Towards the end of 2017, the IRS published the final version of the updated Form 1042 along with the accompanying (available here), following the releases of the respective draft versions in August and early December. The Form 1042 is the annual report submitted by withholding agents to the IRS, documenting, aggregating, itemizing and reconciling a year’s worth of withholding activities. Conceptually, the Form 1042 summarises the information from the assorted Forms 1042-S that withholding agents provide to (and receive from) their counter-parties. Although not yet formally confirmed, it seems that the QDD section on the Form 1042 may supplant or limit the requirements for a QDD to prepare a Form 1120-F (see my prior blog on the draft Form 1120-F instructions for further elaboration and please note that those instructions remain in draft format).
 
The Form (long unloved by QIs) and its new §871(m) segments add to the incoming set of reporting obligations for QDDs. Accordingly, all QDDs must acquaint themselves with the Form and the instructions (or at least the §871(m) portions). Operationally, QDD filers must collect information on their transactions as a QDD in tax year 2017, even the ones exempt from taxation, well in advance of the initial submission in 2018. Usefully perhaps, the §871(m) information that needs to be collected by the filers of the Form 1042 significantly overlaps with the information required for the Form 1120-F and thus the two Forms may be prepared in parallel (provided that the Form 1120-F is even still necessary).
 
New §871(m)-Related Content Requirements of the Form 1042
 
In its tax year 2017 incarnation, the Form 1042 remains densely populated with boxes for different payments types and other inputs. The sections directly relevant to a QDD, however, are segregated at the bottom of the Form and demarcated clearly:

• Section 3: Expanded in order to capture any potential §871(m) transactions intermediated by the filing entity in its role as a withholding agent.
  • Prior versions had included potential §871(m) transactions only if associated with swap transaction (referred to as “notional principal contracts” or “NPCs” in IRS jargon).
• Section 4: Introduced freshly in order to capture all payments made by the filing entity in its role as a QDD (i.e. not as an intermediary but rather as an equity derivatives dealer).

 
On the Form, both these sections are misleadingly simple, requiring the filing entity that intermediated or made qualifying payments to check the box provided. Ominously though, the Form instructs the filer to refer to the instructions. As is typical, the instructions are the messenger of hardship.
 
As noted above, the information required for Section 4 of the Form 1042 closely resembles the information required for the Form 1120-F. Specifically, a QDD filer must prepare the same table as the one that must be attached as part of the Form 1120-F (see Form 1042 instruction at 9). Similar to the draft Form 1120-F instructions, the Form 1042 instructions do not prescribe a format for the table or substantive elaboration on the content. They do, however, furnish some more clarity on a few open points (as highlighted below by means of bolded italics).
 
The Section 4 table must include the following identifying information for each QDD home office and/or any QDD branches:

• Name of the QDD (following the naming protocol used for the QDD application); and
• Regular employer identification number (EIN) of the QI (not the QI-EIN) or a statement that the QI does not have a regular EIN (as applicable).

 
Substantively, it must contain the following information on payments, irrespective of whether such payments were subject to withholding:

• Total section 871(m) amount
  • The Section 871(m) Amount is as follows: “For each dividend on each underlying security, the “section 871(m) amount” is (A) the QDD’s net delta exposure to the underlying security for the applicable dividend multiplied by (B) the applicable dividend amount per share.” (2017 QI Agreement, Section 2.73).
  • For 2017 and 2018, these cells should contain: “Not Applicable”.
• Total dividends received in its equity derivatives dealer capacity
  • Please note: As discussed in detail in my previous Form 1120-F draft instructions blog, this section may be subject to revision.
• Total QDD tax liability pursuant to section 3.09(A) of the QI Agreement
  • The QDD tax liability equals the “Section 871(m) Amount… for each dividend on each underlying security reduced (but not below zero) by the amount of tax paid by the QDD under section 881(a)(1) on dividends received with respect to that underlying security on that same dividend in its capacity as an equity derivatives dealer.” (2017 QI Agreement, Section 3.09(A)).
  • For 2017 and 2018, these cells should contain: “Not Applicable”.
• Total QDD tax liability pursuant to section 3.09(B) of the QI Agreement
  • This row refers to Dividend Equivalent (DE) payments received by the QDD in its non-equity derivatives dealer capacity (e.g. for proprietary trading purposes).
  • Thus, QDDs will enter zero or not applicable across the row so long as they received no DE payments as a QDD, other than in their role as an equity derivatives dealer.

• Total QDD tax liability pursuant to section 3.09(C) of the QI Agreement
  • This row refers to “[a]ny payments, such as dividends or interest, received as a QDD with respect to potential section 871(m) transactions or underlying securities that are not dividend equivalent payments, to the extent the full liability was not satisfied by withholding.” (2017 QI Agreement, Section 3.09(C)).

 
Miscellaneous Matters
 
In addition to the new content requirements articulated above, the Form 1042 instructions also explain the codes to be used on the Form (and on the Form 1042-S) and elaborate on the withholding tax deposit relief for tax year 2017, as set forth in IRS Notice 2016-76 (see Form 1042 instruction at 5).
 
The deadline for filing a Form 1042 for tax year 2017 is 15 March 2018. However, a 6-month extension is readily available so long as the filer submits Form 7004 by the 15 March deadline (id. at 3).
 
Section 10.01(C) of the 2017 QI Agreement grants relief for errors in implementation of a QDD’s duties so long as the QDD made a good faith effort at compliance. Nothing in the instructions to the Form 1042 explicitly applies this relief to the submission of the Form. However, pursuant to section 10.01(C), this relief applies to all provisions of the QI Agreement and Section 1.01 of the 2017 QI Agreement mandates that a QDD: “must report its QDD tax liability on the appropriate U.S. tax return (as prescribed by the IRS).” Seemingly, therefore, the Form 1042 should be subject to good faith efforts defense in the circumstance of any legitimate errors in its preparation.
 
Want further information on this topic? Email: paul@millentaxandlegal.ch

According to reports in the media and from attendees, a Treasury representative indicated at a conference in Washington D.C. last week, that the department was reconsidering the scope of the §871(m) regulations, limiting it to delta one products even in 2019 and beyond. As a refresher, the §871(m) regulations treat equity-linked derivative instruments that are “simple contracts” as in-scope if the delta is 0.8 or above and those that are “complex contracts” as in-scope through application of the substantial equivalent test against a 0.8 delta simple contract benchmark. However, pursuant to IRS Notices 2016-76 and 2017-42, only instruments with deltas of one are in-scope for instruments issued in 2017 and 2018. Prior to last week’s announcement, the general expectation had been that in 2019 the regime would revert to the broader scope set forth in the §871(m) regulations.
 
While it is premature to celebrate, the announcement signals an acknowledgement of industry’s concerns around the disruptive complexity to the market from the broad scope of the §871(m) regulations. Much uncertainty, however, remains around the reduced scope, such as whether delta one is determined mathematically or by design (e.g. no optionality) and whether complex contracts will be excluded entirely. We cannot be certain until the IRS releases a formal declaration of this modification with further elaboration. Hopefully, such formal publication will be forthcoming soon so that affected financial institutions will have ample time to adjust their systems and process in accordance with the newly revised rules.
 
For further discussion on this topic, please email: paul@millentaxandlegal.c

On 10 October, the IRS released draft instructions to the Form 1120-F, following release of the draft version of the form itself in August. This Form is a core component of the reporting obligations for QDDs. In advance of the initial submission in 2018, QDDs must acquaint themselves with the Form and its accompanying instructions, notably the need to gather information on their QDD transactions (even seemingly the ones exempt from taxation) and their QDD tax liability (as set forth in the 2017 QI Agreement, Section 3.09).
 
Form 1120-F Background and Overview
 
The Form 1120-F may be unfamiliar to many readers. It is the IRS form used by non-US entities to report certain 1120-F US tax liabilities, commonly due to active business income earned in the US, income effectively connected to operations in the US (ECI) or income derived from real estate holdings/sales. Prior to this latest draft version, the Form 1120-F did not feature prominently in most QI/FATCA compliance programs. For purposes of reporting payments under those regimes, the IRS developed instead the Forms 1042/1042-S. Many QDDs may have assumed that these well-loved forms would also be the medium for payment reporting under §871(m) in light of §871(m)’s heavy reliance on the existing QI architecture for withholding and reporting. That assumption, while reasonable, is only partially correct: These forms will be in use for §871(m)-related payments made or intermediated, but not for the reporting of the QDD tax liability.
 
Although one could question whether the IRS should not have re-designed the Forms 1042/1042-S for the sake of administrative convenience (to the benefit of both QDDs and the agency itself), the form change is not arbitrary. Conceptually, the use of a Form 1042 for the QDD tax liability would be inapt. The key conceptual difference between the two sets of forms is that the Forms 1042/1042-S are submitted by intermediary withholding agents, whereas the Form 1120-F is submitted by beneficial owners (BOs) of US-source income. Moreover, the Form 1120-F is not in use for all types of US-source income. So long as a non-US BO limited its US-source income to so-called FDAP income (primarily, dividends and interest payments from US corporations) and the taxes owed were deposited by a QI (or US withholding agent) on its behalf, the non-US BO never needed to file the Form 1120-F. That is no longer necessarily the case. All QDDs must submit a Form 1120-F, starting with payments received in tax year 2017 (i.e. first reports due in calendar year 2018).
 
In its latest incarnation, the draft Form 1120-F remains densely populated with boxes for taxpayer inputs and the draft instructions remain lengthy and daunting. For a QDD in its role as a QDD, few of these boxes, however, are relevant. For any particular QDD though, the broader entity may conduct other operations that already require submission of a Form 1120-F (e.g. US branch activities). Thus, the first inquiry for any QDD’s §871(m) compliance team is to determine whether their colleagues already prepare and file a Form 1120-F and, if so, to coordinate their activities.
 
Content Requirements for QDDs
 
Once that topic is settled one way or another, the next inquiry ought to consider the new content requirements applicable to a QDD filer. These obligations are limited, but potentially burdensome, as information must be collected and submitted on both hedging and product issuing activities. Especially onerous is the need to complete information related to dividends received in the role as QDD, even though the 2017 QI Agreement and subsequent Notice 2017-42 relieved QDDs of any tax liabilities on such payments for 2017 and 2018, respectively. The inclusion of such data during the transitional period rang alarms in the industry at such volume that the IRS is rumored to be considering revising the draft instructions on this point. Nevertheless, as currently drafted, the instructions plainly oblige QDDs to collect and provide such data.
 
The information on US-source dividends received is included in a table that must be attached to the QDD’s filing as part of Section CC, a new section on the Form specific to QDDs (see draft Form 1120-F instruction at 14). While specific formatting for the table is not prescribed in the draft instructions, it must have columns for the gross amount, the rate of tax, and the amount of tax liability (id. at 14). Accordingly, a basic table of three columns and five content rows (plus a heading row) seems acceptable.
 
This table must include the following information broken out by QDD home office and QDD branches:

• Total section 871(m) amount
  • As defined in the 2017 QIA Section 2.73, the Section 871(m) Amount is as follows: “For each dividend on each underlying security, the “section 871(m) amount” is (A) the QDD’s net delta exposure to the underlying security for the applicable dividend multiplied by (B) the applicable dividend amount per share.”
• Total dividends received in its equity derivatives dealer capacity
  • As discussed above, this section may be subject to revision, but otherwise will oblige QDDs to collect and submit significant quantities of information that may not be tracked currently for QDD purposes due to the transitional relief in place.
• Total QDD tax liability pursuant to section 3.09(A) of the Qualified Intermediary Agreement
  • Subsection 3.09(A) refers to the “Section 871(m) Amount… for each dividend on each underlying security reduced (but not below zero) by the amount of tax paid by the QDD under section 881(a)(1) on dividends received with respect to that underlying security on that same dividend in its capacity as an equity derivatives dealer.”
  • For this row only, the QDD is instructed to only include the amount of the tax liability.
  • Due to the above-mentioned tax holiday on dividends received in 2017 and 2018 by QDDs in their equity derivatives dealer capacity, the tax liability will be zero for those years.
• Total QDD tax liability pursuant to section 3.09(B) of the Qualified Intermediary Agreement
  • This subsection refers to Dividend Equivalent (DE) payments received by the QDD in its non-equity derivatives dealer capacity (e.g. for proprietary trading).
  • Thus, QDDs will enter zeroes across the row so long as they received no DE payments as a QDD, other than in their role as an equity derivatives dealer.

• Total QDD tax liability pursuant to section 3.09(C) of the Qualified Intermediary Agreement
  • This subsection refers to “[a]ny payments, such as dividends or interest, received as a QDD with respect to potential section 871(m) transactions or underlying securities that are not dividend equivalent payments, to the extent the full liability was not satisfied by withholding.”
  • This subsection seems to refer to payments received by the QDD that were subject to withholding, but not properly withheld upon.
  • As such, it seemingly seeks to capture random items of taxable income that eluded withholding due an error in the upstream withholding process.

 
In addition to the table attached as part of Section CC, a QDD must also complete certain lines in Section 1 by listing assorted items of US-source income. The items germane to a QDD are the following:

• Line 2: On this line, a QDD will ultimately include the total amount of dividends and DE payments received on in-scope derivative instruments.
  • For reporting on tax year 2017 (to be extended into 2018, logically), however, the following items of income are excluded:
    • Dividends received by a QDD in its equity derivatives dealer capacity; and
    • Dividend equivalent payments made to a QDD in its equity derivatives dealer capacity to hedge transactions that have a delta of less than one are excluded (id. at 15).
• Line 10: On this line, a QDD lists any other items of reportable US-source income that it received in its equity derivatives dealer capacity and that was not listed (id. at 15).

 
An important note for the items of income included in Section 1: It does not matter whether any component of its QDD tax liability is subject to withholding or correctly withheld, they remain reportable in any case (id. at 14).
 
Timing of Filing
 
The deadline for filing a Form 1120-F is determined by two factors:

• The fiscal year of the non-US corporation; and
• Whether it has a place of business in the US (e.g. branch operations).

 
Generally, a non-US corporation with a place of business in the US has a deadline of the fifteenth day of fourth month following the end of its fiscal year (id. at 4). Accordingly, a calendar year taxpayer, for example, would need to submit its Form 1120-F for tax year 2017 on or before 15 April 2018 (extended to 16 April as the 15 April falls on a Sunday in 2018). This general rule is subject to modification for shortened fiscal years (id. at 4).
 
A non-US corporation with no place of business in the US has a deadline of the fifteenth day of sixth month following the end of its fiscal year (id. at 4). Accordingly, a calendar year taxpayer, for example, would need to submit its Form 1120-F for tax year 2017 on or before 15 June 2018.
 
Both deadlines may be extended for approximately six months, if the QDD:

• Prepares and submits Form 7004 by the deadline for Form 1120-F;
• Make a proper estimate of any tax due (if applicable); and
• Pays any tax that is due (see instructions to Form 7004 at 1).

 
No provisions of §871(m) or other tax rules seemingly limit the autonomy of a non-US corporation to select the applicable fiscal year for US tax purposes (see e.g. §6072(c)). Presumably, the date is established in its home jurisdiction and therefore not subject to alteration. However, a QDD (with no other types of reportable income relevant to the Form 1120-F) might consider adopting a calendar tax year in order to align with the other elements of its QDD reporting compliance (namely, Forms 1042/1042-S). Such an adoption is neither expressly forbidden nor permitted by any IRS guidance and thus is vulnerable to outright rejection, but it does appear harmless, while conferring massive operational benefits.
 
Applicability of Good Faith Effort Relief to the Form 1120-F
 
Section 10.01(C) of the 2017 QI Agreement grants relief for errors in implementation of a QDD’s duties so long as the QDD made a good faith effort at compliance. Nothing in the instructions to the Form 1120-F explicitly applies this relief to the submission of the Form. However, pursuant to section 10.01(C), this relief applies to all provisions of the QI Agreement and Section 1.01 of the 2017 QI Agreement mandates that a QDD: “must report its QDD tax liability on the appropriate U.S. tax return (as prescribed by the IRS).” Seemingly, therefore, the Form 1120-F should be subject to good faith efforts defense in the circumstance of any legitimate errors in its preparation.
 
For further discussion on this topic, email: paul@millentaxandlegal.ch