For some time, one of the most persistent problems bedeviling US tax officials has been the collection of tax from overseas income. Inevitably, corporations and individuals have complex and disparate financial pictures, with assets often held outside the US for a variety of reasons, including to minimize income tax liabilities. In its quest to get its hands on the billions of dollars worth of revenue lost abroad, the US Government has trained its focus on regulation specifically designed to capture these foreign earnings.
The governments first move on this front came in the form of the Foreign Account Tax Compliance Act (FATCA), which was signed into law by President Obama in 2010 and came into force on July 1st, 2014. FATCA requires US persons, including those living abroad, to file annual reports on any foreign financial accounts. It also requires foreign financial institutions to report any US-sourced assets held by US persons to the US Government. Now, the American government is continuing its efforts in the area of tax compliance by honing in on dividend equivalent payments from derivative transactions involving US equities through an IRS regulation known as 871(m), the implementation of which began in January of 2017.
It will come as little surprise that the implementation of 871(m) has created an array of compliance headaches for financial institutions. Firms are scrambling to establish the appropriate withholding and reporting processes for the financial instruments falling under the jurisdiction of the new regulation. For instance, 871(m) applies to equity-linked instruments (ELIs) where the delta (ratio of change in the value of the instrument vs. the value of the underlying security) of the underlying instrument is 0.8 or greater. In order to determine which instruments are affected, firms must make these often complicated calculations on their own.
In short, to ensure effective compliance with 871(m) without specialist support involves a herculean degree of research, record-keeping, monitoring, and calculations from already overburdened designated teams. The IRS, recognizing the complexity of the regulations implementation, relaxed compliance mandates for the first year (2017), raising the delta requirement for affected securities to 1.0 from 0.8 and announcing that for the first year of implementation they would take into account whether a firm made a good faith effort to comply with the law when assessing penalties. This simplified standard only applies to withholding agents, however, and does not cover taxpayers that are long parties (the buyers), meaning the hardest burden may fall on foreign investors.
Regardless, any foreign investors that trade in US-backed ELIs will need to take concrete steps to prove that they are complying with the reporting provisions of the new law. In order to comply with 871(m), firms will need up-to-date and comprehensive information provided to investors on the financial instruments affected by the Rule.
Having this information will be vital if firms expect to accurately determine which products fall under 871(m)s scope and which do not, to ensure that the appropriate sharing of necessary data has been undertaken, and to successfully execute withholding and reporting requirements.
Compliance is only the beginning, though. After all, investors are not simply interested in avoiding fines; theyre interested in optimizing their portfolios and strategies in order to maximize returns. In order to do this, advisors and investors need to have a clear picture of how the IRS rules affect all investment decisions they might make. Every new regulation represents not just another potential stumbling block, but an opportunity for intelligent, savvy, and well-informed investors to gain a leg up on their peers.
The same principle holds true for 871(m). While it may seem like a minor, obscure rule amongst a sea of tax regulations, financial institutions responses will shed light on the quality of their operations. Complete information on the affected instruments will enable firms to improve their business strategies, alerting them to potential savings and risks and allowing them to better counsel clients. For example, advisors are required to disclose the characteristics of products offered to investors – like the instruments type, risks, and costs, along with the tax implications related to the investments in question, as required under ESMA Knowledge and Competence Guidelines. 871(m)-related data will provide advisors and investors this information regarding the tax implications of particular products, empowering them to make better-informed decisions and helping to make investing easier and more efficient.
While unprepared firms struggle to compile the data necessary for compliance, and most firms settle for a minimum good-faith compliance effort, a select few of the savviest firms will be turning the compliance burden posed by the regulation to their advantage. Even though the IRS has relaxed its compliance standards as firms have stumbled through the early stages of 871(m)s implementation, the most prepared firms–those that have put themselves ahead of the pack–are already ready to go.
Perhaps the question shouldnt be whether financial institutions can navigate the maze of 871(m) compliance, but rather, which institutions are going to come out of the other side first, to the benefit of their clients.
Phillip Lynch is Global Head Markets, Products & Strategy at SIX Financial Information
