EY urges US and non-US funds with derivative exposure to US equities to take action to ensure compliance as the effective date for new Section 871(m) requirements related to withholding rapidly approaches. While recent public government statements imply that the rules may be made less onerous in 2017 through transition guidance, no comments have been made suggesting an outright deferral of the new regime. Accordingly, asset managers should assess their overall readiness and close any remaining critical gaps before the 2016 calendar year-end.

Background

Section 871(m), enacted as part of the HIRE Act in 2010, provides that payments on certain financial instruments that generate a return based on the payment of a US-source dividend are treated as "dividend equivalents." Although the scope of Section 871(m) was initially limited to contracts that clearly passed through substitute dividends, regulations finalized in 2015 greatly expanded its reach beginning January 1, 2017. Starting on that date, dividend equivalents may arise in conjunction with a range of transactions over US equities, including any of the following illustrative transactions: securities loans or sale-repurchase agreements, swaps, listed or over-the-counter options, forwards, futures, structured notes or convertible debt instruments. Based on recent comments made by an IRS official significantly involved in drafting the regulations,¹ it is anticipated that guidance soon will be issued adopting a phased-in approach for potential Section 871(m) transactions, including only "delta one" products (presumably products such as total return swaps, forwards, futures, and contracts for difference) as in-scope in calendar 2017 and all others in 2018. This approach is expected to lessen current taxpayer burden implementation efforts associated with options and other products that are traditionally non-delta one.

Select fundamental rules and responsibilities

When dividend equivalents are considered paid to non-US investors on any in-scope transaction issued or materially modified in 2017 or later, they will be subject to gross-basis taxation and withholding under chapters 3 and 4 as if they were actual US-source dividends. For an instrument to generate dividend equivalents, it must have sufficient correlation with the US equity that it references, and the referenced equity generally must pay dividends. Sufficient correlation is established by a delta² of at least 0.8 at issuance in the case of simple contracts (e.g., most options, swaps, forwards, futures and convertible debt) and by an alternative test of "substantial equivalence" in the case of more complicated instruments such as structured notes, where delta may not be determinable. Scoping is more complicated for so-called combined transactions (e.g., one long call and one short put over the same US equity), where distinct lower-delta financial transactions issued at different points may nonetheless be treated as in scope if, when viewed together, the separate trades would reach the applicable delta or substantial equivalence thresholds.

Under the regulations, brokers and dealers are generally responsible for performing delta and substantial equivalence scoping calculations and for withholding on dividend equivalents deemed paid to their non-US customers and counterparties, including funds with non-US beneficial owners. Notwithstanding the fundamental role that brokers and dealers play, funds and their administrators also have a significant role under these rules, and they will not be able to assume a passive position in the implementation of Section 871(m). As discussed below, they will be responsible for communication and knowledge transfers, certain computations, documentation and, in certain cases, even withholding. Funds and their administrators will encounter fewer operational disruptions and negative effects from the new rules if they proactively coordinate with brokers and dealers now to ensure a mutually agreeable rollout of the Section 871(m) ruleset.

Key Section 871(m) issues in the asset management industry

Some funds and fund administrators are unaware of their Section 871(m) obligations or have substantial work to do with less than two months remaining before the effective date of many parts of the regulations. The following are some examples of key issues for the asset management industry:

Communication with brokers regarding withholding obligations is critical

Brokers and dealers may not be fully prepared for Section 871(m) and may fail to perform the required withholding or apply excess withholding. If the broker or dealer fails to withhold, the fund is responsible for the withholding. It is important for all funds to confirm with their brokers and dealers now that each is prepared to execute its withholding obligations starting on January 1, 2017. Many funds are also independently performing the Section 871(m) determinations to check against information transmitted from the broker or dealer and correct any errors.

Funds are responsible for full compliance with combined transaction rules

Final responsibility for identifying and performing calculations with respect to combined transactions generally falls on funds because the broker or dealer may not have knowledge of the combined transaction (e.g., where two transactions are held in accounts at different firms). Based on comments made during SIFMA's Global Tax Reporting Symposium, forthcoming guidance is expected to modify the combined transaction rules to relax them or provide for a transition period. It is unclear whether any relaxation or transition of these rules would apply to the long party as well, or only to the short party, which currently is able to apply presumption rules that are less onerous than the absolute rules applicable to the long party. In either case, as the combined transaction rules primarily target non-delta one transactions (e.g., many options), expected guidance providing that only delta one transactions will be in scope in 2017 will lessen near-term taxpayer burdens when applying the combined transaction rules.

Funds should consider creating policies and procedures to raise internal awareness and have documentation for audit. Further, they should consider creating operational systems logic upon issuance of the modified combined transaction guidance to be in a position to flag as many combined transactions as possible when the rules apply. The fund also may notify its broker or dealer proactively of the combined transaction to ensure that any upfront withholding done by the broker or dealer is accurate initially (thereby reducing any required additional filings for the fund).

US partnerships must withhold and report on dividend equivalents paid to their non-US investors

Although not as common these days, many legacy fund of funds are structured with US partnerships that have non-US investors. Newer fund of funds generally are "side-by-side" structures where US partners invest in the US feeder fund and foreign partners invest in the offshore feeder fund. But even US partnerships in newer fund structures often have non-US investors as a result of exceptions made during the onboarding process.

US partnerships will be responsible for withholding on items of Section 871(m) income that they allocate to their non-US investors. Any US fund that has non-US investors must be prepared to process Section 871(m) information from its broker or dealer counterparty to perform the required withholding. Brokers or dealers may not recognize that certain US persons, specifically partnerships and other flow-through vehicles, are counterparties for which they must monitor Section 871(m) data due to the potential for non-US owners. Accordingly, the onus is on the US flow-through entities to inform the broker or dealer of their needs in advance to ensure timely receipt of necessary information.

871(m) tax liability will affect net asset value (NAV) calculations

A fund or fund administrator will need to account for Section 871(m) tax when calculating NAV, even when the broker or dealer will perform withholding, as the fund is separately liable for the tax. The fund or administrator will need to: (i) ensure that the broker or dealer transmits accurate information in a timely manner to permit NAV calculations; or (ii) independently perform the Section 871(m) determinations.

Funds should confirm and track QDD status of non-US dealers

A fund paying a dividend equivalent to a non-US dealer that has not elected "qualified derivatives dealer" (QDD) status will be required to withhold and report. In contrast, a fund making a dividend equivalent payment to a QDD is not required to withhold or report. Any fund trading short potential Section 871(m) transactions through non-US dealers should collect a current Form W-8IMY (which indicates QDD status) from each dealer and track the QDD status information. Many dealers are in the process of collecting the necessary information for completing the application to obtain QDD status with the IRS. However, pending changes to the draft QI Agreement in Notice 2016-42, not all dealer entities will be considered "eligible" or have the required QI designation to permit QDD status.³ Asset managers should communicate with their trading counterparties to ensure each counterparty will have QDD status prior to 1 January 2017.

Updating legal agreements

Brokers and dealers are updating their legal agreements with customers and counterparties to remove references to gross-up of withheld amounts or insisting on adherence to the new ISDA protocol to this effect. Funds should expect to be inundated by broker requests to enter into new agreements by December 31, 2016.

Software limitations

Funds or their administrators may want software that, at a minimum, can store Section 871(m) data transmitted from the broker or dealer. Many vendors of existing software are not planning to develop solutions for Section 871(m).

Funds will need to track compliance with the qualified index exception

The "qualified index exception" excludes from the scope of Section 871(m) transactions that reference a "qualified index" meeting certain criteria (e.g., the S&P 500) that exempt the transactions from withholding. Qualified indices are generally used by fund managers as portfolio hedges. Fund managers may specifically request counterparties to provide contracts that meet the qualified index exception. However, a fund that shorts significant components of a qualified index may disqualify the index (with respect to the fund) from meeting the exception and cause the index to be in scope for Section 871(m) and therefore subject to withholding. Asset management clients need to have processes in place to monitor shorting of qualified index components as a planning tool and to communicate significant shorting of an index to the broker or dealer.

Transactions referencing MLP interests may be difficult to evaluate

A derivative transaction that references a partnership interest is in scope if, among other things, the partnership holds investments in applicable securities exceeding the lesser of 25% of its assets or $25 million. Existing guidance does not require a partnership to share information about its assets for purposes of Section 871(m), so brokers/funds may have to presume 30% withholding on a transaction relating to a derivative interest in a master limited partnership (MLP). Claims for refund of overwithheld amounts will be difficult to make without adequate substantiation.

Material modification of pre-existing transactions

Withholding may apply to a transaction issued or "materially modified" on or after January 1, 2017. Asset management clients may need a process in place to monitor material modifications, including certain contract extensions, occurring on or after January 1, 2017, that would bring grandfathered derivative contracts within the scope of Section 871(m).

Funds of funds face an additional hurdle to compliance

The regulations do not provide an explicit mechanism for funds of funds to comply. Consider the typical US fund of funds structure depicted in the diagram below. The US prime broker in this example is obligated to transmit information regarding potential Section 871(m) transactions to the Cayman Master Fund LP, but the regulations do not mandate that Investment Advisor #1 pass this information to the US Fund of Funds LP. Thus, the US Fund of Funds LP may not receive information sufficient to satisfy its obligation to withhold on dividend equivalents allocated to its non-US investors, or to perform accurate NAV calculations.

For this reason, funds of funds should be proactive in communicating with their funds to ensure that they receive required information. Potential Section 871(m) income allocations could be included on the fund of funds' Schedule K-1 (perhaps in a footnote if the IRS does not provide an appropriate line) or the investment advisor could provide any real-time information that the fund of funds needs to calculate accurate NAVs. Funds of funds may wish to address these issues by updating their legal agreements with the funds.

Conclusion

The asset management industry will need to work together with brokers, dealers and other parties to create certain functioning Section 871(m) processes by January 1, 2017. Now is the time for funds and their administrators to assess the full extent of Section 871(m) on their operations and communicate with brokers and others to resolve outstanding impediments to compliance. Failure to review the effect of Section 871(m) on the trading vehicles in your organization and develop appropriate policies, procedures and communication channels in advance may cause your funds to suffer unintended consequences that they are ill-prepared to address real-time. Please feel free to reach out to discuss how we may assist you and your team in applying the current guidance and in interpreting the effect of the expected additional guidance.

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ENDNOTES

¹ SIFMA's Global Tax Reporting Symposium on October 21, 2016.

² Generally speaking, delta measures how closely the pricing of an equity derivative moves with that of the underlying equity it references. Derivatives that move in tandem with their underlying equity (e.g., total return swaps) are often referred to as "delta one" instruments and generally should be in scope under these rules starting on 1 January 2017, even under the expected transition guidance. Funds will need to look to the forthcoming guidance to see which transactions will be defined as "delta one" and therefore be in scope for 2017.

³ On October 26, 2016, IRPAC (Information Reporting Program Advisory Committee) released a report (available on the IRS website) with key recommendations for the IRS in the area of information reporting, including Section 871(m). Multiple recommendations were made by IRPAC to expand the universe of entities eligible for QDD status. IRPAC is an advisory committee to the IRS on information reporting and withholding issues and its members are comprised of persons from diverse parts of the business community.

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