IRS has recently updated its list of general frequently asked questions (FAQs) under the Foreign Account Tax Compliance Act (FATCA), to provide information on how a qualified intermediary (QI) that is not acting as a a qualified derivatives dealer (QDD), is to take into account the good faith standard described in Notice 2016-76 and Notice 2017-42 with respect to its Code Sec. 871(m) transactions as an intermediary, for purposes of its periodic review.
Background on Chapters 3 and 4 of the Code. In general, nonresident aliens and foreign corporations are subject to a U.S. withholding tax on certain items of income that they receive from U.S. sources that are not effectively connected with a U.S. trade or business. Such “fixed, determinable, annual, and periodic income” (FDAP) includes interest, dividends, royalties, compensation, and certain gains. The U.S. withholding tax is generally collected at the source by the withholding agent. Such agent is generally the last person in the U.S. who handles the item before it is remitted to the foreign taxpayer or the taxpayer’s foreign agent.
Under chapter 3 of Subtitle A to the Code, “Withholding of Tax on Nonresident Aliens and Foreign Corporations,” a withholding agent must withhold 30% of any payment that is subject to withholding and made to a foreign payee, unless it can reliably associate the payment with valid tax documentation. (Code Sec. 1441 to Code Sec. 1446)
Chapter 4 of the Code (Code Sec. 1471 through Code Sec. 1474 (FATCA)) requires withholding agents to withhold 30% of certain payments to a foreign financial institution (FFI) unless the FFI has entered into a “FFI agreement” with IRS to, among other things, report certain information with respect to U.S. accounts. (The withholding rules are essentially a mechanism to enforce new reporting requirements.) Chapter 4 also imposes withholding, documentation, and reporting requirements on withholding agents with respect to certain payments made to certain non-financial foreign entities (NFFEs). In cases in which foreign law would prevent an FFI from complying with the terms of an FFI agreement, IRS has collaborated with other governments to develop two alternative intergovernmental agreement (IGA) models that facilitate FATCA implementation.
A QI is an eligible person that submits an application and enters into a QI agreement with IRS. Generally, under the QI agreement, the QI agrees to assume certain documentation and withholding responsibilities in exchange for simplified information reporting for its foreign account holders and the ability not to disclose proprietary account holder information to a withholding agent that may be a competitor. (Reg § 1.1441-1T(e)(5)(ii)) Among other things, a QI agreement can allow certain foreign persons to enter into an agreement with IRS to act as qualified derivatives dealers (QDDs).
QIs must periodically certify to IRS that they are in compliance with the applicable agreement. The certification due date depends on which year the QI selected for its periodic review. In certain situations, a QI may apply for a waiver of the periodic review.
IRS has on its webpage a number of FAQs that provide FATCA guidance. The “FAQs General” section provides FAQs that contain information for financial institutions, withholding agents, and intermediaries on a variety of topics including compliance, reporting, registration and other issues. The FAQs set out how to meet the requirements for a person to enter into a withholding agreement with IRS to be treated as a QI within meaning of Reg. § 1.1441-1(e)(5)and certify to IRS on behalf of a foreign payee that a lower rate of withholding applies.
Background on dividend equivalents.Code Sec. 871(m) treats a “dividend equivalent” as a dividend from sources within the U.S. for purposes of (among other Code sections) Code Sec. 871(a) (dealing with the tax on nonresident alien’s income which is unconnected with a U.S. trade or business) and Code Sec. 881 (dealing with the tax on income of foreign corporations not connected with U.S.).
Code Sec. 871(m)(2) defines a dividend equivalent as (1) any substitute dividend made pursuant to a securities lending or sale-repurchase transaction that (directly or indirectly) is contingent upon or determined by reference to the payment of a dividend from sources within the U.S., (2) any payment made pursuant to a specified notional principal contract (NPC) that (directly or indirectly) is contingent upon or determined by reference to the payment of a dividend from sources within the U.S., or (3) any other payment that IRS determines is “substantially similar” to a specified NPC payment or substitute dividend payment. An NPC is a financial instrument that provides for payments by one party to another at specified intervals calculated by reference to a “specified index” upon a “notional principal amount” in exchange for specified consideration or a promise to pay similar amounts. NPCs include interest rate swaps, currency swaps, basis swaps, interest rate caps and floors, commodity swaps, equity swaps, equity index swaps, and similar agreements.
Final Code Sec. 871(m) regs were to be effective, with exceptions, on Sept. 28, 2015, with certain provisions concerning specified NPCs and equity-linked instruments (ELIs) applying to any payment made on or after Jan. 1, 2017, with respect to any transaction issued on or after that date.
On Dec. 19, 2016, IRS issued Notice 2016-76, 2016-51 IRB 834, which provided for the phased-in application of certain provisions of the Code Sec. 871(m) regs in light of expected amendments to the Code Sec. 871(m) regs and taxpayers’ concerns about complying with certain aspects of the regs by the Jan. 1, 2017 applicability date.
Notice 2016-76, provides that IRS will take into account the extent to which a withholding agent made a good faith effort to comply with the Code Sec. 871(m) regs when enforcing those provisions for delta one transactions for the 2017 calendar year, and for non-delta one transactions, for the 2018 calendar year. See “IRS phases in dividend equivalent regs & announces that modifications are coming.”
Observation: IRS does not define a delta-one transaction. In general, a “delta-based standard” is one that measures the change in the value of an instrument relative to a change in the value of the underlying security. The delta of an NPC or an ELI is the ratio of the change in the fair market value (FMV) of the NPC or ELI to the change in the FMV of the referenced property, determined in a commercially reasonable manner. A delta of one means that, for any change in the value of a derivative, there is expected to be an identical change in the value of the underlying security. For more details on the delta test, see “Final, etc. regs on payments determined by reference to U.S. source dividends.”
Notice 2017-42, 2017-34 IRB 212, extended the period during which IRS will take into account the extent of a withholding agent’s good faith efforts to include 2018 for delta one transactions and 2019 for non-delta one transactions. See IRS intends to delay dividend equivalent regs’ effective date & extends prior phase-in period. For taxpayers and withholding agents, 2017 and 2018 are phase-in years for any delta-one transaction that is a Code Sec. 871(m)transaction under Reg § 1.871-15(d)(2). 2019 will be a phase-in year for any non-delta-one transaction that is a Code Sec. 871(m) transaction under Reg § 1.871-15(d)(2). A Code Sec. 871(m) transaction is any securities lending or sale-repurchase transaction, specified NPC, or specified ELI.
New FATCA FAQ. IRS has revised its general FAQs on FATCA under the heading “Qualified Intermediaries/Withholding Foreign Partnerships/Withholding Foreign Trusts” to provide additional guidance with regard to “Certifications and Periodic Reviews.” New FAQ No. 13 asks: “How should a QI that is not acting as a QDD take into account the good faith standard described in Notice 2016-76 and Notice 2017-42 with respect to its section 871(m) transactions as an intermediary for purposes of its periodic review?”
In FAQ No. 13, IRS states that the good faith standard applies to withholding agents, including QIs acting as withholding agents that are acting as intermediaries for payments made on Code Sec. 871(m) transactions. A QI that is acting as a withholding agent in its intermediary capacity should not exclude Code Sec. 871(m) transactions from its review. Instead, the QI should disclose any Code Sec. 871(m) transactions included in the review that the QI believes should be subject to the good faith standard for purposes of reporting the factual information with its periodic certification that includes the 2017, 2018, or 2019 years. The QI should make the disclosure by uploading an attachment to the Qualified Intermediary/Withholding Foreign Partnership/Withholding Foreign Trust Application Management System, i.e., the secure web-based platform for users to apply to become a QI, WP, or WT, renew, or terminate an existing QI, WP, or WT agreement, and manage their QI, WP, or WT information online. The disclosure should include a brief description of the issue, how the QI will address any such issue by the end of 2018, and why the good faith standard should apply.
References: For reporting under FATCA, see FTC 2d/FIN ¶O-13,230 et seq.; United States Tax Reporter ¶14,714 et seq. For source of dividend equivalents, see Federal Tax Coordinator 2d ¶O-10930 , United States Tax Reporter ¶8614.135.