Nies’s Law posits the amount of effort expended by a bureaucracy in defending any error is in direct proportion to the size of the error. One might think that this observation was coined watching the US Internal Revenue Service (the “IRS”) attempt to defend and implement its wide-ranging regulations issued pursuant to the narrow rule enacted by Congress in Section 871(m) of the Internal Revenue Code of 1986, as amended (the “Code”), to address derivatives that previously facilitated dividend up-lift transactions. This Legal Update explores recently released IRS training materials that synthesize the materials released by the IRS for entities that want to make the election to be treated as qualified derivative dealers (“QDDs”) through the lens of the IRS’s own newly issued rules on what constitutes authority that taxpayers can rely on.
A Short Background
Code § 871(m) imposes US withholding tax on certain US-source dividend equivalent payments made to non-US persons as though the dividend equivalents were the payment of actual dividends. The IRS regulations issued under Code § 871(m) require short parties on derivatives referencing US equities to collect US withholding tax on dividend equivalents paid to non-US persons through two complex regimes: (i) the delta test rules and (ii) the substantial equivalent test rules.2 When a non-US short party hedges its position under structured products, swaps and other financial products that provide long exposure to US equities to non-US clients and counterparties (as is usually the case), absent some relief mechanism, there would be two levels of withholding tax: (i) first, on dividends and dividend equivalents paid on the hedge held by the short party and (ii) second, on dividend equivalents paid on the structured product or derivative written to the client or counterparty. There is no automatic credit forward on the position written to the client for withholding taxes imposed on hedges held by the non-US short party as there has been in securities lending transactions under the qualified securities lending (“QSL”) regime. These multiple levels of withholding tax are sometimes referred to as “cascading withholding taxes.”
To address the double (or more) withholding tax challenge, the IRS has created a new status for non-US equity derivative dealers (now dubbed, “EDDs”) called the “qualified derivatives dealer” regime.3 The QDD relief is available only to qualified intermediaries (“QIs”).4 In other words, the only non-US persons eligible to become QDDs are those who have validly elected to be treated as QIs. For reasons not entirely clear, actual dividends paid to QDDs in connection with Section 871(m) transactions will not be exempt from withholding beginning in 2018. But the important point for our purposes is that the QDD regime is the only avenue being offered by the IRS for non-US issuers of structured products and other derivatives to avoid cascading withholding taxes.
It is worth noting that the challenge of cascading withholding taxes is not posed to US issuers of structured products and other equity derivatives because there is no withholding tax imposed on the payment of dividends and dividend equivalents to US persons. Likewise, the challenge is not posed to non-US EDDs issuing structured products through US branches because there is no withholding tax imposed on payments of dividends and dividend equivalents paid to non-US persons in connection with the conduct of a US trade or business. Accordingly, the challenge only exists for non-US EDDs acting from outside of the United States.
A substantial amount of QDD guidance is contained in the Instructions to IRS Form W- 8IMY, the Foreign Account Tax Compliance Act (“FATCA”) frequently asked questions (“FAQs”) maintained at IRS.gov, the Instructions to the QI Application Form, and IRS regulations. CCA 201727006 (“CCA”) (released July 7, 2017) synthesizes these various sources of guidance and provides an overview of how the IRS sees the QDD regime working.
But What Can Prospective QDDs Rely On?
The courts have consistently held that taxpayers may not rely on instructions issued in connection with IRS forms and publications to avoid non-compliance penalties. Nonetheless, taxpayers, of course, have hoped that the IRS would honor its non-authoritative guidance, especially in areas such as FATCA compliance and the QDD rules, each of which were created solely by the IRS. In a blurb that no one would blame you for missing, the IRS Small Business/Self Employed Division has announced that it will be amending its instructions to tax auditors to specifically provide that IRS FAQs and other authorities not published in the Internal Revenue Bulletin (“IRB”) may not be relied upon:
IRS employees must follow items published in the IRB, and taxpayers may rely on them. Some items, such as FAQs, can be found on IRS.gov but have not been published in the IRB. FAQs that appear on IRS.gov but that have not been published in the IRB are not legal authority and should not be used to sustain a position unless the items (e.g., FAQs) explicitly indicate otherwise or IRS indicates otherwise by press release or by notice announcement published in IRB.
If the IRS Large Business & International Division takes a similar approach, this rule would create a void in the middle of the guidance issued with respect to FATCA and the QDD rules, as both regimes have relied on implementation through instructions, publications and FAQs. The IRS continues to move forward with this non-published guidance on the application of the QDD rules. The CCA provides slides from a May 2017 QDD internal IRS training session, covering an overview of Section 871(m), the eligibility requirements necessary to become a QDD and tax liability issues of a QDD, as well as other procedural and substantive issues. The CCA is the first taxpayers have seen of the IRS’s view of how the Treasury regulations, FAQs on IRS.gov and the QI registration system user guide work together.
You’re All I Got, I Guess You’ll Have to Do
While the CCA generally covers prior guidance and did not include many new revelations, there are a few areas that are worth highlighting. For example, the CCA provides that the “know your customer” (“KYC”) rules generally applicable to a QI also apply to a QDD. The CCA also states that if a QI is a foreign financial institution (“FFI”) applying for QDD status on behalf of the home office or any branch, the applicant may only act as a QDD if that branch is located in a jurisdiction identified on the IRS's Approved KYC List. However, if a QI is an NFFE and applying for QDD status on behalf of the home office or any branch, the QDD is not required to be located in a jurisdiction identified on the IRS's Approved KYC List.
The CCA briefly addresses foreign branches of US financial institutions that act as QDDs, noting that the QDD activities must be included on the appropriate US income tax return, including situations in which the QDD does not have a separate QDD tax liability. With regard to reporting obligations, the CCA notes that a QDD (other than a foreign branch of a US financial institution) must report its withholding tax liability under chapters 3 and 4 on Form 1042 and must report its QDD tax liability on the appropriate U.S. tax return (which, for 2017, is a Form 1120-F) and states that it is expected that a QDD tax liability will be reported on a QDD-byQDD basis (that is, each QDD branch or QDD home office would separately report the QDD tax liability).
A few slides are dedicated to the QDD compliance program, as provided for in the 2017 QI Agreement (Rev. Proc. 2017-15). As we approach the 2018 certification period, we thought it worthwhile to flag some of the items identified by the CCA. For example, the periodic review for the certification period will evaluate the QDD’s (i) determinations as to whether or not transactions are Section 871(m) transactions; (ii) computations and determinations of dividend equivalent amounts, dividends and taxes paid; (iii) determinations regarding whether transactions are in its equity derivatives; (iv) net delta exposure computation; (v) Section 871(m) amount and the calculation of its QDD tax liability; and (vi) calculations of any other amounts required to be included on the reconciliation schedule. Further, the QDD and QI activities must be reviewed separately.
Lastly, the CCA appears to confirm that interbranch transactions should be excluded in calculating net delta exposure for the purposes of computing QDD tax liability. (See “Example 5: Net Delta Exposure with Multiple QDD Branches.”)
As of the date of this Legal Update, the IRS has published more than 90 FATCA and QI FAQs, not including the IT-related FAQs. Taxpayers have found these FAQs to be helpful and an efficient way for the IRS to address public comments and concerns relating to these areas. However, as FATCA and QI audits commence (presumably following the 2018 certification period), it will become apparent just how much taxpayers have relied on FAQs and other forms of non-authoritative guidance to formulate internal policies and procedures relating to the QI and FATCA regimes. Taxpayers who rely on these forms of non-authoritative guidance must also cope with the fact that the IRS is able to edit, and delete, FAQs without any record of the previous version, which can present issues when a taxpayer finds the guidance that was relied on is no longer available.
Taxpayers have heavily relied on nonauthoritative guidance relating to the FFI and QI registration. The IRS has yet to issue authoritative guidance on the registration systems. Rather, the IRS has posted FAQs to its website and published user guides, which, given the absence of other guidance, taxpayers have looked to in order to properly register for FATCA and QI purposes. These issues present challenges for taxpayers that are attempting to properly comply with their FATCA and QI obligations and rely upon whatever guidance has been offered by the IRS, regardless of its form.