Note: This Alert was updated October 31, 2016, to correct an error its documentation discussion. The Alert originally reported that RICs receiving Forms W-8IMY indicating QDD status would be required to report dividend-equivalent payments on Form 1042-S and file Form 1042. In fact, RICs receiving such Forms W-8IMY are not required to report dividend-equivalent payments to the counterparty providing the Form W-8IMY.

Beginning in 2017, Section 871(m) and its regulations will require US mutual funds (specifically "regulated investment companies" or RICs) and other persons and entities that enter into certain types of derivatives and other financial contracts to withhold tax on payments to foreign counterparties or obtain documentation to establish that such withholding is not required. RICs that invest in certain contracts subject to the regulations (generally, contracts over dividend-paying stock of US corporations in which the RIC takes the "short side" and therefore is obligated to make dividend-equivalent payments) should evaluate whether their counterparties for such contracts are US or foreign and either obtain appropriate documentation from these parties to obviate the need for withholding or ensure procedures are in place to perform withholding. Failure to implement proper procedures could result in a RIC being liable for 30% (or lower treaty rate) withholding tax on certain dividend-equivalent payments as well as applicable penalties and interest.

Background

Congress enacted Section 871(m) in 2010 to address dividend arbitrage and related transactions in which non-US taxpayers were engaging to avoid paying US withholding tax on US corporate dividends. The foreign owner of a US dividend-paying stock could sell the stock to another party immediately prior to a dividend record date and simultaneously enter into a total return swap on that stock with the other party in order to maintain its economic exposure to the stock. Immediately after the record date, the parties would terminate the swap and the other party would sell the stock back to the foreign taxpayer. More typically, the foreign investor would just maintain economic exposure through a total return swap or bullet swap for the life of its investment. Prior to enactment of Section 871(m), the dividend-equivalent payment the foreign taxpayer received in connection with these derivative transactions was not subject to US withholding tax, but Section 871(m) changed this result.

The new Section 871(m) regulations

The new regulations under Section 871(m) expand the scope of the section significantly; the regulations apply to contracts entered on or after January 1, 2017 (they do not apply to payments in 2017 or later years on contracts entered before 2017 unless significantly modified). More specifically, the regulations require withholding on dividend-equivalent payments to non-US taxpayers on derivative contracts such as swaps, options, futures, forwards, equity-linked notes and convertible debt that reference US equity securities and that have a "delta" at issuance of 0.8 or greater for simple contracts. Section 871(m) and its regulations do not apply to a contract in which a RIC is the "long party," since the RIC in that case is a US taxpayer receiving the dividend-equivalent payment. Section 871(m) and its regulations also do not apply to interest rate swaps and credit default swaps, since the parties do not make dividend-equivalent payments on these instruments.

Note that a derivative over US equities can be within scope even if it does not explicitly provide for payments based on dividends. The regulations in effect presume that the short party has hedged the contract by holding the underlying equities and the dividend return has been built into the pricing. The regulations contain rules for determining the amount of "deemed dividend- equivalent payments" in this case.

The regulations exempt certain derivatives over broad-based US equity indices in common use, although it is not clear whether every such index is exempt.

"Delta," an options-pricing concept, is roughly similar to a correlation coefficient and measures the sensitivity of changes in the value of a derivative contract to changes in the value of the property the contract references. For example, total return swaps, forwards and futures contracts over a US equity security are designed to have a delta of 1.0. The delta of an option varies depending in part on the extent to which the option is "in the money" or "out of the money" when entered.          

The regulations contain a variety of complex rules regarding matters such as when contracts (for example, a written call and purchased put on the same security that have the same strike price and expiration date) have to be aggregated for purposes of determining delta, how to treat contracts that reference multiple securities and how to treat derivatives over partnership interests. Rather than deal with these complexities and the associated withholding, funds entering into contracts that are potentially subject to Section 871(m) may be able to establish that no withholding is required by obtaining appropriate documentation.

To the extent that the RIC is not facing a broker in the trade and the RIC is on the short side, the RIC will become the determining party in the 871(m) transaction. As such, the RIC will have to identify in-scope contracts, track relevant event types, calculate dividend equivalents, and disseminate information needed for compliance with the regulations to affected parties and their agents (upon request).

Documentation to establish no withholding is required

The documentation needed to establish that the RIC is not subject to withholding under Section 871(m) depends on whether the party through which it is trading the contract is US or foreign. Because both US and many foreign regulatory regimes are increasingly requiring the central clearing of derivatives and other financial contracts, RICs are likely to trade such contracts through a broker, dealer, futures commission merchant or the foreign equivalent (collectively, a "broker"). If the RIC makes a dividend-equivalent payment to an executing or clearing broker that is a US entity, the payment is not subject to withholding under Section 871(m). To ensure that the broker is, in fact, a US entity, a Form W-9 should be obtained from the broker.

As to payments to foreign banks/brokerages, such payments are exempt if the recipient both: (i) is or becomes a "qualified intermediary" for US withholding tax purposes under existing law and (ii) also agrees under a new regime to become a "qualified derivatives dealer" (QDD).¹ A QDD may receive payments free from Section 871(m) withholding. Although market participants as of October 2016 may be waiting for the IRS to release final guidance under the QDD rules, it is expected that most foreign banks/brokerages that intend to continue handling derivatives over US equities will need to become QDDs or otherwise face double taxation. Thus, if the RIC makes a dividend-equivalent payment to a foreign executing or clearing broker (but not directly to a central counterparty or clearinghouse), the RIC will not have to withhold if it obtains a Form W-8IMY on which the broker has indicated that it is both a "qualified intermediary" and a QDD. Contrary to conventional Form 1042-S reporting logic, if a RIC receives a Form W-8IMY indicating QDD status, the RIC will not have to report dividend-equivalent payments to the counterparty that provided the Form W-8IMY. A RIC that receives such a W-8IMY still will have to report dividend-equivalent payments on Form 1042-S and file Form 1042. In the unlikely event that a RIC makes a dividend-equivalent payment to a foreign entity that does not provide such a W-8IMY, the RIC must withhold on the payment at 30% or the applicable treaty rate, if the contract is within scope, i.e., the delta at issuance is 0.8 or greater for a simple contract.

Amending master agreements for derivatives

Derivatives master agreements often provide for tax gross-ups. For example, if X owes Y $100, and tax must be withheld, an agreement may require X to pay Y whatever is necessary to ensure that Y receives $100 after taxes are withheld. Such a provision arguably is not appropriate for Section 871(m) withholding, since the recipient of the dividend-equivalent payment is intended to bear the withholding. The International Swaps and Derivatives Association (ISDA) has published a "2010 HIRE Act Protocol," providing that withholding under Section 871(m) will not be grossed up, and, if the IRS later contends that tax should have been withheld from a prior payment, the payee will reimburse the payor. RICs should determine if the master agreements under which they trade US equity derivatives include tax gross-up provisions and, if they do, strongly consider including this protocol (or incorporating it by reference) in those master agreements.

Additional IRS guidance possible

Speaking at an October 21, 2016 Securities Industry and Financial Markets Association (SIFMA) global tax reporting symposium, an IRS official indicated that the Service is working on a guidance package that will include transition rules under Section 871(m). The IRS indicated that the guidance will include the grandfathering of non-delta-one products to 2018 and transition rules for combined trades and QDD. The guidance is not expected to be issued before mid-November. Taxpayers should be on the lookout for any such new guidance.

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ENDNOTES

¹ An entity that is not a qualified intermediary cannot become a QDD.