Originally Posted on 4/13/17
In order to implement measures to address U.S. offshore tax evasion and aggressive tax avoidance strategies, the U.S. Treasury and Internal Revenue Service (IRS) have introduced a large number of changes to U.S. tax regulations. The most significant change to the U.S. tax code in the last decade was the introduction of the Foreign Account Tax Compliance Act (FATCA) which has changed how non-U.S. financial institutions identify account holders and has influenced global rules for financial institutions to identify the countries in which their account holders are tax resident(s).
The IRS has recently shifted their attention to providing FATCA-related guidance and clarity on regulations designed to bring into the scope of the U.S. non-resident tax regime payments that reference U.S. source dividends – notably those associated to derivative instruments that are highly correlated to U.S. equities (“dividend equivalents”). These rules are of relevance to parties that issue, invest in, or act as intermediary for such financial instruments.
Final regulations modifying this area of the U.S. tax code (IRC Section 871(m)) went into effect January 1, 2017.
This issue of our In Focus series intends to provide answers to questions frequently raised by Brown Brothers Harriman (BBH) clients about U.S. non-resident tax on dividend equivalent amounts under IRC Section 871(m), and the Qualified Derivatives Dealer (“QDD”) account type introduced by these regulations.
Questions and Answers:
What is Section 871(m) and why was it introduced?
As background, U.S. source dividend payments are subject to a 30% withholding tax (subject to reduction under tax treaty) when paid to a non-U.S. investor. Before the introduction of Section 871(m), payments from derivative instruments (e.g. equity swaps) referencing U.S. dividends were considered to be sourced to the investor, and therefore out of scope for the purposes of U.S. sourced withholding where the investor was non-U.S.
After investigation, the U.S. Congress believed that these derivatives were being used by non-U.S. investors (such as hedge funds) to avoid withholding tax on U.S. dividends, and the IRS responded by introducing changes to Section 871(m) regulations to bring them into the scope of U.S. nonresident alien (USNRA) and FATCA withholding taxes.
|An example of a trade that the IRS viewed as problematic: Foreign hedge fund (F) owns shares of U.S. equity. Shortly before dividend ex-date, F transfers its shares to a bank and simultaneously enters into an equity swap for the referenced shares. This permitted F to receive a dividend equivalent amount under the equity swap free of U.S. withholding tax, and to reacquire the stock shortly after the dividend payment.|
These regulations introduce new rules for U.S. withholding tax on ‘Dividend Equivalents’ (DEs), that reference dividends paid by U.S. securities. Such DEs are to be treated as sourced from the U.S. and the rules bring them in scope for withholding and reporting under USNRA and FATCA.
What financial instrument/transaction is “in-scope” for determining withholding under 871(m)?
A financial instrument is in-scope where, at the time of its issuance, the economic return of the transaction is highly correlated to the underlying U.S. equity on which the instrument or transaction is based (e.g. total return swap has perfect correlation of 1–see ‘Delta test’ below for further details).
It is important to note that these rules will only apply to derivatives that are issued on or after January 1, 2017 (the effective date of the regulations) as for 2017 only financial instruments or transactions issued with a perfect correlation of one are in scope for 871(m) withholding. From January 1, 2018, derivatives that have a delta of 0.8 to 0.99 will come into scope of the regulations.
Any DE made with respect to an in-scope instrument will be subject to a 30% withholding tax (or less under a tax treaty) upon their payment or upon the termination of the instrument (including by offset or lapse) generally and subject to Form 1042-S reporting.
When will the Section 871(m) regulations come into effect?
The regulations generally apply to derivative instruments issued on or after January 1, 2017.
Is there a ‘phase-in’ period of the Section 871(m) withholding rules?
Yes. On August 4, 2017, the Internal Revenue Service (IRS) issued Notice 2017-42, delaying the broad implementation of the US s871(m) regulations related to dividend equivalent payments.
Under the transitional guidance, the IRS extended withholding only derivative securities issued with a perfect correlation, or delta of 1, to its underlying equity are subject to US withholding tax effective January 1, 2017 through December 31, 2018. Derivative securities issued with a delta from .80 to .99 will be subject to US withholding tax effective January 1, 2019.
In addition to the phase-in of transactions having a delta other than 1, the IRS further extended the requirement to withhold on dividend equivalents payments made to Qualified Derivative Dealers (QDDs). Accordingly, withholding will not apply on dividends that a QDD receives in its capacity as an equity derivatives dealer prior to January 1, 2019. A QDD remains responsible however for withholding on dividend equivalents it pays to a foreign person on a section 871(m) transaction. Please reference the table below for a comparison between the enforcement of the 871m regulations from 2017-18 and 2019.
871m: Enforcement of regulations 2017 vs 2018
The following table highlights some of the significant differences of the listed section 871(m) related topics from 2017 to 2018 (with consideration given to Notice 2017-42 issued on August 4, 2017):
What is a ‘Dividend Equivalent’?
A DE is generally defined as a payment that references a U.S. source dividend on:
- Securities lending or sale-repurchase agreement;
- Specified notional principal contract (NPC) (e.g. swaps);
- Equity Linked Instrument (ELI) (e.g. futures, forwards, options or structured products), or;
- Any other substantially similar instrument
Section 871(m) regulations specify that DE payments will be taxed and treated as if they were a dividend from the issuer of the referenced U.S. security.
Who are the impacted parties?
The final regulations define various parties to an 871(m) transaction:
- Long Party: Party to a potential 871(m) transaction with respect to an underlying security that is entitled to receive a DE
- Short Party: Party to a potential 871(m) transaction with respect to an underlying security that makes a DE
- Determining Party: Party responsible for identifying the transaction as being subject to 871(m) and calculating the Delta used for withholding and reporting DEs.
- Withholding Agent: US or non-US person that makes a DE payment to a non-U.S. payee
What is “delta” and how does the “delta test” work?
Delta refers to the ratio of a change in the fair market value of the derivative instrument in relation to a small change in the fair market value of the referenced security for determining whether a transaction is subject to withholding under section 871(m):
Derivative instruments that are calculated by the Determining Party to have a delta of >0.80 are subject to the 871(m) rules.
The concept of a delta “test” is used to determine if the NPC, ELI or other substantially similar derivative instrument is in scope for 871(m).
As provided in the final regulations, delta is measured at the earlier of when a derivative instrument is priced and when issued. The delta determination will generally apply for the life of the instrument, or upon a material economic change or event in the terms of a transaction. A material event may include a reset date for an option, requiring issuing brokers/dealers to recalculate delta.
NOTE: In accordance with transitional guidance issued by the IRS in December 2016, only DE’s with a delta equal to one are in scope for 871(m) withholding for 2017. At the time of this writing, it is expected that DE’s with a delta equal to or greater than .80 at issuance are in scope for 871(m) withholding starting January 1, 2018.
|An example of how delta is calculated: A non U.S. fund purchases a call option that references 100 shares of U.S. stock and the value of the option is expected to change by $0.80 for every $0.01 change in the price of a share of the underlying stock, the call option has a delta of 0.8 (0.8/(0.01x100)).|
The final regulations create two categories of derivative instruments (or contracts) for purposes of calculating Delta:
A. Simple contract: contract that references a single, fixed number of shares of one or more issuers, and the contract has a single maturity or exercise date on which all amounts are required to be calculated with respect to the underlying security.
B. Complex Contract: any contract that is not a simple contract. For example, a structured note with a formulaic return based on the performance of the underlying security or basket of securities.
Complex contracts are subject to a more intricate delta calculation, taking into consideration more factors than the calculation for simple contracts. This particular calculation is called the “substantial equivalence test”. For 2017, the requirement to identify and classify ‘complex contracts’ under section 871(m) are not in-scope.
Who determines whether Section 871(m) applies?
One of a variety of parties may be responsible for determining whether Section 871(m) applies. Generally the party that creates the financial instrument that is being tested will calculate the delta. For example, many ELIs are created by Investment Banks that offer such products to support their Prime Services business. In this example, the Investment Bank would perform the required delta test.
It is important to note that the determining party will be required to maintain records (including certain information on the calculation of the delta) for possible inspection by the IRS.
Are there any exceptions to the applicability of Section 871(m) rules?
The final regulations offer the following few exceptions:
1. Qualified index exception
Financial instruments that reference a ‘Qualified Index’ are exempt from Section 871(m) withholding. A Qualified Index generally means an index that:
- Reference 25 or more component securities (may include foreign securities);
- Reference only long positions (subject to certain de-minimis exceptions);
- No component underlying security represents greater than 15% of the weighting in an index and no five or fewer component underlying securities together comprise more than 40% of the weighting of an index;
- Modified/rebalanced according to publicly stated, predefined criteria;
- Does not provide previous year dividend yield greater than 1.5x the dividend yield of the S&P500 Index for the previous calendar year;
- Traded through futures or option contracts on an SEC registered exchange, CFTC designated domestic board of trade or certain limited foreign exchanges;
Determination of Qualified Index status is made on first business day of the year of issue.
2. Qualified Derivatives Dealers (QDD)
Payments of DEs made to QDDs can be made free of U.S. Withholding tax. See below for further information on QDDs.
3. Other exceptions
Payments such as compensation under restricted stock plans, return of capital distributions, due bill payments for outstanding dividends, certain insurance contracts, also qualify for exception.
What is the ‘combination rule’ under 871(m) and what is the expected impact to non-U.S. Financial Institutions?
Under the U.S. tax regulation, two or more 871(m) transactions are treated as a single transaction (or combined) for purposes of calculating delta, when:
- A person is the long party with respect to each 871(m) transaction;
- The potential 871(m) transactions reference the same underlying security;
- The potential 871(m) transactions, when combined, replicate the economics of a transaction that would be an 871(m) transaction, if the transactions had been entered into as a single transaction; and,
- The potential 871(m) transactions are entered into in connection with each other.
Under the 2017 transitional relief, a withholding agent is required to combine transactions, for purposes of calculating delta, for 871(m) only when the transactions are executed over-the-counter (not listed securities), and the transactions are priced, marketed and sold with each other. However, the 2017 transitional relief does not extend to the long party of potential 871(m) transactions, and additional analysis by the long party is required to determine whether or not transactions are marketed and sold together (i.e. OTC or listed) should be combined to determine delta under the rule.
The regulations provide for presumption rules for the short party of a potential 871(m) transaction, whereby the combination rules will not apply when:
- The long party reflects transactions in separate accounts maintained by the short party, or
- The transactions are entered into two or more business days apart.
Practically, a non-U.S. financial institution entering into potential 871(m) transactions must confirm with a broker-dealer whether the combination rules apply as it pertains to calculating delta, and subsequently, the withholding tax implications.
What is a Qualified Derivatives Dealer (QDD) and who can become one?
QDD is a designation that enables a non-US resident financial institution to assume responsibility for withholding and reporting on DEs. In effect, the Treasury expanded the US Qualified Intermediary (QI) regime to enable non-US resident financial institutions to assume such responsibility under contract with the IRS. Certain eligible entities can apply to the IRS to become a QDD. As a QDD, and acting in a dealer capacity, they can receive DEs free of US withholding tax*. As referenced in the note below, unlike a qualified intermediary, a QDD may be the end beneficiary for its in-scope derivative dealings. Thus, a QDD may be subject to tax based on their respective US tax treatment when applicable. QDD eligible entities are generally: regulated securities dealers, banks and entities wholly owned by a bank.
By becoming a QDD and receiving DE payments free of US withholding tax*, the QDD assumes the following obligations:
- Documents account holders as US/non-US through KYC or the collection of a W-8/W-9 form
- Assumes primary US withholding tax and reporting responsibilities for the DE
- Subject to certification and compliance requirements under the QI regime
QDDs will evidence their status to US payors by providing a valid W-8IMY and a qualified intermediary withholding statement (QIWS) to the US withholding agent to certify their status as a QDD.
*NOTE: As a phase-in period for the QDD account model, any US source payments to a QDD during 2017 and 2018 are not subject to US withholding tax. Effective January 1, 2018, it is expected that payments of actual US source dividends will be subject to the withholding tax rate of the beneficiary (when applicable).
Why might a Qualified Intermediary want to become a QDD?
One of the main benefits of becoming a QDD is to prevent or mitigate “cascading withholding.” This could occur where there is a chain of multiple parties in a Section 871(m) transaction, which could potentially create a scenario where withholding tax on the DE could be applied more than once to the same payment. Therefore, it may benefit QIs (when acting as principal to an in-scope transaction) to become a QDD so that they can receive DE payments free of U.S. withholding tax and assume responsibility and control around the tax due on the chain of payments.
What will happen to the existing Qualified Securities Lender (QSL) regime?
In summary, the QDD regime includes QSL and expands its principles to the additional DE payments included by revisions to 871(m) regulations, such as derivative instruments including NPCs and ELIs that reference U.S. source dividends. As background, Notice 2010-46 introduced the QSL regime, where non-U.S. intermediaries in securities lending and sale-repurchase transactions could elect for QSL status. The general principles and operation of the regime is similar to that of the QDD regime, however, QSL applies mainly on DEs made on U.S. securities lending transactions (e.g. substitute dividend payments).
Note, Rev. Proc. 2017-15 further confirms the Qualified Securities Lender (“QSL”) account type will remain through December 31, 2017. Thus, BBH’s qualified intermediary withholding statement (QIWS) continues to reflect this account type as an option for the current taxable year. Effective January 1, 2018, it is currently expected that the QSL account type will lapse, and the benefits of this account type will fall within the scope of the QDD designation.
When must U.S. non-resident tax be withheld on DE payments in scope of Section 871(m)?
The withholding agent’s obligation to withhold tax on a DE is on the receipt of an actual DE payment, or when there is a final settlement of the transaction. U.S. withholding tax will apply to these transactions in accordance with existing Chapter 3 and Chapter 4 regulations.
The calculation of withholding tax on DE payments is as follows:
The maximum amount of withholding is 30% of the DE for both simple and complex contracts. The calculation of withholding tax on a DE for a simple contract is as follows:
Amount of the per share dividend with respect to the underlying U.S. security x the number of shares referenced in the underlying transaction x delta of the contract.
The calculation of withholding tax on a DE payment from a complex contract is as follows:
Amount of the per share dividend x number of shares that constitute the initial hedge of the complex contract x delta of the contract
Who will perform the required withholding tax and reporting to the IRS?
In summary, the party responsible for withholding tax and reporting on a DE is:
- Withholding agent: the party acting as the ‘short’ party to the transaction. This is likely to be the counterparty to the party taking the ‘long’ position, i.e. looking to gain economically from price appreciation
- QDD: a principal in the transaction that has assumed primary U.S. withholding and reporting responsibility on DEs
It should be noted that many of the products that are likely to fall into scope of Section 871(m) (e.g. NPCs and ELIs) have different payment chains compared to that of ‘regular’ publicly traded U.S. equities. In many instances, in-scope products are unlikely to be deposited with a U.S. custody bank or other institution that withholds tax from other payments such as those received on U.S. issued stock or bond holdings. Due to the characteristics of the instrument (e.g. exchange traded vs over –the-counter etc.) the depository and parties involved in making DE payments for the products can vary. Therefore, it may not be the traditional U.S. custody acting as a withholding agent on DEs.
As U.S. withholding agent, BBH will deduct and withhold tax on qualifying ‘dividend equivalent’ payments having a delta of one as defined under s871(m) when, and if, it is the primary withholding agent as defined under these regulations, for the period beginning January 1, 2017. In those cases where it is the primary withholding agent, BBH will also report DE payments and withholding (if any) to the IRS and recipients.
How is Section 871(m) expected to impact non-U.S. Financial Institutions?
There could be multiple impacts to non-U.S. financial institutions depending on whether they are creating financial instruments, acting as an intermediary, or using in-scope instruments as part of an investment strategy:
- Issuer (of financial instruments potentially in scope of Section 871(m) rules): will generally be required to make determinations as to whether the financial instrument(s) being created are in scope of the rules. This includes performing the Delta test. They are likely to have record keeping responsibilities (to back-up the determination as to whether the instrument is in scope of Section 871(m)) and may be working with vendors to distribute information regarding the products and payments.
- Intermediary (acting as an intermediary/ agent to the transaction): will need to decide on how best to facilitate transactions for their clients.
- Long party: Financial Institutions that use derivatives referencing U.S. equities as part of their investment strategy will need to consider that there could potentially be tax withheld on DEs from January 1, 2017. They may need to be prepared to furnish W-8/ W-9 forms to demonstrate their status as U.S. or non-U.S, which could consequently determine the tax expected to be withheld on DE payments received.
- Other considerations: Those that are part of the payment chain of derivatives referencing U.S. equities will need to assess whether they are a determining party in the transaction. In addition, accountants will need to consider how to source information to record and reflect the tax withheld on such derivatives on the financial statements of the parties they represent, to the extent that they are withheld upon under Section 871(m).
What is Section 305(C) and how does it interact with the Final Section 871(m) regulations?
IRC Section 305(C) sets out rules for U.S. withholding tax and reporting on “deemed distributions”. Such deemed distributions will arise on instruments which are convertible to U.S. stocks, including convertible bonds, warrants, subscription rights and other rights to acquire U.S. stock. The rules have been in focus separately in light of the new Section 871(m) regulations, and the two regulations have been frequently discussed together. Please reference BBH’s 305(c) service announcements available in Worldview®.
What should I be doing now for the Section 871(m) regulations?
Familiarization of the rules is essential, but equally understanding your role in any in scope transactions as well as your overall financial products strategy will be important for determining whether you will be acting in principal, intermediary or as an issuer of financial products that could potentially be in scope of the rules (including calculating delta, making or receiving payments of DE payments, withholding and depositing U.S. non-resident tax, and satisfying corresponding tax information reporting requirements)
FOR MORE INFORMATION, PLEASE CONTACT YOUR BBH RELATIONSHIP MANAGER OR LOCAL GLOBAL TAX SERVICES REPRESENTATIVE.
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