On September 20, 2018, the Office of the Associate Chief Counsel (International) at the US Internal Revenue Service (IRS) issued Notice 2018-72: Extension of the Phase-in Period for the Enforcement and Administration of Section 871(m).
Notice 2018-72 (the Notice) provides relief for taxpayers and withholding agents still struggling to interpret and implement complex regulations issued by the IRS under Internal Revenue Code (IRC) section 871(m), which deals with the taxation of derivative products that reference a US security. The Notice:
Securities lending participants may continue to rely on the transitional guidance provided in Notice 2010-46 for securities lending payments made through December 31, 2020. Specifically, withholding agents may continue to rely on this transitional guidance, which does not require the agent to withhold on payments to qualified securities lenders, but gives the agent the ability to rely on a credit-forward withholding mechanism, thereby reducing the risk of cascading withholding on securities lending payments.
The IRS has repeatedly stated that it intends to sunset the QSL regime and replace it with the Qualified Derivatives Dealer (QDD) regime established under the section 871(m) regulations and the Qualified Intermediary Agreement. The IRS had previously extended the QSL regime in Notice 2016-76 and Notice 2018-5; this further extension is welcomed by the securities lending industry, which has advocated for the continuance of the QSL regime.
The Notice resolves an issue previously raised with the IRS in respect of entities engaged only in securities lending that had already obtained QDD status in anticipation of the end of the QSL regime. Absent the relief provided in the Notice, QDDs and QSLs engaged in securities lending would have been on uneven footing as of January 1, 2019, when withholding on dividend payments to QDDs was scheduled to take effect. The delay on withholding or taxation of dividend payments to QDDs means that QDDs and QSLs will continue to be treated similarly in securities lending transactions through calendar year 2020.
Changes to the effective dates under section 871(m) regulations will result in extending the current status quo through calendar year 2020, as discussed below.
Delta-one transactions (i.e. transactions that replicate the performance of the referenced or underlying security) have been in scope under section 871(m) since January 1, 2017. The Notice does not change the identification, withholding or reporting requirements already in place for delta-one transactions.
The Notice reiterates that long parties may not rely on the simplified combination rule. Long parties remain subject to the “full” combination rules that are outlined in Treasury Regulation section 1.871-15(n), which includes applying the combination rules to listed options. Given that only minimal guidance has been issued, the operationalization of the combination rules continues to be a significant challenge for industry participants.
Custodians, qualified intermediaries (QIs) and other long party agents have been concerned that they might be expected to assume the responsibilities of their long party customers and account holders with respect to the combination rules. The Notice provides some clarification, referring only to withholding agents, rather than alternating between the terms “withholding agent” and “short party” as in prior guidance.
An entity that is a withholding agent should be able to rely on the relief provided in the Notice, even if the entity also acts as a long party agent for the same transaction. An entity that is a principal to a transaction, and is the long party, may not rely on the simplified combination rule, even if that entity acts as a withholding agent in other situations.
Note that QIs must still conduct periodic reviews as required by the terms of the Qualified Intermediary Agreement, and these reviews encompass all reportable payments and reportable amounts. To the extent an entity acts as a QI for payments that include in scope dividend equivalent amounts (e.g. a forward contract held by a retail customer), that account and payment are in scope for the QI’s periodic review covering the year in which the dividend equivalent amount is deemed paid to the QI account holder.
The good faith efforts standard is an enforcement standard. QIs and other industry participants implementing section 871(m) should not rely on the good faith efforts standard as a line of defense. It should not be viewed as a practice period during which non-compliance is deemed acceptable. If section 871(m) compliance is later put under scrutiny, entities should be ready to provide documentation of their good faith efforts.
This much needed relief gives industry participants more time to continue the difficult task of implementing these complex section 871(m) regulations; however, with delta-one products already in scope today, industry participants should take the following actions: