The Problematic Delta Test for Dividend Equivalents

Prop. reg. section 1.871-151 suggests a protocol for ensuring that U.S.-source dividends embedded in specified derivative instruments2 are subject to withholding tax. This article highlights problems with the use of delta in prop. reg. section 1.871-15 and suggests how the regulations might be revised. Although the alternatives we discuss have some problems, substantial improvements are possible, and we describe how they might best be achieved. The proposed regulations define delta as ‘‘the ratio of the change in the fair market value of [a contract] to the change in the fair market value of the property referenced by the [contract],’’ with the denominator being calculated as the change in value of the number of shares ‘‘referenced’’ by an instrument.3 An instrument is subject to the regulations only if the delta is at least 0.7 when the long party4 acquires the contract. This definition of delta can be decomposed into two factors in the following way: