(Editor’s Note: On November 14, 2016 SIFMA asked the US Treasury to postpone the implementation date of IRS Section 871(m) from January 1, 2017 so that it can resolve a difference of opinion with G5 countries. The UK, Germany, Spain, France, and Italy have told the Treasury that dividend equivalent payments made outside the US to non-US investors should not be treated as dividends under the applicable tax treaties. Instead, they should be treated as “other income”.
If operations, compliance and IT managers at fund management shops, broker-dealers and banks thought they had their work cut out for them helping the Internal Revenue Service catch US tax dodgers, they are now quickly discovering they have even more heavy lifting to do when it comes to taxing foreign investors in US equity-linked derivative transactions.
The prospect of compliance with the IRS’ new Section 871(m), beginning in January 2017, is generating plenty of angst as evidenced by the what panelists and attendees at a recent global tax event hosted by the Securities Industry and Financial Markets Association (SIFMA) say. There are still too many unanswered questions about how to correctly calculate the withholding tax. The IRS has promised it will come up with additional guidance and a transition timetable for compliance. However, based on what its officials revealed at the tax event, financial firms won’t have a clue until November at the earliest. In the meantime, they can only do their best to change their withholding and tax reporting applications and procedures according to what they now know.
Although the IRS decided to exempt foreign investors from withholding tax for deals in US swap contracts, it wanted to close a loophole for dividend equivalent payments made through transactions in derivatives that reference US equities. The IRS’ logic: the foreign investors are enjoying the same economic benefits as if they were holding the actual US equities and receiving cash dividends. Therefore, they should not be allowed to sidestep paying withholding tax whether intentionally through “yield enhancement strategies” or even unintentionally.
Foreign hedge fund managers and retail investors would likely incur the withholding tax as the long parties to the affected trades. US banks and broker-dealers, as the short parties, would be responsible for calculating the withholding tax and making the deductions from payments. They are also the ones responsible for notifying the short parties about the tax.
Financial firms say they already have plenty to worry about when it comes to complying with FATCA. Both FATCA and Section 871(m) are intended to prevent tax evasion, but Section 871(m) is a far harder nut to crack. Short for Foreign Account Tax Compliance Act, FATCA requires foreign financial firms to know whether or not they have US persons who are receiving US-sourced income. The compliance challenge comes down to identifying the investor involved and the IRS has already published clear-cut documentation and criteria necessary to make that determination. In meeting the requirements of Section 871(m), withholding agents must navigate a mindboggling path to figure out whether a payment made on a derivative contract linked to a US equity is equivalent to a dividend payments for a US equity before even calculating the amount of withholding tax.
“Section 871m is the most complex tax regulation since cost-basis reporting,” says Cyrus Daftary, chief executive of the CTI tax solutions unit of global data and analytics giant IHS Markit in New York. “Withholding agents, such as banks and broker-dealers have never been required to withhold tax on US equity- linked derivatives, let alone do any reporting to the IRS.” As a result, they will need to come up with new policies and procedures as well as adjust existing back-office applications.
Adopted beginning the 2011 tax year, cost-basis reporting involves broker-dealers and banks making labor intensive efforts to determine the original cost of an investor’s holdings when it sells its shares or bonds. Investors can either pick from one of several methodologies to make the calculation, depending on the type of asset class involved, and if they don’t make a selection, the broker-dealer or bank can do so based on the IRS’ rules.
Tax operations managers must keep track of all the outright purchases, sales, wash sales, and even corporate actions. When it comes to complying with Section 871(m), tax operations managers at the SIFMA-hosted event tell FinOps Report they will have to monitor a US equity-linked derivative product from the time it is issued or sold through the time any event on the underlying US equity involved takes place that would constitute a Section 871(m) eligible payment.
In the case of cash or equivalent payments on made on US equity-linked derivative transaction after January 1, 2017, foreign investors will be subject to a maximum withholding tax of 30 percent. US banks and broker-dealers who will have the burden of withholding the correct tax and reporting to the IRS will have to take into account the type of asset class and the delta of the transaction affected, as well as any double tax treaties between the US and other countries. The UK has called for the payments on US equity-linked derivatives to be taxed as “other income” under its tax treaty with the US — a stance which would likely reduce the withholding tax paid by fund management firms domiciled in the UK. However, the IRS has rejected that viewpoint saying that tax relief should be given based on the payment being considered the same as an equity dividend.
To ease the compliance challenge of Section 871(m), the IRS has decided to raise the delta required for a transaction to be affected from its original proposal of 0.7. The IRS has also indicated it will phase in the new rule so that for any payments made after January 1, 2017 the delta on a single or combination of transactions must be 1.0 for the transaction to be considered in scope or subject to the withholding tax. The threshold will be reduced to 0.8 as of January 1, 2018. Delta refers to the ratio of the change in the fair market value of the equity derivatives contract over a change in the fair market value of the underlying security.
As is the case with cost-basis reporting, the number crunching for 871(m) will not come easy. “There is no single method for calculating delta and the IRS has indicated that multiple transactions taking place at the same time need to be taken into account when measuring delta,” says Craig Gibian, principal of the financial instruments group at global consultancy Deloitte in New York.
Although as withholding agents banks and broker-dealers carry the greatest compliance burden, fund managers aren’t entirely off the hook. The IRS will penalize withholding agents for any mistakes, but fund managers will be responsible for paying their fair share of taxes. Even if the withholding agent is at fault for underestimating the correct tax, fund managers will be responsible to come up with the money and pay interest. “I anticipate that the most sophisticated fund management firms will likely be verifying the calculations of withholding agents,” says Gibian.
Fund management firms will also likely want to do some pre-trade analytics to come up with calculations as to whether or not it will be cost-effective to do a particular transaction. “What was initially thought of as a back-office compliance issue will also turn into a front-office discussion,” says Richard Shapiro, tax director for accounting and tax advisory firm EisnerAmper in New York. It could even turn into a middle-office problem because fund managers will need to take into account their Section 871(m) withholding payments when calculating a fund’s net asset value.
Steering a Course
What’s a financial firm to do? For starters, withholding agents — banks and broker-dealers — and their fund management counterparties will need to determine just which financial instruments are affected. The term equity derivatives is broad reaching and encompasses a wide range of equity swaps, exchange-traded options or equity futures, equity-linked notes, equity indices, convertible bonds, and structured products. Not all indices will meet the IRS requirements, while most convertible bonds will be exempt based on the delta threshold.
Measuring delta comes next. It might relatively easy for a simple contract that references a fixed number of shares of a US equity security. Not so for complicated or complex contracts where the IRS calls for a “substantial equivalence” test to be used. That means that the withholding agent has to rely on advanced financial modeling techniques.
Even the best prepared banks and broker-dealers could end up with a hard time depending on the type of financial instrument involved. “Regardless of whether issued by US or European issuers, some structured products can have coupon payments that might include an element of dividend payment on the underlying equity,” explains Jurg Stalder, senior product manager for data giant SIX Financial Information, based in Zurich. “However, there are also products that have no coupon payments or where the duration of the product straddles a dividend payment event on an underlying US equity.”
What then? In such cases, the issuer must publish the dividend-equivalent event or the delta at issuance, says Stalder. That stance is also shared by SIFMA and international securities depositories Euroclear and Clearstream which have asked issuers to provide them with the information.
But what happens in the case of a listed US option where the delta changes depending on when the option was purchased? The IRS has not publicly responded, but financial firms are hopeful that the US tax agency will agree to stand by what it has privately promised. Withholding agents can use the delta published by the OCC, the clearinghouse for US listed options, on the day before the option was bought by the foreign investor. That’s the good news. The bad news is that withholding agents will still have to redesign their withholding systems to always keep track of the delta for each option and the underlying dividend paid before they can calculate the withholding tax.
If calculating the delta for a single transaction weren’t hard enough, what happens when there are back-to-back transactions on the same-day or within two days of each other. “The regulations do not provide strict rules regarding how to combine transactions, leaving some amount of flexibility as an operational matter,” says Daniel Iacovitti, tax counsel for Morgan Stanley in New York.” The IRS has also not explained what happens with legacy positions. What is the delta of the remaining leg of a transaction if one leg is disposed of, exercised or expires.” The answer, according to Iacovitti could be the original delta, the combined delta from the combined transaction or a new delta measured on the date of the leg-out event.
Given that delta and withholding tax calculations depend on having the right information, what happens if a firm doesn’t? Such is the case with custodian banks who fit the IRS’ definition of a broker-dealer for withholding tax purposes. “Custody functions have limited information about clients’ 871(m) transactions and lack the infrastructure to determine delta,” say BNY Mellon, Brown Brothers Harriman, Northern Trust, and State Street in a joint letter to the IRS dated April 18, 2016. “Custodians rely on data vendors to pass information to them as they are downstream from the issuers of securities and other instruments.” Their request: that the IRS allow custodians, as withholding agents who are not a party to the 871(m)-eligible transactions, to base any withholding tax calculation on data obtained from the short party to the trade. The short party should also provide them with the necessary data points for back-to-back or combined transactions.
New QDD Designation
For those who think the IRS is being draconian in taxing equity derivative transactions, the IRS has provided some relief. To avoid “cascading withholding” or excessive withholding on related transactions, the IRS will allow non-US broker-dealers or banks to become “qualified derivatives dealers.” The designation requires them to complete the necessary paperwork and confirm procedures are in place to test, track and report transactions associated with their activities as QDDs. Wannabe QDDs, who have already met the requirements as qualified intermediaries under FATCA, will likely have an easier time fulfilling the IRS’ requirements to become QDDs than first-time applicants.
Foreign broker-dealers and banks will have to weigh the steep compliance costs of fulfilling the IRS’ requirements to become QDDs against the withholding tax benefits. Foreign broker-dealers that enter into derivative contracts as principals often receive dividend or dividend equivalent payments and make offsetting payments to counterparties through hedging transactions. If the QDD designation didn’t exist the foreign broker-dealer would have to pay withholding tax twice — on the payments they receive as well as the payments they make.
Iacovitti offers the following example of how a foreign bank or broker-dealer would benefit from having the QDD designation: a QDD writes a total return swap to a fund management client on 100 shares of IBM which means that the client has a long position and the QDD has a short position. The QDD then hedges with a back-to-back total return swap of 100 shares of IBM with a US broker-dealer so the QDD is then long and the US firm is short. IBM pays a US$1 per share dividend so that there is a US$100 dividend equivalent amount paid to the long part on both swaps. What is the amount due the IRS? That would be the US$100 dividend equivalent payment received by the QDD on the hedge minus the US$100 dividend equivalent amount paid to the client. That comes out to zero.
However, the QDD isn’t always off the hook when it comes to paying withholding tax. To end up with no withholding tax it must have offsetting transactions or deals where it earns as much in equivalent dividend payments as it pays out. If it earns more in equivalent dividend payments it will owe the IRS the difference. Attendees at the SIFMA event raised the issue of what would happen if there were a “mismatch” or the QDD entered into two back-to-back transactions, one of which was considered covered under Section 871(m) and one which was not.
The IRS says that under that circumstance the QDD would have to pay a “residual tax” prompting attendees at the SIFMA-hosted event to counter that the IRS’ stance violated the spirit of Section 871(m). QDDs aren’t trying to abuse the US tax code so why not give them a break. SIFMA, for one, has asked the IRS to accept an easier alternative approach. Instead of having to calculate dividend equivalent payments paid and received on a transaction-by-transaction basis, a QDD should be permitted to rely on a “net delta exposure” multiplied by the dividend amount per share.
What does the IRS think? “We took into account the request but decided that it was not within the statute of Section 871(m) for us to make changes that would affect the withholding tax,” responds Peter Merkel, a senior technical reviewer at the IRS. He would not comment further on what the IRS would decide about other industry feedback.
As is often the case with new regulatory requirements, a cottage industry of third-party helpers is cropping up to capitalize on the information intensive needs. “We anticipate the demand for security-level and issuer-level data to grow as withholding agents look to comply with the IRS rule. That data is necessary to determine when and how much to withhold,” says Chris Casey, global head of regulatory products and reference data for data giant Bloomberg. “Foreign investors, in turn, will also need to understand if an investment they are considering could be in scope of the rule and trigger a withholding requirement.”
Bloomberg, SIX Financial Information and IHS Markit will offer data feeds which pass along information from issuers about which of their instruments would be affected by Section 871(m) and their deltas. Bloomberg says it will also calculate the delta for listed options and warrants and test whether an equity index is subject to the withholding tax. IHS Markit says it will also determine the dividend equivalent amounts, calculate the withholding tax rate and the applicable tax as well as provide the data points for reporting about the withholding tax to the IRS.
Although all of the data and number crunching may provide financial firms with much-needed relief, they are still left with legal liability for any errors. In the case of bilateral derivative transactions, withholding agents alone are responsible for calculating delta. However, when issuers are the only ones with the information, withholding agents are left at their mercy. The IRS has indicated that issuers must provide delta and other necessary information, but what happens if they don’t is anyone’s guess. “Withholding agents might end up deciding to use a delta of 1 which would make the deal in scope or subject to the withholding tax,” speculates one tax operations manager attending the SIFMA event.
For now, at least most of the financial industry’s attention is on adjusting their back office withholding tax and reporting modules to account for the IRS requirements. “We are spending a lot of late nights working with our technology folks to recode our platforms to accept the third-party data feeds. We are also adding new withholding tax fields and reporting fields to account for Section 871(m),” says the IT manager at a US broker-dealer attending the SIFMA tax event. “We would be a lot happier if the IRS offered clearer methodologies for calculating delta in complex transactions, back-to-back combined transactions and transactions affecting QDDs. Of course, the longer the transition period offered by IRS, the better.”