding Dividend Equivalents

A dividend equivalent is a payment that mirrors the income an investor would receive from a traditional dividend on a financial instrument. Unlike a direct dividend, which is a distribution of a company’s profits to its shareholders, a dividend equivalent arises from a derivative contract that references the underlying stock’s dividend. This distinction is important because the payment is made pursuant to the terms of the derivative, not directly from the issuing company.

The concept behind dividend equivalents aims to prevent tax avoidance, especially for non-U.S. persons who might otherwise use derivative instruments to receive U.S.-source income without incurring applicable withholding taxes. Internal Revenue Code Section 871(m) defines what constitutes a dividend equivalent. These rules treat specific payments on equity-linked instruments as if they were U.S.-source dividends, subjecting them to U.S. tax and withholding. The goal is to ensure that non-U.S. investors engaging in transactions that synthetically provide dividend exposure are taxed similarly to those who directly own U.S. equities. This helps maintain a level playing field.

The amount of a dividend equivalent is generally determined by reference to the actual per-share dividend paid on the underlying security. For instance, in a securities lending or sale-repurchase transaction, the dividend equivalent is typically the actual dividend amount per share multiplied by the number of shares referenced. For more complex contracts, such as options or swaps, the dividend equivalent calculation often incorporates a “delta,” which represents the sensitivity of the derivative’s price to changes in the underlying asset’s price. A higher delta indicates a closer economic correlation to owning the underlying stock.

Financial Instruments Generating Dividend Equivalents

Dividend equivalents can arise from various financial instruments and transactions that provide an economic return similar to holding direct equity, but without actual share ownership. These instruments allow investors to gain exposure to the price movements and dividend payouts of underlying U.S. equities synthetically. The primary categories include securities lending and sale-repurchase (repo) transactions, notional principal contracts (NPCs), and equity-linked instruments (ELIs). Each of these structures can create a scenario where a payment is made in lieu of a direct dividend, thus triggering the dividend equivalent rules.

In securities lending, an owner of shares temporarily transfers them to a borrower, who then pays a substitute dividend to the original owner during the loan period. Similarly, in a repurchase agreement, the seller retains economic interest in the securities, and any dividends paid during the transaction are passed back as dividend equivalents from the buyer. These arrangements are common in financial markets for liquidity and hedging purposes. Their purpose is to prevent the circumvention of U.S. withholding tax on dividend income that would otherwise apply to foreign investors.

Notional principal contracts (NPCs), such as equity swaps, involve an exchange of payments based on a notional amount or index, where one leg of the swap references dividend payments. These contracts allow parties to gain exposure to equity returns, including dividends, without owning the underlying shares. Equity-linked instruments (ELIs) include options, futures, and structured notes whose value is linked to U.S. equity performance and dividends. For these instruments, if their “delta”—a measure of their price sensitivity to the underlying stock—is 0.80 or greater at the time of issuance, they are considered “in-scope” for dividend equivalent rules. This delta threshold helps identify instruments that closely replicate direct equity ownership.

Taxation and Withholding

The taxation of dividend equivalents primarily targets non-U.S. persons to ensure U.S.-source income is appropriately taxed. Under Internal Revenue Code Section 871(m), dividend equivalents are treated as U.S.-source dividends for tax and withholding purposes. They are generally subject to a flat 30% U.S. withholding tax when paid to nonresident alien individuals, foreign corporations, or other foreign organizations. This withholding obligation falls on the U.S. or foreign financial institution acting as a withholding agent.

Income tax treaties between the United States and other countries can reduce or eliminate this 30% withholding tax rate. For a non-U.S. person to claim treaty benefits, they typically need to provide proper documentation, such as a Form W-8BEN or W-8BEN-E, certifying their foreign status and eligibility for treaty rates. Many treaties include a “Limitation on Benefits” (LOB) provision, which is designed to prevent treaty shopping—the practice of residents of third countries using a treaty country entity to improperly claim treaty benefits. LOB clauses ensure that only genuine residents of treaty countries can access reduced withholding rates.

A Qualified Derivatives Dealer (QDD) status is available for financial institutions that deal in derivatives and elect to assume primary withholding and reporting responsibilities under Section 871(m). QDDs typically operate under a Qualified Intermediary (QI) agreement with the IRS. This status allows QDDs to receive U.S. dividend and dividend equivalent payments without U.S. withholding tax, provided they meet IRS requirements. The QDD is responsible for calculating and applying the appropriate withholding tax rate when making dividend equivalent payments to their own counterparties. This structure helps prevent multiple layers of withholding tax in complex derivative chains.

For U.S. persons, dividend equivalents are generally treated as ordinary income or capital gains, similar to how actual dividends are taxed. Unlike non-U.S. persons, U.S. individuals and entities are typically subject to income tax on their worldwide income, so the specific withholding rules under Section 871(m) are not directly applicable to them. U.S. persons report dividend income and related gains or losses on their regular tax returns, often receiving a Form 1099-DIV for traditional dividends from corporations. The distinct treatment for non-U.S. persons underscores the primary purpose of Section 871(m) to capture U.S.-source income for foreign investors.

Reporting Requirements

Compliance with dividend equivalent rules involves specific reporting obligations for financial institutions and other withholding agents. The primary form used for reporting dividend equivalent payments to non-U.S. persons is Form 1042-S, “Foreign Person’s U.S. Source Income Subject to Withholding.” This form is filed by the withholding agent, which is typically a financial institution or other payer, to report the amounts paid and any U.S. tax withheld from non-U.S. beneficial owners. Form 1042-S must be filed even if no tax was actually withheld due to a treaty exemption or other reasons.

Form 1042-S includes specific income codes for various types of dividend equivalents, such as substitute dividends and dividend equivalents resulting from combined transactions. Withholding agents must accurately identify the income type, the amount of the dividend equivalent, the tax rate applied, and the amount of tax withheld. The annual deadline for filing Form 1042-S with the IRS is generally March 15th of the calendar year following the payment. Copies of Form 1042-S are also furnished to the recipients of the dividend equivalent payments, allowing them to report the income and any withheld tax on their own tax returns.

Beyond Form 1042-S, financial institutions involved in Section 871(m) transactions have additional internal record-keeping requirements. They must maintain sufficient information to determine whether a transaction falls under Section 871(m) and to calculate the amount of any dividend equivalent. This includes documentation and workpapers supporting delta calculations or substantial equivalence determinations. These detailed records are important for IRS audits and examinations. The overall reporting framework ensures transparency and accountability in the taxation of synthetic dividend income, reinforcing the U.S. government’s ability to monitor and enforce its tax laws on cross-border financial activities.