The US Internal Revenue Service issued a new proposed Qualified Intermediary (“QI”) Agreement on July 1. This new QI Agreement, once finalised later in 2016, will be effective from 1 January 2017. The previous QI Agreement (Revenue Procedure 2014-39) will expire on 31 December 2016 so all QIs will be required to renew their QI Agreements via the IRS FFI portal before March 31, 2017, for their agreements to be effective January 1, 2017.

Summary of the Changes

The proposed QI Agreement introduces four significant changes:

1. A revision to the QI compliance review and certification procedures (see section 10 of the proposed QI Agreement);
2. An allowance for a QI to assume primary withholding responsibility for substitute interest payments, even if it is receiving such payments as a principal rather than as an intermediary (see section 3 of the proposed QI Agreement);
3. Limitation on benefits provision; and
4. The requirements for Qualified Derivatives Dealers (“QDDs”) (throughout the proposed QI Agreement).

What is Section 871(m) and QDD status?

US congress believed swaps and other derivative contracts had been used historically by non-US persons to circumvent US withholding tax since they were not holding the actual security at the ex-dividend date.  The intention of Section 871(m) is thus to apply withholding tax to dividend equivalent amounts (DEAs) from derivatives which closely reference US equities and pay dividends.

Section 871(m) imposes 30% US withholding, unless reduced by a validly claimed treaty benefit, on DEAs which potentially arise in securities lending and sale-repurchase agreements, specified notional principal contracts, specified equity-linked instruments and any other substantially similar payments.

Final US regulations were published in September 2015 with a subsequent extended due date announcement that in-scope contracts issued on or after 1 January 2017 would need to be identified and withheld upon.

QDD status eliminates excessive withholding on back-to-back dealer transactions with clients, provided that the dealer ultimately receives no long exposure on a net basis. Without QDD status, a dealer would otherwise be subject to withholding on the hedge it employs to offset its exposure to a client transaction.

A dealer may act as a QDD for payments made as principal with respect to a potential Section 871(m) transaction and underlying securities, regardless of whether it makes those payments in its dealer capacity.

Notwithstanding this favourable development for would-be withholding agents, the QDD still remains liable for tax on any proprietary transactions that are not ultimately part of its dealer operation and must appropriately identify and track those amounts.

The proposed QI Agreement requires a QDD to assume primary withholding responsibility for potential Section 871(m) transactions, which means that current non-withholding QIs will be required to accept withholding responsibility and update their system capabilities accordingly should they wish to act as QDDs.

To view the full details of the changes please see Notice 2016-42.