United States: Tax Talk: Volume 9, Issue 4


Tax Talk doesn't remember much about 1985. But we do remember that, after Ronald Reagan was re-elected president in 1984, tax reform was a very hot topic (remember the Tax Reform Act of 1985?). Anyway, for all the talk, it took Congress until October, 1986 to come up with the landmark Tax Reform Act of 1986. We're not saying it will take that long for fundamental tax reform this time around but, for all the talk of Big Tax Reform, we are still only looking at two "plans" actually in writing: the one on the President's campaign website (three pages—and we're being generous) and the one the House Republicans released last June. As discussed in our article below, the rest is speculation, including about how a "destination based cash flow tax" ("DBCFT") would work.

Speaking of a DBCFT, one fascinating tidbit is that the outline of a cash flow tax was set forth in a U.S. Treasury paper in 1977, the first year of the Carter Administration. One of the report's authors, David Bradford, went on to expand the concept in papers written in 2001 and 2003 before his untimely death in 2005. Other authors (and other tax reform panels) have also weighed in so there is quite a bit of academic thought on the topic.1 Unfortunately, there is no practical experience.

In the meantime, Tax Talk observes that, in the vacuum surrounding Big Tax Reform, bar associations continue to meet and talk about the section 385 regulations, financial institutions are earnestly complying with the Section 871(m) Delta One guidance, seminars are being given on all sorts of topics which may be obsolete by 2018 and tax advisors keep advising based on current law. The only place tax reform is having any impact is in some public securities disclosures. "Kitchen sink" disclosures that anything and everything might change in a Trump tax reform are now creeping into Edgar filings. Also, tax advisors are struggling to develop contract clauses that attempt to protect their clients against the unknowable and unforeseeable tax reform (we've even seen provisions that can be activated based on a Twitter "tweet"). Apart from that, there is not much tax advisors can do except soldier on and watch their Twitter feeds very carefully.

So, is it 1985 or 1986? No one knows...


In case you haven't heard, Donald Trump is now president of the United States. Republicans now control the House, Senate, and Presidency. With this trifecta, the GOP is in the best position in years to push sweeping tax reform. The question then, is what form that tax reform will take. In terms of official guidance, we only have a few documents to work with: (1) the House GOP plan entitled A Better Way – Our Vision for a Confident America (the "House Plan"),2 (2) president-elect Trump's tax plan released in September3 (based on an earlier plan of the Trump campaign entitled Tax Reform That Will Make American Great Again (together the "Trump Plan")).4 Separately, Republicans are moving forward legislation that could significantly alter the way IRS regulations are interpreted by courts.

Tax Reform Plans

Both plans would reduce the number of individual income tax brackets from seven brackets to three, with the top marginal rate of each plan being 33 percent. Both plans would repeal the 3.8 percent tax on net investment income and the alternative minimum tax. The Trump Plan would put a limit on the use of itemized deductions, while the House Plan would eliminate itemized deductions apart from the home mortgage interest deduction and deductions for charitable contributions.

Currently, under section 1014 of the Code,5 the basis of property acquired from a decedent is adjusted to be the fair market value of such property, without taxation on this step up. The Trump Plan would eliminate the estate tax, but capital gains held until death valued over $10 million would be subject to tax, with some exceptions. The House Plan would repeal the estate tax, but would no longer allow for a step-up in basis at death.

Both plans call for overhauls to the corporate and business income tax system, although each plan lacks technical detail. Both plans would eliminate the corporate alternative minimum tax, and while the Trump plan calls for a 15 percent corporate tax rate, the House Plan calls for a 20 percent corporate tax rate. The Trump campaign stated the Trump Plan was intended to give all pass-throughs a 15 percent rate, but only if such taxpayers elect to file their taxes as if they were incorporated. It is so far unclear how this would work in practice. The House Plan

would tax small businesses and pass-throughs at 25 percent, but such taxpayers will be treated as having paid reasonable compensation to their owners.

The House Plan would repeal the current depreciation system and allow the cost of capital (for both tangible and intangible assets) to be fully and immediately deductible. However, deductions for net interest expenses on debt would only be allowed as a deduction against interest income; unused deductions could be carried forward. The Trump proposals would allow firms engaged in U.S. manufacturing to fully expense capital investments, with no deduction for corporate interest expense.

In addition, the House Plan proposes the United States switch to a border adjusted cash flow tax for businesses. Under a cash flow tax, a business is taxed on its cash flow, i.e., its business receipts less its expenditures. With a cash flow tax, assets would be immediately expensed. A border adjusted tax conforms to a "destination-based" principle – generally, tax is levied where goods end up rather than where the goods were produced. This would exclude from the U.S. federal tax base the sale of goods and services to non-U.S. persons, but include sales to U.S. persons, including sales by non-U.S. persons into the U.S. A change to a border adjusted tax flow tax would be a drastic departure from the current U.S. system. Also, there is no clarification on a topic near and dear to Tax Talk: the treatment of financial instruments, financial institutions, and financial transactions in a cash flow tax world.

Ending Chevron Deference?

The Regulatory Accountability Act of 2017 (the "Act"), passed by the House on January 11, 2017, would eliminate the deference courts give to agency regulations, including Internal Revenue Service ("IRS") regulations. In Chevron, U.S.A. Inc. v. Natural Resources Defense Council Inc., 467 U.S. 837 (1984), the Supreme Court held that a court cannot overrule an agency regulation under an ambiguous statute unless it is "arbitrary or capricious in substance, or manifestly contrary to the statute." Moreover, under Chevron, a court is required to give deference to an agency's interpretation. This so-called "Chevron deference" allows agencies, including the IRS, to issue interpretive regulations with a high threshold for challenge. The Act would modify a number of the rules surrounding the Administrative Procedure Act, including replacing "Chevron deference" with a de novo review of regulations. If the Act were to become law, taxpayers would have greater opportunity to argue that IRS regulations should be overturned.



Section 871(m) is the Code provision that treats "dividend equivalents" paid under certain contracts as dividends from sources within the Unites States and therefore subject to U.S. withholding tax if paid to a non-U.S. person. The current guidance on section 871(m) exists in three places: (1) the final regulations from September 2015;6 (2) Notice 2016-76 (the "Notice") from December 2016,7 which announces changes to the final regulations; and (3) the final qualified intermediary agreement from December 2016, found in Rev. Proc. 2017-15, which implements and expands on Notice 2016-76 regarding the withholding tax liability of qualified derivatives dealers ("QDDs"). For practical purposes, the main takeaways for dividend equivalent withholding generally from the December guidance are threefold. First, the effective date for the application of section 871(m) is January 1, 2017, for delta-one instruments but will be delayed until January 1, 2018, for non-delta-one instruments. Second, QDDs are no longer exempt from withholding on dividends received on physical shares. Third, a QDD will not be liable for withholding tax on dividends paid to the QDD on physical shares or on dividend equivalents the QDD receives in its capacity as an equity derivatives dealer in 2017.8

The Notice indicates that the section 871(m) regulations will continue to apply beginning January 1, 2017, to any payment with respect to a potential 871(m) transaction that has a delta of one, including combined transactions; however, 2017 will be a phase-in year for such transactions. As for non-delta-one transactions, the Notice announces the IRS's intent to amend the section 871(m) regulations so that the regulations will not apply to payments made with respect to any non-delta-one transaction before January 1, 2018, and 2018 will also be a phase-in year for these non-delta-one transactions. When enforcing the section 871(m) regulations for the applicable phase-in years, the Notice states the IRS will afford relief to taxpayers or withholding agents who have made a good faith effort to comply with the regulations.

Final regulations were released on January 19, 2017, and published in the Federal Register on January 24, 2017. However, on January 20, 2017, President Trump's Chief of Staff, Reince Priebus, sent a memorandum to all heads of

executive departments and agencies instructing, among other things, that all regulations released but not yet published must be immediately withdrawn for review and approval. The IRS on the other hand announced on January 24, 2017 that the new section 871(m) regulations were "approved by the Office of Management and Budget," and had "an effective date of January 19, 2017."9 Despite this announcement and the publication of the regulations in the Federal Register, practitioners are unclear on whether these regulations were published in contravention of the order from the Executive Branch, and if so, what that means.


On December 30, 2016, the IRS issued Rev. Proc. 2017-15 and 2017-16. Rev. Proc. 2017-15 contains the final qualified intermediary ("QI") agreement in Rev. Proc. 2017-15, originally proposed in July 2016 in the form of Notice 2016-42.10 Rev. Proc. 2017-16 contains amendments to the foreign financial institution ("FFI") agreement.

New from the proposed QI agreement, the final agreement (1) implements and expands on Notice 2016-76 regarding the withholding tax liability of qualified derivatives dealers ("QDDs"), and (2) generally makes other modifications to compliance rules.

Notice 2016-76 announced the IRS's intention to revise the final regulations to provide that a QDD will remain subject to withholding under chapter 3 and 4 on dividends it receives from physical shares held. The Notice announced that a QDD's "section 871(m) amount" will be determined by looking to a QDD's "net delta exposure," which involves aggregating a QDD's delta for all physical positions and potential section 871(m) transactions with respect to an underlying security. Further, the Notice stated that a QDD's tax liability with respect to an underlying security would be reduced, but not below zero, by the amount of withholding tax suffered by the QDD on the receipt of the same dividend payment on that underlying security. This left some ambiguity with respect to whether a cascading withholding tax might apply, because the rule in Notice 2016-76 could have been read to mean that a QDD's liability was determined based on its net delta exposure (which if perfectly hedged by physicals would be zero), and that liability could be reduced, but not below zero, by withholding on dividends from a hedge of physical shares. It was not clear from the proposed QI agreement or Notice 2016-76 whether a QDD's withholding tax on physical shares could be credited against any amounts a QDD would be required to withhold.

The final QI agreement provides relief to QDDs. Under the final QI agreement, a QDD will not be liable for withholding tax on dividends paid to the QDD on physical shares or on dividend equivalents the QDD receives in its capacity as an equity derivatives dealer in 2017 (but a QDD will remain liable for tax on dividends and dividend equivalents received in any other capacity). The final QI agreement implements the "net delta exposure" concept from Notice 2016-76.

Further, the final QI agreement calculates a QDD's tax liability as the sum of (1) for each dividend on each underlying security, the amount by which its tax liability under section 881 for its section 871(m) amount exceeds the amount of tax paid by the QDD in its capacity as an equity derivatives dealer under section 881(a)(1) on that dividend; (2) its tax liability under section 881 for dividend equivalent payments received as a QDD in its non-equity derivatives dealer capacity; and (3) its tax liability under section 881 for any payments such as dividends or interest, received as a QDD with respect to potential section 871(m) transactions that are not dividend or dividend equivalent payments to the extent the full liability was not satisfied by withholding.

The final FFI agreement contains updates for foreign financial institutions to comply with the Foreign Account Tax Compliance Act ("FATCA"), generally reflecting updates to the FATCA regulations (discussed below) and the expiration of transitional periods.


On December 30, 2016, the IRS published modifications to regulations under FATCA. The regulations generally make technical changes to existing FATCA regulations and incorporate FATCA guidance that was previously issued by the IRS. For example, the regulations provide that no withholding on "foreign passthru payments" will be required until the later of January 1, 2019, or the date on which final regulations are published that define the term "foreign passthru payments." Similarly, withholdable payments under FATCA do not include gross proceeds from a sale of property occurring before January 1, 2019. Both of these provisions were contained in Notice 2015-66, and are now incorporated into the regulations.


DTC Eligibility Procedures

The implementation of the section 871(m) regulations has far reaching impacts that extend beyond the realm of tax law. Recently, the Depository Trust Company ("DTC") has responded to the regulations by adjusting its eligibility procedures.11 Under the new procedures for a security to qualify as DTC eligible, an officer of the issuer will be required to certify if the security is treated as a "Section 871(m) transaction"; if it is such a transaction, the officer must then certify whether it is a "simple contract" or a "complex contract."12 If the security is treated as a "simple contract," then the applicable "delta" will also be required to be provided. In connection with the initial qualification, the officer must also agree that the issuer will provide DTC with information on dividend equivalent payments as they occur. DTC has created an "871(m) Dividend Equivalent Payment" template that sets forth the data that is required for the processing of these payments. As the DEPs occur, issuers will need to send this information to a designated DTC e-mail address.

DTC has warned market participants that the failure to timely comply with this new attestation requirement may result in a delay in DTC approval. Of course, a delayed approval could result in delayed settlements, and issuers and underwriters will be updating their procedures.

Compliance in January 2017

Historically, the DTC eligibility process was completed by the relevant distributors, without significant participation from the applicable issuers. The new required procedures, especially for frequent issuers, will require ongoing involvement from the relevant officer or officers from the issuers who make the required certifications, and accordingly, issuers will want to establish a means to reliably verify their accuracy. Together with their tax advisors and underwriters, these issuers will need to establish procedures to ensure that the certifications can be accurately completed on a timely basis, and that any required periodic notifications can be made to DTC.13

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1. See Simple, Fair, and Pro-Growth: Proposals to Fix America's Tax System, President's Advisory Panel on Federal Tax Reform (Nov. 2005), available at https://www.treasury.gov/resource-center/tax-policy/Documents/Report-Fix-Tax-System-2005.pdf; and Alan J. Auerbach & Douglas Holtz-Eakin, The Role of Border Adjustments in International Taxation, American Action Forum 10 (Nov. 30, 2016), available at https://www.americanactionforum.org/wp-content/uploads/2016/11/The-Role-of-Border-Adjustments-in-International-Taxation.pdf.

2. Available at https://abetterway.speaker.gov/_assets/pdf/ABetterWay-Tax-PolicyPaper.pdf. For a more detailed discussion of the House plan, please see our last issue of Tax Talk, available at https://media2.mofo.com/documents/161012-tax-talk.pdf.

3. Available at https://www.donaldjtrump.com/policies/tax-plan.

4. Available at https://assets.donaldjtrump.com/trump-tax-reform.pdf.

5. All section references are to the Internal Revenue Code of 1986, as amended, and the regulations promulgated thereunder, unless otherwise indicated.

6. For a more detailed discussion of the Final Regulations, see our Client Alert, available at https://media2.mofo.com/documents/150921dividendequivalent.pdf.

7. For a more detailed discussion of Notice 2016-76, see our Client Alert, available at https://media2.mofo.com/documents/161206-irs-guidance-871m.pdf.

8. The QDD changes are discussed in more detail in the following article.

9. Marie Sapirie, Clarification Needed on PTP and Dividend Equivalent Regs, 2017 TNT 17-2 (January 27, 2017).

10. For a discussion of the Proposed QI Agreement, please see Vol. 9 Issue 2 of Tax Talk, available at https://media2.mofo.com/documents/160805taxtalk.pdf.

11. The DTC announcement is available at www.dtcc.com/~/media/Files/pdf/2016/10/31/4463-16.pdf.

12. A complex contract is any NPC or ELI that is not a simple contract; a simple contract is an NPC or ELI that has a fixed term and references a fixed number of underlying shares.

13. For more information, please see our December 27, 2016 special issue of Structured Thoughts, available at https://media2.mofo.com/documents/161227-structured-thoughts.pdf.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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