New Form 1042 Instructions Shift Reporting Obligations for QDDs

The IRS recently released new Form 1042 instructions (Annual Withholding Tax Return for U.S. Source Income of Foreign Persons), including changes to reporting for a withholding agent that is a qualified intermediary (QI) acting as a qualified derivative dealer (QDD).  As discussed in an earlier blog post, the QDD regime was developed to mitigate cascading withholding that would occur as a result of the withholding requirements imposed on dividend equivalents, pursuant to Code section 871(m).

The Form 1042 instructions appear to respond to comments received after draft 2017 Form 1120-F instructions were released last October that required the reporting of QDD liabilities on the Form 1120-F (U.S. Income Tax Return of a Foreign Corporation) and an accompanying schedule.  The updated instructions require the same information regarding QDD tax liability that the draft instructions required to be reported on Form 1120-F, which most QIs were not required to file absent the new QDD tax liability.  Accordingly, it is expected that QDDs will report their QDD tax liability on the Form 1042 (and Form 1042‑S) rather than the Form 1120‑F.

The 2017 Form 1042 includes a new Section 4, which a QI that is a QDD (or has a branch that is a QDD) must complete if it made any payments reportable on the Form 1042 in its QDD capacity.  The updated instructions provide guidance to QDDs regarding the proper withholding agent status code to use when filing Form 1042 and Form 1042‑S.  A QI that is a QDD should use the chapter 3 status code for a QI (code 12) on Form 1042, regardless of the types of payments it made for the calendar year.  But a QI that is a QDD is required to use the withholding agent chapter 3 status code for a QDD (code 35) on Form 1042-S for a payment that it made in its capacity as a QDD.  A filer must enter both a chapter 3 and a chapter 4 withholding agent status code on the form regardless of the type of payment being made.

The updated instructions also provide guidance to QDDs applying the transitional guidance in Notice 2016-76 for 2017 (see prior coverage).  This notice allows a QDD to deposit amounts withheld for dividend equivalents on a quarterly basis, and allows a QDD applicant awaiting a QI‑EIN to wait until it receives its QI‑EIN to deposit amounts withheld on dividend equivalents.  The withholding agent should write “Notice 2016‑76” on the center, top portion of the 2017 Form 1042.  For 2017 and 2018, the columns for total section 871(m) amount and total QDD tax liability pursuant to Section 3.09(A) of the Qualified Intermediary Agreement should state “not applicable.”