IRS Guidance Provides Transition Relief for Withholding Agents and Qualified Derivative Dealers under Section 871(m)

Last week, the IRS issued Notice 2016-76 providing phased-in application of certain section 871(m) withholding rules applicable to dividend equivalents.  In addition to providing good-faith relief to certain transactions in 2017 and 2018, the Notice eases several reporting and withholding requirements for withholding agents and qualified derivatives dealers (QDDs).

Section 871(m) of the Code imposes withholding on certain payments that are determined by reference to or contingent upon the payment of a U.S. source dividend.  Thus, when a foreign financial institution issues derivatives based on U.S. equities to non-U.S. investors, it must withhold on the dividend payments it makes to the non-U.S. investors.  In 2015, the IRS issued final and temporary regulations (T.D. 9734) specifying certain withholding and reporting requirements under section 871(m).  Earlier this summer, the IRS proposed a qualified intermediary (QI) agreement (Notice 2016-42) that spells out a new QDD regime, which was developed to mitigate cascading withholding that would occur as a result of the withholding requirements imposed on dividend equivalents (see prior coverage).

Good-Faith Relief

Notice 2016-76 provides good-faith transition relief during 2017 for delta-one transactions and during 2018 for non-delta-one transactions.  (Delta means the “ratio of a change in the fair market value of a contract to a small change in the fair market value of the property referenced by the contract.”  A delta-one transaction is a transaction in which changes in the fair market value of the derivative precisely mirror changes in the fair market value of the underlying property.)  The IRS will take into account the extent to which a taxpayer or withholding agent made “a good faith effort” to comply with the section 871(m) regulations.  Relevant factors include a withholding agent’s efforts to build or update documentation and withholding systems and comply with the transition rules under Notice 2016-76.

Quarterly Deposit of Withholdings in 2017

During 2017, a withholding agent will be considered to have satisfied the deposit requirements for section 871(m) dividend equivalent payments if it deposits amounts withheld during any calendar quarter by the last day of that quarter.  The agent should write “Notice 2016-76” on the center, top portion of the 2017 Form 1042.

Qualified Derivative Dealers

The Notice also eased, in four ways, the reporting obligations of intermediaries applying for QDD status.  First, the IRS’s enforcement of the QDD rules and the 871(m) regulations in 2017 will take into account good-faith efforts by intermediaries to comply with the regulations and the QI agreement.

Second, the Notice allows an intermediary to certify its QDD status during interim periods.  Generally, a QDD must provide a valid Form W-8IMY certifying QDD status to a withholding agent, and the agent is not required to withhold on its payments regarding a potential or actual section 871(m) transaction to a QDD in its QDD capacity.  An intermediary that has submitted a QI application by March 31, 2017 may claim QDD status on Form W-8IMY for six months after submitting the application, pending approval of its QI agreement and QDD status.  If an intermediary has not yet submitted a QI application but intends to do so by March 31, 2017, it may claim QDD status on Form W-8IMY until the end of the sixth full month after the month in which it actually submits the QI application (provided the application is submitted by March 31, 2017).  An intermediary may not represent QDD status if it no longer intends to submit an application by March 31, 2017, or if its application has been denied.

Third, the Notice allows an intermediary to provide a Form W-8IMY certifying its QDD status to a withholding agent before it has received a QI-EIN from the IRS.  The intermediary must write “awaiting QI-EIN” on line 8 of Part I of the Form W-8IMY.  While the intermediary must provide its QI-EIN to the withholding agent as soon as practicable after receiving it, the intermediary need not provide a newly executed form, provided the original form remains accurate and valid.  If QDD status is denied, however, an intermediary must notify the withholding agent immediately, and the agent must notify the IRS such notification when it files its Form 1042, listing the name and EIN (if available) of any intermediary whose QDD status was withdrawn for any of these reasons.

A withholding agent may rely on the “awaiting QI-EIN” statement unless it knows or has reason to know that the intermediary cannot validly represent that it is a QDD.  Thus, a withholding agent is not required to determine when a QDD has applied for or actually possesses a QI agreement.  Nor is it required to verify whether a QDD’s EIN is a QI-EIN.  A withholding agent may only rely on an “awaiting QI-EIN” statement for up to six months after receiving the form, unless a QI-EIN is provided within that time.

Fourth, the Notice provides that failure-to-deposit penalties will not be assessed against a QDD before it actually receives its QI-EIN (which the IRS issues upon approving a QI application).  This relief from penalty is available only if the QDD deposits the amounts withheld within 3 days of receiving its QI-EIN.  Extended relief is available to a QDD that applies to enroll in the Electronic Federal Tax Payment Systems (EFTPS) within 30 days of receiving a QI-EIN, provided that the QDD deposits the amounts withheld within 3 days of enrolling in EFTPS.

Other Rules

The Notice also addressed other issues under the section 871(m) regulations.  Specifically, the Notice provided: (a) a simplified standard that withholding agents may use to determine whether transactions are combined transactions under Treas. Reg. §1.871-15(n); (b) a net-delta exposure test for a QDD’s section 871(m) amount; and (c) transition relief for certain existing exchange-traded notes listed in section V.d of the Notice until January 1, 2020.

Proposed QI Agreement Includes Rules for Qualified Derivatives Dealers

The IRS recently issued a proposed qualified intermediary (QI) agreement (Notice 2016-42) that spells out the new qualified derivatives dealer (QDD) regime.  The final QI agreement will be issued later in 2016 and will apply to agreements in starting January 1, 2017, replacing the 2014 QI agreement that will expire on December 31, 2016.  The QDD regime replaces the qualified securities lender (QSL) regime in Notice 2010-46.  The QSL rules will continue to apply for substitute dividend payments made under sale-repurchase or securities lending transactions.

The QDD regime was developed to mitigate cascading withholding that would occur as a result of the withholding requirements imposed on “dividend equivalents.”  Section 871(m) of the Code imposes withholding on certain payments that are determined by reference to or contingent upon the payment of a U.S. source dividend.  As a result, when a foreign financial institution holds U.S. equities and issues derivatives to non-U.S. investors that are based on the stock, it may be subject to withholding on dividend payments made with respect to the underlying equities and have to withhold on the payments it makes to the holders of the derivatives.

Under the proposed QI agreement, only a subset of QIs called “eligible entities” will be permitted to act as QDDs.  Eligible entities are: (1) regulated securities dealers; (2) regulated banks; and (3) certain entities wholly-owned by regulated banks.  Under the QDD regime, a dividend payment to a QDD is not subject to withholding if the QDD provides the withholding agent with a Form W-8IMY indicating the QDD’s status.  The QDD certification is made on Form W-8IMY even though the QDD is acting as a principal with respect to the transaction.

If a QI acts as a QDD, it must act as a QDD for all payments made as a principal with respect to potential Section 871(m) transactions, including any sale-repurchases or securities lending transactions that qualify as such, and all payments received as a principal with respect to potential Section 871(m) transactions and underlying securities, excluding payments effectively connected with a U.S. trade or business. All securities lending and sale-repurchase transactions the QI enters into that are Section 871(m) transactions will be deemed to be entered into by the QI as a principal.

When a QI is acting as a QDD, it must assume primary withholding responsibilities under Chapters 3 and 4 and primary Form 1099 reporting and Section 3406 backup withholding responsibility for all payments related to potential Section 871(m) transactions that it receives as a principal—even if such payments are not dividend equivalent payments.  As a consequence, a QDD will be required to withhold to the extent required for the applicable dividend on the dividend payment date.  In contrast, when a QI is acting as intermediary, i.e., not as a principal, with respect to such a payment, it may choose to act as a QI (and choose whether or not to assume primary withholding and reporting responsibility with respect to the payment) or a nonqualified intermediary (NQI).

A QDD is liable for any tax on any dividends and dividend equivalents it receives in its dealer capacity to the extent the QDD is not contractually required to make offsetting payments that reference the same dividend or dividend equivalent that it received as a dealer.  For purposes of determining the QDD tax liability, payments received by a QDD acting as a proprietary trader are treated as payments received in a non-dealer capacity, while transactions properly reflected in a QDD’s dealer book are presumed to be held in its dealer capacity.  A QDD will reports its QDD tax liability on Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons.  When a foreign branch of a U.S. financial institution acts as a QDD, the branch is not required to report the QDD tax liability for income related to potential Section 871(m) transactions and underlying securities; instead, the U.S. financial institution will file the appropriate tax return to report and pay its tax liability.

The proposed QI agreement also updated requirements relating to periodic review and certification of compliance, substitute interest, limitation of benefits for treaty claims, and other items.