What is section 871(m) and why do I need to worry about it?
Section 871(m) is a US legislative measure that is intended to prevent the avoidance of withholding of US tax on dividends paid by US corporations. Previously, US dividend withholding did not apply to returns on certain financial instruments – such as notional principal contracts and equity linked instruments – which are related to underlying US equities.
The measure forms part of the Hiring Incentives to Restore Employment (HIRE) Act of 2010, the US legislation that also introduced FATCA to the world.
Section 871(m) treats payments on certain financial instruments as "dividend equivalent payments" with a US source. As a result, the payments are treated like dividends paid by a US corporation, and are subject to withholding of 30% US tax. A reduced rate of withholding may be claimed under an applicable double tax treaty.
Some commentators have suggested that this change sounds a "death knell" for US equity derivatives, or at the very least imposes significant new tax risks and compliance burdens on investors.
Which instruments are affected?
Section 871(m) applies to instruments relating to underlying US equity securities, where the return is based on the payment of a US-source dividend, but only if the "delta" (the ratio of changes in the value of the instrument compared to changes in the value of the underlying security) is 0.8 or greater, or where there is a substantial equivalence between the returns on the instrument and on the equity.
The "delta" only needs to be calculated at the date when an instrument is "issued", that is when it is entered into at its inception, or when there is a material modification to the derivative. However, the delta must be calculated on a combined basis where several instruments are interrelated.
Initially, it was hoped that section 871(m) would only affect payments that in effect directly passed on the underlying dividends to another person. However, final US tax regulations were issued in September 2015 which significantly widened its scope. These regulations are expected come into effect for any instruments issued or modified from 1 January 2017.
The widened interpretation of section 871(m) means that US withholding is potentially relevant for "dividend equivalent" payments arising from transactions linked to US equity securities, including securities loans, repos, swaps, options, forwards, futures, convertible debt, structured notes, and other derivatives.
We understand that further regulations may be issued before the end of 2016, under which the widened interpretation of section 871(m) may be introduced in phases, with "delta one" products such as total return swaps, forwards, futures, and contracts for difference (where payments on the instrument directly map dividends on an underlying US equity security) being affected from 1 January 2017, and other instruments affected from 1 January 2018.
Who is required to withhold?
The obligation to withhold will depend in each case on whether the party is the "short" party or the "long" party.
The "short" party to an affected instrument is required to withhold 30% US tax on payments to the "long" party, where the "long" party is a non-US person. In principle, the US rules apply, whether or not the "short" party is a US person: for example, a UK broker entering into a total return swap over the returns of US equities with a UK fund would be required to withhold under section 871(m). It is not clear how this extraterritorial tax obligation can be enforced.
The "short" party is also required to pay over the tax withheld to the US tax authorities, and report the payments it has made.
The "long" party may claim the benefit of an applicable double tax treaty to obtain a lower rate of withholding (potentially zero in some cases).
If a person making an affected payment fails to withhold tax, in some circumstances the recipient could themselves be required to account for the tax that should have been withheld, particularly where the combined effect of two or more transactions with different counterparties means that the overall transaction is caught in a situation where the separate transactions are not.
What is ISDA doing?
In 2015, the International Swaps and Derivatives Association (ISDA) published a new protocol to its standard forms of master netting agreement, under which the risk of section 871(m) withholding is allocated to the "long" party. The protocol remains open for adherence: if you trade in these instruments, you are likely to be encouraged to adhere if you have not already done so.
How does it affect me?
Section 871(m) only applies to instruments issued or materially modified from 1 January 2017. Where possible, parties should avoid modifying existing instruments, which are grandfathered and should remain free from US withholding.
For new instruments which may be affected, many financial intermediaries who will be making affected payments (including banks and brokers) should already have asked their counterparties for withholding information for FATCA purposes on a W8 form (usually W8-BEN, W8-BEN-E, or W8-IMY).
Where a double tax treaty applies, lower rates of withholding can be claimed: for example, under the UK-US double tax treaty, the rate may be zero.
Where these forms have not been completed, or a payee has not made a claim for gross payments under a double tax treaty, then be prepared for 30% US withholding to apply.
All entities that regularly trade the instruments that may be affected should carefully consider their position and seek US advice as necessary.
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.