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.”

IRS Adds Five New FATCA FAQs Addressing QDD, QI, and WP Concerns

The IRS updated its FATCA frequently asked questions to include five new FAQs.  The new FAQs address issues involving qualified intermediaries (QIs) that are or are seeking to become qualified derivatives dealers (QDDs), non-financial foreign entities (NFFEs) seeking to become withholding foreign partnerships (WPs), the period review requirements applicable to QIs that are QDDs, and the independence standard applicable to external reviewers of a QI, WP, or withholding foreign trust (WT).

Three FAQs were added to the “New Applications/Renewals” section, the first two of which address QIs.  In FAQ#17, the IRS clarifies that a QI that is not currently a QDD does not have to wait for its QI agreement to expire before applying for QDD status.  It also reiterates that branches of QIs wishing to become QDDs must complete their own separate QDD application.  FAQ#18 addresses the effective date (i.e., the date on which the QI can represent itself as a QDD on Form W-8IMY) of a newly-granted QDD status.  If a QI is granted QDD status prior to March 31 of a calendar year, or after March 31 for QIs that have not received any reportable payments before being granted QDD status, that status will become effective as of January 1 of that year.  Otherwise, QDD status will become effective the first day of the month in which the QDD application is approved.  FAQ#19 addresses the circumstances in which an NFFE that is a foreign reverse hybrid entity (a foreign entity that is fiscally transparent for foreign tax purposes but not transparent for U.S. tax purposes) can become a WP (a status reserved for foreign reverse hybrid entities that are FFIs under section 6.03(C) of the WP agreement).  The FAQ clarifies that a foreign reverse hybrid entity that is an NFFE may apply to be a WP but only with respect to payments of personal services income effectively connected with a U.S. trade or business.

The IRS also added a new section titled “Certifications and Periodic Reviews,” consisting of two review-related FAQs.  FAQ#1 addresses the circumstances in which QIs that are QDDs can avoid periodic review for certification periods ending in 2017 and 2018.  Section 10.07 of the QI agreement permits waivers of periodic review requirements for QIs not acting as QDDs, but Notice 2017-42 extended this waiver to QIs that are QDDs for its QDD activities with respect to certification periods ending in 2017 and 2018.  This left open the question of whether such QIs could seek a waiver of periodic review for their non-QDD activities.  FAQ#1 answers this question in the affirmative and provides instructions on the process of applying for a waiver.  In FAQ#2, the IRS expands on the requirement in section 10.04 of the QI agreement and section 8.04 of the WP and WT agreements that an external reviewer of a QI, WP, or WT not review the work of others in the same “firm,” a standard that has raised questions.  Accordingly, the IRS clarifies that for years before 2018, external reviewers may apply the standards otherwise applicable to their engagement to conduct the review (e.g., procedures for a certified public accountant).  The IRS intends to provide further guidance for calendar years 2018 and later.

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.