An Overview Of The Substantial Equivalence Test Under Internal Revenue Code Section 871(M)

Internal Revenue Code Section 871(m) and the regulations thereunder treat "dividend equivalent payments" on certain equity derivatives as dividends from sources within the United States.^{1, 2} That is, federal withholding tax applies to such payments made to non-U.S. parties.³

More specifically, the 871(m) regulations generally impose U.S. withholding tax on equity derivatives that reference one or more U.S. equities and that (i) have a delta greater than or equal to 0.8 (if the derivative is a "simple contract," as explained below) or (ii) fail a "substantial equivalence test" (if the derivative is a "complex contract," as explained below).⁴

A simple contract is, essentially, an equity derivative that has (i) a single, fixed number of shares of the underlying asset and (ii) a single exercise or maturity date.⁵ A complex contract is, essentially, an equity derivative that is not a simple contract and, therefore, for which computing delta would be conceptually