September 22, 2019

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IRS Proposed Qualified Intermediary Agreement Addresses Cascading Withholding on Dividend Equivalents

On July 1, the U.S. Internal Revenue Service issued Notice 2016-42, which proposes changes to the qualified intermediary (QI) agreement to address cascading U.S. withholding tax on dividends and “dividend equivalents” received and paid by qualified derivatives dealers (QDDs) with respect to U.S. equity securities.

Background

Section 871(m) of the Internal Revenue Code imposes withholding on “dividend equivalents” paid on derivatives that reference U.S. equity securities.  The regulations under section 871(m) can result in multiple withholdings on the same stream of dividends.  For example, when a non-U.S. bank holds U.S. stock and issues derivatives with respect to the stock to non-U.S. investors, the non-U.S. bank may be subject to withholding on dividends paid on the stock, and also may be required to withhold on the dividend equivalents that it pays on the derivatives.

Certain foreign financial institutions and foreign clearing houses can receive U.S.-source dividends and dividend equivalents without being subject to withholding tax if they certify to the withholding agent that they are receiving the payments as intermediaries (and not as principals) and have entered into a QI agreement with the IRS under which they have agreed to assume primary withholding responsibility with respect to the payments.  However, banks and dealers often cannot act as qualified intermediaries with respect to a dividend or dividend equivalent because they receive the payment as principals (for example, as part of a dynamic hedge that offsets one or more transactions to which the bank or dealer is a short party).

Proposed Changes

The newly proposed rules under Notice 2016-42 would mitigate cascading withholding by expanding the QI regime to include QDDs.  Under the proposed rules, a QDD is a QI that is either:

  • A securities dealer that is regulated as a dealer in the jurisdiction in which it was organized or operates; or

  • A bank that is regulated as a bank in the jurisdiction in which it was organized or operates (or a wholly owned affiliate of such a bank) that issues U.S. equity derivatives to customers and receives dividends or dividend equivalent payments on its hedges of these derivatives.

Very generally, a QDD would not be subject to withholding on dividends or dividend equivalents that it receives as a principal if it:

  • Assumes primary withholding and reporting responsibilities with respect to the payments;

  • Agrees to remain liable for any tax on dividends and dividend equivalents it receives to the extent that it does not make offsetting payments as a short party on another transaction that references the same stock; and

  • Complies with certain compliance procedures.

The new QI agreement is proposed to be effective beginning January 1, 2017 for QIs that sign or renew the agreement before March 31, 2017. 

A copy of Notice 2016-42 can be found here.

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About this Author

Brian Foster, Cadwalader, interest rate lawyer, currency hedging arrangements attorney
Partner

Brian Foster is a Partner in Cadwalader's Financial Services Group and represents financial institutions in a wide range of transactional and regulatory matters. He represents both sell-side and buy-side clients in connection with financing transactions to funds of funds, hedge funds, private equity funds and mutual funds, including term and revolving loans, VFN facilities, repurchase, securities lending and prime brokerage transactions, and various derivatives, together with related currency and interest rate hedging arrangements. He also advises clients on the...

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Mark P. Howe, Cadwalader Law Firm, Corporate Taxation Attorney
Partner

Mark Howe's practice is concentrated in partnerships, financial products, securitization, the tax aspects of capital markets, general corporate finance, securities, and commodities. His work includes emphasis on the tax structuring of domestic and offshore investment funds and in the development, structuring, and implementation of a wide variety of financial and derivative products and transactions, such as fixed income, currency, equity, and commodity linked swaps, forwards, notes, options, and similar instruments and transactions, securities and other instruments with embedded derivatives, and hybrid and synthetic products.

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Steven Lofchie, Cadwalader, financial services regulation attorney, derivatives market lawyer
Partner

Steven Lofchie, a partner in the Financial Services Group, concentrates his practice in advising financial institutions on regulatory issues and on derivatives and other financial instruments. He is consistently recognized in the United States by Chambers USA, Legal 500, and IFLR 1000 in the areas of financial services regulation and derivatives. The Best Lawyers in America also selected Steven as one of the nation's leading lawyers in several areas including: Administrative/Regulatory, Derivatives and Futures, Securities/Capital Markets, and...

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Jason D. Schwartz, Tax attorney, Cadwalader law firm
Associate

Jason D. Schwartz focuses primarily on tax issues relating to structured notes, derivatives, domestic and cross-border lending transactions, collateralized debt obligations and other securitizations, hedge fund formation, and corporate reorganizations.

Jason received his B.A., cum laude, from New York University, his J.D., magna cum laude, from American University Washington College of Law, where he was inducted into the Order of the Coif, and his LL.M. in Taxation from New York University. He is admitted to practice in New York and the district of Columbia.

202 862 2277
Ray Shirazi, Cadwalader, securities lending attorney, prime brokerage lawyer
Partner

Ray Shirazi maintains a market-leading practice in derivatives, advising investment banks, domestic and foreign commercial banks, asset managers, hedge funds, private equity funds and mutual funds on related transactional and trading regulatory issues. His practice covers a wide spectrum of equity, hedge fund, currency, commodity and fixed income derivatives. He is particularly noted for his work in equity derivatives, involving traded securities, hedge funds, and other financial products.

Ray also regularly represents clients with respect to a...

212 504 6376