On Dec. 2, the U.S. Department of the Treasury (Treasury Department) and the Internal Revenue Service (IRS) issued Notice 2016-76 (Notice) announcing a phased implementation of the final regulations published in 2015 (Final 871(m) Regulations) under Section 871(m) of the Internal Revenue Code (Code). The Final 871(m) Regulations will apply to any payments made with respect to any potential 871(m) transaction issued or entered into on or after Jan. 1, 2017, that has a delta (generally, the ratio of the change in the fair market value of the contract to the change in the fair market value of the underlying security) of one (Delta-One Transaction), including a transaction that is a “combined transaction” under the Final 871(m) Regulations. The Final 871(m) Regulations will, however, generally not apply to any payments made with respect to any transaction that does not have a delta of one (Non-Delta-One Transaction) issued or entered into before Jan. 1, 2018. The Notice also clarifies certain administrative rules for entities seeking to become qualified derivatives dealers (QDDs).

Background

Section 871(m) generally treats “dividend equivalent” payments on certain financial contracts that reference U.S. equities as U.S. source dividends that are generally subject to a 30 percent withholding tax when paid to non-U.S. persons (871(m) Transactions). The Treasury Department and IRS issued regulations under Section 871(m) in several parts. Through the end of 2016, Section 871(m) withholding applies only to securities lending transactions, sale-repurchase agreements and notional principal contracts that meet certain requirements. The Final 871(m) Regulations expand Section 871(m) withholding to apply generally to any 871(m) Transaction if such transaction has a delta of 0.80 or greater. The Final 871(m) Regulations were previously generally effective for transactions entered into on or after Jan. 1, 2017.1

Phased-In Application for Delta-One and Non-Delta-One Transactions

The Final 871(m) Regulations will apply to any dividend equivalent payment made with respect to any potential 871(m) Transaction issued or entered into on or after Jan. 1, 2017, that is a Delta-One Transaction, including a transaction that is a “combined transaction” under such regulations. However, the Final 871(m) Regulations will not generally apply to any dividend equivalent payment made with respect to any transaction that is a Non-Delta-One Transaction issued or entered into before Jan. 1, 2018.

The Treasury Department and IRS acknowledged the challenges taxpayers and withholding agents face with complying with the Final 871(m) Regulations, and the Notice provides for relaxed administration and enforcement of Section 871(m) during the “phase-in years” if the taxpayer or withholding agent makes a “good-faith effort” to comply with the Final 871(m) Regulations. 2017 will be considered a “phase-in year” for Delta-One Transactions, and 2018 will be considered a “phase-in year” for Non-Delta-One Transactions.

Simplified Standard for Determining Whether Transactions Are Combined Transactions

The Notice provides a temporary simplified standard for withholding agents (though not for taxpayers who are long parties) to determine whether transactions entered into in 2017 are combined transactions. Under these standards, a withholding agent will be required to combine transactions entered into in 2017 only when the transactions are over-the-counter transactions that are priced, marketed or sold in connection with each other. Accordingly, withholding agents will not be required to combine any transactions in respect of listed securities that are entered into in 2017. Transactions that are treated as combined under this standard will continue to be treated as combined transactions for future years. Transactions that are not treated as combined under this standard will not be considered combined in future years unless they have to be retested under the Final 871(m) Regulations.

Clarification Regarding Certifying QDD Status

The Notice provides details in respect of which non-U.S. entities may apply for and certify as to their QDD status. The QDD regime addresses potential cascading or overwithholding on certain derivative transactions by providing that no withholding tax is required on certain payments made to a QDD when the QDD is acting as a principal. The IRS provided preliminary guidance on the QDD regime in Notice 2016-42,2 pursuant to which prospective QDDs are directed to request QDD status by submitting a new qualified intermediary agreement (QI Agreement) application to the IRS. Upon approval of the applicant’s QDD status, the IRS will send the applicant a QI employer identification number (a QI-EIN) certifying the applicant’s status as a QDD. The IRS intends to issue an updated QI Agreement form prior to Jan. 1, 2017.

Prospective QDDs can certify their QDD status on a valid Form W-8IMY given to a withholding agent. Thus, for example, a prospective QDD that submits a QI Agreement and applies for QDD status on or before March 31, 2017, may represent on a Form W-8IMY that it is a QDD prior to IRS approval of a QI Agreement and QDD status until the end of the sixth full month after the month in which it submits its QI application requesting QDD status.

Phase-In Year for Qualified Derivative Dealers

Additionally, to facilitate the implementation of the QDD regime, the Notice clarifies that a QDD’s tax liability under Section 871(m) will be determined by determining the QDD’s “net delta exposure” and establishes 2017 as a “phase-in year” in which the IRS will consider the QDD’s “good-faith efforts” of complying with the Final 871(m) Regulations and respective QI Agreement when administering and enforcing the Final 871(m) Regulations.

Action Items

Investment managers should consider this additional guidance in connection with any request from a fund-trading counterparty in respect of either adhering to the 2015 ISDA Section 871(m) Protocol or executing a bilateral contractual amendment incorporating the substance of such protocol. Investment managers should specifically (A) evaluate whether or not the protocol is relevant to a fund’s investment strategy and how the phased-in implementation impacts the net after-tax costs of certain derivative investments, (B) understand that the protocol appropriately allocates the tax risk to the non-U.S. long counterparty, (C) diligence whether any non-U.S. counterparty is a QDD so the fund doesn’t need to be concerned about being a withholding agent in respect of any short positions and (D) adhere to the protocol or execute an amendment thereof before year-end to avoid any trading disruptions.

The Final Section 871(m) Regulations are complex and address a significant number of other important issues.