US Tax Regulation: Dealing With Section 871m Complexities

Tax does not necessarily have to be taxing. However, when it comes to complying and dealing with US Internal Revenue Service’s (IRS) impending rule 871m that governs withholding on certain derivatives, notional principal contracts and other ‘equity-linked’ instruments with payments referencing dividends on US equity securities, a recent industry briefing in London heard that matters are far more complex.

It could be described as akin to a pandora’s box of rules and obligations that firms need to take on board. But whatever the level of complexity, non-US based financial institutions on the buyside as well as the sellside now have around nine months – before the compliance deadline of 1 January 2017 – to get up to speed, install and test systems to track their withholding tax obligations, and train staff.

The onus on firms confronted by these rules should not be underestimated going by this event convened at the British Bankers’ Association (BBA) on 24 February 2016 and hosted by Merit Software, a leading provider of Receivables, Payables and Tax automation solutions.

Extremely Complex Rules

Let’s get straight to the point: the rules under the 871m regulations are extremely complex and come next January there will likely be a few tricky situations for market participants to navigate around.

As one head of securities tax from a leading accountancy firm in The City of London, who has over a decade of experience in the financial services sector and is a qualified lawyer, nicely put it: “It clearly isn’t plain sailing and there are lots of obstacles and rocks in the sea that your ship might crash up against.”

This specialist, who manages global tax issues arising from holding and trading capital market securities, pointed out that 871m throws up “far more questions than answers” in one of three key presentations given during the Merit-hosted briefing.

And, if this tax expert is uttering such words perhaps the industry should sit up pretty sharpish and take note before they stumble over a plethora of Section 817m obligations.

Daniel Carpenter, a director from Merit Software who moderated the proceedings, told a packed room of attendees from both buy- and sell-side institutions that: “Transaction tax is the name of the game here and 871m is yet another Financial Transaction Tax (FTT). However, this isn’t just about calculating tax and applying exoneration rules.”

He added: “It’s about complex calculations based on complex rules and scenarios, and working out what needs to be paid, who is going to pay, to whom, when and how to reclaim it.” So, not too much to consider then or is it?

‘Rules-Based’ Workflow – Key

For the past fifteen years Merit’s focus as a vendor has been to deliver solutions to the market that help to manage such processes and integrate them with in-house systems at financial institutions. Essentially it’s all about having software solutions in place that provided and assist in facilitating a ‘rules-based’ workflow.

In fact, Merit has been looking at rules around Section 871m since the middle of 2015. They saw early on that institutions will have to invest significant time and effort into creating their systems to handle the new US tax rule and that an industry wide solution was both viable and needed.

Clearly the last thing a firm needs – buyside or sellside – is contending with multiple interfaces with the same derivatives system going to an FTT system in one place and an “871m machine” or system in another place. It therefore makes some sense to feed it all into one process, rather than having a whole host of separate systems and trying to interface them all, which leads ultimately to more static and more fails (i.e. transactions).

Offering a word of advice, Carpenter said: “Whatever system and approach your firm ultimately chooses fundamentally you should be building a structure for the future and change – make your system flexible and future proofed for even more Transaction Taxes.”

Furthermore, the new regulation centres on how non-US based investors (dubbed ‘Aliens’) comply with the legislation from the US tax authorities, which many of the attendees were clearly struggling to get their heads around by some of the questions asked at the end of the presentations in the Q&A session.

Indeed, some of the final issues and rules around 871m were still to be clarified at the time of the briefing.

One positive to note perhaps from the proceedings was that apart from the complexity that has been outlined and communicated by the US authorities, they have not indicated or mandated precisely which technology or systems firms should be deployed in order to comply their obligations under the rules. At least that was good to know.

The three tax experts who spoke at the BBA gave insightful presentations spanning the history of 871m, the thinking behind why the US tax authorities had ushered it into play, likely pain points ‘Short’ parties can expect to encounter as well as some key considerations in planning for the impending regulatory deadline.

Issues confronting ‘Long’ parties, which means any party to notional principal contracts entitled to receive a payment of a dividend from sources within the US with respect to underlying securities, was also addressed, as were Qualified Derivatives Dealer (QDD) status, Qualified Foreign Intermediaries (QFI), Qualified Intermediaries (QI) and QSL compliance.

Simple versus Complex Transactions

While ‘Simple’ derivatives transactions are not so hard theoretically to handle under 871m, firms impacted still need to “catch and trap” significant amounts of data according to one speaker.

This encompasses and includes the underlying dividend event, handling new holdings, calculating the tax if Delta is less than 0.8, applying the lower/high rate of withholding tax and subsequently accruing tax payable to the US IRS off the back of underlying dividends.

The final regulations issued by the US tax authorities raised the Delta threshold from 0.7 to 0.8 and provide that Delta is tested only upon initial issuance of a transaction (or upon a material modification) – and not upon a later acquisition.

What Is The Delta of An Instrument?

The Delta of an instrument is a measure of the relationship between changes in value of the instrument and changes in value of the underlying security or stock. Therefore, if an instrument has a Delta of one, changes in the value of the instrument should reflect or mirror changes in the value of the stock exactly (i.e. 1:1).

Should transactions be of a more complex nature, then firms need to choose either a similar ‘Simple’ approach or a benchmark to compare against (i.e. movements up/down by one standard deviation point). If the actual investment is less than a certain benchmark then they have to calculate tax the underlying holdings and associated dividends, withhold tax and DTT. So, it would all hardly appear to be a stroll in the park on the compliance and logistical front by any stretch of the imagination.

A London-based tax practitioner from top accountancy firm and an ex in-house counsel for a leading US investment bank, gave a presentation and a run through of the history and background to the 871m regulations as well as offering insights and practical advice.

The thrust of his presentation sought to answer questions on how to “resolve issues relatively quickly” and make compliance successful. But after digesting his exhaustive presentation the attendees appear somewhat stunned, which might well illustrate how hard it is when it comes to handling Section 871m.

The Role of Different Parties

Referring to a situation akin to “air traffic control” and dependencies in the role of different financial institutions in the value chain – from agents, broker/dealers, the issuers, underwriters, custodians, intermediaries, and clearing organizations – the tax consultant said: “Critically firms need to think about who is party to the transaction and work out their capacity and what their role is.”

He added: “We really also have to work out the rules [behind 871m] as to our capacity. Therefore, are we a withholding agent, a ‘Short’ party, a ‘Long’ party or are we an intermediary?” So, much to consider.

Furthermore, there is the US definition of a withholding agent to consider, which this practitioner noted is “quite broad”. For example, an organization could be a Short party and a withholding agent, or a Long party and a withholding agent.

“So where are the particular rules?” he opined. “You have to work it out and understand the ordering, the dependencies and look at some scenario planning to where all this fits together.” This calls for a clear business plan to be formulated and documented. And, probably sooner rather than later.

Raising a question in front of the audience at the BBA he asked: “Who is going to be a QDD (Qualified Derivatives Dealer) in the chain. It’s not as if you just sign up to be a QDD – right?”

If, for example, you are a Short party you are the “responsible party”, he pointed out, adding: “Generally, the broker/dealer is going to be the responsible party. And, if there isn’t any other one [i.e. party] it will basically be whoever is the Short party in the transaction.” A point worth noting even if it’s a bit fuzzy.

In relation to simple or complex transactions, the speaker explained that if it’s simple then we have the Delta test, while for complex transactions there is the ‘Substantial Equivalence’ test, which was developed by a “rocket scientist” where “the devil is the detail” he said.

This is because firms need to look at the “probabilities of different payments” as he also acknowledged that the Substantial Equivalence test was “really tough”. Once firms have figured out what set of rules to apply and know if it is simple or complex, they then have to apply the rules.

They need also to think about ‘in-scope’ and ‘out-of scope’ products and exceptions (e.g. qualified indices). Further, on this latter score – due bills and certain compensation-related payments are out-of-scope under the 871m regulations, as are payments made by US insurance companies and certain foreign insurance companies.

Of course depending on the size of a buy- or sell-side institution, firms ultimately need to address “scoping and scale” too as well as work out how big the problem they face is and how many instruments are in/out of scope.

However, even if firms work all that out mechanically and what the withholding tax looks like, subsequently they have to communicate this out to the market and deal with various incoming requests.

The 10-Day Rule

Here there is the ‘10-day rule’ and the IRS says in relation to this that such communication can be by mail, fax, email or other mechanisms.

But as this tax expert pointed out “10 days is not a huge amount of time to go through the process and identify, then communicate to appropriate parties whether it [an instrument] is in scope and then try to understand what the withholding implications are.” Some firms’ calculations could be “fairly large and tricky” too he said. Clearly, having an “871m machine” in place might well be the answer to many firms’ pain points.

And, just to illustrate how confusing matters can be, the tax consultant revealed that he had actually heard someone on the trading floor ask: ‘When exactly is issuance for a batch of structured notes?’ Is it, for example, when they [the notes] are dropped into Clearstream or Euroclear and you effectively place them into the market? It all certainly raises an awful lot of questions.

Operational Issues

Whatever else, firms need to be cognizant that there are many steps to consider as regards the operational issues in dealing and complying with 871m and the tax calculations.

As well as identifying and processing ‘Simple’ versus ‘Complex’ transactions appropriately, they also need to make checks for taxation on Substantial Equivalence, initiate a proof/audit of the benchmark equivalence used, accrue and track tax and payments, ensure 10-day confirmation and 2-day validation, handle Withholding Tax/DTT treatment, where required reclaim tax, and then ultimately file returns.

Decision Time For Firms

Generally the 1 January 2017 deadline for 871(m) might seem far away in the distance, but realistically with around nine months to go before the industry reaches that point firms need to quickly make some decisions about how they address their obligations under the regulations.

Patently there are significant amounts of data/items that require pulling together – statics and trades across many instrument types. It’s a tight deadline for sure given that typical projects of this size can take at least nine months to bed down within organizations.

One also has to appreciate the backdrop of current in-house IT initiatives at some firms is already being stretched on numerous other mandatory projects and banks are downsizing internally. So, that begs the question: Who will help your firm address the big 871m compliance issue and pain points?”

Furthermore, 871m is one of many transaction taxes alongside others like FTT in the European Union and an area that is only set to grow further. The bottom line, as Merit’s Carpenter asserted, is that firms need to “future proof” their platforms and technology. Carpe diem.

Potential Unintended Consequences From 871m

Question: Could the Section 871m regulations potentially drive market participants away from the derivatives products covered by the US Internal Revenue Service’s (IRS) rules?

Answer: At this stage the issue had certainly been discussed according a senior tax specialist and FACTA practitioner presenting on QI and QDD at the Merit Software’s event.

“There are some institutions, particularly where they are not in this business in a large way, that are thinking obviously about whether they want to run products through the UK or an open entity elsewhere,” he revealed. He added: “This is because of the compliance and the risks around withholding tax, And, I think people are having discussions around this right now.”

However, it may not be as simple as deciding not to trade certain derivatives products covered by the 871m rules from next January. As a head of securities tax at a leading accountancy firm remarked: “In the context of securities lending we have found that clients have been unable to switch off US securities – even if they wanted to.”

He explained: “They [firms] would go out to say ‘We just don’t offer any service in US securities’, but inevitably they end up with it because they receive it in the form of collateral for example.”

Consequently, his firm’s experience has been that it was “impossible to tail-off US products.” Such products referred to here could encompass an index or a basket of securities where a US company name pops up.

“So, even though we’ve had clients who very consciously disavowed any kind of US strategy, they still end up with them [securities] – like it or not. I think while sounds potentially doable…in practice it’s impossible. For sure firms can limit their exposure but they cannot exclude these kinds of products altogether.”

Furthermore, this expert revealed that his firm have also had discussions about whether – if you were on the ‘Long’ side – you could always use a US broker so that you would never have withhold (i.e. through a ‘W9’ form).

He pointed out here that the Markets In Financial Instruments Directive (MiFID) in Europe and best execution requirements means that this cannot be done. “So, all the sensible things one might think you could do just don’t work,” he said.


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