On December 30, 2016, the IRS issued Revenue Procedure 2017-15, which sets forth the final qualified intermediary (QI) agreement (the 2017 QI Agreement), and Revenue Procedure 2017-16, which sets forth the updated foreign financial institution agreement (the FFI Agreement). These agreements are used by non-US financial institutions and non-US branches of US financial institutions that have agreed with the IRS to act as US withholding agents. The QI Agreement relates to withholding under the Section 1441/Chapter 3 rules. The QI Agreement also sets forth the rules for QIs that wish to become qualified derivatives dealers (QDDs) for purposes of the new rules under Section 871(m) that begin to come into effect in 2017. The FFI Agreement relates to withholding under the FATCA/Chapter 4 rules for institutions resident, or branches located in, countries that have not entered into a "Model 1 Intergovernmental Agreement" with the United States.

The 2017 QI Agreement incorporates changes previewed in December in Notice 2016-76, as well as changes in response to comments on the draft QI agreement contained in Notice 2016-42 (Proposed QI Agreement). It is anticipated that these changes, in addition to others, will be included in the revised final Section 871(m) regulations expected later this month. The FFI Agreement was set to expire December 31, 2016, and this updated draft makes a few significant changes that are consistent with the newly released Chapter 4 regulations.

This Alert assumes that the reader is generally familiar with the US withholding tax and FATCA rules, including the provisions relating to QIs and participating FFIs, as well as changes to Section 871(m) that are beginning to come into effect in 2017. (See Tax Alert 2017-51 for discussion of the most recent rules on US withholding tax and FATCA, Tax Alert 2016-2084 for discussion of Section 871(m) transition rules, Tax Alert 2016-1173 for information on the Proposed QI Agreement, and Tax Alert 2014-13 for information on the original FFI agreement.)

Changes to the QI Agreement, including QDD provisions

The 2017 QI Agreement provides changes to the compliance requirements of a QI, including a QDD, and removes the obligation to perform a projection of under-withholding if a single error or failure occurs. It also reintroduces the spot check procedures for reviewing withholding and reporting compliance. For an entity that is both a QI and QDD, compliance requirements remain intertwined. The 2017 QI Agreement retains certain key requirements, including that: (i) an entity have only one responsible officer (RO), (ii) an entity have one certification of internal controls that depends on both QI and QDD compliance; and (iii) the periodic review year be the same for both QI and QDD activities. Furthermore, QDDs are relieved of the certification of internal controls and periodic review requirement for 2017. The 2017 QI Agreement also provides QIs using the third year of the certification period for their periodic review an additional six months to make the certification. In such cases, the certification will be due December 31 of the year following the end of the certification period (for example, December 31, 2018, for a certification period ending December 31, 2017).

The 2017 QI Agreement provides significant transition relief for QDDs for the tax year 2017 for their own tax liability. In 2017, QDDs will neither be subject to withholding tax on actual dividends or dividend equivalents that they receive in an equity derivatives dealer capacity nor be required to perform any complex net delta computations that potentially could result in additional tax being owed by the QDD. Proprietary holdings of US stock and Section 871(m) transactions outside the dealer book (i.e.,positions from trading and investing) nonetheless could give rise to tax obligations in 2017, as could non-dividend-related amounts received (e.g., interest).

Beginning in 2018, Revenue Procedure 2017-15 calls for QDDs to be subject to withholding on any actual dividends received (i.e., from physically holding US stock or from taxable conversion rate adjustments on convertible debt) and to self-assess on any net long exposure to US equities retained in its dealer book. For this purpose, net long exposure is measured by net delta, which is then converted to a share number that is multiplied by the appropriate dividend rate. This method effectively takes into account actual dividends received as well as dividend equivalents from in-scope and out-of-scope trades flowing into and out of the dealer book (the Section 871(m) amount).

This method will create significant issues for non-US dealers that issue derivatives over US equities that are within scope for Section 871(m) and hedge themselves by owning the underlying equities or convertible bonds on those equities (as opposed to hedging with derivatives). Such dealers will be subject to withholding on dividends received on the underlying physicals. They will also be required to perform withholding on the US equity-linked derivatives that they issue. But they will have no direct mechanism to offset the withholding to which they are subject against the withholding they must perform. The result will be double withholding. The IRS has indicated that it is aware of this problem and open to suggestions on how to mitigate it.

Also, beginning in 2018, there will be the new net delta methodology. The net delta exposure to an underlying security for an applicable dividend is the number of shares by which: (A) the aggregate number of shares in the underlying security to which the QDD has exposure through long positions (including through ownership of physicals) exceeds (B) the aggregate number of shares in the underlying security to which the QDD has exposure through short positions in the underlying security. The net delta exposure calculation only includes long and short positions that the QDD holds in its equity derivatives dealer books and records. Any long or short positions that are treated as effectively connected to the QDD's business are excluded and subject to tax on a net basis under the rules generally applicable to non-US entities engaged in a US trade or business.

In addition, the 2017 QI Agreement broadens the base of entities eligible to become QDDs to include bank holding companies, wholly owned subsidiaries thereof and any other entity acceptable to the IRS, regardless of whether that entity otherwise could become a QDD under the terms of the agreement. It further clarifies certain aspects of the guidance applicable to branches of non-US entities and securities lending facilitators acting purely in an agency capacity.

— The final changes of note under the 2017 QI Agreement are two new reporting responsibilities for QDDs. First, the 2017 QI Agreement requires a QDD to provide a withholding statement along with the Form W-8IMY it provides to its counterparties. A QDD will have to identify each account for which it receives payments with respect to the following: (1) potential Section 871(m) transactions or underlying securities as a QDD; (2) potential Section 871(m) transactions (that are not underlying securities) for which withholding is not required; and (3) underlying securities for which withholding is required, and, if applicable, identifying the home office or branch that is treated as the owner of the payments for US income tax purposes.

— Second,the timing of withholding required by QDDs is accelerated vis-à-vis US withholding agents and non-QDDs. US withholding agents and non-QDDs must follow the payment timing rules under the Section 871(m) regulations. These rules align the timing for withholding with "payments" on the derivative contract itself, which will often be later than the timing for required withholding by QDDs. Presumably for this reason, the 2017 QI Agreement adds a requirement for QDDs to notify clients in writing upfront when withholding will occur.

All existing QIs will be required to renew their QI Agreements via the QI/WP/WT Application and Account Management System portal before March 31, 2017, for their agreements to be effective January 1, 2017. This portal is also to be used by those applying to be QIs for the first time, including eligible entities applying for QDD status, as well as existing QIs applying to be QDDs. A link to a system user guide (Publication 5262) effectively serves as instructions to the updated IRS Form 14345, Application for Qualified Intermediary, Withholding Foreign Partnership, or Withholding Foreign Trust Status.

Changes to the FFI Agreement

The FFI Agreement includes changes for compliance requirements of a participating foreign financial institution (PFFI), including Reporting Model 2 FFIs. These changes include the ability of the IRS to modify the PFFI's compliance certification to require factual or quantitative information if the IRS provides 90 days for public comment before amending the FFI Agreement. Additionally, the FFI Agreement contains changes to the reporting requirements for PFFIs that are partnerships, requiring them to report the interests of their partners. Lastly, when a business or block of accounts is transferred mid-year, it specifies (in a way similar to the existing guidance under Chapter 3) that the successor entity may choose to perform FATCA reporting for the entire calendar year, rather than having the predecessor report for the first portion of the year and the successor report for the second portion of the year. Until now, there had been no guidance for those situations.

Further the FFI Agreement clarifies that a US branch of a foreign financial institution that does not elect to be treated as a US person need not register as a PFFI. Finally, the FFI Agreement addresses FFIs that do not perform FATCA reporting for a year because they have no reportable accounts. The IRS may request such an FFI to confirm that it had no financial accounts to report for the year. Alternatively, an FFI with no reportable accounts for a year may file a nil return to evidence that it has no such accounts to report.

PFFIs that were expecting to have to renew their agreements prior to December 31, 2016, now have until July 31, 2017, to renew. A participating FFI that does not renew its agreement by this extended deadline will be treated as having terminated its FFI agreement on January 1, 2017.

Implications

This new guidance for QIs, QDDs, and FFIs replaces expiring guidance and coordinates those rules with related transitional guidance. Entities interested in becoming one or more of those types of entities or continuing that status will need to react fairly quickly to ensure such status from January 1, 2017, going forward.

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