The DTC has recently launched a new service called the 1042-S Announcement service. This article is an opinion editorial (op-ed) providing our personal interpretation of the impact of the new service. The contents of this article should not be construed as tax, legal or investment advice. Views expressed are those of the author.

The problem this addresses

At present, when certain kinds of US Issuer make distributions, those distributions may be categorised as dividends, which are withholdable and reportable under US tax regulations. When information is made available sometime later, it can happen that the distribution is actually not supposed to have been categorised as a dividend. As a result, there are two manual processes that must be activated by non-US financial institutions, whether they be #qi or #NQI. The first is a refund of the over-withheld tax. The second is an amendment to any 1042-S information return that had already been previously reported as a dividend. For the types of security that are covered by these new DTC notices, the information about the correct categorisation of the distribution will be made available before the pay date. This means, for any financial institution that acts on them, there will be no need for a reclassification, refund or amended 1042-S reporting.

What happens today?

The most common occurrences of re-classifications are with US mutual funds and US Real Estate Investment Trusts (REITs). These types of US Issuers sometimes re-classify income originally distributed (and taxed and reported) as a dividend into, for example, a return of capital. When a non-US financial institution usually finds out about these it is usually several months into the next US tax year and often after they have already submitted 1042-S information returns to the IRS (on which they had reported the distribution as a dividend). So, apart from responding by refunding their clients, they must also now submit amended 1042-S returns to the IRS and issue recipient copies to any client that would be affected by the change.

Because the US reporting system is cascade in nature every financial institution in the chain of such payments will have to amend its reporting to account for the change or face penalty notices from the IRS. A QI for example with direct clients (individuals or entities), may need to amend one pooled 1042-S by reducing the gross and tax withheld amounts while amending another 1042-S to increase the gross amount by the same amount but leaving the tax withheld at $0 for that pool. If any of their clients were other financial institutions, they would have been separately reported so a QI would also need to amend those specific IRS 1042-Ss and issue recipient copies to their clients, notifying them of the change so that they could go through the same process… and so on down the chain of payment.

What does the DTC service mean?

The DTC is pointing out that re-classifications can also occur on certain Exchange Traded Funds (ETFs) when income that was similarly distributed as a dividend is re-classified as an interest-related dividend. Dividends generally have withholding tax applied, but interest-related dividends do not because they come under the definition of the portfolio interest exemption.

The difference between re-classes of mutual funds or REITs and reclasses of ETFs, is that, for ETFs, the information is available, but has not previously been published whereas the reclassifications from mutual funds and REITs is a decision taken by the issuer after the end of their tax year. By providing record date information about the proper classification of income from these ETFs, the refund and amended reporting processes are no longer needed.

What impact will this have?

The DTC service is new and currently fairly limited in scope but we can expect it to grow. The impact on non-US financial institutions will be directly proportionate to the scale and scope of client exposure to these specific ETFs. Adoption rate will be critical. ETFs that are not included in the list of securities covered by the DTC service will still be exposed to the manual re-classification process. So, it will be important to keep an eye on the number of the ETFs included in this service as it grows.

If the DTC notices are adopted efficiently by US Withholding Agents (USWAs) that are DTC participants and by withholding qualified intermediaries (WQIs). The number of refunds should drop and the number of amended 1042-Ss will drop. Overall, however, because there are different reasons for re-classifications, financial institutions will not be able to fully replace their manual processes with automation. However, it is a step in the right direction.

If you have policy and procedure already in place to handle re-classifications, there will be no impact. ETFs subject to the DTC 1042-S Announcement service will, as far as we understand it, effectively be categorising those distributions as portfolio interest. As most withholding statements used by the industry already allow portfolio interest distributions in a tax rate pool account to be taxed at 0%, there is little direct operational impact. It will be important however for financial institutions to realise what is happening and make sure that their systems are able to handle these types of income distributions.

What next?

Apart from a hopeful expansion of use of the DTC 1042-S Announcement to a greater number of ETFs, DTC has made mention, in its SEC rule change filing, for the use of the system to handle Section 1446(f) distributions and 871(m). The 1446(f) impact will allow DTC to handle a single distribution containing multiple allocation components for withholding and reporting purposes.

If you would like to know more, contact us at +44 (01252) 413551 or email us at [email protected]