Document 2527552

Tax Insights
from Global Information Reporting
Immediate action required by asset
managers to address US tax
withholding and reporting on
dividend equivalent payments
April 1, 2016
In brief
The Internal Revenue Service (IRS) on September 17, 2015 released final and temporary regulations under Section 871(m) of the Internal Revenue Code (Code) that prescribe rules for treating ‘dividend equivalent payments’ with respect to US equities as US source dividend income subject to US information reporting and withholding. These regulations will have a significant impact on asset managers whose portfolios contain instruments linked to US equities, including a broad range of equity derivatives as well as
equity-linked notes and convertible debt instruments.
The final regulations generally refine the tests provided in proposed regulations issued on December 5,
2013 and address many of the comments made with respect to the proposed regulations. See our Tax
Alert: New guidance on US withholding on dividend equivalent payments on swaps over US equities
for more information. The net effect of the revisions has been positive for asset managers, but substantial
work remains for asset managers to be ready for the January 1, 2017 effective date.
Observation: The primary concern for most asset managers is determining the types of transactions
covered by the scope of these rules. While Section 871(m) originally was directed at equity swaps which
represented the equivalent of ownership of the underlying US equity for which no reporting or withholding was required, the regulations apply to a much broader range of instruments. For example, for
derivatives over US equities that provide something less than ‘total return,’ the potential for withholding depends on a complex set of scoping rules. Similarly, certain index derivatives are excluded from
the scope of dividend-equivalent withholding.
The regulations also provide a so-called ‘combination rule’ under which separate transactions may
need to be tested in combination to determine the presence of a dividend equivalent under Section
871(m). This rule creates additional challenges for asset managers. Both withholding agents (basing
their determination on their information) and asset managers are responsible for applying this rule,
which can be challenging where multiple brokers or custodians are being used.
In detail
Background – Section
871(m)
Section 871(m) treats dividend
equivalent payments with respect to ‘Section 871(m) trans-
actions’ as US source income. As
a result, these payments are
now subject to tax in the US in
some manner. If paid to a nonUS person not otherwise engaged in a US trade or business,
the tax generally is collected
through withholding under
Chapter 3 or Chapter 4 (FATCA)
of the Code (if the counterparty
has not provided adequate documentation).
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Tax Insights
Should the withholding not be levied,
the withholding agent and recipient
are still liable for the tax.
The maximum rate of withholding on
income paid to a non-US person absent a treaty benefit or an exception
under the Code is 30% of the gross
payment. Dividend equivalent payments are treated as actual dividends
for tax treaty purposes. As a result, a
treaty provision could reduce the tax
rate (generally to 15% for portfolio
dividends) that applies to Section
871(m) dividend equivalent amounts.
Section 871(m) transactions include
securities lending and repo transactions, specified notional principal
transactions (NPCs), and specified
equity linked instruments (ELIs). The
definition of an NPC includes most
equity swaps. The definition of an ELI
is a financial transaction that references the value of one or more underlying securities that reference a US
entity if a payment on that security
could give rise to a US source dividend. ELIs include futures, forwards,
options, convertible debt, and any
other contractual arrangement.
Observation: The final regulations
treat payments made on a broad
range of US equity-linked transactions as equivalents of payments of
US source dividends subject to information reporting and withholding,
therefore making many common total return derivatives over US equities subject to both information reporting and tax withholding on dividend-equivalent payments beginning
on January 1, 2017.
Two types of contracts
After January 1, 2017, the regulations
will divide, at a high level, the universe of equity linked products into
‘simple’ and ‘complex’ contracts and
provide alternative tests for each type
of contact. Simple transactions are
treated as being within the scope of
Section 871(m) if the delta for the contract is 0.8 or higher. Complex con-
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tracts are tested under a ‘substantial
equivalence test’ that was designed by
the IRS, after consultation with banks,
to mirror how those banks hedged
equity linked transactions.
As such, potential Section 871(m)
transactions must be tested under one
of following tests to determine whether they are within the scope of the
rules:
 For simple contracts, the delta of
the contract is measured against
the delta of the underlying security.
A simple contract is one where all
amounts to be paid are calculated
by reference to a single, fixed number of shares on a single maturity
date. The delta for the transaction
is the ratio of the change in the
value of the NPC or ELI to a small
change in the value of the number
of shares of the underlying security
referenced by the NPC or ELI.
 For complex contracts, the temporary regulations provide a ‘substantial equivalence test’ that measures
whether the performance of the
NPC or ELI replicated the performance of the underlying security.
The test has several components
and involves the comparison of
movements on the contract and its
initial hedge to movements on the
underlying security.
Observation: Given the scope, typical total return derivatives over US
equities will attract US withholding
tax for trades entered on or after
January 1, 2017. For some asset
managers, 2016 is a time to assess the
impact on their trading strategies
and assess whether strategies need to
be revised (or anticipated return on
investment reassessed) based on the
potential imposition of US withholding. The delayed effective date not
only provides opportunities for asset
managers to design, build, or buy
systems and implement processes or
procedures to become compliant with
Section 871(m), but also to prepare
the entire organization for its effective date.
In part, this is an opportunity to address potential US withholding as an
operational risk, rather than a tax
risk, by soliciting feedback from affected stakeholders in legal, portfolio
compliance, operations, and other
lines of business. Given the necessity
to manage potentially high volumes
of trading data (either directly or
through leveraging service providers,
such as custodians and administrators), the broader organization must
both understand the potential US tax
exposure and contribute to building
practical solutions to address it.
The combination rule
The combination rule treats two or
more transactions as a single transaction for purposes of determining
whether a potential Section 871(m)
transaction is covered by the regulations. This rule applies when the
transactions were entered into in connection with each other and the economics of the combined transactions
would create an instrument that is
treated as a Section 871(m) transaction.
The broker or dealer that is the party
to the Section 871(m) transaction generally determines when the transaction is subject to withholding under
Section 871(m). If both parties to the
transaction are brokers or dealers, the
short party must determine whether
the transaction is in scope. A broker
facing a hedge fund must determine
whether the positions that the broker
has with respect to that fund must be
combined to test whether a Section
871(m) transaction exists. For example, a broker that has sold a call option
and bought a put option with respect
to the same US equity with the same
fund must determine whether combining those two positions would cre-
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Tax Insights
ate a derivative with a delta of 0.8 or
greater with respect to the US equity.
The combination rule provides some
relief to the short parties to the individual contracts that may give rise to a
Section 871(m) transaction when
viewed in combination. The relief allows the short party to take advantage
of two presumptions:
 Positions do not need to be combined if they are in separate accounts maintained by the short
party.
 Positions entered into two or
more business days apart do not
need to be tested.
Neither presumption applies if the
short party has actual knowledge that
the transactions were entered into in
connection with each other. The presumptions do not apply to the long
party. Thus, a fund that is a long party
on a portfolio of potential Section
871(m) transactions will be required
to assess the portfolio without the
benefit of the presumption rules. The
fund that is a long party will have to
pay tax on the US source income from
the Section 871(m) transactions if the
combination rule applies.
Observation: The application of the
combination rule will result in increased compliance burdens for
hedge funds or similar entities with
derivative exposure to US equities. To
the extent that such funds are the long
parties to potential Section 871(m)
transactions and the short parties are
either unaware of all of their positions or entitled to rely on the presumptions, the fund will be required
to analyze all of the positions in its
portfolio with the same underlying
security and determine whether any
combination of those positions will
give rise to a Section 871(m) transaction. Both the simple and complex
contract tests are applicable in this
context.
In practice, all positions with respect
to the same underlying security may
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have to be assessed to see if they
‘match up’ to trigger the application
of Section 871(m). Although a trader
may be able to assess the potential for
application of the tests in the majority of cases with relative ease, being
able to demonstrate compliance with
the rules may pose challenges to the
fund. Further, manually conducting
these exercises in sufficient time to
assess withholding and reporting risk
is onerous for funds engaging in high
volumes of activity.
Treatment of payments to US
partnerships
Where amounts subject to US tax under Section 871(m) are paid to a US
partnership, the payor typically treats
these payments as made to another
US entity and does not engage in additional inquiry to determine whether
withholding and/or reporting is required. To the extent that a dividendequivalent payment received is in
scope, the US partnership may be required to withhold an appropriate
amount based on the status of its
partners. The US partnership must
determine whether the payor has determined whether the payment is subject to withholding under Section
871(m) or whether it will have to undertake the analysis itself.
This analysis is complicated in a fundof-funds context, where a US partnership might be receiving dividendequivalent payments from another US
partnership. (These structures are
more common in a post-FATCA world
in which more asset managers rely on
US partnerships to manage investor
disclosure considerations.)
Observation: With respect to the
flow of information, the original
short party should determine whether the payment is made pursuant to a
Section 871(m) transaction. Practically, however, it is not clear that such
information would flow to a US partnership. Consideration could be given
to requesting such information from
the original short party, if they have
privity of contract with such party. It
is not clear whether disclosure
(through a footnote in its Schedule K1 reporting or elsewhere) is required
with respect to tiered partnerships.
Practical considerations
In certain cases, only an asset manager is in a position to determine when
reporting and withholding under
these dividend equivalent rules should
apply. For example, a fund that has
entered into multiple positions over
the same US equity with various brokers will be the only entity with
knowledge of all of the positions to
apply the combination rule.
In addition, when dividend-equivalent
withholding is required on derivatives
over certain partnership interests
(generally hedge funds or other partnerships in the business of investing
or trading in securities), the timing of
the required withholding might not be
known to the withholding agent.
Similarly, the potential scope of reporting obligations when payments
are made through tiers of entities
(some US, some non-US) is not entirely clear from the regulations and
disproportionately affects asset managers with Schedule K-1 reporting obligations.
US funds (that are withholding
agents) also may be affected by these
rules. US funds shorting certain derivatives over US equities with non-US
counterparties, may be required to
compute certain information and report and withhold on such transactions -- functions that they may not
operationally be prepared to conduct
today
The takeaway
While January 1, 2017 is nine months
away, the planning and effort necessary to determine the impact and implement any necessary process improvement clearly makes now the time
to start. Although many asset managers have already begun assessing and
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Tax Insights
addressing the impact of Section
871(m), much work remains. This effort should include identifying the
types of transactions that will be affected by Section 871(m), building
awareness to the corresponding impact on the various areas in the organ-
ization (such as tax information reporting and withholding), and addressing any systems, process, procedure, and trading strategy updates
necessary in advance of the effective
date. For example, manual processes
and procedures may be sufficient
where such transactions are not voluminous. However, consideration may
be given to creating or acquiring software to assist in the computations
where there are large volumes of
transactions.
Let’s talk
For more information on how Section 871(m) may impact you, please contact:
Dominick Dell'Imperio
(646) 471-2386
[email protected]
Candace Ewell
(202) 312-7694
[email protected]
Jonathan Lebow
(646) 471-3480
[email protected]
Rebecca Lee
(415) 498-6271
[email protected]
Jeff Maddrey
(202) 414-4350
[email protected]
Erica Gut
(415) 498-8477
[email protected]
Jon Lakritz
(646) 471-2259
[email protected]
Rob Limerick
(646) 471-7012
[email protected]
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