Navigating the labyrinth of tax regulations can be daunting, especially when dealing with the likes of the IRS. Their rules are some of the most intricate written, particularly in Internal revenue Code `Chapter 1 Section 871(m).  This particular section targets financial products with underlying exposure to US securities (so-called Equity Linked Instruments or ELIs) that distribute US-sourced dividend equivalent payments (DEPs). This means it requires a careful approach to make sure your institution is compliant. Because the rules are so complex, the IRS have a ‘good faith’ provision for Qualified Derivatives Dealers (or QDDs). But what does that mean, and how can you stay on the right side of the IRS by making a good faith effort?

Understanding Section 871(m)

Section 871(m) of the Internal Revenue Code states that US withholding tax will be applied on any ‘dividend equivalents’ that are paid to non-US people on specific financial instruments. The idea is to prevent tax avoidance by non-residents who might otherwise be able to avoid paying tax on any US dividends by using derivatives or other financial products.

Financial instruments like equity swaps, ETFs, CFDs, certain futures contracts, and forwards can generate payments that mimic dividends, referred to as dividend equivalents. Under Section 871(m), these payments are treated as U.S. source income, and hence, are subject to withholding tax. If you’re a QI who works with derivatives, you can apply to become a QDD. This will help you avoid the risk of cascading application of withholding taxes on payments equivalent to US-source dividends, and allow you to take advantage of the good faith effort rule.

The Concept of a ‘Good Faith Effort’

Thankfully, the IRS recognises that their rules, especially around section 871(m) can be complex and difficult to put in place, especially when there are so many different types of financial instruments with their own structures and terms. And so the IRS offers a bit of flexibility (we know, shocking!), which is where the idea of a ‘good faith effort’ comes into play. The IRS describes a ‘good faith effort’ as taking reasonable steps to determine whether a financial transaction falls within the scope of section 871(m), and to apply the appropriate withholding tax if necessary.

What Does That Look Like?

Section 871(m) has 14 standard components, labelled A-N, that QDDs need to adhere to. They are:

A – Document how your systems identify potential section 871(m) transactions

B – Document how your systems calculate and record your net ∆ (delta)

(To clarify here, the delta is a measure of the ratio between the volatility of the price of the derivative and the volatility of the price of the underlying security. So if a derivative is linked to a US security and the price of the derivative moved in the same way as the price of the underlying security, then the delta will be 1.)

C – Document how your systems record your long and short positions

D – Document how your systems record your 871(m) amount

E – Document how your systems record your QDD tax liability

F – Calculate and record DEPs made by the QDD

G – Record dividends received in your equity derivatives dealer capacity

H – Calculate the delta

I – Perform a Substantial Equivalence Test (SET)

J – Can your system calculate QDD tax liability?

K – Record and calculate simple and combined transactions

L – Document how you reconcile 871(m) amounts

M – Document how and what information you report to other parties

N – Document how you make quarterly QDD tax liability estimates

For each of these standard components, a QDD needs to do 3 things:

1. Document the procedure
2. Document which system(s) are involved
3. Document who is responsible for the procedure

You can see why this might get confusing! By showing that they are trying to adhere to these rules, and providing evidence, the IRS can decide if you are making a good faith effort to follow the regulations, even if something isn’t quite right.

Not Making A Good Faith Effort

Failing to make a good faith effort to comply with Section 871(m) doesn’t just leave you in poor standing with the IRS. It can also lead to some fairly significant penalties for you and your financial institution, including but not limited to:

• Financial Penalties: Inadequate withholding or failure to comply with your reporting requirements can mean your institution is hit with some substantial fines, along with interest on unpaid taxes.
• Reputational Damage: Word travels fast in any industry, and non-compliance can really damage your organisation’s reputation in the marketplace. This can then impact your relationships with stakeholders, customers and other institutions, as well as with the IRS themselves.
• Legal Repercussions: Any persistent or severe non-compliance can lead to legal action being taken by the IRS against you and your institution, including audits and investigations.

Section 871(m) compliance requires meticulous attention to detail and a proactive approach to tax management. By making a good faith effort you can avoid a lot of fines and penalties from the IRS, as well as making good headway on getting your processes in order. Remember, in the eyes of the IRS, a proactive and informed approach is always the best defence!

If you’re struggling to meet the requirements for section 871(m), or if you aren’t sure what you need to do, we are here to help. Just get in touch with one of our subject matter experts today to book your free, no-obligation consultation.