CRS & 871(m) INSTITUTE OF INTERNATIONAL BANKERS ANNUAL SEMINAR ON U.S. TAXATION OF INTERNATIONAL BANKS June 12, 2017

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1 INSTITUTE OF INTERNATIONAL BANKERS ANNUAL SEMINAR ON U.S. TAXATION OF INTERNATIONAL BANKS June 12, 2017 CRS & 871(m) Satisfying New Reporting Requirements Tara Ferris, Principal, EY Lucy Farr, Partner, Davis Polk & Wardwell LLP Jeffrey B. Tate, Counsel, Shearman & Sterling LLP Moderator: Carla Pehowski, MD & Senior Tax Counsel, Royal Bank of Canada

2 What is CRS? The OECD Common Reporting Standard (CRS) is an information sharing model developed and approved by the OECD on July 15, 2014 for the automatic exchange of information (AEOI) to support international tax transparency. The standard is enacted via local legislation and Competent Authority Agreements (CAAs) between participating countries. Fundamentally, CRS requires financial institutions to: Identify all tax residencies of account holders (for both new and preexisting accounts) Properly document and classify new and preexisting accountholders Identify reportable accounts and report specified financial information to participating tax authorities, who will share the information with one another As of May 2017, 100 jurisdictions have committed to implement CRS. Fifty early adopter countries agreed to have new account onboarding procedures to comply with CRS in place by January 1, 2016, with the first information exchange in Another 50 countries committed to have onboarding procedures in place by January 1, 2017, with first information exchanges in

3 Persons Subject to Reporting CRS Individuals resident in a participating jurisdiction Entities resident in a participating jurisdiction other than: Corporations the stock of which is regularly traded on an established securities market or any corporation that is a related entity of a such corporation; Governments; International organizations; Central banks; and Financial institutions. Controlling persons of a passive non-financial entity (NFE) or of a managed investment entity in a non-participating jurisdiction. 3

4 FATCA and CRS Common Elements Both FATCA and CRS are meant to combat tax evasion by requiring financial institutions outside a taxpayer s jurisdiction to report financial account information. FATCA is implemented by U.S. regulations, a Model 1 intergovernmental agreement (IGA), or a Model 2 IGA. CRS is implemented through local legislation adopting the OECD s Common Reporting Standard. CRS is modeled on, but not identical to, FATCA Model 1 IGAs. Both FATCA and CRS have due diligence requirements to determine which accounts are reportable. Both FATCA and CRS require reporting of financial account information (e.g., account balance), regardless of whether income is paid or distributed to the account, to government authorities. 4

5 FATCA vs. CRS A comparison of the two reporting initiatives US FATCA CRS Purpose Identify/report certain U.S. persons Identify/report certain tax residents in CRS jurisdictions Due Diligence Withholding Reporting U.S. & Non-IGA: W-8s/W-9s IGA: W-8s/W-9s and self-certification 30% withholding on U.S.-source FDAP income and gross proceeds from the disposition of U.S. stocks and securities (except generally no withholding by FFIs in Model 1 IGA jurisdictions) Who reports: Financial Institutions Who is reported: U.S. individuals, U.S. entities and non-u.s. entities with U.S. owners or U.S. controlling persons Self-certification No withholding Who reports: Financial Institutions Who is reported: Individuals and entities resident in CRS jurisdictions and other entities with controlling persons resident in a CRS jurisdiction Responsible Officer Certification Model 1 IGA: Not applicable Model 2 IGA/PFFI: Yes Not applicable Noncompliance Traditional IRS penalties and/or penalties under local law Loss of compliance status (resulting in withholding described above) Penalties may be imposed under local law 5

6 CRS Challenges Opportunities and limitations of leveraging entity classifications for FATCA and CRS Cross-jurisdictional issues with self-certification Treatment of undocumented accounts Follow-up requirements How to classify in your records and country variations and presumptions Can you open a new account without a self-certification Identifying controlling persons link to OECD Financial Action Task Force (FATF) and local AML requirements Looking through financial institutions that hold an interest in a Passive NFE Senior managing officials when are they considered controlling persons and what to do if passive NFE refuses to identify any controlling persons (including a senior managing official or director)? Accept or reject self-certification? Refuse to open account? Reliance on AML records if no parties required to be identified for AML purposes Impact of changes to domestic AML standards 6

7 CRS Further Transparency Initiatives Now that we have global exchange, what else could governments need? What changes can we expect from the OECD? OECD entity registration database Adjustments to make information more usable What changes can we expect from domestic governments? Consistency with OECD Satisfying domestic objectives 7

8 SELECT ISSUES UNDER SECTION 871(m) Status of Regulations QDD Highlights Structured Notes Section 871(m) Consequences of Possible Taxable Events Qualified Indices 8

9 Section 871(m) regulation updates Updates on Regulations and Related Guidance On December 2, 2016, the Treasury and the IRS released transition guidance in Notice (Transition Notice), providing transition rules for complying with the withholding requirements of section 871(m). On December 30, 2016, the Treasury and the IRS released Revenue Procedure (QI Agreement), which contains the final QI withholding agreement and the requirements and obligations applicable to QDDs. On January 19,2017, the Treasury and the IRS issued the final and temporary regulations (2017 final and temporary regulations) with respect to section 871(m), revising and clarifying the 2015 final regulations. The latest final regulations are in effect as of January 19, 2017, despite the Executive Order signed by the Trump Administration to issue regulatory freeze on January 20, Highlights of the 2017 Final Regulations and Related Guidance Transition Notice Only delta-one transactions in-scope for 2017 with the remaining in-scope products beginning on January 1, Combination trade rules 2017 relief for withholding agents who only have to combine OTC products that they price, market, or sell that, on a combined basis, reach delta-one. Good faith effort The IRS may waive penalties if taxpayer demonstrates good faith attempts to comply with Transition Notice, including building appropriate systems and communication channels and applying limited combined transaction rules in QI Agreement (portion applicable to QDDs) Transition relief for QDDs for 2017: no withholding or self-assessment on actual dividends or dividend equivalents in dealer book; self-assessing may apply if there are any proprietary transactions involving dividends or dividend equivalents. QDDs are relieved of the certification of internal controls and periodic review requirements for Net delta computation beginning in 2018: tax cost should be close to zero except where physicals are used to hedge client trades final and temporary regulations Delta determination for listed option on a regulated exchange generally to be at the close of business day before the date of issuance Election to withhold earlier by U.S. withholding agents and other non-qdds. The election on the timing of withholding by a withholding agent should be applied consistently to all section 871(m) transactions of the same type (not a client-level election). Clarification on when substantive tax liability arises (generally on the ex-dividend date); clarification results in the same tax amount due from long party/beneficial owner regardless of the withholding timing. Clarification on party responsible for delta determination in situations involving multiple parties (including agents and/or intermediaries). 9

10 What is the difference between a pure QI, QDD and other non-u.s. withholding agent? Different tax consequences may arise depending on which non-u.s. person who receives a DEA or dividend related to a potential section 871(m) transaction. Non-U.S. recipients of such amounts on behalf of another person may be considered withholding agents. The table below shows the principal tax differences between potential withholding agent types. Category Pure QI QDD Dividends Receives gross dividends For 2017, receives gross dividends on U.S. equities. For 2018, receives dividends net of withholding DEAs Receives gross DEAs Receives gross DEAs Non-U.S. principal (that is neither a QI nor a QDD) Receives dividends net of withholding and may not have any obligation to file a U.S. tax return Receives DEAs net of withholding and may not have any obligation to file a U.S. tax return Withholding on client transactions A QI may act as a nonwithholding QI. A QI can elect to assume primary withholding responsibility under chapters 3 and 4, primary Form 1099 reporting and backup withholding, both, or neither. Must assume primary withholding responsibility Must assume withholding responsibility (because principal) Reporting of client transaction Must report but may do so on a pooled basis Must report but may do so on a pooled basis Recipient-specific reporting required Entity-level tax liability QI is acting as intermediary, so any tax related to QI activities is not its own tax liability (unless it fails to perform withholding agent duties) Must determine its own QDD tax liability, pay amounts due quarterly and file its own U.S. tax return While a non-u.s. principal (that is not a QDD) has a tax liability, it generally does not have to pay the tax as it is withheld upon from funds it otherwise would have received 10

11 Qualified Derivatives Dealer Withholding Timing A QDD that is a short party to a section 871(m) contract must impose withholding on the payment date for the underlying dividend (as opposed to contracts that are not issued by a QDD, in which case a withholding agent could withhold on the payment date under the contract). The Regulations provide that the QDD must inform the payees under the contract that withholding will be imposed at such time. If a QDD issues a structured note, would it satisfy this obligation if it states the time of withholding in the offering document for the note? There may be no way for the QDD to notify investors that acquire notes in the secondary market. What are the consequences if the QDDdoes not provide notification?

12 Structured Notes Issued through non-u.s. ICSDs Imperfect information at each entity in the chain: Issuers (including QDDs) do not typically know who the beneficial owners of their products are Clearstream, Euroclear, and other non-u.s. ICSDs do not have sufficient data to withhold properly without receiving source data downstream and upstream Custodians have access to beneficial owner data but not DEA and other section 871(m) data To bridge the information gap, the proposed solution is: For issuers to withhold at 30% on all beneficial owners and price in the tax upfront Issuers will remit the withholding at the time of dividend payment by the underlying security Custodians will need to facilitate refund requests for beneficial owners Issuer Depository Custodian Beneficial Owner 30% withholding at source Receive Form 1042-S, net DEAs, and source data on DEAs from issuer Receive the data, net DEAs from depository, and allocate to beneficiaries; file Form 1042-S Receive Form 1042-S and DEAs from custodian; apply for refund where over withholding occurred

13 Section 871(m) Consequences of Possible Taxable Events Corporate events affecting single-name derivatives: is retesting delta required? Example: Option on Target stock automatically becomes option on Acquiror stock at a time when delta has increased Has there been a tax event under Section 1001? Does it matter whether Target was acquired in a tax-free transaction? Nonqualified Indices Effects of rebalancing pursuant to index methodology Corporate events affecting components For derivatives that are subject to section 871(m) withholding, is dividend from new underlying used? Is the result different for a total return vs. a price return derivative? 13

14 Qualified Indices Issues in determining qualified index status: Purpose test ((l)(1)): Index must be passive, widely-used by numerous market participants and based on a diverse basket No short positions ((l)(3)(ii)): Potential section 871(m) transaction may not reference short positions unless reference entire qualified index or are de minimis (5% of value of long components) Is de minimis test performed at issue, or continuously? Rebalancing test ((l)(3)(v)): Index must be modified or rebalanced only according to publicly stated, predefined criteria, which may require interpretation by the index provider or a board or committee responsible for the index... How much board/committee discretion is permitted? (See, e.g., the Dow) Futures/options trading test ((l)(3)(vii): What level of trading frequency is required? 14

15 Qualified Indices Other qualified index issues ETFs: how closely must an ETF track a qualified index in order for derivatives referencing it to be exempt? What reporting (if any) is required for derivatives linked to qualified indices? Responsibilities of withholding agents (e.g., to check for offsetting short positions) 15