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:
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:
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 firstname.lastname@example.org 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:
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:
Substantively, it must contain the following information on payments, irrespective of whether such payments were subject to withholding:
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.
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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.
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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:
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:
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:
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:
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.
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