Final Form 1042 and Instructions: The QDD Edition

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