In this blog post we want to highlight some of the problems that seem to be endemic to our industry surrounding the use of Form W-8BEN-E by brokerages and issuers of equity linked instruments (ELIs).

There are three big problems that we see in the marketplace:

1. Income Ownership vs Asset Ownership

A W-8BEN-E is designed to certify that you are the beneficial owner of the income from assets held in an account. It is not a certification of ownership of the assets themselves.

This means that a broker can co-mingle the assets of its customers into an omnibus or nominee account in what’s often called “street name”. However, for the purpose of US withholding tax, it is not the beneficial owner of the income because, if income is received by the broker (e.g., a dividend payment), that income must be paid down the chain to the underlying investor.

If you’re a financial institution and you receive a W-8BEN-E from a client, you should do some basic due diligence to check that the W-8BEN-E is reasonable. Check your customer’s website. If they are offering brokerage services to investors, then they are likely to be an intermediary and you should expect a W-8IMY not a W-8BEN-E. The only situation in which a W-8BEN-E would be appropriate is if the account being documented holds the proprietary assets of your customer and is separate from accounts that hold underlying client assets. Do not co-mingle proprietary and client assets in the same omnibus account.

2. “Just give us a W-8BEN-E”

This problem is more insidious.

It has come to our attention over the last couple of years that some financial institutions are “guiding” their customers – particularly when those customers are smaller brokerage firms – to present a W-8BEN-E in relation to accounts that contain client assets.

The reason this is happening is pretty simple: by receiving a W-8BEN-E, the requesting financial institution can include income paid to the account into its pooled 1042-S report and therefore not have to provide its brokerage customer with a copy.

This makes life very easy for the financial institution receiving the form but places the firm that gave them the form into a difficult legal position because all the W-8 forms are signed under penalty of perjury. What is worse is that the receiving financial institution may then grant treaty benefits to its client even though the underlying investors may not be eligible or may not even have claimed such treaty benefits.

Because there is no 1042-S copy, the chain of expected reporting is broken. This means that even though there are payments being made down to an underlying investor, perhaps through a number of financial intermediaries, those financial institutions in the chain cannot report the income. If they do, they’ll get a penalty notice and a claim for payment from the IRS.

3. The 871(m) Problem

The IRS has, for some years, been responding to industry pressure to defer implementation of Chapter Section 871(m) that deals with US tax withholding and reporting on dividend equivalent payments (“DEPs”) related to equity linked instruments (“ELIs”). In essence, if you own a non-US derivative security that tracks or is connected to an underlying US security, the US wants tax and reporting to take place when the underlying US security distributes income.

The rules are extremely complex, and the IRS transition period called “good faith efforts” comes to an end on December 31st 2022. Until then, if you are able to prove that you met the good faith efforts standard, you should not be subject to enforcement proceedings from the IRS.

This is also the last year that non-delta one transactions are exempt from withholding and reporting. “Delta” is the term that describes the mathematical relationship between the derivative and the underlying US security. Only derivatives with a delta of one are currently in scope for withholding and reporting. That will change on January 1st 2023. Typically, it’s the creator or issuer of the derivative that establishes and publishes the delta so that others can apply the 871(m) rules correctly (although there are now some third party data vendors publishing delta). 

So, what’s the problem?

Well, apart from the complexity, it is becoming clear that some issuers of some derivatives may be inadvertently or deliberately breaking the rules. In order for these ELIs to work, someone has to purchase the underlying US securities before creating the derivative security to which they will be linked. This would typically be a broker who, on purchase, transfers the assets to a custodian for safekeeping. The derivative issuer can then issue the derivative instrument to investors. When the ELI issuer purchases the shares, they are sometimes assuming that they should present a W-8BEN-E without taking into account that they are creating a new equity-linked instrument that is connected to those US securities. A payment from a US issuer will then usually mean a contingent payment made to the holders of the ELI. This is exactly what 871(m) is for.

In this circumstance, while the ELI issuer may have legal title to the securities, they are not the beneficial owner of the income related to them on the payments of the ELI. As with the W-8BEN-E problem described above, even if the maximum amount of US tax is withheld on the US security when paid to the ELI issuer, this breaks the chain of reporting required by the IRS and leaves everyone in the chain of payment exposed to investors who may be using this weakness to evade tax. As someone once told me, if you could find a way to ensure that a US person only got taxed at 30%, you’d have them queuing up at your door.

Conclusions

If you’re a broker, make sure that when you provide a W-8 to a counterparty financial institution, you understand the difference between having the legal title to the shares and being the beneficial owner of the income on those shares. They aren’t always the same thing.

If you’re an issuer of ELIs, i.e., you create, sell or distribute non-US derivative securities with a US connection, make sure you understand your 871(m) obligations and avoid the W-8BEN-E problem that otherwise places you at the top of a chain, and in the cross-hairs of compliance failure and reporting enforcement.

We help financial forms in nineteen countries to understand cross border investment tax matters. That’s either helping them to plan for effective compliance or helping them figure out where they went wrong and how to fix their compliance.