As hot U.S. tech stocks seem to only get hotter, many investors may be considering getting in on the action. But as James Causton of transaction monitoring service SIX explores, an obscure IRS regulation could see many investor gains chomped by taxes.
The world is currently witnessing an unprecedented surge in technological disruption. The rapid advancement in the capabilities of generative artificial intelligence (AI) models like those created by Microsoft’s OpenAI, Google’s Gemini and Meta Platforms’ Bard, combined with the significant growth in revenue of Big Tech firms, has created a trading frenzy in trending U.S. tech stocks. And who can forget the astonishing run of Nvidia, the chip behemoth that has captivated investors, achieving a market capitalization of over $2 trillion?
Known as the Magnificent Seven or Mag 7, these high-performing tech companies have asserted themselves as clear leaders in the Big Tech boom. Included in the posse are Nvidia, Apple, Amazon, Alphabet, Microsoft, Tesla and Meta. Together, they account for half of the weighting of the Nasdaq index and have been driving the S&P 500. In 2023, the Bloomberg Magnificent 7 Total Return Index advanced 107%, versus the overall S&P 500 Index at 24%.
As investors seek to supercharge their returns in these high-flying stocks, there has been a significant increase in the popularity of derivatives trading. According to UBS, retail trading now accounts for 42% of total equity options volumes, up from 30% at the beginning of 2019. The worldwide volume of exchange-traded derivatives reached 16.3 billion contracts in February 2024, the second-highest level ever recorded.
While derivatives trading in U.S. stocks presents exciting opportunities for investors to amplify their returns, it also comes with additional risks, particularly from the IRS. Section 871(m) is a U.S. tax regulation that treats payments on certain financial instruments as “dividend equivalent payments” with a U.S. source. This means that non-U.S. investors trading in derivatives of U.S. dividend-paying stocks could potentially face a 30% withholding tax on their returns.
Recently, Alphabet, the parent company of Google, announced its first-ever dividend to great investor fanfare. The company declared a 20-cent-per-share dividend, and its board authorized the repurchase of up to $70 billion in stock. This announcement has significant implications for investors trading in derivatives of Alphabet’s stock. Under Section 871(m), any returns from these derivatives could be subject to 30% tax withholding. Those caught out may end up paying significantly more.
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Over the past decade, the IRS has extended certain transitional relief for the implementation of Section 871(m) withholding for transactions that do not meet the requisite high delta threshold. However, as of May 2024, this relief period has since been once again extended until Jan. 1, 2027, an additional two-year delay to the regulation for non-delta one equity derivatives. After this date, the regulation will begin to apply more broadly, impacting a larger number of financial instruments.
One significant change is the adjustment of the delta threshold. Currently, only “delta one” transactions are in scope for Section 871(m) withholding. However, subject to IRS confirmation, from January 2027, transactions with a delta less than 1 but greater than 0.8 (known as “delta 0.8” transactions) will also be in scope. This means that more transactions will be subject to the 30% tax withholding under Section 871(m), potentially affecting a larger number of investors.
In addition, the combined transaction rules will also come into effect. These rules treat two or more transactions as a combined transaction if they reference the same underlying security, are entered into in connection with each other and the potential payout is calculated by reference to the same dividend payment.
Section 871(m) is a complex piece of legislation that investors need to understand when trading in derivatives of U.S. dividend-paying stocks. The measure can have significant tax implications and could see unaware investors being caught out.
Determining which instruments are in scope is a difficult task that requires a thorough understanding of equity-linked derivatives. Without the in-depth knowledge of derivatives’ delta, constituents, weighting and performance, it makes this a near-impossible task to complete.
By continually monitoring dividend payments on the underlying instruments used by 871(m)-relevant derivatives, firms can ensure they have an accurate, timely and reliable identification of the in scope securities. Given the recent dividend announcement by Alphabet and the popularity of U.S. tech stocks, compliance under section 871(m), despite its extension in the relief period, remains more relevant than ever.
James Causton is a regulatory sales consultant at SIX financial information, supporting the sales organisation as a sanctions, tax and regulatory SME pitching its diverse portfolio of data service offerings for financial institutions in the Atlantic region across the buy and sell-side.
