IRS proposes updated qualified intermediary agreement

from Global Information & Reporting IRS proposes updated qualified intermediary agreement July 8, 2016 In brief The Internal Revenue Service (IRS) on July 1, 2016 issued Notice 2016-42 (Notice) setting forth proposed changes that will apply to non-us entities that elect to enter into qualified intermediary (QI) agreements with the IRS. The QI agreement generally permits foreign persons to simplify their obligations as a withholding agent under both Chapter 3 (withholding at source) and Chapter 4 (the Foreign Account Tax Compliance Act or FATCA) of the Internal Revenue Code (IRC or Code) and as a payor under Chapter 61 and Section 3406 of the Code. The Notice sets forth terms and requirements for QIs. Our discussion below highlights the following: QIs that act as qualified derivative dealers (QDDs) with respect to transactions subject to the treatment of dividend equivalents from US sources under Section 871(m) of the Code (871(m) transactions), Procedures a QI must execute in order to satisfy its compliance review obligations, Circumstances where a QI is eligible for a waiver of the requirement to conduct a periodic review and only provide some factual information, and Requirement of QIs that use documentary evidence to document an entity account holder claiming reduced withholding under a tax treaty to collect an enhanced limitation on benefits (LOB) treaty statement from the holder. The current QI agreement in Rev. Proc. 2014-39 (the 2014 agreement) expires on December 31, 2016. See our Insight: IRS releases updated QI agreement providing guidance for QIs under FATCA and Chapter 3 for more information on the current QI agreement. While the proposed effective date of the amended QI agreement is January 1, 2017, the IRS intends to issue a final QI agreement later this year that could modify some of the requirements included in the Notice. The final QI agreement will apply to any QI agreement in effect on or after January 1, 2017. A QI that seeks to renew its QI agreement must renew prior to March 31, 2017; the renewed agreement will have a January 1, 2017 effective date. The IRS is requesting that comments to the proposed QI agreement be submitted by August 31, 2016. In detail QDDs The QDD regime is a new set of reporting and withholding guidelines tailored to non-us (foreign) derivatives dealers and securities lenders to alleviate the potential problem of overwithholding on certain 871(m) transactions. The framework for these rules was originally announced in September 2015 when the US Department of the Treasury (Treasury) and the IRS issued regulations under IRC Section 871(m). See our Insight: Immediate action required by asset managers to address US tax withholding and reporting on dividend equivalent payments for more information. www.pwc.com

Treasury and the IRS have determined that the most comprehensive and efficient way to create the QDD regime was to expand the existing QI agreement to accommodate financial intermediaries on 871(m) transactions. These transactions include securities lending or sale-repurchase transactions, specified notional principal contracts, and specified equity-linked instruments. The proposed QI agreement contains provisions that permit a QI that is an eligible entity to act as a QDD, and also describes the requirements and obligations that pertain to a QDD. The QDD regime addresses the problem of over-withholding by providing that no withholding tax is required on certain payments made to a QDD when the QDD is acting as a principal. The QDD regime is intended to replace the qualified securities lender (QSL) regime described in IRS Notice 2010-46. The proposed QI agreement will require a QI to act as a QDD for all securities lending and sale-repurchase transactions the QDD enters into that are 871(m) transactions. Securities lending and sale-repurchase transactions the QI enters into that are 871(m) transactions will be deemed to be entered into by the QI as a principal and therefore within the QDD regime. Until the QDD regime is implemented, the QSL rules will continue to apply for substitute dividend payments made pursuant to a securities lending or a salerepurchase transaction. Other QDD items addressed in the proposed agreement include: The types of entities that are eligible to act as QDDs, The types of payments for which a QI may act as a QDD, The determination and payment of a QDD s tax liability, The information QDDs must provide as part of the QI agreement, and A QDD s reporting and withholding responsibilities. For a more in-depth analysis of the proposed QI agreement provisions relating to QDDs, see our Insight: Proposed qualified intermediary agreement includes qualified derivatives dealer provisions. QI compliance program In general The 2014 agreement made significant changes to a QI s audit requirements, such as replacing the external audit requirement with an internal compliance and review program (compliance program). As part of the compliance program, a QI is required to designate a responsible officer to establish and administer the compliance program as well as make periodic certifications to the IRS and designate an internal or external auditor to perform a periodic review. The 2014 agreement provides more flexibility in performing the audit, such as allowing the use of an independent internal auditor, eliminating the requirement to provide the external auditor s findings to the IRS, and allowing QIs to exercise more judgment in conducting the review by eliminating the requirement to follow the specific step-by-step audit procedures previously outlined in Rev. Proc. 2002-55. Observation: Since the 2014 agreement was issued, the IRS has received numerous comments from practitioners and QIs regarding the administrative burdens associated with the new procedures, including the potential costs for implementing the program, the timing of the periodic review, and the lack of specific detailed guidance for performing the review. The proposed agreement attempts to address some of these concerns as well as expand and clarify the guidance provided in the 2014 agreement. Below are brief descriptions of the more significant changes included in the Notice. Periodic compliance certifications The 2014 agreement requires a QI to make periodic compliance certifications to the IRS every three calendar years based on the results of the periodic review. The proposed agreement broadens this approach by allowing the responsible officer to rely on the findings of other processes or reviews to make the certification (rather than simply relying on the periodic review). For example, a responsible officer now has the flexibility to determine whether to engage an external reviewer (previously described as an auditor (e.g., CPA firm, law firm, etc.)) to perform the internal controls review and to define the overall scope of the engagement. However, the responsible officer must clearly document the specific processes and procedures relied upon in making the certification and the documentation must be retained for as long as the QI agreement is in effect. The proposed agreement still allows for the use of an internal reviewer to conduct the periodic review, but clarifies that the internal reviewer should not be reviewing its own work, procedures, or results (e.g., the reviewer cannot be part of the team that is primarily responsible for collecting and validating documentation, etc.). In addition, the results of the periodic review cannot influence or affect the internal reviewer s compensation, bonus, employment status, etc. The proposed agreement also clarifies that the 2 pwc

periodic review does not need to satisfy the standards of a financial audit or other attestation engagement typically imposed on a certified public accountant. Factual information A QI is required to provide certain factual information to the IRS regarding its documentation, withholding, and reporting compliance under the proposed QI agreement, and in the case of a QI acting as a QDD, certain information related to the determination of its QDD tax liability. It is expected that the factual information will be gathered, in part, through the testing of accounts and transactions required as part of the periodic review. Appendix I to the proposed QI agreement describes the factual information that will be required to be reported to the IRS upon completion of the review. Observation: Appendix I of the proposed QI agreement is over 20 pages in length and contains seven sections that cover a broad range of topics, including basic information related to the QI s status and activities, confirmation that the QI maintains effective internal controls, the type of factual information that must be provided in connection with the periodic review as well as confirmation that the QI is eligible to obtain a waiver from performing the periodic review (discussed in more detail below). The Appendix also provides general instructions to assist QIs in reporting the information and making the certifications contained in the Appendix. For example, only QIs that are acting as QDDs must complete Part V while only QIs that assume primary withholding responsibility for payments of substitute interest must complete Part VI. In contrast, all QIs must complete Parts I and II. Timing of Review and Certification The 2014 agreement requires the QI to perform the periodic review in the final year of the certification period. However, many practitioners advised the IRS that this would result in resource constraints if all QIs were required to conduct the periodic review at the same time. As a result, the proposed agreement provides greater flexibility by allowing QIs to conduct the review in any calendar year covered by the certification period. However, a QI that is acting as a QDD must use the 2017 calendar year for the initial certification period since QDD status is not applicable for 2015 and 2016. In addition, the timing of the review also must take into account the statute of limitations period related to the QI s Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons. Specifically, there must be at least 15 months remaining on the statutory assessment period at the time the factual information relating to the periodic review is due. Otherwise, the QI must agree to extend the statute of limitations by submitting to the IRS Form 872, Consent to Extend the Time to Assess Tax. For purposes of determining the certification period, the initial certification period is the period ending on the third full calendar year that the 2014 agreement and any superseding revenue procedure is in effect. Thus, a QI that has a QI agreement with a June 30, 2014 effective date must treat the initial certification period as ending on December 31, 2017, and will be required to make the required certification on or before July 1, 2018. Scope of review The IRS has opted not to provide a step-by-step audit plan as was previously provided in Rev. Proc. 2002-15. Instead, QIs now are required to create their own step-bystep plan to ensure that the objectives of the review are satisfied and to provide the factual information discussed above. In addition, Appendix II of the proposed agreement provides a safe harbor methodology for determining sample sizes when performing the periodic review. The sampling of accounts should be used only if a QI has more than 50 accounts to review. In contrast, sampling is not permitted (and all accounts are to be reviewed) if a QI has fewer than 50 accounts or if an examination of all accounts would not be prohibitive in terms of time and expense. A QI is permitted to use a different sampling technique than the one described in Appendix II as long as it properly documents the methodologies that were used in case the IRS wishes to review or reconstruct the sample. A reviewer may request approval to either modify the safe harbor method or use a different sampling methodology by contacting the IRS. Coordination with FATCA requirements A QI that is a foreign financial institution (FFI) is required to comply with the FATCA requirements applicable to its Chapter 4 status as a participating FFI, registered deemed compliant FFI, Model 1 intergovernmental agreement (IGA) FFI. A QI that is a non-financial foreign entity (NFFE) acting on behalf of its shareholders is required to comply with the requirements of a direct reporting NFFE. The proposed agreement clarifies that a QI s responsible officer can rely on any other personnel with oversight or responsibility for the QI s FATCA requirements, as applicable, in making its certifications relating to its FATCA obligations. As part of the periodic review, a QI must only review its FATCA compliance for those accounts for which it acts as a QI. 3 pwc

Consolidated compliance program Consistent with the 2014 agreement, the proposed agreement allows a QI to be a member of a consolidated compliance program under the supervision of a compliance QI (subject to the approval of the IRS). Observation: The Notice requires QIs that want a consolidated compliance program to consult the IRS Financial Intermediaries Team to determine if the proposed program is acceptable. The timing for submitting the proposal is not defined. Presumably a QI using a compliance program must submit their proposal to the IRS with enough time for the Financial Intermediaries Team to review and notify of acceptance or rejection of the plan. QIs using a consolidated compliance program should plan to seek IRS review as early as possible. Waiver of requirement to conduct periodic review One of the more significant changes included in the proposed agreement is a QI s ability to apply for a waiver with respect to the periodic review requirements if certain conditions are met. A QI is eligible to apply for a waiver if the QI: is an FFI that is not also acting as a QDD, is not part of a consolidated compliance program, does not receive reportable amounts which exceed $5 million (during each calendar year covered by the certification period), has filed all requisite Forms 1042, 1042-S, 945, 1099 and 8966 (or equivalent) on a timely basis (for all calendar years covered by the certification period), and has made all periodic certifications and reviews required by the QI agreement (as well as all certifications required by its FATCA requirements). The waiver is not automatic and does not apply indefinitely. A QI must apply for the waiver when the responsible officer makes the periodic certification of internal controls and a new waiver must be requested for each certification period. Even if the waiver request is approved, the QI still must provide certain factual information to the IRS along with its periodic certification. Additional provisions LOB for treaty claims The IRS recently issued a revised Form W-8BEN-E, Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities), to enhance and improve procedures for claiming reduced rates of withholding under an income tax treaty. The revised form requires an entity to indicate the specific LOB provision that it satisfies under the applicable income tax treaty. Corresponding changes were made to the 2016 Form 1042-S, Foreign Person s U.S. Source Income Subject to Withholding, to include a line for the withholding agent to report the corresponding LOB code. The IRS did not issue guidance regarding the standards a withholding agent must apply when reviewing a Form W-8BEN-E that contains the new LOB information. For example, it was unclear whether a withholding agent could simply accept a foreign person s claim regarding the LOB provisions without further inquiry or whether a withholding agent would have reason to know that a person s claim regarding an LOB provision was unreliable or incorrect if certain conditions were met (e.g., if a particular treaty does not contain the LOB provision claimed by the foreign entity). Many practitioners expected the guidance to be provided in a future update to the Instructions for the Requester of Forms W-8BEN, W- 8BEN-E, W-8ECI, W-8EXP, and W- 8IMY. In the interim, the IRS has provided some guidance relative to the review standards in the Notice. The proposed agreement provides that withholding agents will be subject to the actual knowledge standard with respect to the LOB claims. The IRS plans to amend the Chapter 3 regulations to incorporate these new requirements. The proposed agreement also modifies the documentation requirements associated with accounts owned by entities using documentary evidence to claim treaty benefits. Specifically, the treaty statement provided by an entity account holder must be accompanied by a written statement that certifies it meets the specific LOB provisions as outlined in the revised Form W- 8BEN-E. The timeline for obtaining the LOB information depends on the account holder s status as a new or preexisting account. A QI is required to collect the LOB information for entity account holders that open a new account on or after January 1, 2017. In contrast, the IRS is allowing a twoyear transition period for pre-existing accounts (i.e, until January 1, 2019) to collect the requisite LOB certification statement. However, if a pre-existing account is documented with a Form W-8, then the QI may rely upon it until the form expires (or the account holder experiences a change in circumstances). Observation: It is anticipated that many QIs may find the two-year transition period to obtain LOB information from pre-existing entity account holders seeking a reduced 4 pwc

rate of withholding under a treaty with the US burdensome. As such, advance planning to obtain this information should commence shortly and coincide with the receipt of refreshed documentation to make certain the statements from account holders are received in a timely manner. Observation: The IRS has indicated that the revised Form W-8BEN-E must be used beginning November 1 2016. This is consistent with a transition rule in IRS regulations which states that withholding agents have six months to implement a revised Form W-8. In light of the new LOB requirements, and the lack of clear guidance from the IRS related to a withholding agent s due diligence obligations when accepting a treaty claim on Form W-8BEN-E, many interested stakeholders have requested that the new Form W- 8BEN-E not be required to be accepted prior to January 1, 2017. Perhaps the Notice signals the IRS willingness to delay by two months the implementation of the revised Form W-8BEN-E. In addition to the standard of knowledge for the LOB claims discussed above, the proposed agreement addresses the validity of treaty claims more broadly. Specifically, it provides that a QI will have reason to know that a treaty claim is unreliable or incorrect if the account holder claims benefits under a treaty that does not exist and is not included on the IRS s website. Substitute interest In response to comments seeking to have substitute interest payments covered under the QDD regime in addition to substitute dividend payments, 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 security dealer. Accordingly, a QI will be able to provide Form W-8IMY to a withholding agent certifying that the QI is assuming primary withholding responsibility without requiring the QI to distinguish between payments of interest and substitute interest the QI receives as a principal and those that it receives as an intermediary. QIs that assume primary withholding responsibility for payments of interest and substitute interest will be required to assume primary withholding responsibility for all such payments. Partnerships and trusts applying the joint account or agency options The proposed QI agreement permits a QI to apply the joint account or agency option to partnerships that are covered as accounts that are excluded from the definition of financial accounts under Annex II of an applicable IGA. Consistent with the withholding foreign partnership (WP) and withholding foreign trust (WT) agreements, a QI can apply the joint account or agency option to partnerships or trusts that are ownerdocumented FFIs with respect to the QI. Effective date of QI agreement The effective date of the proposed QI agreement will depend upon when the non-us entity submits its application and whether the entity has received any reportable payments prior to the date on which it submits its application. Beginning on January 1, 2017, a prospective QI that applies for QI status prior to March 31 of a calendar year, and a prospective QI that applies for QI status after March 31 of a calendar year and has not received a reportable payment prior to the date it applies for QI status, if approved, will have a QI agreement with an effective date of January 1 of that year. However, if a prospective QI applies for QI status after March 31 and has received a reportable payment prior to the date that it applies, if approved, its QI agreement will have an effective date of the first of the month in which its application is approved and the prospective QI is issued a QI-employer identification number (EIN). Changes to the WP and WT agreements The proposed changes to the requirements for the QI compliance review also are intended (with appropriate modifications) to be incorporated into upcoming revised WP and WT agreements. The revised agreements will be effective on or after January 1, 2017. The WP agreement also will provide requirements for a reverse hybrid entity that seeks to enter into a WP agreement with respect to the requirements for documentation and withholding on owners claiming treaty benefits. The takeaway While the thresholds for waiving the requirement to conduct a periodic review are a welcome change for many smaller QIs, the proposed agreement continues to emphasize the compliance program even though many stakeholders felt such requirements were relieved as part of the Model 1 IGA. With the recent completion of the preexisting account due diligence period under FATCA and just a few months until 2017, many potential QIs are just now beginning to assess whether their procedures are sufficient to address risks and whether controls are operating effectively. As such, potential QIs should be working with external resources (e.g., managed services providers, agents, and tax advisors) and internal resources (e.g., compliance, internal audit, and 5 pwc

others) to understand not only who is performing what requirement, but the sufficiency of what is being done. Moreover, QIs that are considering becoming a QDD should be incorporating the requirements into their assessments under their 871(m) compliance program, as these rules generally are effective on January 1, 2017. Let s talk For a deeper discussion of how this development might affect your business, please contact: Dr. Karl Küpper +49 69 9585 5708 karl.kuepper@de.pwc.com Dominick Dell' Imperio +1 (646) 471-2386 dominick.dellimperio@pwc.com Jon Lakritz +1 (646) 471-2259 jon.w.lakritz@pwc.com Katja Morgia +49 69 9585 2896 katja.morgia@de.pwc.com Candace Ewell +1 (202) 312-7694 candace.b.ewell@pwc.com Rob Limerick +1 (646) 471-7012 robert.limerick@pwc.com Sandra Horst +49 69 9585 2757 sandra.horst@de.pwc.com Christoph Theobald +49 69 9585 2290 christoph.theobald@de.pwc.com Erica Gut +1 (415) 498-8477 erica.gut@pwc.com Stay current and connected. Our timely news insights, periodicals, thought leadership, and webcasts help you anticipate and adapt in today's evolving business environment. Subscribe or manage your subscriptions at: pwc.com/us/subscriptions SOLICITATION 2016 PwC. All rights reserved. PwC refers to the PwC network and/or one or more of its member firms, each of which is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. PwC helps organisations and individuals create the value they re looking for. We re a network of firms in 157 countries with more than 195,000 people who are committed to delivering quality in assurance, tax and advisory services. Find out more and tell us what matters to you by visiting us at www.pwc.com. 6 pwc