Proposed QI Agreement Includes Derivatives Dealer Provisions

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By Allyson Versprille

July 1 — New IRS guidance adds several requirements for securities dealers and banks that want to become qualified derivatives dealers to avoid cascading withholding tax.

In order for an entity to act as a qualified derivatives dealer for purposes of tax code Section 871(m) transactions—such as securities lending and sale-repurchase transactions—that entity must enter into a qualified intermediary agreement with the Internal Revenue Service and adhere to certain compliance procedures. The provision was included in the proposed qualified intermediary agreement the IRS released July 1 (Notice 2016-42). The guidance reduces the potential for multiple withholdings on a single stream of dividends.

While adopting several ideas from proposed regulations (REG-127895-14) issued in September 2015, there are also a “few departures that are significant,” Tara Ferris, a principal at Ernst & Young LLP, said (181 DTR G-2, 9/18/15).

Ferris is a former IRS employee who drafted the last QI agreement and much of the new guidance before moving to EY.

“The proposed regulations provided that the QDD could act as a QDD with respect to dividends and dividend equivalent payments made in a dealer capacity,” she told Bloomberg BNA July 1. Industry “responded in comments to say it was very difficult to determine what was a dealer capacity and what was not.”

Therefore, the IRS has expanded what payments a QDD can act for, which includes all potential Section 871(m) transactions, regardless of whether they are made in a dealer capacity, she said.

Mark Leeds, a partner at Mayer Brown LLP,said he didn't see any real alternative to this expansion. “Without having the QDD regimen apply to propriety transactions as well as dealer transactions, there would be such a huge potential for the whole system messing up and there not being the right amount of withholding,” he said.

The new guidance is related to final regulations (T.D. 9734) published alongside the proposed rules that govern withholding on certain notional principal contracts, derivatives and other equity-linked instruments with payments that reference dividends on U.S. equity securities. The rules are aimed at preventing foreign investors from skirting the U.S. withholding tax on dividends.

Replacing QSL

The qualified derivatives dealer regime will replace the existing qualified securities lender standard.

“With QSL in the past there wasn’t an agreement that you signed up for. It was discussed that there would be some compliance and verification requirements but those were never published,” Ferris said.

“Now with QDD there is a requirement to enter into a QI agreement with the IRS, and then the compliance procedures that apply to all QIs, a QDD will have to comply with for purposes of its 871(m) transactions,” she said.

Less Than Expected

Leeds said from a Section 871(m) perspective, the notice on QIs provided less detail about qualified derivatives dealers than practitioners were expecting or hoping.

“When they came out with the QSL rules, they had a notice—2010-46—that was really robust, and while it didn’t actually contain the physical procedures of a QSL agreement, it contained really detailed rules of what was expected of someone who was acting as a qualified securities lender,” he said.

“This approach is 180 degrees from what they did in the QSL regimen,” he added. Rather than coming out with a very specific notice or other type of release with respect to someone who is acting as a QDD, they just folded what they’ve gotten so far into the existing QI regimen,” he said.

More QDD Requirements

According to the notice, a QI may not act as a QDD when it receives or makes a payment pursuant to a potential 871(m) transaction as an intermediary, as opposed to a principal.

The IRS used the example of a complex contract called a structured note. The QI wouldn't be able to act as a qualified dealer if it was acting as a custodian of such a note with a payment referencing a dividend of a domestic corporation.

The IRS notice also includes a provision on how a QDD determines 871(m) tax liability, which Ferris said is a new addition to the dealer rules.

“Many were curious about what offsetting payments would be counted for purposes of determining the 871(m) liability,” she said.

Under the IRS notice, a “qualifying dividend equivalent offsetting payment” is defined as any payment made to a U.S. person that would be a dividend equivalent payment if made to a non-U.S. person; or any payment made to a foreign person that would be a dividend equivalent payment if the payment weren't treated as income effectively connected with the conduct of a U.S. trade or business.

Tracking Non-Exempt Recipients

Included in the IRS notice is a requirement for QDDs to track payments made to U.S. non-exempt recipients, meaning a payee that isn't exempt from Form W-9, Request for Taxpayer Identification Number (TIN) and Certification, and Form 1099, Miscellaneous Income, reporting requirements.

For payments to a U.S. person that would otherwise be dividend equivalent payments if paid to a non-U.S. person, “the QI is required to obtain a waiver if those U.S. persons are non-exempt recipients,” Ferris said.

A QDD is required to keep track of the name, address and U.S. taxpayer identification number of the non-exempt person and provide it to the IRS upon request, she said.

“If they don’t obtain that waiver then they can’t treat it as an offsetting payment in calculating their 871(m) liability and they have to report those payments in a pool in a separate 1042-S,” Foreign Person's U.S. Source Income Subject to Withholding, Ferris said.

Leeds said the waiver requirement will have a notable impact on structured note transactions because foreign banks often issue such notes to U.S. persons.

“There’s going to have to be a revamping of how information about the owner is retained and the documentation is going to have to include specific waivers from U.S. persons so that their ownership of the note can be disclosed to the IRS,” he said.

The provision is “aimed at ensuring compliance of these U.S. non-exempt recipients in reporting their income associated with these transactions,” Ferris said. “They’re not subject to withholding because they’re U.S. persons but they would have to report income because income to U.S. persons we tax regardless of source,” she said.

Leeds said in his view it appeared the IRS was “very afraid that people were going to game the system and the foreign bank would say, ‘Okay I’ve received this dividend in and I wasn’t subject to withholding because I’m a QDD and I made a payment out to a U.S. person so there was no withholding at all.' ”

QI Compliance Changes

Outside of the qualified derivatives dealer provisions, the IRS notice includes several changes to compliance requirements for QIs in general.

The guidance provides that a QI that is a foreign financial institution and isn't acting as a QDD can apply for a waiver from the periodic review and from providing some factual information regarding its documentation, withholding, reporting and other obligations under the QI agreement. However, the QI is still required to make the periodic certification of its internal controls, Ferris said.

“That’s a significant change from where the QI agreement previously was,” she said.

Under the guidance, industry was also given more flexibility on which year to have the periodic review for purposes of providing factual information, which is something that was requested by practitioners, Ferris said.

Additionally, all references to an “auditor” in the proposed QI agreement have been changed to “reviewer” in order “to prevent unintended inferences that the periodic review must satisfy the standards of a financial audit or other attestation engagement of a certified public accountant,” the notice said.

The proposed changes to the QI agreement, which are subject to modifications until finalized, will apply to agreements in effect on or after Jan. 1, 2017.

That is also the effective date for the requirements and obligations applicable to QDDs.

To contact the reporter on this story: Allyson Versprille in Washington at

To contact the editor responsible for this story: Cheryl Saenz at

For More Information

Text of Notice 2016-42 is in TaxCore.

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