The §1446(f) Proposed Regulations for the withholding tax due on sales of designated partnership interests spreads the compliance burden across multiple Swiss market participants. Swiss banks, fund managers and investors all incur their own separate - but interrelated - duties under the new regulations released on 7 May. Satisfaction of these obligations necessitates a mixture of updated documentation, new withholding awareness and adjusted reporting processes. The following paragraphs examine the provisions and pitfalls for Swiss banks, fund managers and investors, respectively, due to the §1446(f) Proposed Regulations.
 
Background to IRC §1446(f) and the §1446(f) Proposed Regulations
Of the numerous substantive provisions contained in the 2017 tax bill, §864(c)(8) stands out by resolving a specific problem with a direct solution. The statutory provision overruled a US Tax Court decision from summer 2017 called Grecian Magnesite. The ruling had challenged the long-standing IRS interpretation that the sale or other disposition of an interest in a partnership that could earn effectively connected income (ECI) likewise qualifies as ECI. The new statutory provision codified the IRS interpretation: The proceeds from sales of such Specified Partnership interests are treated as effectively connected gain or loss and thus taxable by the IRS.
 
As such, the new provision essentially re-affirmed the substantive status quo. Except that Congress also added a new withholding dimension, imposing on any buyer of an interest subject to §864(c)(8) the obligation to withhold 10% of the gross proceeds paid to any non-US seller. The §1446(f) statutory provision, however, did not explain how that ought to work in practice, least of all for Publicly-traded Partnerships (PTPs), where the buyer and seller are typically invisible to one another. As such, the Treasury Department promptly suspended the withholding regime for PTPs. Shortly thereafter, via Notice 2018-29, the Treasury invoked a pre-existing set of regulations for withholding on US real property income to serve as a temporary bridge until Treasury could conjure an appropriate set of rules for withholding around PTPs, private equity funds and other myriad types of investments captured by the new provisions. The stop-gap rules will remain in effect until the Treasury Department publishes final regulations announcing their expiration dates (see the last section of this blogpost for further elaboration on the timeline for the §1446(f) regulations).
 
Previously, I addressed the preliminary and subsequent developments of §§ 864(c)(8) and 1446(f) in several blogs (available here) and at the Operational Taxes for Banks, Europe Conference in Zurich last November (available here).Prior to last month’s release of the Proposed Regulations, however, material doubts remained as to the final rules, their impact on various affected parties and their manner of implementation. As set out below, with several crucial exceptions, those doubts are now settled.
 
Swiss Banks (see generally, Prop. Regs. §1.1446(f)-4)
Swiss banks will need to renovate their withholding and reporting mechanisms in order to encompass the withholding and reporting required by qualifying brokers on the sale or other disposition of in-scope PTPs by non-US Person investors. A common aim for bank associations in submitting comments to the IRS on 1446(f) was to fold the new PTP withholding regime into the existing Qualified Intermediary (QI) regime. To a large extent, they were successful as the overall structure, documentation and reporting Forms and deposit procedures are lifted from the QI regime.
 
However, they were not completely successful in achieving this common aim and so, major operational and legal issues will arise. The need to withhold on unpredictable sales proceeds, rather than on stable periodic income flows, will complicate the identification of withholdable payments for banks custodying PTPs. Also, and more dramatically for Swiss banks, the Form 1042-S reporting will oblige them to list sellers on a named, individuated basis - rather than on a pooled and anonymized basis - which will collide with Switzerland’s bank confidentiality laws. Several industry groups (e.g. SIFMA, the Swiss Bankers Association) submitted comment letters to the IRS explaining the fallibility of the approach as set forth in the Proposed Regulations. It is scant exaggeration to assert that the on-going viability of the PTP market in Switzerland depends on the malleability of these provisions.
 
Swiss Investors (see generally, Prop. Regs. §§ 1.1446(f)-1, -2)
Swiss investors will face a double-edged sword that cuts at them coming and going. When they buy a Specified Partnership interest, the obligation to withhold and report on the gross amount of sales proceeds applies. When the Swiss investors sell the same or any other Specified Partnership interest, they will need to understand the exceptions to withholding and/or the mechanics of claiming a credit for the amount withheld under 1446(f). The foremost goal for affected Swiss investors is to ensure that they are not taxed needlessly or twice under the regime. The outstanding challenge will be to calculate the correct amount of tax due per the §864(c)(8) regulations and then to navigate the multiple forms and operational pitfalls in their path to preventing inappropriate withholding and/or claiming appropriate tax credits.
 
Swiss Fund Managers (see generally, Prop. Regs. §§ 1.1446(f)-2, -3)
Swiss fund managers will have limited foreground duties. They need to prepare for back-stop withholding in case the buyer neglects the primary duty and to conduct primary withholding duty in the limited circumstance that a distribution from the fund is treated as sales proceeds. On the other hand, their background duties will be considerable.
 
The other parties mentioned above will request certain information from their fund managers and that information must be provided in the timeframe and format mandated by the IRS. Accordingly, fund managers must become fluent in a variety of official IRS Forms and unofficial notifications, statements and certifications and their correct usages. By my count, the Proposed Regulations reference 7 new or amended IRS Forms and 7 new notifications, statements or certifications, each with its own delineated purpose.
 
More strategically, Swiss fund managers will need to consider how and how much of the burdens imposed on the others, notably their investors, they wish to assume on their behalf.  In order to preserve the market for in-scope fund offerings, fund managers may need to disencumber their clients and counterparties at their own expense.
 
Finally, to the extent Swiss fund managers operate over-the-top blocker corporations on behalf of their clients in Cayman, Luxembourg or elsewhere, these will qualify as non-US Persons for purposes of §1446(f) and be subject to the range of compliance duties set forth in the Swiss Investors’ section above.
 
Timeline and Action Items
One more aspect of the §1446(f) Proposed Regulations that has drawn scrutiny from commentators is the implementation schedule. As set out above, Swiss banks and fund managers must adjust or invent processes and procedures in order to cope with novel developments under §1446(f). However, rather than grant these financial institutions ample implementation leeway, the §1446(f) Proposed Regulations declare that the new rules will come into effect only 60 days following publication of the Final Regulations in the Federal Register. With the comment period window already shut, affected parties ought to anticipate Final Regulations – and the subsequent activation of this compliance regime in full - in the near term.
 
This aggressive timeline compels affected parties to initiate their compliance plans in advance of the publication of the Final Regulations. In so doing, they ought to consider the following concrete steps towards readiness:

• Examine operations to identify and isolate Specified Partnership interests subject to the §1446(f) withholding regime;
• Determine whether – and under what conditions – the business case justifies remaining in the market, an action item of especial relevance to banks holding PTPs;
• Institute contingency plans in case the conditions for remaining in the market are unmet, such as the prospect of forced divestment;
• Review and revise terms and conditions, prospectuses, offering memoranda and so forth in order to reflect §1446(f) withholding risks;
• Familiarize the compliance team with the new and revised IRS Forms – some of which are already available in draft format – and the parameters for valid notifications, statements and certifications; and
• Be prepared to press forward swiftly in case the IRS retains the onerous 60-day activation timeline in the Final Regulations.

 
If you wish to discuss this topic in further detail please contact us at: [email protected]

On 3 April the US Securities and Exchange Commissions (SEC) clarified the criteria for digital tokens and similar assets to qualify as “securities” under US law through the release of new framework guidance (the “Framework”) by its Strategic Hub for Innovation and Financial Technology (“FinHub”). Once classed as a security, the issuance of these digital assets in an initial coin offering (ICO) is subject to the SEC’s registration requirements. These registration requirements can be unwieldy and expose the issuer to investor lawsuits for any arguably misleading claims. While there are multiple exemptions to the registration requirement, any such exemption must be identified, evaluated and affirmatively adopted. Crucially, this not a new standard, but rather a comprehensive restatement of the current rules as applied to digital assets. Thus, the analysis applies to prior ICOs, which at the time may have been assessed – reasonably but incorrectly – not to qualify as a security offering (which may then require a curing of the initial non-registration).
 
What is the Framework?
In spite of multiple public announcements on the treatment of ICOs under federal securities law, the Framework is the first piece of written, consolidated guidance from the SEC on the regulation of digital tokens. Curiously, following such considerable wait and anticipation, the guidance is non-binding on the agency. Rather than a regulation or formal statement of the SEC’s position, the Framework is a compilation of existing jurisprudence on the defining characteristics of a “security” and their application to digital assets. Despite such an odd provenance, the Framework provides invaluable details and insights into the SEC’s perception of digital tokens as securities. Coupled with the SEC’S first “no-action” letter in the ICO sphere (see below), released in parallel with the Framework, 3 April marks the date on which the SEC unveiled its views on ICOs to the crypto community.
 
What does the Framework do?
Beyond the traditional understanding of securities such as stocks and bonds, US federal securities law (the 1933 and 1934 Acts together) includes the category of “investment contracts”. As the Framework acknowledges, the investment contract category is the one the SEC uses to capture “unique or novel instruments or arrangements.” As the term itself is sufficiently vague to be both substantially over- and under-inclusive, US federal courts developed criteria to narrow the scope, while sustaining the core objectives of the securities laws. In the SEC v. W. J. Howey Co. holding of 1946, the US Supreme Court provided a defining set of analytical factors known since as the Howey Test. Per the Howey Test, a financial instrument or arrangement qualifies as an investment contract for purposes of the US federal securities law if there is:

1. An investment of money (or other consideration of value);
2. In a common enterprise;
3. With a reasonable expectation of profits;
4. To be derived from the efforts of others.

Notably, the Framework asserts that the criteria be assessed on matters beyond the terms and forms of the digital assets themselves. Accordingly, a proper analysis must additionally contemplate the circumstances surrounding the asset, including the “network” (defined as broadly encompassing all elements comprising the digital asset’s network, enterprise, platform or application), its marketing and its sale and potential re-sale. Tested against this broader background, if an investment satisfies all four elements of the Howey Test, then such investment would qualify as an investment contract and thus a security.
 
The Framework explores each of the four elements, but operates on the assumption that most digital assets squarely satisfy the first two elements – both of which are broadly construed by the SEC, if sometimes less so by US courts. Accordingly the Framework eschews significant investigation into them. Instead, it targets the “reasonable profit expectation” and “efforts of others” factors as the elements ripe for uncertainty and thus in want of further guidance.

In conceptual terms, these two factors - taken together - effectively query whether based on “economic reality” an investor expects to be enriched thanks to someone else’s efforts that are essential to the success of the enterprise. Delving into this concept, the Frameworks sets out a litany of evidentiary factors for issuers of digital tokens to consider, such as the following:

• Whether the digital token allows the investor to benefit from income streams or value appreciation;
• Whether there is a secondary market for the digital token (or one is anticipated);
• Whether the issuer or other parties in control of the “network” (referred to in the Framework as the “Active Participant” or “AP”) will benefit from appreciation in the value of the digital token and, if so, how;
• Whether the digital asset’s “network” is fully realized or will be financed in part by funds raised through the ICO and subsequently completed;
• Whether the digital token is offered to a broad group of prospective buyers or limited to a small clan of expected “network” users and in quantities in excess of expected use on the “network”;
• Whether there is strong correlation between the price of the digital assets and that of the goods or services available through the “network”; and
• Whether the ICO is marketed as an investment opportunity.

 
No one factor from the list of evidentiary factors is dispositive and the list itself is not exhaustive. Rather, the more of these evidentiary factors that are met and the more squarely each factor is met, the more likely that a digital token will qualify as a security.
 
Finally, an initial analysis may be reconsidered if the characteristics of the digital assets evolve. Digital assets that qualify as securities upon issuance may develop or lose characteristics relevant to the Howey Test and permit subsequent re-appraisal as non-securities (and, presumably, vice versa).
 
What does qualification as a security entail?
Qualification as a security carries an unwelcome burden. Absent an exemption, an issuer of securities must register the security prior to sale by divulging the following required information:

• A description of the commercial purpose of the issuer;
• A description of the security;
• Relevant background on the issuer’s senior management; and
• Financial statements certified by independent accountants.

For many token issuers, SEC registration requirements are too steep a price for an ICO and alone could deter the issuer from embarking on one (especially as misstatements in the registration materials may be grounds for private fraud claims against the issuer). Luckily, Regulation D of the Securities Act (“Reg D”) permits unregistered issuances (also called “private placements”) in a variety of scenarios. The eligibility of an issuance for an exemption under Reg D pivots on two primary factors: The total value of securities issued and the types of investors to whom the securities are sold.
 
What does all of the above mean for an issuer of digital assets?
Generally, the Framework is a positive development for issuers of digital assets as it introduces greater certainty into the analytical process. Despite the odd conditions of the Framework (i.e. not a formal SEC ruling or the like), such a comprehensive exploration of the relevant concepts and legal holdings, further contoured to the ICO sphere, should be regarded as the blueprint for the securities law inquiry prior to an ICO.

In furtherance of these standards, the SEC’S first ICO no-action letter (essentially, a private letter ruling on a securities law matter) hewed to the Framework analysis in declaring that the agency did not regard the pending ICO by TurnKey Jet, Inc. as security issuance. This letter also illuminates how rigidly the SEC will apply the evidentiary factors set forth in the Framework, how the agency will weight certain factors and how the SEC generally views digital assets as securities.

​Coupling the Framework with the no-action letter, the SEC’s publications on 3 April 2019 provided the guidance necessary to assess ICOs under the US federal laws. Any party contemplating an ICO ought to determine (a) whether the tokens issued will qualify as a “security” by means of the Framework analysis and, if so, (b) whether an exemption from registration is available, before deciding (c) whether, based on (a) and (b), the ICO remains worthwhile in its present form.
 
If you wish to discuss this topic in further detail please contact me at: [email protected]

Over the holiday season, the US Treasury Department released the Proposed Regulations to IRC §864(c)(8), governing the sale, transfer or other disposition of certain partnership interests (mainly, private equity fund investments) by non-resident aliens (NRAs). The Proposed Regulations resolve the inconsistencies between the statute and existing US tax principles by incorporating heaps of existing federal tax provisions by reference. This deference molds the new statute to existing rules covering partnership interest sales by NRAs, but, as a result, this topic demands exhaustive prior exposure to multiple areas of US federal tax law. Alone, Example Three of the illustrative examples at the end of the Proposed Regulations implicates multiple tricky concepts from the partnership rules under subchapter K, such as the scope of §704 allocation discretion, the calculation of outside basis and the recharacterization of sales proceeds per §751, plus various international and corporate tax concepts, such as ECI, USRPIs and sourcing rules. Moreover, these concepts merely serve as the background landscape to the Proposed §864(c)(8) Regulations, which then apply their own special mustard to the topic. In sum, those with a taste for the diverse provisions referenced in this regulatory hot pot, will delight in savoring each one. The rest though may feel quite queasy when a single reference (even one from inside a parenthetical) leads to a hundred pages of extra regulations.
 
Content of Proposed §864(c)(8) Regulations
For those with the stomach to digest all these background prerequisites, the Proposed Regulations effectively settle many statutory ambiguities attendant to the sale, transfer or other disposition by NRAs of partnership interests earning potential ECI. Foremost, it informs the taxpayer how to calculate the amounts of gain or loss taxable as ECI. First, it instructs the NRA taxpayer to calculate effectively connected gain or loss and to characterize portions of the gain or loss as capital gain or ordinary income under the prevailing principles of subchapter K. Then, it sets forth a three-step process in order to cap this amount: Calculate the amount of gain or loss by means of a hypothetical sale scenario of all the partnership’s assets; determine the portion of such amounts qualifying as ECI; and identify the distributive share of such ECI attributable to the NRA transferor (consistent with §704). These two calculations, heavily reliant on themes from subchapter K, are the essence of the Proposed Regulations.
 
However, other topics are addressed as well in an effort to ensure that the core aim of taxation of such interests as ECI is reached, but not overreached. In order to accomplish this purpose, the regulations contemplate the following items:

• Multi-tier structures and the calculation of the taxable amount of ECI from sales of interests in the uppermost partnerships (e.g. a funds of funds’ scenario), which, regrettably, offers no de minimis relief and depends on information that may not be readily accessible;
• The treatment of transactions that permit deferred taxation (i.e. non-recognition events);
• The interaction of §864(c)(8) with §897, governing the dispositions of US Real Property Interests (USRPIs), the proceeds from which are also treated as ECI for NRA sellers;
• The application of §864(c)(8) where the activity falls under a tax treaty, rather than under the Treasury Regulations (which may, if taken to logical ends, result in treaty disputes and/or double taxation);
• The treatment of §707 distributions in excess of an NRA partner’s outside basis in the partnership;
• A sui generis sourcing rule, applicable solely to this provision and positing the anomaly in which non-US source income is characterized as ECI; and
• Anti-abuse rules (called “anti-stuffing” rules here), which seek to prevent any re-structuring of partnership allocations in order to reduce ECI exposure for NRA partners.

 
Implications for Swiss Taxpayers, PE Funds and other Swiss Financial Institutions
These Proposed Regulations set out the method of calculation for taxable income from the sale or other disposition of qualifying partnership interests by NRAs. Such information is crucial to NRA taxpayers who must calculate their taxable income following the sale of such an interest. Furthermore, private equity funds ought to rely on these Proposed Regulations in order to determine which information their NRA investors will expect to receive in order to calculate their §864(c)(8) tax liabilities.
 
But there are other party-goers at this banquet and several corollary topics remain unaddressed, two of which will play significant roles for Swiss private equity funds and financial institution, as follows:

• The §1446(f) withholding regulations will set the scope and application of the withholding obligations, which fall primarily on the buyer of an in-scope partnership interest and, residually, on the partnership itself (please find my blog on the current state of the withholding rules at http://millentaxandlegal.ch/blogs/private-equity-withholding-regulations-released). Once final, these regulations will determine the withholding and reporting mechanisms that private equity fund managers will need to establish. The  §864(c)(8) Proposed Regulations aid in that determination by calculating the baseline value of the total taxable amount, but complicate it materially in other ways and, thus, the final withholding regulations may set out some further limitations.
• The treatment of the sale, transfer or other disposition of interests in qualifying Publicly-Traded Partnerships (PTPs), which have been necessarily severed from their non-PTP brethren. This treatment will determine whether custodial banks can comfortably fold such PTP interests into their current QI positions or need to consider alternatives, including potentially forced divestment of qualifying PTP interests by their account holders.

 
Through the release of the Proposed §864(c)(8) Regulations, the regime governing the sale or other disposition of certain partnership interests by NRAs advances, but it does so fitfully and through resort to daunting preparatory knowledge. The incorporation of so many provisions from other sections of the US tax code and regulations, however, while helping ensure consistent flavor, may deter newcomers from taking a first bite.
 
Timelines and Other Sources of Information
As Proposed Regulations, these rules are not in force until released in final form. If finalized by 22 June 2019 the §864(c)(8) Regulations will be retroactive to 27 November 2017 (or, if not finalized until after 22 June 2019, to 20 December 2018).
 
Previously, I addressed §864(c)(8), along with §1446(f)’s associated withholding rules, in several blogs (http://millentaxandlegal.ch/blogs.html) and at the Operational Taxes for Banks, Europe Conference in Zurich last November (http://millentaxandlegal.ch/speaking-engagements.html). In the latter case, however, I concentrated on the treatment of PTP interests, as the audience consisted primarily of bankers, rather than investors or fund managers.

Here's the good news: The IRS referenced well-known regulations in order to implement the new withholding provision applicable to dispositions of certain partnership interests.​

Here’s the bad news: Those well-known regulations are the not very well-loved FIRPTA regulations for withholding on dispositions of US real property interests.

This blog will set out and review the following related matters:

• The background to the new statutory withholding provision;
• The questions emerging from it;
• The contents of IRS Notice 2018-29, addressing those questions; and
• The consequences for affected funds and investors in the Swiss marketplace.

Background to §§ 864(c)(8) and 1446(f)
Amongst the strategic transformations and pork barrel addenda that collectively define the 2017 tax bill, the US Congress enacted one provision, §864(c)(8) that stood out in by squarely addressing a specific problem with a mainly uncontroversial solution (see my earlier review of the new provision). In summary, the provision overruled a Tax Court decision from last summer called Grecian Magnesite. The ruling had challenged the IRS interpretation that the sale or other disposition of an interest in partnership that could earn effectively connected income (ECI) likewise qualifies as ECI. The new statutory provision codified the IRS interpretation.

In addition to affirming the IRS position, Congress added a new withholding dimension, §1446(f), obliging the buyer of an interest (referred to as the “transferee”) to withhold 10% (a seemingly arbitrary percentage) of the acquisition price from any non-US seller (referred to as the “transferor”). The amount realized is calculated via a deemed sale hypothetical - i.e. as if the partnership had sold all its assets at current FMV - in order to determine the amount, if any, of ECI it would have earned. If such withholding is not conducted by the transferee/buyer at the time of the acquisition, then the fund itself must withhold on subsequent distributions to the transferee/buyer.

The Practical Issues Arising from the Statutory Text
The statutory provisions settled the theoretical question posed by Grecian Magnesite, while generating a host of practical ones. Primarily these practical questions concern the exceptions to the withholding requirement and the determinants of the amount to be withheld, such as the following:

• How can the transferee/buyer confirm that the transferor/seller is a US Person and thus not subject to the withholding requirement?
• Where withholding is conducted, how (and how soon) must the revenue be deposited with the U.S. Treasury?
• How does the transferee/buyer report the withholding activity to the IRS?
• What if the transferor/seller enjoys no gain on the sale and, if so, how is such a loss position evidenced?
• Is there a de minimis exception if the value of the partnership’s assets yielding ECI is relatively small in proportion to the total value of the assets held by the partnership?
• What if the partnership makes a distribution to a partner in excess of the partner’s adjusted basis in the partnership interest (which is conceptually regarded as a partnership interest disposition under §731)? 
• How do the fund’s liabilities (the transferor/seller’s share of which transfers to the transferee/buyer along with the sale of the interest) affect the calculation of the amount realized and thus the withholding due?
• How is the value of the sale calculated when the partnership’s expenses were not yet allocated to the transferor/seller?
• Will the withholding rules apply (and if so, how) to a non-recognition transaction, where taxation is deferred?

Release of Notice 2018-29
The absence of any guidance on such fundamental operational matters helped persuade the US Treasury Department to swiftly suspend the application of the new withholding rules to the sale of publicly-traded partnership (PTP) interests at the end of December 2017, while inviting comments on other similarly-affected transactions. This uncertainty for the sale of non-PTP interests lingered until April, when the IRS released Notice 2018-29, addressing - in full or in part - the key questions emerging from the new statute (see list above) and inviting taxpayers to rely on the Notice until formal regulations could be prepared, proposed and published. By referencing the FIRPTA regulations as the source for guidance, supplemented by a few additions specific to the text of §864(c)(8), the IRS erected a short-term bridge across the holes in the statute.

Further, the Notice suspended the operation of the residual withholding obligations imposed on the funds themselves to withhold on subsequent distributions to any transferee/buyer that neglected to apply the 10% withholding at the time of the transaction. Finally, it waived the application of interest and penalties for any deposits due but not made prior to 31 May (tolling them until 31 May).

Despite the significant color daubed on the withholding picture by the Notice, several big questions remain outstanding. The most seismic is the treatment of PTPs. In a comment letter from SIFMA (the “voice of the [US] securities industry”) dated 2 August 2018, SIFMA outlined the impracticability of the FIRPTA-based approach to PTPs due to the current set-up for holding PTP interests, namely, the non-visibility of the relevant parties to one another. As an alternative, SIFMA proposes a system similar to the Qualified Intermediary (QI) regime for US publicly traded equities which imposes the withholding obligation on the client-facing custodian of the PTP interests, and relief for funds from any residual withholding responsibility. 

A second consideration overlooked by the Notice is the impact of the withholding regime on non-US flow-through entities with US partners/owners. This omission most notably implicates US partners in non-US funds of funds with investments through multiple tiers that ultimately yield ECI. Under international and flow-through taxation principles, such US partners are not subject to ECI taxation. Accordingly, the possibility ought to avail for the non-US partnership to provide a certification and underlying documentation that correspondingly reduces the withholding due on the disposition of lower tier partnership interests. For chapter 3 (QI) purposes, the Form W-8IMY and accompanying withholding statement collectively serve this objective. Therefore, the solution is at hand, even if not yet formally blessed by the IRS.

While more of a niche topic for non-PTP interests, doubts prevail concerning the correct treatment for the lending of partnership interests under §1058. Presumably, the general understanding for securities lending - that it does not constitute a sale or other disposition of the asset - applies to partnership interests with respect to §864(c)(8). However, the absence of any express expansion of the §1058 standard to the lending of partnership interests may distort or deter the sec lending market.

The single most outstanding question is, of course, whether the final regulations dedicated to withholding under §1446(f) will continue in this FIRPTA vein or swerve in another direction. While it would be unlikely (and ferociously vexing) for the IRS to compel the affected parties to adopt and implement a temporary withholding regime based on FIRPTA and then abandon it in favour of something else entirely for the permanent one, it is not inconceivable.

Considerations for Affected Swiss Parties
Swiss-based parties involved in US-based private equity investments may be impacted by the new rules in myriad ways depending on their specific role in such investment. Each role entails its own areas of concern, as follows:

• Swiss-based private equity fund managers/sponsors with US holdings yielding ECI, for example, need to:
  • Assess their holdings in order to identify relevant holdings and develop a sense of their risk exposure;
  • Develop the various certifications that their investors will request from them in order to evidence crucial factors, such as ECI amounts, expenses and liabilities;
  • Update their offering memoranda and other legal documentation;
  • Issue communications to investors; and
  • Begin to consider residual withholding operations for once the suspension expires for funds to withhold on subsequent distributions to neglectful transferees/buyers.
• Swiss-based, non-US investors, for example, need to:
  • Investigate their holdings by re-reviewing offering memoranda and K-1s to determine their exposure to §1446(f) withholding;
  • Evaluate the economic impacts on their investment strategies and cash flow scenarios;
  • Identify their own eligibility for withholding exceptions and prepare or obtain the certifications needed to evidence such eligibility; and
  • Set up a withholding function for acquisitions implicating §1446(f) that can determine if withholding required (i.e. request, obtain and validate relevant certifications), calculate the correct amount of withholding, withhold, deposit and report all on a strict timeline.
• Swiss-based funds of fund managers/sponsors, for example, need to:
  • Implement both sets of activities above for Swiss-based funds and Swiss-based investors;
  • Settle on an approach to self-documentation (e.g. Forms W-8IMY plus withholding statements) as a non-US flow through entity with US beneficial owners (if relevant); and
  • Conduct an historical review for any retrospective withholding due on prior acquisitions.
• Swiss-based, US investors, for example, need to:
  • Investigate their holdings by re-reviewing offering memoranda and K-1s to determine any exposure to possible §1446(f) withholding; and
  • Liaise with the fund managers in order to ensure that will not suffer undue §1446(f) withholdings as refunds will be a hassle.

In the end, the reliance on FIRPTA principles is as useful in Switzerland as elsewhere: Potentially beneficial, but mainly for those affected parties that have some experience with them. For the rest, the Notice introduced a new set of challenging regulations that will need time, resources and patience to master.

For all the sound and fury, Sturm und Drang, massive expenditure and general anxiety about its implementation, one peculiar element of FATCA has been the near total absence of enforcement by the IRS or other authorities. Predictions that FATCA reports would be compared instantly with FBAR submissions, discrepancies identified automatically and inquiry letters dispatched forthwith, have not been fulfilled. Instead, the IRS seemed content to deputize the major custodial banks and other large Financial Institutions (FIs) through the dual threat of withholding and the Responsible Officer (RO) Certification requirement and then to rely upon them to ensure that everyone else obeyed. As of today, I have seen a single story of a FATCA violation resulting in an enforcement action and, in that case, the FATCA violation seemed a pretext for prosecuting a securities fraud unrelated to FATCA entirely.
 
That may be about to change...
 
On 9 July, the Treasury Inspector General for Tax Administration (TIGTA) published an audit report, castigating the IRS for its lenient enforcement of FATCA. This report highlighted the massive outlay by the US fisc for FATCA implementation (Note: This eye-popping sum of USD 380M omits the multiples of it spent by non-US FIs on FATCA activities). Despite this sum TIGTA contended, the IRS had failed to implement its own blueprint for enforcement. While the criticisms and recommendations had several shades, the main thrust was that the IRS does not adequately ensure the collection of bona fide Taxpayer Identification Numbers (TINs). Accordingly, the IRS struggles to conduct reconciliation and crosschecking across Forms submitted by other parties to a transaction, a critical step for the identification of non-compliance by US taxpayers and withholding agents.
 
Generally, the IRS did not contest the report’s main claim that it needed to improve TIN collection and exploit the information to stiffen enforcement mechanisms. Specifically, the TIGTA report issued six recommended modifications, four of which the IRS agreed to adopt. Notably, one it rejected (to the chagrin of TIGTA) was the validation of all TINs collected. Instead, the IRS countered that the TIGTA recommendation to improve certain automated processes, which it had accepted, would also encompass this activity (which seems correct to me only if you squint very hard at it).
 
In any case, the IRS will need to show more FATCA enforcement return on its investment in order to allay internal pressure. That is clear. One way would be to prosecute US Person taxpayers for not filing FBARs or not reporting income earned through financial accounts abroad. But the TIGTA report suggested that the IRS might not have sufficient data for such a crackdown. If so, could IRS attention turn elsewhere? Perhaps and, thus, the real question for us is: What will be the consequences for Swiss and non-Swiss Reporting FIs? With that in mind, I contemplated a few scenarios and then thought through the ramifications, as set forth below.
 
Possible Outcome 1 - The IRS implements the agreed-upon TIGTA recommendations with a keen eye for Reporting FIs that repeatedly submit TINs identified as inaccurate. 
 
How many ROs would state unequivocally that the TINs on their FATCA reports or Forms 1042-S are 100% correct? Few, if any, is my guess. Therefore, if the IRS decides to review the FATCA-related submissions - current, future and perhaps past - many reports and submissions will need to be revised. That means lots of busy work for Reporting FIs that must re-process rejected submissions, re-confirm TINs from account holders and potentially argue with the IRS where the account holder confirms an original TIN different from the IRS one.
 
In the short term, this scenario threatens a broad, but shallow ripple across the marketplace. It means that many Reporting FIs will need to re-document US Person account holders and prepare amended reporting. In the longer term, these Reporting FIs will need to invest more in operational processes in order to upgrade and monitor their TIN collection process. The alternative - an on-going stream of reports submitted with bad TINs - could lead to unwelcome IRS scrutiny. 
 
 
Possible Outcome 2 - An under-resourced IRS cannot implement the audit revisions in a timely fashion, but needs to deflect the pressure to enforce FATCA more strictly.
 
In this scenario, the IRS adopts the old Chinese adage: Kill the chicken to scare the monkey. By ostentatiously cracking down on blatant non-compliance by means of a few, high-profile examples of punishment, the IRS will spook the rest into compliance, thereby relieving the auditor pressure temporarily while it pursues the agreed-upon fixes.
 
One source of ammunition for such an assault could be amnesty programs, plea bargains or the like. As the Justice Department did with Wegelin & Co. - the Swiss bank it torpedoed in order to jump-start the so-called Swiss Bank Program - the IRS might amass evidence of FATCA non-compliance against a bank vulnerable to the imposition of FATCA withholding. If a few client advisors helped a few well-heeled US Person account holders to avoid FATCA reporting and the Reporting FI cannot point to a top-notch compliance program that should have thwarted such misdeeds, the IRS could claim non-compliance sufficient to revoke its FFI Agreement. While its discretion is tempered somewhat for Model 2 IGA FIs and there is a 12-month period afforded Swiss FIs to address such claims, the prospect alone of revocation could be damning. If executed, such a revocation would convert the Reporting FI into a Non-participating FFI and other banks would start withholding on US-source FDAP payments made to it in its role as intermediary, essentially freezing the bank’s account holders out of the US capital markets and thus presumably triggering asset flight and cratering the share price.
 
The potential objects of such a campaign are in the unenviable position that they already committed the infractions for which they could be punished. All is not lost, however, for any Reporting FI concerned that it could be vulnerable to a charge of substantial non-compliance. The review of the Reporting FI’s FATCA compliance program, an element of the pending RO Certification process, is an ideal time to identify and redress concrete errors through amended reporting and systematic defects though compliance program enhancements. Such efforts would help the Reporting FI to depict the FATCA violations as the actions of rogue employees, rather than any institutional negligence. Conversely, any Reporting FI with serious compliance lapses known to the IRS whose RO submits an unqualified certification will be a ripe target for enforcement action.
 
 
Possible Outcome 3 - Some other form of heightened enforcement entirely.
The IRS may well have multiple FATCA enforcement strategies under development and ready to be unleashed. Timing-wise, it makes sense to have waited until non-compliant FIs had the chances to miss multiple action deadlines and thus will struggle to argue in their defense that they are just a bit late in getting everything in order, but are acting in good faith. At this point, non-compliance across multiple reporting cycles and potentially with the RO Certification will carry the whiff of reckless or intentional disregard for compliance duties, rather than innocent oversight. 
 
Examples of abuses endemic to FATCA that the IRS might be primed to confront include:

• Non-compliant registered Reporting FIs - A crosscheck of Reporting FIs registered on the IRS FATCA Portal against those submitting FATCA reports and RO Certifications could lead to a purge of non-compliant registered Reporting FIs from the GIIN list.
• Intermediaries and advisors - Piggy-backing off the OECD’s Mandatory Disclosure Rules, the IRS could propose a similar framework for FATCA, obliging intermediaries and advisors to report on avoidance efforts by principals and clients. This approach would be heavy-handed, extra-territorial and controversial, but that is nothing new for FATCA.
• Model 1 IGA compliance deserts - A somewhat common view is that certain Model 1 IGA tax havens have scant intention of enforcing FATCA and that entities governed by those IGAs enjoy carte blanche to conceal US Person account holders or otherwise flaunt their FATCA duties. By singling out one or more such Model 1 IGA jurisdictions and threatening to annul the IGA, the IRS and the Treasury Department would hope to spur these jurisdictions to discharge their treaty obligations more strictly.

 
Possible Outcome 4 - A combination of some or all of the above?
As the fairly breezy analysis of IRS enforcement options set forth above suggests, the IRS has an array of options, doubtless many of which I overlooked. As with much of FATCA implementation, enforcement too will be new. Accordingly, the IRS may adopt a multi-pronged approach in order to test which specific approach is most effective. Hopefully, in spite of the internal pressure, the IRS will not shoot first and ask questions afterwards.

The 2017 Tax Bill (commonly referred to as the Tax Cuts and Jobs Act or TCJA) expands the scope of (and further complicates the application of) the  CFC/Subpart F rules. As mentioned in my earlier blogs on the 2017 Tax Bill, the potential impact on non-US investors needs to be assessed. The impact does not stop there however. Far from it. Many US Person taxpayers face the prospect of sudden inclusion in a regime that previously did not implicate their holdings and consequent surges in taxable phantom income over the coming years. Moreover, their non-US investment partners may start asking them questions about their unrelated holdings for their own CFC/Subpart F purposes. In short, these are the sorts of changes that catch law-abiding taxpayers unawares until the IRS deficiency notice arrives bristling with interest and penalties.
 
First though, some light background music: The CFC/Subpart F rules, in simplified essence, oblige US Shareholders of Controlled Foreign Corporations (CFCs) to include in current taxable income relevant items of income earned by such CFC (so-called Subpart F income), even if not yet distributed to the US Shareholder via a dividend. The theory underlying this special treatment is that US Person taxpayers should not be permitted to defer the recognition of income by holding it through an off-shore corporation if such US Person taxpayers could compel the corporation to pay them a dividend, which would be taxable under the standard income taxation provisions of the Internal Revenue Code. Basically, you cannot defer taxation on income earned through a foreign corporation so long as it’s within your power to cause it be taxed. The core concept is relatively straightforward, but the rules rely on several specifically defined terms, the scopes of which determine inclusion or exclusion from the regime and any of which might present tricky analyses in certain taxpayer situations. Further, these definitions just acquired a few more wrinkles. This blog addresses four major modifications to key definitions, while leaving aside a host of more minor modifications.
 
Modification to a "US Shareholder"
Prior to the 2017 Tax Bill, the term, “US Shareholder” for Subpart F purposes generally covered any US Person owning 10% or more of a non-US corporation by vote of all classes of outstanding shares. The limitation to voting shares was logical as the aim of these rules was to capture US Persons with the authority to compel the non-US corporations to cough up a dividend. As such, the amount of holdings by value was, in theory, inconsequential. In addition to segregating those with real control from those with purely passive investment stakes, however, it tended to incentivise tax planning. No surprises there. Affected taxpayers sought to restructure their holdings of possible CFCs in order to reduce formal voting control below10%, while retaining actual control and full entitlement to economic benefits. For that reason, presumably, the 2017 Tax Bill adds US Persons owning 10% or more of a non-US corporation by value of all classes of outstanding shares to the definition of US Shareholder. As such, more lucky folks will qualify as US Shareholders of CFCs.
 
Modification to a "Controlled Foreign Corporation"
The term CFC generally covers any non-US corporations owned greater than 50% by vote or value – directly or indirectly – by US Shareholders. In calculating the percentages of ownership for this purpose, certain attribution rules per §318 apply. The CFC definition long required the application of the so-called upwards attribution rules. As a result shares owned indirectly by a US Person through an entity (of any type, including, corporations, partnerships, trusts or estates) would be treated as constructively owned by that US Person for purposes of this calculation. The 2017 Tax Bill adds downwards attribution to the possible additional sources of constructively owned shareholdings in a CFC.
 
What is this downwards attribution and how does it work? Well, if upwards attribution means that the holdings of an entity are attributable to its owners (e.g. shareholders, partners, beneficiaries, as the case may be), downwards attribution is the flipside of that: The holdings of one of an entity’s owners may be attributed to the entity itself. For example, in a sister company scenario, the presence of a US subsidiary alongside a non-US subsidiary, both wholly-owned by a non-US holding company, would now result in the downwards attribution of the holding company’s shares in the non-US subsidiary to the US subsidiary. As a result, the non-US subsidiary would qualify as a CFC and any US Shareholders (including US corporations) of the non-US holding company would start incurring potentially includible income if they previously hadn’t. Overall, many more non-US corporations will qualify as CFCs unless the IRS narrows the application of this rule (or suspends it, as it did per Revenue Notice 2018-13 for the Transition Tax rule described below).
 
As an aside to non-US investors: Due to these downwards attribution ownership rules, the holdings of US Person co-investors may affect your own investments because some of your US holdings may need to start paying more tax than previously as they now qualify as CFCs.
 
Modifications to includible income (two major modifications here)
Last but not least (actually, last and most of all), the 2017 Tax Bill expands the types of income earned by CFCs that must be treated as currently includible in the incomes of their US Shareholders. While not technically Subpart F income, the rules newly treat the following amounts as currently includible for US Shareholders of CFCs: Deferred foreign income corporation (DFIC) earnings and profits (E&P) and Global Intangible Low Tax Income (GILTI).
 
The Transition Tax
DFIC taxation per §965 (a/k/a the Transition Tax) is the levy on any post-1986 accumulated E&P of Specified Foreign Corporations that was not yet distributed or otherwise subject to US federal taxation (for further elaboration on this topic, please refer to my prior blog, The Trump Tax Bill: What it means in Switzerland (Part III)). Not all Specified Foreign Corporations are CFCs; it is a broader definition. However, all CFCs are Specified Foreign Corporations, meaning that all CFCs with positive and as-yet untaxed post-1986 accumulated E&P must pay the Transition Tax, which may be paid in installments over eight years. US Shareholders of CFCs with calendar year tax periods owe the Transition Tax starting for tax year 2017, which is thus evidently due by 17 April 2018. Presumably, therefore, in advance of this date, affected US Shareholders must calculate the total amount owed and commit to the installment plan. Somehow. To further complicate the matter, so far, the IRS has issued no forms or guidance on the process. A postponement to this particular deadline may seem inevitable, but even a laxer timetable will necessitate prompt action.
 
GILTI
Whereas the Transition Tax is one-time levy on historical income irrespective of its derivation, GILTI under §951A, on the other hand, is an on-going tax on contemporaneous income flows derived from intangible assets. Its underlying objective is to disincentivize the stashing of IP and other intangible assets in low-taxed overseas subsidiaries. It aims to achieve this objective by compelling US Shareholders to include a portion of this income earned by CFCs in their current taxable income prior to the payment of any dividends. An in-depth explanation of the formula used to isolate the specific class of income targeted is beyond the scope of this blog. In essence, however, it taxes a certain amount of the net income earned by a CFC that is not otherwise taxable (e.g. as ECI, Subpart F income, etc.), but reduced by 10% of the adjusted costs bases of depreciable (but not amortizable) assets held by the CFC (an amount itself reduced by interest expenses). The low tax jurisdiction component is implicated by FTCs allowable for 80% of the taxes paid on the income by the CFC (subject to §904 bucket limitations). In short, if a CFC in a low tax jurisdiction is earning mainly non-passive income and holding mainly intangible assets, its US Shareholders are supposed to be handing a portion of that income over to the US fisc each year.

Part I of this blog series addressed the larger thematic issues for Swiss financial institutions and investors from the new US tax code provisions. Part II set out the scope and consequences of the reduced corporate tax rate and changes relevant to taxation of certain US investments. Part III explores several more relevant topics, including the movement towards a territorial tax system for US corporations and notable miscellaneous provisions before ending with a light-hearted, non-technical look at some of the more idiosyncratic elements of the Trump Tax Bill.
 
Towards a Territorial Tax System
Most countries operate a territorial tax system. That means, that income is taxed where earned, irrespective of where the taxpayer is located. Historically, the US does not. Instead, the US relies on a quasi-territorial system for corporate tax under which a US corporation was subject to taxation on income earned by its subsidiaries abroad. However, the US parent could defer such taxation until the subsidiary distributed such earnings to the parent by means of a dividend. Receipt of such a dividend payment often entitled the US parent corporation to claim a foreign tax credit (FTC) for taxes paid by the subsidiary in its home jurisdiction. Nonetheless, for dividend payments from subsidiaries operating out of tax-friendlier jurisdictions, the FTC was substantially lower than the tax rate imposed in the US. Therefore, many US corporations hoarded cash in overseas subsidiaries, rather than repatriate it. This approach was upended in December.
 
Per the new tax bill, dividends paid from non-US subsidiaries (or at least the portion consisting of non-US earnings) are entitled to a 100% dividends received deduction (DRD). The result of this DRD is non-taxation of such dividends for the US corporate parent (provided it owns 10% or more of the non-US subsidiary). In parallel, the provision granting an FTC for any taxes paid by the non-US subsidiary is repealed (as is any FTC attached to any dividend entitled to the 100% DRD). The overall re-shaping through these two changes looks a lot like a move to a pure territorial tax system.
 
However, there are other international bits of the US tax code – new and pre-existing – that maintain some aspects of the previous universal (i.e. non-territorial) system. The most obvious one is the treatment of the historical aggregate earnings and profits (E&P) of the non-US subsidiaries that were not yet distributed (i.e. the amount that would have been subject to US taxation had the dividends been paid under the previous system). Per the recent changes, this E&P will be deemed to have been repatriated (i.e. paid to the US parent as a dividend), even though it was not yet. This hoarded E&P will be taxed at varying rates, depending essentially on whether it is held in liquid (cash or equivalent) or non-liquid form (15.5% and 8%, respectively). The amount owed pursuant to the deemed repatriation provision may be paid in installments as set forth in the tax code. Once taxed, dividends containing such historical E&P are also entitled to the 100% DRD deduction.
 
Furthermore, certain exceptions will constrain the 100% DRD going forward, such as:

• The non-US source qualification;
• The requirement for a 10% ownership threshold in the non-US company;
• The non-application to passive investment companies;
• The exclusions of hybrid dividend payments (i.e. dividend payments qualifying as debt interest payments under the subsidiary’s local law); and
• The ineligibility of dividend payments on shares held for less than one year.

 
Oddly, branch profits remittances seem not to enjoy similar tax exemptions, remaining subject to the existing quasi-universal system with US headquarters taxed on the difference between the local tax rate and the new US corporate tax rate. Additionally, a new loss limitation basket for FTCs was introduced specifically for foreign branch operations. This differential treatment is bound to influence the business judgment of US corporations when deciding on the form of their overseas operations. All things being equal, branch operations will be less attractive economically due to their US tax treatment. This differential seemingly violates a cardinal norm of international taxation: To avoid tax rules that distort business decisions.
 
Meanwhile, in other parts of the tax code, the non-territorial aspects of the US corporate tax regime continue to prevail. Foremost, the controlled foreign corporation (CFC) rules remain intact, meaning that certain non-US corporations owned in part by US Persons will continue to pay US taxes on specified types of current income earned outside the US. Moreover, new treatments for certain types of income derived from intangible assets further muddy the subpart F waters. Non-US investors ought to take another look at the rules governing CFCs – the new ones and their effect on the existing ones – in order to spot any knock-on consequences to their investments.
 
Miscellaneous Items of Interest
Scattered changes that merit a mention include the following:

• The deemed repatriation tax, phantom income and fund investors
  • Under US federal tax principles, a partnership itself it not subject to tax. Instead, the taxable income of the partnership must be allocated to the partners pursuant to the negotiated terms of the partnership agreement (with some specified limitations on the freedom of allocation in order to thwart abusive practices). Critically, the taxable incidence (i.e. the allocation) need not be connected to a distribution of income to the partner.
  • In order to avoid the dreaded scenario under which partners are taxed on income not actually received, an investment fund may make a limited tax distribution in the amount of the maximum possible tax on the income allocation. However, a fund may not have the wherewithal to cover the new deemed repatriation tax on its affected foreign corporate holdings.
  • Thus, investors may wish to inquire if they might receive an allocation of deemed repatriated income without the cash to pay the tax on it.
• A derivative, defined.
  • Despite clear-cutting entire forests in order to produce the regulations for §871(m), a code provision that taxes payments from non-US derivative instruments that substantially replicate the economic benefits of holding an underlying US equity, the IRS did not define a derivative for that purpose. In fact, prior to last month, nowhere in the US tax code was a derivative defined.
  • However, in an effort to set out a formula for calculating the new transfer pricing provision (called BEAT), the code now enjoys a definition of a derivative. Whether his definition will be imported for purposes of §871(m) or any other code sections is as-yet unknowable.
  • Nevertheless, in the absence of any other guidance, if you are in need of a handy tax definition for a derivative, you might consider IRC §59A(d)(4)(h)(4)), which broadly defines one, as follows:
    • “The term ‘derivative’ means any contract (including any option, forward contract, futures contract, short position, swap, or similar contract) the value of which, or any payment or transfer with respect to which, is (directly or indirectly) determined by reference to one or more of the following:
      • (i) Any share of stock in a corporation.
      • (ii) Any evidence of indebtedness.
      • (iii) Any commodity which is actively traded commodity
      • (iv) Any currency
      • (v) Any rate, price, amount, index, formula, or algorithm.”
• “Carried interest” carries on
  • The “carried interest” exception is a long-panned IRS interpretation of partnership taxation rules. In essence, it entitles the performance fees paid to a fund’s managers (e.g. 20% of the fund’s profits) to claim preferential capital gains rates, thus incentivizing fund managers to convert (tax-free) their management fees (e.g. 2% of total assets under management) into profit participations solely for tax purposes.
  • Both 2016 Presidential candidates declared their resolve to revoke this treatment, which is negatively perceived as a license for fund managers to slash their tax rates. While the new bill extends from one to three years the holding period needed to obtain the preferential capital gains treatments (for non-corporations only), conceptually the beneficial treatment remains otherwise untouched.
• A stay of execution for the death tax
  • Despite long-standing Republican aspirations to eliminate the estate tax, the recent tax bill merely restrained its impact by doubling the threshold value of an estate at which it applies to USD 10M (the baseline number, which is indexed to inflation from 2011 and thus projected to reach USD 11.2M per person for 2018). The higher the threshold is, the greater the number of estates that will be excluded from the tax (all things being equal).
  • The new baseline is scheduled to sunset (i.e. automatically expire) in 2025 unless extended by Congress.
• Sourcing rule for inventory produced
  • The new code simplifies (the aim of any good tax reform) the sourcing rule for income from the sale of inventory produced by the seller (as opposed to inventory bought and then re-sold) per §863(b).
  • Previously, any inventory produced abroad, but sold in the US by a non-US Person was subject to partial treatment as US-source income.
  • Under the new bill, such income will be sourced entirely to the location of production and thus generally not subject to US taxation.
• Intragroup Interest Deductions, Ltd.
  • Due to the previously high rate of US corporate taxation, international groups had an incentive to bulk up their US operations with deductible expenses. One common method was through debt and thus deductible interest costs. Under the new revisions to §163(j), the interest deductions of a US corporation will be limited to 30% of its adjusted taxable income (as defined in the code and subject to its own adjustment in 2022). Any unused interest expenses may be carried forward to subsequent tax years (provided, of course, that the limit is not breached).
  • This provision is already receiving lashings for some of its details, so may be narrowed through IRS regulations.

 
The Peculiarities
In order to close on a lighter note, let’s consider some of the odder elements of the Trump tax bill. Sometimes, strange revisions may address quirks or lacunae in the current rules and are thus bonafide clean ups of debris leftover in the tax system from previous revisions. However, other times, these curios are the products of the personal leverage of individual politicos over the drafting process. Such “pork-barrel” provision are promoted by or promised to one or a small cadre of legislators for the benefit of a narrow and/or local constituency. A few provisions in the new bill stand out as particularly peculiar (and smell a bit bacon-y), such as:

• Lower taxes on mead
  • Admittedly, the set of rule changes are more concerned with beer and wine than with mead, a honey-infused ale more commonly quaffed in medieval courts than contemporary pubs.
  • This rather ancient intoxicant is, however, notably included by name in the broader excise tax reductions on various forms of alcohol and timing of the tax’s application.
  • So, heft thee flagons aloft, ye olde mead drinkers, in a toast: Long live the new tax bill!
• Native American trusts in Alaska
  • Is it a coincidence that a crucial senate vote and one of the more highly specific revisions in the new bill both feature Alaskans? Could be, but it’d be a fairly remarkable one if it were.
• Aircraft management fees
  • This reduction in taxation on, and thus the costs of, air travel should be welcomed by all frequent flyers out there … oh wait... You fly commercial? How awful for you. Never mind then.
  • This provision applies to taxation of airplane flights where a company administers, but does not own the fleet of aircraft. Such circumstances are common in the case of corporate and private jets, but will have no foreseeable impact on normal flights with regular airlines.
• It’s my tax bill, I’ll deduct what I want to
  • Heaps of new provisions that affect the taxation of real estate income and real property holding vehicles, which may or may not benefit a certain unnamed real estate magnate.

 
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Part I of this blog series addressed the larger thematic issues for Swiss financial institutions and investors from the new US tax code provisions. Part II will explore the first of several significant topics, coupled with an analysis of the implications for Swiss financial institutions and investors.
 
Competitive Corporate Tax Rates
Prior to the Tax Cuts and Jobs Act, the US imposed one of the developed world’s steeper corporate tax rates at 35% (coupled with a further tax of up to 39.6% on the shareholder for dividends received). The new bill slashes that rate to 21% (and repeals the alternative minimum tax for corporations). The business- and investor-friendliness of this rate reduction is indisputable. In a flash, it will enhance the post-tax return on investment for US corporations, which ought to make the US operations of Swiss companies more profitable and the investment holdings of non-US investors more valuable. As noted in Part I of this series of blogs, numerous non-tax factors may mitigate the intended impact, but the tax wind clearly gusts in the direction of higher corporate post-tax profits and thus presumably a more attractive investment destination (for further illustration of this attractiveness, please see ECI section below).
 
One quirk of the rules for tax accounting, however, will result in an immediate harm to the balance sheets of US corporations (both US-headquartered companies or the subsidiaries of non-US parents) due to the reduction of the corporate tax rate. This harm is superficial, but may lead to some holes on the asset side of the balance sheets for US corporations with significant accumulated losses (called “net operating losses” in tax parlance or NOLs, for short). The US tax code permits US corporations to carry forward NOLs from one year for use against positive earnings in future years (subject to multiple limitations). As such, NOLs are valuable for reducing future tax costs and thus may be treated as an asset in the financial reports of the corporation. For accounting purposes, the amount of future deductible losses is known as a deferred tax asset (DTA) and boosts the asset side of a balance sheet so long as the corporation has a reasonable expectation that it will earn enough income to offset it in future years before it expires.
 
Well, in 2008 a lot of banks lost a lot of money. A LOT. Since then, they have been carrying DTAs of up to USD 20B, inflating their balance sheets correspondingly. However, the amount of a DTA is a product of the total NOL multiplied by the corporate tax rate. For example, if you have an NOL of USD 100, it still can only offset USD 100 of future income. Going forward though, the value to the corporation on taxes saved will be 100 x 0.21 or a DTA of USD 21, whereas previously it would have been 100 x 0.35 or a DTA of USD 35. Fortunately, the financial markets tend to discount such tax elements of a balance sheet as they do not signal the overall health and future prospects of the corporation (arguably, a large DTA signals the opposite). Nonetheless, there may be some secondary effects in response to this tax accounting adjustment.
 
Lower Rates on ECI, an Incoming Withholding Regime and More
Effectively Connected Income or ECI is income earned through a direct investment in an active trade or business (mainly). At its most straightforward, the US branch or other permanent establishment-type operations of non-US corporations generate ECI. Non-US investors can also earn ECI through investments in private equity, venture capital or other investment funds that acquire ownership stakes in start up companies, which tend to operate as LLCs or in other flow through forms. In the absence of a “blocker” corporation, the earnings of the portfolio companies pass through to the investment fund and then on to the non-US fund investors as if such non-US fund investor had earned the active operating income directly. Accordingly, income earned through such investments is taxed at the rate applicable to US corporations, not the standard dividend or capital gains rates that typically avail for non-US investors in US securities.
 
The new tax bill contains several provisions that will affect ECI calculations for non-US investors. It also institutes a new withholding requirement that will impose a further operations burden on QIs and other withholding agents. The core changes are as follows:

• First, as noted above, the tax rate for ECI is tied to the corporate tax rate. Thus, the reduction in the standard corporate tax rate reduced the ECI rate to 21% as well (for corporate recipients of ECI).
  • However, to the extent that a non-US investor receives the payment directly as an individual, the corporate tax rate reduction has no impact. The reduction in the individual tax rates and thresholds will apply, but the rate cut is less dramatic (e.g. top rate dropped from 39.6% to 37%).
• Second, the reduced corporate tax rate may make the use of US blocker corporations by investors (or by funds on behalf of investors) more attractive because of the reduced US rate and the non-reduction in the Branch Profits Tax rate.
• Third (and at odds with the second point), individual investors may opt to eschew blockers entirely to the extent the new deductions for income earned through qualifying flow through entities per §199A is available.
  • While this section is particularly complex and thus primed for substantial modification through the eventual IRS regulations, nothing currently disqualifies non-US Person taxpayers or fund investors from claiming the deduction.
  • So long as the taxpayer is not a corporation (trusts and estates qualify, as well as individuals), such non-corporate taxpayer may deduct 20% from “qualified business income” (QBI) allocated to such investors by a flow through entity (e.g. an investment fund).
  • This deduction is, however, limited by numerous constraints, which may render the deduction markedly less valuable to many fund investors, as follows:
    • Most types of investment income (e.g. capital gains, dividends) are omitted from the scope of QBI (i.e. passive income earned at the portfolio company level is not eligible for the deduction once allocated to the investor taxpayer);
    • Income from specified types of service-oriented businesses are excluded (including, tragically, the provision of tax and legal advisory services); and
    • Wages paid and depreciable assets owned by the company operate as discrete limits on the amount of QBI eligible for the deduction (though subject to an overall taxable income threshold exemption).
  • In light of the complexities of the rules, the effects of the limitations, the 2025 sunset clause (i.e. expiration date), the potential for gamesmanship at the lower levels in the investment structure and the on-going operational hassle of filing US tax returns act as a blunt deterrent to this set up, nonetheless, for non-US investors accruing significant amounts of QBI through indirect investment in active business with salaried employees, this option should be examined.
  • Please note: QBI earned through investments in publicly traded partnerships are eligible for the deduction free of the wage limitation, making it more readily available.
• Fourth, the statute overrules a court decision from summer 2017. Grecian Magnesite challenged the IRS position set forth in Revenue Ruling 91-32 that the sale of a partnership interest in a fund investing in assets that yield ECI must also be treated as ECI. In Grecian Magnesite, the Tax Court contended that in certain circumstances it might not qualify as ECI. Congress overturned that ruling, reaffirming the long-standing IRS view.
  • Congress did not stop there, however.
  • The new provisions introduce a withholding requirement of 10% of the gross purchase price paid to the transferee (i.e. the seller of the partnership interest) under §1446, unless the seller self-certifies as a US Person.
  • Non-compliance by the selling partner will result in withholding obligations foisted on the partnership itself with respect to subsequent distributions to the purchaser.
  • The new withholding requirement looks likely to yield a tangled gnarl of new withholding rules. An assessment of the impact on QIs and other custodial banks must wait, however, for these regulations to be drafted and released.
  • While the new rule withholding requirements on qualifying sales of partnership interests are technically in effect since the start of 2018, the withholding rules are deferred for sales of interests in publicly–traded partnerships (PTPs) until 2019 per IRS Notice 2018-8.

 
Part III of this blog series dissecting the new US tax code provisions will be published in a few days’ time. If you wish to be automatically notified when it’s posted, please send an email to [email protected] and you will be added to our subscriber list.

Hey, anyone hear the one about the new tax rules enacted by the US Congress in late 2017? Of course, we all did. Inevitably, unavoidably, somewhere, sometime in December, we read or heard something about the new US tax bill signed into law just before Christmas. However, what you have heard about it might be irrelevant to your circumstances or, worse, might generate “white noise”, distracting you from what is in fact relevant to your circumstances. Even more worrisome, the distinction may not be clear. The modification of an organism as vast, complex and ungainly as the US Internal Revenue Code is like dredging an ocean harbor to install port facilities: From the perspective of the harbor, the entire ocean is now different; from the perspective of the ocean, nothing much has changed at all. Therefore, a beneficial analysis of tax code revisions must understand when its readers are in the ports and when they are in the middle of the ocean.
 
Accordingly, this blog (or rather set of blogs) will seek to do just that, concentrating on the elements of the new tax laws that are relevant – either directly or indirectly – to its core readership: Swiss financial institutions and Swiss (or other non-US) investors in US financial assets. Thus, it will de-emphasize the parts that have little impact on an international readership (even the…. drumroll please… HEADLINE political news). Finally, it will seek to present a three-dimensional view of the package of changes that affect a specific type of non-US taxpayer or industry, rather than simply listing each changed provision while expecting the reader to integrate the various parts into a comprehensive understanding of the new US tax landscape.
 
As I am a tax specialist, you’ll not be surprised when I begin with caveats. The blog will not cover the following topics in detail, though some or all may be critical to the impact of the new tax bill:

• Opaque and hasty negotiations over tax legislation tend to result in loopholes and/or leeway for self-serving interpretations by taxpayers. As such, we will almost certainly see technical amendments designed to patch up unintended results as the new rules settle and the bill’s defects emerge.
• Concurrently, the IRS may draft their regulations in order to preemptively thwart certain interpretations or adjust their trajectories in unforeseen ways. In certain circumstance (or to certain interested observers), the IRS may appear to exercise more authority than granted to it by congress. Such overreach – especially, where disfavorable to taxpayers – may lead to litigation and thus further uncertainty.
• Typically, new tax provisions need to percolate through the various cogs in the tax system before unforeseen consequences are identified and remedied. Thus, normally, we would expect to wait for new rules to be applied across a few tax cycles before abuses emerge. That may not be the case here though; possible loopholes and sheltering techniques (along with proposed remedies) are already being mooted openly in the tax press.
• The reactions of America’s tax treaty and trade organization partners may compel further alterations as – fairly or not – the recent revisions are perceived to violate various treaty obligations and norms of international tax comity. As a result, these partners may seek agreement with the US to moderate the effects of certain provisions or (more likely) enact unilateral changes to their own tax codes designed to counteract aggressive US tax policy-making.
• Furthermore, the domestic political response – so far, abnormally negative for a bill reducing many people’s taxes – may persuade Congress to amend swathes of the code, especially if that Congress is no longer a Republican-majority one and a material reason for the incoming Democratic-majority is the adverse reaction to this tax bill.
• Monetary policy may restrain the desired economic growth. It is highly unusual (and decidedly anti-Keynesian) to enact a fiscal stimulus following a decade of continuous (albeit sluggish and fitful) economic growth. As such, the intended stimulus may be blunted by a dampening reaction from the Federal Reserve Bank.
• Although the tax rate cuts and certain reforms are undeniably business-friendly (more on that later), it ought to be assumed that some portion of the anticipated tax benefits are already priced into current stock valuations by Wall Street and investment calculations ought to be discounted accordingly.
• The following topics were not touched by the changes to the tax code despite rampant speculation that they would be included:
  • FATCA and the OECD Common Reporting Standard (CRS) – Despite a repeal amendment tabled by longtime FATCA foe, Senator Rand Paul of Kentucky, FATCA remains in force and OECD CRS remains highly unlikely to be enacted into US law anytime soon.
  • Section 871(m) regulations – The roundly criticized regulations were not addressed by the tax bill, though that may reflect a Treasury Department impulse to restrain the regulations at the agency level (see my earlier blog, entitled “Is a tactical retreat on §871(m) coming?”, for further elaboration.)
  • A so-called “border adjustment” tax or other form of neo-tariff – An initiative to tax imported goods in hopes of bolstering domestic manufacturing, a topic of heated debate over the summer, fell into disfavor long before the bills were enacted and is not contemplated in the final statute.
  • Interest deduction limitation – Earlier versions of the bill restricted claims for interest expense deductions based on a worldwide group’s overall debt amount per §163(n).

 
And thus, we move onwards to Part II, the actual analyses of the bill, which will be posted over the coming days and feature the following themes:

• The renovation of the US corporate tax regime, including:
  • The sharp reduction in tax rates (as noted above, it’s a business friendly set of new rules)
  • The virtual elimination of taxation on income earned abroad
  • Sourcing of inventory sales
• The further complication (and attractiveness) of non-corporate business entities, including:
  • Deduction of pass-through income
  • Sales of partnership interests with Effectively Connected Income (ECI)
  • New ECI withholding regime
• A shift to reliance on set thresholds, rather than on market forces, for the determinations of factors prone to manipulation, including:
  • The limitation on the interest deduction
  • New base erosion provisions

 
Part II of this blog series dissecting the new US tax code provisions will be published in a few days’ time. If you wish to be automatically notified when it’s posted, please send an email to [email protected] and you will be added to our subscriber list

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: [email protected]

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: [email protected]

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: [email protected]