Sec. 871(m) Withholding Compliance Challenges Remain After IRS Issues Updated Final Regulations

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1 When you have to be right Commentary Sec. 871(m) Financial Services Sec. 871(m) Withholding Compliance Challenges Remain After IRS Issues Updated Final Regulations Author Stevie D. Conlon Senior Director & Tax Counsel Wolters Kluwer Robert Schwaba Tax & Regulatory Specialist Wolters Kluwer Summary In 2010, Congress passed a new law intended to prevent financial firms and investors from using financial derivatives to avoid U.S. withholding taxes on dividend-like payments relating to U.S. source stocks. U.S. source dividends on U.S. stocks that are paid to non-u.s. persons are generally subject to U.S. withholding tax. Congress had become aware that financial derivatives based on U.S. stocks were being used to avoid U.S. withholding taxes. The new law is now Section 871(m) and it explicitly applies to specified equity swaps and similar notional principal contracts. The law also provides the Internal Revenue Service authority to issue rules intended to prevent other types of financial derivatives besides equity swaps from being used to permit non-u.s. persons from obtaining dividend-like payments relating to U.S. source stocks. In the related legislative history, Congress specifically instructed the IRS to issue regulations intended to prevent the avoidance of U.S. withholding tax relating to financial derivatives on U.S. source stocks. In September 2015, the IRS issued final regulations under Section 871(m) (the (m) Regulations ) setting forth these new rules with a prospective effective date. The (m) regulations applied to any payment made on or after January 1, 2017, with respect to any transaction issued on or after January 1, 2017, on an in-scope financial derivative. Financial firms, industry organizations, bar associations and others, including Wolters Kluwer, raised concerns and submitted comments requesting changes to the (m) Regulations. Accordingly, in December 2016, the IRS issued Notice (the Notice ) and on January 24, 2017, the IRS issued revised final and temporary regulations (the (m) Regulations ) that made additional changes and provided additional effective date delays and implementation relief to the 2015 Section 871(m) Regulations. Collectively, the current guidance under the (m) Regulations, 2016 Notice and (m) Regulations are referred to herein as the Section 871(m) Rules.

2 2 Sec. 871(m) Withholding Compliance Challenges Remain After IRS Issues Updated Final Regulations This paper notes key changes included in the January 2017 Regulations, summarizes key aspects of the Section 871(m) regulations, and highlights key implementation and compliance challenges for U.S. withholding agents. Background The dividend equivalent payment rules imposing U.S. withholding tax on certain U.S. stock related financial derivatives held by non- U.S. persons were originally enacted in Entitled Treatment of Dividend Equivalent Payments, this section treats payments relating to financial derivatives linked to U.S. stocks as dividends from sources within the U.S., and thus subject to withholding. The purpose of Section 871(m) is to prevent avoidance of dividend taxation by nonresident aliens using derivative securities that pay dividend equivalents that were previously not subject to withholding as U.S. source dividends. Members of Congress had obtained marketing literature from financial firms promoting the use of these financial derivatives to avoid U.S. withholding taxes, which led to the broad legislative mandate to try to prevent future abuse. The qualified derivatives dealer (QDD) rules are similar to the qualified intermediary rules and IRS guidance regarding these rules has been controversial. The QDD rules are not discussed herein. II. An Overview of the Section 871(m) Rules Under the Section 871(m) rules, U.S. withholding tax can apply to financial derivatives but only if they are equity linked instruments or notional principal contracts ( NPCs, a term which include swaps and other similar synthetic instruments) that individually or on a combined basis pass an applicable delta or substantial equivalence test and are held by a non-u.s. person at the time there is a dividend payment on the related underlying U.S. stock that gives rise to a derivative equivalent payment. Equity linked instruments (ELIs) are broadly defined to include futures contracts, forward contracts, options, debt instruments or other contracts referencing the value of one or more underlying securities on which a payment could give rise to a U.S. source applicable dividend. Both exchange traded and over-the-counter instruments are included and there is no exclusion from these rules merely because an ELI is privately placed rather than publicly traded. Simple versus Complex Contracts The Section 871(m) rules classify ELIs and NPCs as either simple or complex contracts. Different formulas are used to determine whether instruments are subject to withholding depending on whether the instruments are simple or complex. A simple contract is an NPC or ELI in which, with respect to each underlying security: 1. Payments are calculated by reference to a fixed number of shares of a single underlying security, determinable when the contract is issued; and 2. There is a single maturity or exercise date on which all amounts are required to be calculated with respect to the underlying security. 2 A complex contract is an NPC or ELI that is not a simple contract. 3 A simple contract can refer to fixed numbers of shares of multiple underlying stocks (a Multistock Contract ). The assessment of whether a Multi-stock Contract is subject to Section 871(m) and related dividend equivalent amount calculations is generally made individually for each underlying stock referenced in such contracts. As a result, some simple contracts may not be easy to analyze, and assessing and complying with Section 871(m) may in fact be burdensome. 1 The legislation was initially enacted as Internal Revenue Code Section 871(l) as part of the HIRE Act (Pub. L. No ). It was later changed in subsequent legislation to Section 871(m). 2 Treas. Reg (a)(14)(i). 3 See Treas. Reg (a)(14)(ii)(A).

3 Sec. 871(m) Withholding Compliance Challenges Remain After IRS Issues Updated Final Regulations 3 For simple contracts, the delta as of the issue date of the contract must be determined. Complex contracts are tested under the substantial equivalence test (discussed below), which employs an initial hedge and a benchmark simple contract, as well as multiple testing prices. 4 Delta Generally, under both the 2015 and (m) Regulations, whether a simple contract is in-scope is determined by assessing whether such contract s delta as of its issue date (as defined below) equals or exceeds a specified threshold. For calendar year 2017, the threshold is a delta of one and for calendar year 2018 and thereafter, the threshold is a delta of 0.8. The Section 871(m) Rules define delta as the ratio of the change in the fair market value of an NPC or ELI to a small change in the fair market value of the number of shares of the underlying security. 5 The preamble to the (m) Regulations explains that delta was used as the litmus test because it is widely used by participants in the derivatives markets to measure and manage risk. 6 We note that although the Section 871(m) Regulations include rules intended to make access to delta readily available to withholding agents and the (m) Regulations added additional rules to make access even easier, obtaining delta information can remain a challenge for withholding agents because the operations teams responsible for withholding may not have ready access to delta information. Delta Determined as of Issue Date Under the Section 871(m) Rules, delta is generally determined as of the contract s issue date, subject to some refinement in the (m) Regulations. This was a simplifying rule included in the (m) Regulations and differs from derivatives market practice where delta is assessed on the date a contract is acquired. This simplifying rule means that for stock rights and warrants, convertible stocks and bonds and similar simple ELIs, it is only necessary to obtain and store the deltas as of the issue dates of such contracts in order to assess whether they are subject to Section 871(m). Exchange traded options are essentially newly written each time an option is sold to or written by an investor. This is the case even though such options may have terms that are identical to options that were written on earlier dates. Treasury officials have stated that the purchase date of exchange traded options is the issue date. Thus, if such options with identical payout terms are purchased or written by investors on different dates, they will likely have different deltas. Obtaining different deltas on different dates creates operational challenges. 7 Substantial Equivalence Test The delta test does not work adequately for complex contracts because the delta for such contracts is indeterminate. Accordingly, the Section 871(m) Rules include the substantial equivalence test. The substantial equivalence test was originally released as a temporary regulation but was adopted with clarifications as a final regulation as part of the (m) Regulations. 8 As is the case with delta, the ultimate objective of the substantial equivalence test is to assess whether a complex contract substantially replicates the economic performance of the underlying security by comparing, at various testing prices for the underlying security, the differences between the expected changes in value of that complex contract and its initial hedge 9 4 See Treas. Reg (h). 5 Treas. Reg (g)(1). 6 T.D. 9734, 80 Fed. Reg. 56,866 56,867 (Sept. 18, 2015). 7 We note the (m) Regulations include special rules for determining deltas for listed options discussed later. See Treas. Reg (g)(4). 8 Treas. Reg (h). 9 Treas. Reg (h)(1).

4 4 Sec. 871(m) Withholding Compliance Challenges Remain After IRS Issues Updated Final Regulations The substantial equivalence test achieves this analytical goal through comparative analysis of the difference between the movement in value of the complex contract and its initial hedge against the differences between the expected changes in value of a simple contract benchmark and its initial hedge. 10 If the expected change in value of the complex contract to its initial hedge is equal to or less than the expected change in value of the simple contract benchmark to its initial hedge, the complex contract is subject to Section 871(m) and the number of referenced shares of underlying stock are used to compute dividend equivalent amounts. 11 Under the substantial equivalence test, it is necessary to construct a simple contract benchmark and determine the initial hedges for both the complex contract and the simple contract benchmark. Such construction and related determinations can be complicated and burdensome. Moreover, the test presents risks of differing calculations by different parties relating to the same contract and potential manipulations of calculations aimed at avoiding the application of Section 871(m) to particular contracts. The Section 871(m) Rules include recordkeeping and responsibility rules that are intended to mitigate these burdens. 12 A more in-depth discussion of the substantial equivalence test is intentionally omitted herein. Computing Dividend Equivalent Amounts If a simple or complex contract is subject to Section 871(m), dividend equivalent amounts must be computed and such income is subject to withholding and U.S. income taxation. A dividend equivalent amount is determined for a simple contract by multiplying the per share dividend amount on the underlying stock by the number of shares referenced by such contract and its delta. 13 For a complex contract, the dividend equivalent amount is determined by multiplying the per share dividend amount on the underlying security by the number of shares of the underlying included in the complex contract s initial hedge. 14 Dividend equivalent amounts are determined on the earlier of the record date or the day prior to the ex-dividend date for the related dividend on the underlying stock referenced in the simple contract or complex contract. 15 If the contract includes a multiplier or otherwise modifies the number of referenced shares for valuation purposes, the number of shares for purposes of dividend equivalent amount calculations must be similarly adjusted. 16 For example, if a contract references 100 shares but its payout is based on a factor of two, the relevant number of shares for dividend equivalent amount calculation purposes is 200 shares. Combination Rule The Section 871(m) Rules include a combination rule that treats two or more potential section 871(m) transactions as a single transaction if, in part, such potential transactions, when combined, replicate the economics of a transaction that would be a section 871(m) transaction if the transactions had been entered into as a single transaction. 17 The combination rule includes two short party presumptions that permit a broker to not combine separate transactions, provided that such transactions are entered into in separate accounts or are separated by two or more business days. 18 The combination rule also includes as a subcomponent an ordering rule requiring that separate transactions must be analyzed by a short party to determine whether such transactions must be combined into a single transaction. 19 Because the two short 10 Treas. Reg (h)(1). 11 See Treas. Reg (h)(1) and (j)(1)(iii). 12 See Treas. Reg (p) and T(p). 13 Treas. Reg (j)(1)(ii). 14 Treas. Reg (j)(1)(iii). 15 Treas. Reg (j)(2). 16 Treas. Reg (j)(3). 17 Treas. Reg (n), (n)(1)(iii). 18 Treas. Reg (n)(3)(i) and (ii). 19 Treas. Reg (j)(3).

5 Sec. 871(m) Withholding Compliance Challenges Remain After IRS Issues Updated Final Regulations 5 party presumptions permit a broker to not combine transactions in separate accounts or transactions separated by two or more business days, the Section 871(m) Rules effectively require a broker to combine separate transactions entered into within a single account if they are not separated by more than one business day. For example, if a transaction is entered into on business day 3, transactions that occur on business day 1 occur two business days earlier and, therefore, transactions occurring on day 3 and day 1 are separated by more than one business day. Similarly, transactions occurring on business day 5 are separated from transactions occurring on business day three by at least one business day. Thus, this two or more business day separation presumption creates a three business day period of time (business days 2 through 4 in this example) that is not eligible for the presumption and, accordingly, would need to be evaluated for potential combinations of transactions. In order to apply the ordering rule over a calendar year, based on the simplifying assumption that a calendar year consists of 250 business days (50 business weeks), it is necessary to test for combinations for each business day during the year. As described above, each business day testing date includes a three business day period (the testing date plus the one business day preceding and the one business day succeeding such testing date). The ordering rule provides, in part, that a short party is required to apply [the combination rule] by combining transactions in a manner that results in the most transactions with a delta of 0.8 or higher with respect to the referenced underlying security. 20 In essence, the ordering rule looks to find the most combinations that have a combined delta of 0.8 or higher, rather than the number of combinations with the highest deltas. Presumably, the combined delta for any combination should not exceed one, although this is not explicitly addressed in the Section 871(m) Rules or the Notice. 21 In addition, the example set forth in the ordering rule explicitly provides that a portion of a transaction may be combined with another to account for potential differences in the quantities of individual transactions. It seems apparent that a portion of a transaction that was not combined with another remains eligible for potential combination with other transactions. It should be noted that although the broader combination rule applies to both complex and simple contracts, the ordering rule by its literal terms only addresses simple contracts where the computation of delta is relevant for purposes of determining whether Section 871(m) applies and for computing dividend equivalent amounts. Moreover, the mathematics of the substantial equivalence test, which includes the construction of a delta 0.8 simple contract benchmark and the use of identified hedges, only tests whether a complex contract has an effective delta equal to or in excess of 0.8. Subsequent dividend equivalent amounts from complex contracts are not delta-adjusted in the same way as those from simple contracts. This appears to create an apples and oranges problem with trying to combine simple and complex contracts for purposes of the ordering rule and could explain why the ordering rule focuses strictly on simple contracts. The (m) Regulations made several important clarifications relating to the combination rule and the ordering rule that are discussed below. Exclusion for Qualified Indices The Section 871(m) Rules include an important exclusion for derivatives that reference a qualified index of stocks. In other words, even though the Section 871(m) Rules generally impose withholding on derivatives that relate 20 Treas. Reg (j)(3). 21 The Preamble to the (m) Regulations specifically declined to provide further guidance concerning such combinations.

6 6 Sec. 871(m) Withholding Compliance Challenges Remain After IRS Issues Updated Final Regulations to and closely track U.S. stocks, a derivative that references an index of U.S. stocks is not subject to Section 871(m) provided the index is a qualified index. A qualified index is defined in the rules as an index that references 25 or more component securities; only long positions in such securities; where no component represents more than 15 percent of, and no five or fewer components represent more than 40 percent of, the weighting of the securities comprising the index; is modified or rebalanced only based on publicly stated and predefined criteria; did not provide an annual dividend yield in the immediately preceding calendar year from its component securities that exceeds 1.5 times the annual dividend yield of the S&P 500 Index for such year; and is traded through futures contracts or options on a national securities exchange, or a foreign exchange or board of trade that is a qualified board or exchange where in the aggregate less than 50 percent of the component securities are U.S. stock linked. 22 The rules include special provisions relating to de minimis short positions, transactions that indirectly reference a qualified index, and transactions that reference both a qualified index and one or more component securities or indices. 23 The qualified index exclusion essentially exempts many derivatives linked to broad and widely traded stock indices such as the S&P 500 and others. However, because many overthe-counter derivatives can be linked to fairly customized or narrow indices, determining whether such an index is a qualified index could be complicated and burdensome. Derivatives that Reference Partnerships The Section 871(m) Rules include special rules for determining whether a derivative that references a partnership will be subject to Section 871(m). These rules were included because the IRS was concerned that market participants might try to avoid Section 871(m) by creating derivatives referencing partnerships that hold U.S. stocks. There are three requirements that must be assessed in order to determine if the Section 871(m) Rules apply. The partnership: 1) carries on a trade or business of dealing or trading in securities; 2) holds significant investments in securities; or 3) directly or indirectly holds an interest in a lower tier partnership that is a covered partnership. 24 A partnership holds significant investments in securities if either 25 percent of the value of its assets consist of underlying securities or potential section 871(m) transactions, or the value of the underlying securities or potential section 871(m) transactions exceeds $25 million. 25 Timing of Dividend Equivalent Amount Withholding In general, under the Chapter 3 withholding rules for payments to non-u.s. persons, withholding occurs at the time amounts are paid. This approach begs the question of when dividend equivalent amounts determined under the Section 871(m) Rules are treated as paid. Under the (m) Regulations, dividend equivalent amounts are generally treated as paid as of the later of when the amount of a dividend equivalent amount is determined under the rules and when 1) a payment of money to or by a long party occurs with respect to a Section 871(m) transaction (note there are concerns regarding whether this could trigger early withholding for structured products and other Section 871(m) transactions where ongoing interest or interest-like payments are made); 2) as of the end of the calendar quarter (under a special rule for specific basket transactions referencing long positions in more than 25 underlying securities) 26 ; 3) or at the time the long party sells, exchanges, transfers, or otherwise disposes of the Section 871(m) transaction (including by settlement, offset, 22 Treas. Reg (l)(3). 23 Treas. Reg (l)(6)(ii). 24 Treas. Reg (m)(1). 25 Treas. Reg (m)(2). 26 Treas. Reg (i)(3). 27 Treas. Reg (e)(8).

7 Sec. 871(m) Withholding Compliance Challenges Remain After IRS Issues Updated Final Regulations 7 termination, expiration, lapse, or maturity). 27 Thus, this rule broadly treats many events as triggering payments that result in withholding. Note that there is a special rule for instruments that have been combined under the combination rule. 28 The (m) Regulations modified these payment timing rules as discussed below. III. Transition Relief Due to the complexity of the Section 871(m) rules, financial industry participants raised objections to the regulations, and requested that the rules be delayed beyond In response to these requests, the IRS issued Notice on December 2, 2016, granting partial relief as described below. Potential Penalty Relief for Good Faith Compliance First, the Notice provides that the IRS will be lenient in compliance enforcement in 2017 and 2018 to the extent the taxpayer or withholding agent made a good faith effort of compliance with the Section 871(m) rules. Good faith efforts may include building or updating documentation and withholding systems, application of the simplified combination rule, reporting of information to other parties to a transaction, and, for 2018, implementing the substantial equivalence test. Importantly, the Notice also provides that [a]ny person that did not make a good faith effort to comply with the section 871(m) regulations will not be given relief from IRS administration or enforcement, including penalties. 29 Thus, withholding agents need to take substantive actions, such as those just described or similar, in order to obtain penalty relief under the Notice. Simplified Phase-in Rules for is a phase-in year for Section 871(m). During the phase-in year, implementation of the regulations with respect to non-delta one contracts has been postponed. While this relief was welcome, it immediately raised questions concerning contracts very close to delta one (e.g., delta of 0.99). Although IRS documents have not provided clear guidance, Treasury and IRS representatives speaking at conferences have stated that deltas very close to one could likely be subject to 2017 withholding. Similarly, during 2017 a simplified version of the combination rule applies. Under the simplified combination rule, only over-thecounter transactions priced, marketed or sold in connection with each other must be combined. In 2018, the full combination rule set forth in the 2015 Final 871(m) Regulations will apply. These simplified rules generally only apply for calendar year The complete Section 871 Rules are scheduled to go into effect for calendar year The rules have been modified as described below based on revisions set forth in the (m) Regulations. IV. Substantive Rule Changes On January 24, 2017, the (m) Regulations were published. The (m) Regulations included a number of important changes to the Section 871(m) Rules that were generally beneficial for withholding agents, including revisions to the definition of a broker responsible for Section 871(m) information and reporting, dividend equivalent amount calculations when a derivative references an underlying security that has a Section 305(c) dividend, the definition of a simple contract, rules for insurance contracts, determining deltas and the initial hedge, the substantial equivalence test, the amount and timing of withholding, qualified indices, and the combination rule. Delta & Substantial Equivalence Tests Many industry comments raised concerns regarding the determination of delta used for simple contracts. Under the (m) 28 Treas. Reg (b)(4)(xxiii). 29 Notice p. 6 (December 2, 2016).

8 8 Sec. 871(m) Withholding Compliance Challenges Remain After IRS Issues Updated Final Regulations Regulations, the delta of a simple contract was calculated on issue date. In response to industry comments concerning the realities of security issuance, the (m) Regulations change the date of delta calculation to the earlier of the (a) pricing date and (b) issue date. However, if the pricing date is more than 14 calendar days before issue date, then delta must be calculated on the issue date rather than the pricing date. 30 For listed options, the (m) Regulations provide that delta is calculated at close of business on the day before issuance. 31 This rule aligns the delta determination for listed options with the Option Clearing Corporation (OCC) pricing system, which provides end-ofday valuations. The (m) Regulations adopt the substantial equivalence test as part of the final regulations (previously the substantial equivalence test was included in temporary regulations). The (m) Regulations include a clarification that the simple contract benchmark used can be either an actual or a hypothetical contract. Simple Contracts Multiple Underlyings Under the (m) Regulations, where a simple ELI or NPC references 10 or more securities and is hedged by an exchange traded security (e.g., an ETF) referencing substantially all of the underlying securities, the delta of the simple contract may be calculated by reference to the exchange traded security rather than to each specific underlying. Comments requested, and the (m) Regulations allow, that this simplifying method be used as long as the contract could be hedged by the exchange traded security, regardless of whether the contract is actually hedged by the exchange traded security. 32 Note that the delta calculated under this simplifying method must still be used with respect to each underlying security in the calculation of dividend equivalent amounts. Simple Contracts Corporate Actions Corporate actions such as stock splits, mergers, and others may cause an adjustment to the terms of an 871(m) transaction to maintain the economic status quo. For example, a contract that referenced 100 shares may reference 200 shares following a two-for-one stock split of the stock underlying the contract. Responsive to comments requesting clarification following the (m) Regulations, the (m) Regulations specify that where a change in the number of shares referenced by a contract represents an adjustment for a corporate action affecting all holders of the underlying securities proportionally, a simple contract will not become complex solely as a result of that change. 33 Combination Rule The combination rule is considered by many to be overly complex and burdensome. The IRS rejected requests to replace the combination rule, stating in Notice that the priced, marketed, or sold standard would provide an inadequate long-term substitute for the combination rule and would undermine enforcement of the Section 871(m) regulations. 34 As discussed above, a simplified combination rule applies for calendar year 2017 transactions (only over-the-counter contracts priced, marketed, or sold in combination with one another must be combined) and the combination rule included in the (m) Regulations remains essentially unchanged and applicable to transactions occurring in calendar year 2018 and thereafter. The Preamble clarifies that when two simple contracts are combined under the ordering rule, the contracts remain simple contracts. The Preamble also noted that the Treasury and 28 Treas. Reg (b)(4)(xxiii). 29 Notice p. 6 (December 2, 2016). 30 Treas. Reg (g)(2)(ii). 31 Treas. Reg (g)(4). 32 Treas. Reg (h)(6). 33 Treas. Reg (a)(14)(i). 34 Notice p. 8 (December 2, 2016).

9 Sec. 871(m) Withholding Compliance Challenges Remain After IRS Issues Updated Final Regulations 9 the IRS recognize the continuously developing understanding of the application of the rules as the industry develops systems, and that additional guidance may come as issues arise. The Preamble states that taxpayers may adopt any reasonable methodology to combine transactions with the general framework of the final regulations. Section 305(c) Coordination The (m) Regulations provided that convertible debt, preferred stock, and warrants already subject to withholding under Section 305(c) for conversion ratio adjustments were coordinated to reduce the withholdable amounts under Section 871(m) by reason of such prior withholding. Multiple comments expressed concern about how the (m) Regulations coordinated with Section 305(c), specifically with regard to derivatives referencing convertible instruments to which Section 305(c) applies; some noted the fact that the reduction provided due to tax paid under Section 305(c) could arguably also apply to such derivatives. The (m) Regulations (a) amend the Section 305(c) coordination provisions to provide that only long parties to convertibles subject to Section 305(c) can reduce their Section 871(m) amounts under the coordination provisions, 35 and (b) amend the definition of dividend, to clarify that no actual distribution of cash or property is required. 36 This change was deemed necessary to apply the rule that reduces a dividend equivalent by any Section 305(c) dividends. This rule applied under proposed regulations to a security which had both dividend equivalents and Section 305(c) dividends, and as comments noted, could arguably apply to a Section 871(m) transaction which referenced a security with Section 305(c) dividends. Under the (m) Regulations, a convertible note holder both receives a dividend when the conversion rate adjusts under Section 305(c) and can reduce its Section 871(m) dividend equivalent. A long party holding a section 871(m) transaction that merely references the convertible note, on the other hand, only receives a dividend equivalent, and so cannot reduce that amount. Qualified Indices In response to comments concerning the qualified index rules, the (m) Regulations make minor changes, providing that qualified indices must be widely traded and not created or availed of with a principal purpose of tax avoidance. 37 The (m) Regulations also clarify that in the year it is created, an index is tested to determine whether or not it is qualified on the first business day of listing. 38 The relevant dividend yield is calculated by treating its components on that day as though they were included for the entire prior year. 39 Broker Issues and Responsible Parties The (m) Regulations also revised the definition of broker to not apply to a corporation solely because it redeems its own shares. 40 This was necessary because mutual funds that redeem their own shares could be considered a broker under the earlier definition and it was believed that this treatment inappropriately shifted the burdens for broker reporting under the Section 871(m) Rules from its derivative dealer counterparty to such funds. The (m) Regulations did not explicitly address the withholding agent consequences of transfers of Section 871(m) transactions from one broker or custodian to another. Comments, including comments from Wolters Kluwer, noted possible interpretations could result in an undue withholding tax burden on the receiving broker or custodian, who could be deemed responsible for withholding relating to dividend equivalent amount calculations for dividends that occurred before such receiving broker held the section 871(m) transaction on behalf of a long party. As a result, the (m) Regulations provide that a transfer of 35 Treas. Reg (c)(2)(ii). 36 Treas. Reg (a)(3). 37 Treas. Reg (l)(4). 38 Treas. Reg (l)(2)(i). 39 Treas. Reg (l)(2)(ii). 40 Treas. Reg T(a)(1).

10 10 Sec. 871(m) Withholding Compliance Challenges Remain After IRS Issues Updated Final Regulations an account to a different withholding agent or a termination of the relationship by the long party with the withholding agent is considered a payment triggering withholding under the regulations. 41 Operational issues and accounting burdens may still remain for withholding agents when customers transfer Section 871(m) transactions from one account to another if such accounts are both held by the same withholding agent or custodian. Some comments also expressed concern about the responsible party for determining delta and other calculations when intermediaries and agents are involved. The (m) Regulations provide that the broker or dealer in the chain that is closest to the short party is responsible; if no broker or dealer is in the short party chain, then the broker or dealer closest to the long party is responsible. 42 Where potential Section 871(m) transactions are traded on an exchange and cleared by a clearing firm, whichever party has an ongoing relationship with the foreign investor is the responsible party. 43 Finally, for certain specific ELIs such as structured notes, warrants, convertible preferred stock, and convertible debt, the issuer is the responsible party. 44 While a variety of comments requested amendments explicitly permitting withholding agents to rely on third party data, the (m) Regulations do not include such a provision. The Preamble does, however, state that the Treasury Department and the IRS note that nothing in the regulations prohibits a taxpayer from obtaining information from a third party. Thus, although a withholding agent or broker may rely on a third party for information or otherwise, such withholding agent or broker remains ultimately responsible for withholding. Deemed Reissuances Comments with respect to structured notes observed that the issuer of such a note acting as a market maker could potentially give rise to deemed reissuances and a loss of fungibility for Section 871(m) purposes due to repeated delta testing on each such reissuance. The (m) Regulations did not provide the requested relief, but did request further comment. Withholding New in the (m) Regulations, a withholding agent may elect to shift the timing of withholding and generally accelerate such withholding from the time of payment for each Section 871(m) transaction held on behalf of investors to the time the dividend equivalent amount is calculated. This election essentially simplifies withholding from being transaction specific for each tax lot held by each non- U.S. investor with the withholding agent to being security specific based on the timing of dividends on the related underlying stock. The election is made by attaching a statement to a timely filed IRS Form 1042 for the year in which the election is effective indicating that it has been made. The election applies to all transactions of the same type (the QDD rules suggest that same type may mean all ELIs or all NPCs) acquired on or after the date of the election. Thus, withholding for Section 871(m) transactions entered into before the start of the election are not eligible for accelerated security-level withholding under the election. The regulations clarify that an eligible entity, even if not otherwise eligible for qualified intermediary (QI) status, can enter into a QI agreement under Rev. Proc to implement the QDD provisions. V. Key Implementation and Compliance Challenges Remaining Because Notice and the (m) Regulations merely defer the key aspects of the Section 871(m) Rules to 2018, significant implementation and compliance challenges remain. 41 Treas. Reg (e)(7)(C). 42 Temp. Reg T(p)(1)(ii). 43 Treas. Reg T(p)(1)(iii). 44 Treas. Reg T(p)(1)(iv).

11 Sec. 871(m) Withholding Compliance Challenges Remain After IRS Issues Updated Final Regulations 11 Beginning on January 1, 2018, withholding agents must quickly identify all Section 871(m) transactions with a delta of 0.8 or higher. Moreover, because the combination and ordering rule have been retained, withholding agents must actually identify and track daily all potential Section 871(m) transactions regardless of their deltas because the combination rule and ordering rule means that the aggregate absolute delta of multiple offsetting positions could result in a deemed delta of 0.8 or greater. Thus, transaction information based on specific lots and days of acquisition will be necessary in order to perform the required analysis under the combination rule and ordering rule. Withholding agents may also find that the broker reporting provisions set forth in the Section 871(m) Rules, although well intended, are unable to provide delta or substantial equivalence test information rapidly enough in order to facilitate withholding agent compliance with the combination rule and ordering rule. The IRS statement in Notice and the minor changes to the combination rule set forth in the (m) Regulations strongly suggests that the IRS is unwilling to simply eliminate or replace the combination rule or ordering rule. Accordingly, withholding agents should act quickly to implement systems that will permit them to comply with the combination rule and ordering rule. The timing of withholding election permitting a withholding agent to withhold as of dividend equivalent amount calculation dates rather than payment dates should be evaluated as soon as possible. The broad scope of the election means that withholding agents are forced to weigh the administrative convenience of accelerating withholding with the benefit to their clients of delaying withholding. And the inability to apply the election to Section 871(m) transactions before the date of the election means that delays in making the election could create operational difficulties in supporting withholding at two different dates for similar positions. Conclusion The (m) Regulations have provided some welcome relief for good faith attempts to comply and necessary refinements, particularly with respect to coordination with Section 305(c). Notice provided a welcomed delay in implementing difficult aspects of the (m) Regulations. A phase-in period for 2017 grants withholding agents muchneeded additional time to develop and refine compliance tools without losing the focus of the regulations, while simplified standards for delta testing and a much-simplified combination rule allows withholding agents to focus their resources for Clarifications and guidance, such as concerning the withholding consequences of transferring Section 871(m) transactions from one withholding agent to another and corporate actions, should further ease the transition to full application of the (m) Regulations. Nevertheless, significant challenges are imminently approaching given the January 1, 2018 effective date for many aspects of the Section 871(m) Rules. Warning! Dangerous waters ahead! Stevie D. Conlon is a senior director & tax counsel for Wolters Kluwer and has written and spoken extensively on tax law matters relating to financial products and compliance. Robert Schwaba is a tax & regulatory specialist who addresses tax law compliance matters relating to financial transactions. Robert is also a licensed attorney. Contact: John Kareken, senior tax & regulatory analyst at (847) or Anna Vayser, product manager at (847) DISCLAIMER: The information and views set forth in this Wolters Kluwer Financial Services communication are general in nature and are not intended as legal, tax, or professional advice. Although based on the law and information available as of the date of publication, general assumptions have been made by Wolters Kluwer Financial Services that may not take into account potentially important considerations to specific taxpayers. Therefore, the views and information presented in this Wolters Kluwer Financial Services communication may not be appropriate for you. Readers must also independently analyze and consider the consequences of subsequent developments and/or other events. Readers must always make their own determinations in light of their specific circumstances.

12 About Wolters Kluwer Governance, Risk & Compliance Wolters Kluwer Governance, Risk & Compliance (GRC) is a division of Wolters Kluwer which provides legal, finance, risk and compliance professionals and small business owners with a broad spectrum of solutions, services and expertise needed to help manage myriad governance, risk and compliance needs in dynamic markets and regulatory environments. The division s prominent brands include: AppOne, AuthenticWeb, Bankers Systems, BizFilings, Capital Changes, CASH Suite, CT Corporation, CT Lien Solutions, ComplianceOne, Corsearch, Expere, GainsKeeper, LegalVIEW, OneSumX, Passport, TyMetrix 360, Uniform Forms, VMP Mortgage Solutions and Wiz. Wolters Kluwer N.V. (AEX: WKL) is a global leader in information services and solutions for professionals in the health, tax and accounting, risk and compliance, finance and legal sectors. Wolters Kluwer reported 2015 annual revenues of 4.2 billion. The company, headquartered in Alphen aan den Rijn, the Netherlands, serves customers in over 180 countries, maintains operations in over 40 countries and employs 19,000 people worldwide Wolters Kluwer Financial Services, Inc. All Rights Reserved. Contact information: Wolters Kluwer 130 Turner Street Building 3, 4th Floor Waltham, MA United States For more information about our solutions and organization, visit WoltersKluwer.com, or for our financial services solutions, visit WoltersKluwerFS.com (m) Commentary When you have to be right