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871(m) – What is it?
871(m) – What is it?
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871(m) – What is it?

21/11/2017

Section 871(m) of the US Internal Revenue Code, a US tax initiative on derivatives, is still causing implementation headaches for financial institutions worldwide and focusing their attention

Financial intermediaries and institutional investors are no strangers to tax regulatory initiatives. Since 2014, non-US financial institutions have had to comply with the US Foreign Account Tax Compliance Act (FATCA) regulation. Since January 2016, the Common Reporting Standard (CRS) for the Automatic Exchange of Information (AEOI), involving close to 100 jurisdictions worldwide, has begun to come into effect

What is it?

Through the introduction of Section 871(m) of the Internal Revenue Code (IRC), the US Congress aims to prevent non-US persons from using derivative instruments to avoid US withholding tax on US equities. These new rules apply withholding tax to dividend equivalent amounts (DEAs) received by non-US persons from derivatives or securities that reference dividends paid by US equities.  Section 871(m) already applies to delta-one transactions issued since 1 January 2017 and will be subsequently applied to non-delta-one transactions issued as from 1 January 2019.

What is the scope?

Warrants, convertible bonds, certificates, structured notes, indices, repos, securities lending and listed derivatives fall within the scope if:

  • The underlying securities are US equities – regardless of the issuer’s country of residence
  • These US equities pay a dividend during the life-cycle of the derivatives
  • The derivatives have a delta calculated by the issuers equal to 1 (however, derivatives issued as from 1 January 2019 with a delta greater or equal to 0.8 will be also covered) or meet a substantial equivalence test

How does it work?

With a Section 871(m) transaction, the long party will receive a “dividend equivalent payment” from the short party.

How does it work?
 

Two key stakeholders are involved in a Section 871(m) transaction:

Two key stakeholders are involved in a Section 871(m) transaction

What is the new Qualified Derivatives Dealer (QDD) status?

The qualified intermediary (QI) agreement now includes a status of QDD introduced by the 871(m) regulations. The QDD status enables entities to receive 100% of a dividend equivalent amount.

This status – allowed only for entities regarded as acting as principal in the transaction – will avoid the cascading of withholding tax. This could occur when withholding tax on a dividend equivalent is applied more than once to the same payment due to a chain of multiple parties involved in a Section 871(m) transaction.

What is still to be clarified?

Both US and non-US institutions are still facing some operational challenges and uncertainties to smoothly implement Section 871(m)’s new rules. Some market data providers built offers dedicated to Section 871(m) but are struggling to collect relevant information from issuers. Markets all around the world have seen the birth of working groups on this regulation and an issuer solution is taking shape. In this scenario, the issuer applies a 30% withholding tax to any DEA generated by a 871(m) transaction. Indeed, several markets are considering or have already implemented the issuer solution.

Conclusion

BNP Paribas Securities Services is closely monitoring any information regarding Section 871(m) regulations to ensure adequate implementation. We applied for QDD status in the frame of QI renewal and act as such with regards to our principal lending and clearing of listed derivatives activities. Due to the US administration change at the beginning of 2017, it took some time to meet smooth communication again with the IRS and US Treasury’s representatives. Lobbying from States and market players is still ongoing.

Key dates

30/12/2016      Publication of a new QI agreement, including QDD status

01/01/2017      871(m) regulation effective date for delta-one transactions

31/03/2017      Deadline to renew QI agreement extended to 31/05/2017

01/03/2018      First reporting of DEA via adequate US tax forms

01/01/2019     871(m) regulations effective date for non-delta-one transactions

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