Section 871(m) Counterparty Reporting: IRS and Financial Institutions May be Underestimating Work Involved
Paperwork Reduction Act (PRA) notices often fall by the wayside. This might especially be true if they are from the IRS and published in the Federal Register (FR) in the dead of summer. But a curious reference in one of these notices published in the FR on August 2, 2019 caught our eye. The notice asked for "burden-reduction" related comments on Form 1042 and Form 1042-S, but it also referenced the Section 871(m) regulations and information collection requirements under those rules.
The apparent reference is to counterparty reporting under the Section 871(m) regulations, which is separate from the annual Form 1042/Form1042-S filing requirements and occurs, interestingly, on a transactional basis. In Section 871(m) compliance discussions, counterparty reporting is often overlooked. If nothing else, the PRA notice should prompt us to begin conversations about this transactional information exchange challenge that both the IRS and industry may be underestimating.
The 2 August PRA notice's reference to information collection under Section 871(m) was rather cryptic. It referenced Treasury Decision 9374, which would mean the final 2015 Section 871(m) regulations. However, the notice did not specify what information collection requirements under the regulations it was referring to. The notice stated as follows in regard to information collection under the regulations:
"These regulations provide guidance regarding when payments made pursuant to certain financial instruments will be treated as US-source income and subject to US withholding tax. The information provided is necessary to permit withholding agents to determine whether US withholding tax is due with respect to a payment of a dividend equivalent and the amount of the tax. The information will also be used for audit and examination purposes."
While Treas. Reg. Sec. 1.871-15(p) does reference Form 1042/Form 1042-S reporting, the section principally sets forth the requirements for a "responsible party" to provide Section 871(m) information to counterparties and other parties to a potential Section 871(m) transaction. Given the phrasing in the notice and the preamble to the regulations that the information to be collected is to establish or determine whether a payment is a Section 871(m) dividend equivalent payment subject to withholding, it appears that the reference is to these counterparty reporting requirements under Treas. Reg. Sec. 1.871-15(p).
From our experience, counterparty reporting has not been a serious part of many Section 871(m) compliance discussions. At least not yet. It may be partly due to the fact that we are still in a transition period where Section 871(m) only applies to delta-one transactions and the combined transaction rule applies only in limited circumstances. This means not only fewer transactions are currently in-scope, but the ones that are may not trigger the granular questions that may arise when non-delta one transactions (and perhaps the full brunt of the combined transaction rule) come into play in 2021.
The last category is relatively broad and likely will require, after the expiration of the transition period at the end of 2020, the inclusion of such information as whether the transaction is a simple vs. complex contract and for complex contracts, substantial equivalence testing information such as the number of initial hedge shares.
The information requested must also be provided within a reasonable time, not to exceed 10 business days, but can be communicated in one or more of the following ways: (1) by telephone, and confirmed in writing; (2) by written statement sent by first class mail to the address provided by the requesting party; (3) by electronic publication available to all persons entitled to request information; or (4) by any other method agreed to by the parties, and confirmed in writing.
From a systems perspective, it is key that counterparty reporting occurs with respect to each transaction and must happen concurrent with the transaction (at least within 10 business days). As such, the IRS' estimate of 3,000 responses does not seem right. The IRS is likely underestimating the work that will be involved in implementing systems to provide Section 871(m) counterparty reporting; industry may be as well in many cases.
How are financial institutions thinking about their obligations to provide counterparty reporting for potential Section 871(m) transactions? Moreover, how are they thinking about obtaining such information in situations where they are not the responsible party but is the withholding agent? Beyond actually having systems to source Section 871(m)-relevant data sets, is there a process for transmitting and receiving Section 871(m) counterparty reports?
As we approach 2021, when the floodgates open with respect to non-delta one and complex transactions and potentially a more robust application of the combined transaction rule, thinking through counterparty reporting processes become more and more important. Given the volume of potential transactions and the short time frame given for producing Section 871(m) counterparty reports, systems automation will be key. Interested in finding out more? Contact us to discuss our Section 871(m) solution and our plans for a common electronic repository that will allow financial institutions to exchange counterparty reports.
IHS Markit provides industry-leading data, software and technology platforms and managed services to tackle some of the most difficult challenges in financial markets. We help our customers better understand complicated markets, reduce risk, operate more efficiently and comply with financial regulation.
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