871(m) Tax Code Explained: Delta Test, Withholding, and Refunds

Section 871(m) of the Internal Revenue Code applies a 30% U.S. withholding tax to payments that foreign investors receive from derivatives linked to U.S. stocks, treating those payments the same as if the investor had received an actual dividend.¹ Without the rule, a nonresident could use a swap or a structured note to capture the economic return of a U.S. stock, dividends included, while avoiding the withholding tax that would apply to owning the shares directly. Enforcement has been phased in since 2017, and as of 2026 only the most stock-like derivatives are actually subject to withholding.

What the Rule Taxes

Section 871(m) reaches three types of payments: substitute dividends made under securities loans and repurchase agreements that track a real U.S. dividend, payments under “specified notional principal contracts” tied to U.S. dividends, and any other payment the Treasury identifies as substantially similar.¹ In practice, that captures total return swaps, contracts for difference, and equity-linked notes.

The regulations also pull in equity-linked instruments that are not notional principal contracts, provided their price tracks the underlying stock closely enough. Whether a contract tracks the stock closely enough is decided by a numerical test.² Only the dividend-mimicking portion of the return is taxed. Capital gains on price movement in the derivative itself are not.

The Delta Test

Delta measures how much a derivative’s price moves in response to a small change in the price of the underlying stock. A delta of 1.0 means the derivative moves in lockstep with the stock. A delta of 0.5 means it captures roughly half the movement. Firms already calculate delta for risk management, and the regulations generally accept that figure for tax purposes as long as the calculation is commercially reasonable.²

The regulations sort derivatives into two buckets. A simple contract references a fixed number of shares of one underlying stock, known at issuance, with all payments tied to a single maturity or exercise date. A plain-vanilla option or a straightforward single-name total return swap fits here. Simple contracts are tested at issuance, and if the delta is 0.8 or above, the contract is a covered 871(m) transaction.²

Anything that is not simple is complex. That covers structured notes with variable share exposure and derivatives whose delta cannot be pinned down at issuance. Complex contracts skip the delta test and are run through a “substantial equivalence test” that compares their expected payoff at various stock prices to a benchmark simple contract.²

Where Enforcement Stands

The IRS began enforcing 871(m) in 2017 but only on “delta-one” transactions, meaning contracts with a delta of exactly 1.0 at issuance. Enforcement of non-delta-one contracts (delta of 0.8 up to but not including 1.0) and of complex contracts has been repeatedly deferred.

Under IRS Notice 2024-44, the rules for non-delta-one transactions do not apply to any contract issued before January 1, 2027. For delta-one transactions, the IRS said it will consider good-faith compliance efforts through 2026. The same good-faith standard applies to non-delta-one transactions during their first year of coverage in 2027.³

So through 2026, only derivatives that perfectly track a U.S. stock face mandatory withholding. Contracts at 0.8 or above but below 1.0, along with complex contracts that fail the substantial equivalence test, are scheduled to enter the withholding regime in 2027. Given how many times the IRS has pushed this date back, another extension is not out of the question.

The Qualified Index Exception

Derivatives that reference a “qualified index” instead of an individual stock sit outside 871(m). The regulations treat a qualified index as a single security that is not an “underlying security,” which is what keeps broad-market products like S&P 500 futures from triggering the tax.²

To qualify, an index must satisfy every one of these criteria:

It references at least 25 component securities.
It references only long positions, with limited exceptions.
No single U.S. stock exceeds 15% of the weighting, and no group of five or fewer U.S. stocks together exceeds 40%.
It is modified or rebalanced only under publicly stated, predefined rules.
Its U.S. component stocks’ aggregate dividend yield in the prior calendar year does not exceed 1.5 times the S&P 500’s dividend yield for that year.
Futures or options on the index trade on a registered national securities exchange or domestic board of trade.

The qualification is fixed on the first business day of the calendar year and stays in place for the whole year. A separate test governs indices where U.S. equities make up 10% or less of total weight. An index is also disqualified if related short positions cut exposure to component securities by more than 5% of the value of the long positions.²

Who Actually Pays

The tax applies to nonresident alien individuals and foreign corporations receiving dividend-equivalent payments from U.S. sources. Federal law taxes those parties at 30% on dividends and dividend-like income that is not connected to a U.S. business.¹ Whether you count as foreign turns on green card status or the substantial presence test, which counts you as a U.S. resident if you are physically present in the country for at least 31 days in the current year and 183 days across a weighted three-year lookback (all days this year, one-third of last year’s, one-sixth of the year before).⁴

U.S. citizens and resident aliens are already taxed on worldwide income under the normal income tax rules, so 871(m) does not reach them. The rule exists specifically for foreign investors who would otherwise collect dividend-like returns from U.S. companies with no tax collected at the source.

How the Withheld Amount Is Calculated

A dividend equivalent is the portion of a derivative’s return that stands in for a real cash dividend from a U.S. company. The statute treats that portion as a U.S.-source dividend, which is what makes it subject to the 30% rate.¹

For a simple contract, multiply the per-share dividend by the number of shares the contract references, then multiply by delta. A swap covering 1,000 shares of a stock that pays a $1.00 dividend at a delta of 1.0 produces a dividend equivalent of $1,000; at a delta of 0.9, the figure is $900. For complex contracts, the calculation substitutes the number of shares in the contract’s initial hedge for a fixed share count, because share exposure moves over the contract’s life.²

The taxable amount is the gross dividend equivalent, whether or not the foreign investor actually receives cash. A credit posted to the account is enough. The point is to match what a direct shareholder would have owed.

Treaty Relief and Refunds

Many foreign investors can reduce the 30% rate through a tax treaty between the U.S. and their home country. Treaty dividend rates commonly drop to 15%, and some treaties reduce the rate to zero for certain investors. Individuals claim the reduced rate by giving their broker a completed Form W-8BEN; entities use Form W-8BEN-E. The withholding agent then reports the payments and any tax withheld to the IRS on Form 1042-S after year end.

If withholding was too high, for example because a treaty rate should have applied but didn’t, the investor can file Form 1040-NR to claim a refund of the excess.

Who Withholds and What Happens If They Don’t

The legal duty to collect the tax sits with the withholding agent, usually the broker or financial institution handling the derivative. When a dividend-equivalent payment happens, the agent deducts 30% of the calculated amount at the source.¹ If the agent fails to withhold, it becomes personally liable for the full amount that should have been collected.⁵

The IRS can add penalties on top for failure to deposit, failure to file information returns, and negligence, and separate penalties can apply to late or incorrect Forms 1042-S.⁶ Interest runs on the unpaid amounts until they are cleared.

1
Office of the Law Revision Counsel. 26 USC 871 – Tax on Nonresident Alien Individuals
2
eCFR. 26 CFR 1.871-15 – Treatment of Dividend Equivalents
3
Internal Revenue Service. Extension of the Phase-in Period for the Enforcement and Administration of Section 871(m)
4
Internal Revenue Service. Substantial Presence Test
5
Office of the Law Revision Counsel. 26 USC 1461 – Liability for Withheld Tax
6
Internal Revenue Service. U.S. Withholding Agent Frequently Asked Questions