What Are Dividend Equivalents and How Are They Taxed?

Dividend equivalents are cash payments made under a derivative contract that replicate the dividend a shareholder would receive on the referenced stock, without any actual share ownership. For non-U.S. investors, Section 871(m) of the Internal Revenue Code treats these payments as U.S.-source dividends and subjects them to 30% federal withholding, unless a tax treaty reduces the rate. For U.S. investors, the same cash flows are generally taxed as ordinary income rather than as qualified dividends.

What a Dividend Equivalent Payment Is

A dividend equivalent is money exchanged between two counterparties in a derivative contract that mirrors the dividend a shareholder would have received on the underlying stock. The company that issued the stock is not involved. The payment comes from the counterparty on the other side of the derivative, not from corporate assets. If a company declares a $1.00 per-share dividend and a swap references 1,000 of those shares, the paying counterparty owes a $1,000 dividend equivalent.

The federal regulations define a dividend equivalent as any payment referencing a U.S.-source dividend that arises from a securities lending or repurchase transaction, a specified notional principal contract, a specified equity-linked instrument, or any other substantially similar arrangement.¹ That final catch-all lets the IRS pull in new transaction types as products evolve.

The economic result closely resembles a dividend, but the legal mechanics do not. An actual dividend is declared by a corporate board and paid from company profits. A dividend equivalent is a private contractual obligation. If the counterparty defaults, the long party has no claim against the underlying company.

Where Dividend Equivalents Come From

Three main transaction types produce these payments.

Securities Lending and Repurchase Agreements

When shares are lent, the borrower becomes the legal owner and collects any dividend paid during the loan. Loan agreements typically require the borrower to “manufacture” an equivalent payment back to the lender. Repurchase agreements work the same way: the interim buyer receives the dividend during the repo term and owes a matching payment to the original owner. The statute expressly treats these manufactured payments as dividend equivalents.²

Notional Principal Contracts

Total return swaps are the common example. One party pays the full economic return on a stock or basket, including dividends, while the other pays a financing rate. The dividend piece of that total return leg is a dividend equivalent. A notional principal contract becomes a “specified” contract subject to the withholding rules when it meets the delta threshold discussed below.²

Equity-Linked Instruments

“Equity-linked instrument” is a catch-all for a financial transaction that references a stock’s value but is neither a notional principal contract nor a lending or repo arrangement. Structured notes, convertibles, and certain exchange-traded products fall here. An equity-linked instrument becomes specified when it meets the same delta threshold that applies to notional principal contracts.³

How Non-U.S. Investors Are Taxed

Section 871(m) treats a covered dividend equivalent as a U.S.-source dividend for withholding purposes.² The withholding agent making the payment must deduct 30% of the gross amount, the same rate that applies to actual dividends paid to nonresident aliens under Section 1441.⁴ An income tax treaty between the investor’s country of residence and the United States can reduce that rate.

The withholding agent is generally the financial institution or broker-dealer on the paying side of the derivative. That agent calculates the dividend equivalent amount and remits the tax. For a simple contract, the amount subject to withholding equals the per-share dividend multiplied by the number of referenced shares multiplied by the contract’s delta. Delta matters because not every derivative moves one-for-one with the underlying stock.

Which Contracts Are Covered: The Delta Test

Not every derivative that references a dividend-paying stock is caught by Section 871(m). The regulations use delta, which measures how much a derivative’s value changes in response to a small change in the underlying stock’s value. A delta of 1.0 tracks the stock perfectly. A delta of 0.5 captures roughly half the price movement.³

A simple notional principal contract or equity-linked instrument is specified, and therefore subject to withholding, when its delta is 0.8 or greater at issuance.³ Complex contracts without a single calculable delta run through a “substantial equivalence test” that compares the payout profile to holding the underlying stock. Delta is generally set once, at issuance.

The regulations also block simple splitting. When multiple transactions are entered into in connection with one another, such as a long call and a short put that together synthesize stock ownership, their deltas can be combined to reach the 0.8 threshold. Withholding agents may presume transactions are independent if they are held in separate accounts or entered more than two business days apart, but that presumption falls away if the agent has actual knowledge that the positions are connected.

What Is Actually Being Withheld On Right Now

The IRS has phased in Section 871(m) in stages, and the phase-in still governs what is covered. Through 2026, withholding applies only to “delta-one” transactions, meaning derivatives that track the underlying stock essentially one-for-one. The broader rule reaching contracts with a delta of 0.8 or higher does not apply to contracts issued before January 1, 2027.⁵

In practical terms, a non-U.S. investor holding a delta-one swap on a U.S. stock in 2026 faces withholding on the dividend equivalent. The same investor holding a derivative with a delta of 0.9 does not, at least not yet. The combination rule for multiple linked transactions is expected to take full effect on the same 2027 date.⁵

The IRS has applied a “good faith effort” enforcement standard during the transition. For delta-one transactions through 2026, and for non-delta-one transactions in 2027, the agency will consider whether a withholding agent made a genuine attempt to comply before pursuing penalties.⁵ The anti-abuse rule is a separate matter and remains fully in effect at all times, so a transaction structured specifically to avoid 871(m) can still be reclassified regardless of the phase-in schedule.⁶

The Qualified Index Carve-Out

Derivatives linked to broad equity indices are generally exempt. A diversified index is not an efficient way to replicate any single stock’s dividend stream, so the regulations carve out derivatives referencing a “qualified index.”

The most consequential conditions in practice are:

The index references at least 25 component securities.
No single U.S. stock exceeds 15% of the index, and the top five U.S. positions together do not exceed 40%.
The index is rebalanced only under publicly stated, predefined rules.
The prior-year U.S. equity dividend yield of the index does not exceed 150% of the S&P 500’s dividend yield for the same period.
Futures or options on the index trade on a registered U.S. exchange or a qualifying foreign exchange.

There is a shortcut: an index automatically qualifies if it is widely traded, U.S. equities make up 10% or less of its weight, and it was not created to avoid withholding tax. The qualified index determination is made annually on the first business day of each calendar year.

Qualified Derivatives Dealers

Derivatives often pass through an intermediary, such as a dealer standing between two counterparties. Without special rules, that dealer could receive a dividend equivalent on one side and pay one on the other, generating withholding at each step even though the economic dividend flows through to a single ultimate party.

The IRS allows eligible entities to apply for Qualified Derivatives Dealer status under a qualified intermediary agreement. A QDD can receive and make dividend equivalent payments without incurring cascading withholding on the same underlying dividend flow. The tradeoff is heavy compliance work, including detailed certification and reporting to the IRS. Institutions with substantial equity derivatives books often find it worthwhile.

How U.S. Investors Are Taxed

Section 871(m) and its 30% withholding regime apply only to non-U.S. persons. A U.S. taxpayer receiving a dividend equivalent through a derivative is generally taxed on it as part of the derivative’s overall income, not as a separate dividend. A total return swap payment, for instance, is typically ordinary income to the recipient, not a qualified dividend eligible for preferential capital gains rates, even though the cash flow tracks an actual dividend.

The term also shows up frequently in equity compensation. Holders of restricted stock units often receive dividend equivalent payments matching dividends paid on the underlying company shares during the vesting period. Those payments are treated as wages and subject to income tax and payroll taxes when paid, not as investment dividends.

The practical difference is meaningful. A U.S. investor holding shares directly might pay tax on qualified dividends at 15% or 20%. The same investor receiving economically identical cash flows through a total return swap or an RSU dividend equivalent will typically owe tax at ordinary income rates, which can be roughly double. Structure, not just the dollar amount, drives the tax bill.

1
GovInfo. 26 CFR 1.871-15 – Treatment of Dividend Equivalents
2
Office of the Law Revision Counsel. 26 USC 871 – Tax on Nonresident Alien Individuals
3
eCFR. 26 CFR 1.871-15 – Treatment of Dividend Equivalents
4
Office of the Law Revision Counsel. 26 USC 1441 – Withholding of Tax on Nonresident Aliens
5
Internal Revenue Service. Notice 2024-44 – Extension of the Phase-in Period for Section 871(m)
6
Internal Revenue Service. Notice 2016-76 – Enforcement and Administration of Section 871(m)