US IRS releases proposed Qualified Intermediary Agreement

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1 7 July 2016 International Tax Alert US IRS releases proposed Qualified Intermediary Agreement EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: The US Internal Revenue Service (IRS) released the long-awaited proposed Qualified Intermediary (QI) Agreement on 1 July 2016, in Notice This new QI Agreement, when it is finalized later this year, will be effective 1 January As expected, the proposed QI Agreement contains revised compliance review and certification procedures and provides the requirements to allow non-us broker/dealers to become Qualified Derivative Dealers (QDDs) under Internal Revenue Code 1 Section 871(m). Background A QI Agreement allows non-us intermediaries to simplify their obligations as withholding agents under Chapters 3 and 4, and as payors under Chapter 61 and Section 3406, if the intermediary agrees to the terms of the agreement, which include fulfilling certain compliance verification obligations. The current QI Agreement (published in Revenue Procedure ) expires 31 December 2016, so all QIs will be required to renew their QI Agreements via the IRS Foreign Financial Institutions (FFI) portal before 31 March 2017, for their agreements to be effective 1 January Those applying to be QIs for the first time (including eligible entities applying for QDD status) must file IRS Form 14345, Application for Qualified Intermediary, Withholding Foreign Partnership, or Withholding Foreign Trust Status.

2 2 International Tax Alert Changes The proposed QI Agreement introduces three significant changes: Revisions to the QI compliance review and certification procedures (see Section 10 of the proposed QI Agreement) Requirements for QDDs (throughout the proposed QI Agreement) Authorization for a QI to assume primary withholding responsibility for substitute interest payments, even if it is receiving those payments as a principal rather than as an intermediary (see Section 3 of the proposed QI Agreement) Other important changes include the effective date and termination date of the QI Agreement as well as changes to the limitations on benefits statements required for documentation purposes. In addition, the draft QI Agreement contains several corrections to the current QI Agreement that were previously communicated by the IRS. For example, the Form 1099 reporting requirements applicable to non-us payors that are Model 1 FFIs are revised to conform to the coordination rule under Treas. Reg. Section (c)(4)(i), which eliminates Form 1099 reporting if the account is reported under domestic law on the equivalent to Form The preamble to the proposed QI Agreement further previews that the compliance procedures for Withholding Foreign Partnerships (WPs) and Withholding Foreign Trusts (WTs) will be similar to the requirements for QIs. Compliance procedure The compliance procedure has two key components: (1) certification of internal controls (the subjective component); and (2) periodic review (the objective component). The certification of internal controls must be made by the responsible officer and the factual information documented during the periodic review must be provided at the time the certification is made. Toward the certification of internal controls, the proposed QI Agreement allows the QI s responsible officer (RO) to rely on any reasonable procedure that enables the RO to make the required certification of effective internal controls or a qualified certification. As set forth in the current QI Agreement, the proposed QI Agreement provides the specific certification that the RO will need to make to the IRS. The qualified certification is required if an event of default is identified or one or more material failures have not been remediated with the establishment of an internal control to prevent those failures from reoccurring. The RO must document the procedure, process or review that was relied upon to make that certification. ROs should review their internal controls with ample time to remediate any issues before the certifications are due in order to avoid making a qualified certification. The periodic review is a fact finding and reporting exercise similar to the external audit report in the original QI Agreement (Revenue Procedure ). The current QI Agreement requires the periodic review to be performed for calendar year The new proposed QI Agreement states that the QI is free to choose which year it will select for the periodic review. If the QI is acting as a QDD or a QI for substitute interest payments, however, 2017 is the required year since it will be the only applicable year during which these rules will be effective. A new Appendix I has been added to the QI Agreement detailing the factual information that must be gathered and reported for any one calendar year of the compliance period through the testing of accounts and payments, but does not prescribe a specific process for determining that information. This process must also be documented and made available to the IRS upon request. The factual information reported in Appendix I should reflect the results of the compliance review prior to any curing, and the curing process should not delay certification of internal controls or factual information required in Appendix I. A QI with more than 50 accounts may rely on a sample of accounts for its periodic review. A new Appendix II provides a statistical sampling safe harbor similar to former QI Agreements. The maximum sample size under the safe harbor method is 321. The factual information to be submitted to the IRS requires the QI to state whether it used the statistical sampling safe harbor or another methodology. If another methodology is used, it must be described to the IRS. QIs should consider whether any preparation is needed in advance of the periodic review to ensure that they have made all relevant changes to comply with the new QI Agreement. The proposed QI Agreement also reintroduces the concept of a consolidated compliance program for QIs under common control. The consolidated compliance program must be under the supervision of a Compliance QI, and is subject to

3 International Tax Alert 3 approval by the IRS. The consolidated compliance program allows the RO of the Compliance QI to make one certification of internal controls for the consolidated compliance group. For the periodic review, however, each QI must provide its own factual information. A sampling plan can be approved for the consolidated compliance group. For smaller QIs, similar to former QI Agreements, a waiver of the periodic review requirement will be available if certain criteria are met. In order to be eligible for the waiver, the QI s reportable amounts for each calendar year (e.g., ) cannot exceed $5 million and, among other things, the QI must have timely filed Forms 1042, 1042-S, 945, 1099, and 8966 for all years, as applicable. Further, the waiver is not available to a QI acting as a QDD or a QI that is part of a consolidated compliance program. Additionally, the waiver does not exempt the QI from the required certification of effective internal controls as required under the QI Agreement, as well as all certifications required under the QI s Foreign Account Tax Compliance Act (FATCA) requirements as a participating FFI, registered deemed-compliant FFI, or registered deemed-compliant Model 1 IGA FFI. The waiver will relieve the QI from providing detailed factual information, though some information will be required within the waiver request. Qualified derivatives dealer Eligible entities (including regulated banks, wholly owned subsidiaries of regulated banks and regulated securities dealers) that would like to obtain QDD status for Section 871(m) purposes will also be required to have QI status by the later of 1 January 2017, or the date the entity obtains QDD status. QDD status eliminates excessive withholding on back-to-back dealer transactions with clients, provided that the dealer ultimately receives no long exposure on a net basis. Without QDD status, a dealer would otherwise be subject to withholding on the hedge it employs to offset its exposure to a client transaction. The proposed QI Agreement also reflects revisions to the QDD requirements that will be included in the final Section 871(m) regulations. It remains unclear whether the label of eligible entity will extend to all subsidiaries of a banking group or to any subsidiaries of a securities dealer group. The preamble to the proposed QI Agreement clarifies that an entity does not need to become a QDD when it receives or makes a payment with respect to a potential Section 871(m) transaction as an intermediary as opposed to as a principal (for example, when the QI acts as a custodian of a structured note with a payment referencing a dividend of a domestic corporation). A dealer may act as a QDD for payments made as principal with respect to a potential Section 871(m) transaction and underlying securities, regardless of whether it makes those payments in its dealer capacity. This is a welcomed expansion of the regulations, which limited QDD status to dividends and dividend equivalent amounts paid in the entity s dealer capacity. This would have caused operational issues for withholding agents, who had been concerned about the need to track QDD status on a transaction-by-transaction basis. Notwithstanding this favorable development for would-be withholding agents, the QDD still remains liable for tax on any proprietary transactions that are not ultimately part of its dealer operation and must appropriately identify and track those amounts. The proposed QI Agreement requires a QDD to assume primary withholding responsibility for potential Section 871(m) transactions. There is no mention of extending the current credit-forward system under the qualified securities lender (QSL) regime (published in Notice ), which means that current non-withholding QIs will be required to accept withholding responsibility and update their system capabilities accordingly should they wish to act as QDDs. As provided in the regulations, a QDD must satisfy its own tax liability to the extent that dividend equivalent amounts received by the QDD in its QDD capacity exceed the dividend equivalent amounts the QDD is contractually obligated to pay. In making this calculation, the QDD may include dividend equivalent amounts paid to US and non-us persons. Payments to US persons who are non-exempt recipients, however, may only be included if the QDD maintains, and is able to provide upon request, the persons names, addresses and TINs (if any) to the IRS upon request. The QI Agreement requires a QDD to maintain a reconciliation schedule to track, across calendar years, the aggregate of: (1) all dividends on underlying securities associated with potential Section 871(m) transactions; (2) dividend equivalent

4 4 International Tax Alert amounts that it receives referencing the same dividend; and (3) all dividend equivalent amounts that it is contractually obligated to pay as a dealer that reference the same dividend. A QDD will be subject to the compliance procedures previously discussed (i.e., the certification and periodic review), limited to potential Section 871(m) transactions. Any new QI, or existing QI, that obtains QDD status will be required to provide a new Form W-8IMY to upstream withholding agents. For example, we expect that an existing QI that obtains QDD status by 1 January 2017, will need to update its Form W-8IMY to indicate its QDD status when applicable. It is not expected, however, that an existing QI that is simply renewing its QI Agreement with the IRS will be required to provide a new Form W-8IMY to upstream withholding agents since the renewal is not expected to constitute a change in QI status with respect to the Form W-8IMY requirements. We expect the IRS to issue a revised Form W-8IMY to accommodate QDD status. Substitute interest The proposed QI Agreement allows a QI to assume primary Chapters 3 and 4 withholding responsibility and primary Form 1099 reporting and backup withholding responsibility for payments of interest and substitute interest it receives in connection with a sale-repurchase or similar agreement, a securities lending transaction, or collateral that it holds in connection with its activities as a securities dealer. This will allow a QI to provide a Form W-8IMY to certify that it is assuming primary withholding responsibility without requiring the QI to distinguish when it is acting as principal and when it is acting as an intermediary. Effective date and termination date The effective date of the proposed QI Agreement will depend upon when the prospective QI submits its application and whether it has received any reportable payments before the application was submitted. Beginning 1 January 2017, a prospective QI will have a QI Agreement with an effective date of 1 January of that year (upon IRS approval) if: The prospective QI applies for QI status before 31 March of a calendar year, or The prospective QI applies for QI status after 31 March of a calendar year and has not received a reportable payment before the application date Otherwise, the prospective QI s Agreement will have an effective date of the first of the month in which the application is approved and the prospective QI is issued a QI-EIN. Furthermore, a QI s Agreement expires at the end of the third full calendar year the agreement is in effect, unless terminated by either the IRS or QI prior to the end of its term by delivery of a notice in accordance with the QI Agreement. As a result, an existing QI seeking to renew its QI Agreement must renew before 31 March 2017, and the renewed QI Agreement will be effective 1 January 2017, and will expire 31 December Limitation on benefits provision Consistent with the 2016 Form W-8BEN-E and the 2016 Form 1042-S, the proposed QI Agreement modifies the requirements for collecting limitation on benefits treaty statements by QIs that use documentary evidence to establish that an entity account holder is entitled to a reduced rate of withholding. A QI opening an account or obtaining documentation for an entity account holder on or after 1 January 2017, will be required to collect this limitation on benefits information at that time. For QIs with pre-existing entity accounts (as described in the proposed QI Agreement) that were documented with documentary evidence, a two-year transition period will be provided for collection of the appropriate limitation on benefits information (unless a change in circumstances requires the QI to obtain corrected information before the end of the two-year period). QIs that documented entity accounts with Forms W-8 may rely on those forms until their normal expiration period (unless a change in circumstances requires the QI to obtain new documentation). Under the proposed QI Agreement, a withholding agent will be subject to an actual knowledge standard regarding the limitation on benefits certifications. The Chapter 3 regulations will be similarly amended to apply an actual knowledge standard for limitation on benefits certifications.

5 International Tax Alert 5 Request for comments by 31 August 2016 The IRS has requested submission of any comments on the proposed QI Agreement by 31 August There are many viewpoints on how best to align the QDD requirements with the QI regime, and we expect the industry to have ample commentary in response to Notice Taking into account the time needed for the Government to consider comments, there will not be much time for QIs to implement the final version of the rules by 1 January Some key issues likely to be of primary concern to QIs and prospective QIs during the comment period include the following: Becoming a withholding QI for the first time will be challenging in many jurisdictions where that status has not been common. Providing the extensive reconciliation schedules contemplated by the IRS to show fully offsetting payment amounts will also be challenging. Self-assessing tax on any residual dividend equivalent amounts left with a dealer that essentially represent the spread earned on a client transaction will be difficult. The Section 871(m) regulations and the proposed QI Agreement conflict on when withholding tax is due. The proposed QI Agreement requires the QDD to deposit tax related to its 871(m) amount on the dividend payment date for the applicable dividend, while the Section 871(m) regulations require the QDD to deposit tax when the payment is made or the transaction is closed. Endnote 1. All Section references are to the Internal Revenue Code of 1986, and the regulations promulgated thereunder.

6 6 International Tax Alert For additional information with respect to this Alert, please contact the following: Ernst & Young LLP, International Tax Services Lilo Hester, Washington, DC Ernst & Young LLP, Financial Services Tara Ferris, New York Lauren Lovelace, New York Justin O Brien, New York justin.obrien@ey.com Deborah Pflieger, Washington, DC deborah.pflieger@ey.com John Staples, Washington, DC john.staples@ey.com Todd Larsen, Philadelphia todd.larsen@ey.com International Tax Services Global ITS, Alex Postma, Tokyo ITS Director, Americas, Jeffrey Michalak, Detroit ITS Markets Leader, Americas, Stephen O Neil, New York Ernst & Young LLP, National Director of ITS Technical Services, Jose Murillo, Washington Member firm contacts, Ernst & Young LLP (US) Northeast Johnny Lindroos, McLean, VA Financial Services Chris J Housman, New York Central Mark Mukhtar, Detroit Southeast Scott Shell, Charlotte, NC Southwest Amy Ritchie, Austin West Beth Carr, San Jose, CA Canada Ernst & Young LLP (Canada) Albert Anelli, Montreal Israel Kost Forer Gabbay & Kasierer (Israel) Sharon Shulman, Tel Aviv Mexico Mancera, S.C. (Mexico) Koen Van t Hek, Mexico City Central America Ernst & Young, S.A. Juan C Chavarria Pozuelo, San José South America Ernst & Young Serviços Tributários S.S. Gil F. Mendes, São Paulo

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