Institutions with high stakes in the US Equities business have been awaiting the publication of the Equity Derivatives Regulations (871(m)) with bated breath.

The rules were released by the Internal Revenue Service (IRS) and US Treasury on 18 September 2015 and are an enhancement of the US withholding tax framework to address perceived tax avoidance on derivative contracts based on US equities.  Withholding tax will apply on all dividend equivalent payments for eligible contracts / products (Notional Principal Contracts (NPCs) such as Equity Swaps and Warrants and Equity Linked Instruments (ELIs) such as Options, Forwards and Futures).

US equity-based derivatives contracts will be affected

The regulation affects all financial institutions dealing in US equity based derivative contracts for non-US clients. All NPCs and ELIs will need to be checked to identify whether they fall under the remit of the regulation, i.e., if they have a US equity underlying (such as a reference to a US stock holding, a basket of securities containing US equities or a stock index).

The regulation stipulates additional eligibility checks on these products in the form of a delta test or a 'substantial equivalence' test depending on whether the product is classified as simple or complex respectively. Products meeting these eligibility criteria will be considered in scope for 871(m) withholding.

There are additional provisions within the regulation concerning the identification of eligible transactions where they are 'in connection' with other eligible transactions (the so-called 'combination rule').

Front-to-back functional impact and large-scale infrastructure change expected

The key requirement from 871(m) is to apply a withholding tax on eligible payments and perform corresponding reporting to the IRS. Middle and back office functions (especially settlements, tax operations and reporting) will need to be involved.

Identification of transactions that are in scope has been complicated by the introduction of the delta and 'substantial equivalence' tests. This will need involvement of front-office functions to flag transactions as eligible based on issuance delta.

Additionally, 871(m) eligible products may have an impact on the bottom line – withholding may squeeze profitability of eligible products – and banks may need to decide whether the impact will be felt on their prices or on their bottom line.

Furthermore, compliance with these rules will depend on appropriate legal and tax documentation being in place for the compliance date, as well as ensuring that appropriate processes are in place to both withhold and report on withholding.

Staged readiness is required with first withholding applying from 2017

The final regulations add two new sets of effective dates to the existing regulation. For eligible transactions issued from 1 January 2017, withholding must apply on all dividend equivalent payments. For eligible products issued through 2016, a grace period of a year has been given and withholding will apply only from 2018.

Start preparing now to achieve compliance 

To make the most of the 15 months left to comply, financial institutions should start assessing the impact on their business and how it will need to change to comply with these new rules.

As a firm that combines both tax advisory and regulatory compliance expertise, Deloitte has been monitoring the development of 871(m) regulation closely to support our clients' journey to compliance. Our specialised tax counsel team under Chris Tragheim provides guidance and interpretation of the new rules, while our team of regulatory change experts under Nina Gopal has been supporting clients in identifying the impact to their business and the changes required to their operating models.

Watch this space for more news on 871(m) compliance requirements.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.