What Is the 871(m) Tax on Dividend Equivalent Payments?

The 871(m) tax on dividend equivalent payments is a 30% U.S. withholding tax that applies when a foreign investor receives a dividend-like economic benefit through a derivative that references U.S. stock. It exists to close a gap: without it, a non-resident could hold a swap or structured note that tracks a U.S. share, collect the value of its dividends through the contract, and pay nothing, while a direct shareholder in the same stock would be taxed at 30%. Through 2026, the IRS is only actively enforcing the rule against derivatives that move dollar-for-dollar with the underlying stock. Starting with transactions issued on or after January 1, 2027, enforcement is scheduled to extend to a broader set of derivatives with a delta of 0.80 or higher.1Internal Revenue Service. Notice 2024-44 – Extension of the Phase-In Period for the Enforcement and Administration of Section 871(m)

What Counts as a Dividend Equivalent Payment

A dividend equivalent payment is any economic benefit a foreign holder receives from a covered derivative that mirrors a dividend paid on the underlying U.S. stock. It doesn’t have to be labeled a dividend, and it doesn’t have to be cash. Price adjustments built into the derivative’s terms, credits to an account, and reductions in settlement amounts all count if they reflect a dividend event on the referenced stock.

The statute itself reaches three buckets of payments: substitute dividends tied to a U.S. dividend under a securities lending or repurchase agreement, contingent payments under a specified notional principal contract, and any other payment the Treasury Department determines to be substantially similar to those two.2Office of the Law Revision Counsel. 26 USC 871 – Tax on Nonresident Alien Individuals The third bucket is what lets the IRS pull new derivative structures into the rule as they appear.

The rate is 30% of the gross dividend equivalent.3Depository Trust & Clearing Corporation. 871(m) Announcements That matches the standard rate on a regular U.S. dividend paid to a foreign person, and the parity is intentional.

Which Derivatives Are Covered

Treasury regulations sort covered instruments into notional principal contracts and equity-linked instruments. Notional principal contracts are arrangements where the parties exchange payments based on a reference asset without transferring ownership of any shares. Total return swaps are the most common example. Equity-linked instruments cover a broader group, including structured notes, convertible debt, forwards, and certain options that derive value from U.S. equities.

Equity-linked instruments are then split into simple and complex contracts. A simple contract references a fixed, known number of shares of one or more issuers at issuance. A complex contract is everything else, including contracts where the share count moves with market conditions.

For simple contracts, the test is delta. Delta measures how much the derivative’s value changes when the underlying stock moves: 1.0 means dollar-for-dollar tracking, 0.50 means capturing about half the price movement. If the delta at issuance is 0.80 or higher, the contract is a covered 871(m) transaction.4KPMG. Section 871(m) Final and Temporary Regulations Released The delta is fixed at issuance and doesn’t get retested in the secondary market, so a derivative that starts below 0.80 stays outside the rule even if later market moves push its effective delta higher.

Complex contracts skip the delta test and instead run a “substantial equivalence” test. The underlying stock’s price is hypothetically shifted up and down by one standard deviation, and the contract’s change in value is compared to what a direct hedge in the shares would do. If the complex contract’s economic exposure is at least as close to the stock as a simple contract with a delta of 0.80, it’s treated as substantially equivalent and falls under the rule.4KPMG. Section 871(m) Final and Temporary Regulations Released

What Actually Applies Now, and What Changes in 2027

This is where most confusion sits. The IRS has been phasing in 871(m) since 2017 and has repeatedly pushed out the broader rules. Under Notice 2024-44, the current state is straightforward:

The good-faith standard is also extended into 2027 for the newly covered non-delta-one transactions as the market adjusts. Because the IRS has delayed the non-delta-one effective date several times since the regulations were finalized in 2015, watch for further extensions. The 2027 date in Notice 2024-44 is the current operative timeline.

Reducing the 30% Rate Under a Treaty

Foreign investors resident in countries with a U.S. income tax treaty can often claim a reduced rate on dividend income. Common treaty rates on dividends are 15%, 10%, or 0%, depending on the treaty and the investor’s status.5Internal Revenue Service. Table 1 – Tax Rates on Income Other Than Personal Service Income Under Chapter 3, Internal Revenue Code, and Income Tax Treaties Because 871(m) treats a dividend equivalent as a dividend from U.S. sources, those treaty rates apply to derivative payments the same way they apply to a regular stock dividend.6Practical Law. IRS Further Delays Until 2027 Section 871(m) Withholding on Non-Delta One Equity Derivatives and Extends Phase-In Relief

To get the reduced rate, you have to give the withholding agent the right documentation before the payment is made. Individuals file Form W-8BEN; entities file Form W-8BEN-E. Both forms certify foreign status, claim beneficial ownership of the income, and identify the treaty article being invoked. A U.S. or foreign taxpayer identification number is generally required, though there is an exception for certain marketable securities.7Internal Revenue Service. Claiming Tax Treaty Benefits Without a valid form on file, the agent must apply the full 30%.

The Qualified Index Exception

Derivatives that reference a broad, passive market index rather than individual stocks can be exempt. A diversified index isn’t a practical tool for targeting one company’s dividends, so the tax-avoidance concern behind 871(m) doesn’t bite in the same way.

The regulations define a “qualified index” with specific criteria, and the bar is higher than many market participants expect:

  • The index must reference at least 25 component securities.
  • No single underlying security can represent more than 15% of the index’s weight, and no five underlying securities together can exceed 40%.
  • The index’s prior-year annual dividend yield from underlying U.S. securities cannot exceed 1.5 times the S&P 500’s annual dividend yield for the same year.
  • The index must be modified or rebalanced according to publicly stated, predefined criteria.
  • The index must be traded through futures or option contracts on a registered national securities exchange or qualifying foreign exchange.
8eCFR. 26 CFR 1.871-15 – Treatment of Dividend Equivalents

A separate safe harbor covers indices that mostly reference non-equity assets. If U.S. underlying securities make up 10% or less of the index’s weight, the index is widely traded, and it wasn’t created with a principal purpose of avoiding U.S. withholding tax, the index qualifies without meeting the other criteria.8eCFR. 26 CFR 1.871-15 – Treatment of Dividend Equivalents The S&P 500 is a common example of an index that meets the primary qualified index test.

Structuring Below 0.80 Is Not a Safe Harbor

The regulations contain an anti-abuse rule in Treasury Regulation 1.871-15(o) that operates as a backstop throughout the phase-in period. Even if a transaction would otherwise escape the rule because its delta is below 0.80 or because it was entered into before the non-delta-one effective date, the IRS can still treat it as a covered 871(m) transaction if the arrangement was designed to avoid the withholding tax.9PwC. Section 871(m) Dividend Equivalent Rules Phase-In Period Extended

A related combination rule lets the IRS aggregate two or more transactions entered into “in connection with” each other and test the combined position against the 0.80 delta threshold, so splitting a single economic position into smaller derivatives doesn’t work.

If Too Much Was Withheld

When more tax was withheld than the investor actually owed, a foreign investor can claim a refund by filing Form 1040-NR. This most often happens when the treaty documentation wasn’t on file at the time of payment and the agent applied the full 30%, or when withholding was applied to a transaction that turns out not to be covered.

There’s a simplified filing route for nonresident aliens whose only U.S. tax obligation was satisfied through withholding at source. You complete Form 1040-NR with Schedule NEC and Schedule OI, report the dividend equivalent income, and enter the withheld tax shown on Form 1042-S. The gap between the correct liability and the amount withheld comes back as a refund.10Internal Revenue Service. Instructions for Form 1040-NR (2025) If you’re claiming treaty benefits on the refund return, identify the specific treaty article and attach Form 8833 if required. Attach copies of any Form 1042-S showing the withheld amounts.

Who Withholds and Reports

The obligation to withhold, deposit, and report the tax sits with the withholding agent, typically the U.S. broker, dealer, or financial intermediary closest to the foreign investor in the payment chain. The agent has to determine whether the transaction is covered, identify the beneficial owner’s tax status, apply the correct rate, and deposit the tax with the IRS.

Reporting uses two forms. Form 1042-S is filed for each recipient to report income paid and tax withheld, including 871(m) dividend equivalents.11Internal Revenue Service. Instructions for Form 1042-S Form 1042 is the agent’s annual return summarizing chapter 3 and chapter 4 withholding for the year.12Internal Revenue Service. About Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons An agent that fails to withhold when required can become personally liable for the tax that should have been collected, plus interest.