A new rule that brings some equity derivatives into the ambit of US withholding tax may undermine demand for hedging among overseas investors as brokers scramble to implement the requirements.
Dividends from US securities paid to a non-US person are generally subject to a 30% withholding tax. Investors have in the past been able to use a loophole in US law to avoid the tax by buying a derivative (such as swap) on the same equity, and receiving dividend-equivalent payments that are not taxable.
A common practice has been for overseas taxpayers holding a US security to unwind the direct holding shortly prior to a dividend payment and enter into a swap on the same security, reversing the process after the payment. However, from January 1 that will no longer be possible, making equity derivatives less attractive.
“The new regulations will establish up to a 30% withholding tax on foreign investors on dividend-equivalent payments under equity derivatives,” said Cyrus Daftary, CEO of Markit CTI Tax Solutions. “Firms face a big operational challenge preparing for the new tax ahead of implementation, and in some cases we may see foreign investors exiting the US market.”
The Internal Revenue Service in September issues a new final set of regulations for its Code Section 871(M), setting out conditions for determining when payments under swaps or equity-linked instruments might be treated as US “dividend-equivalent” payments and therefore subject to withholding tax for non-U.S. investors.
“The regulations could potentially apply to a broad swath of equity derivatives: equity swaps, exchange-traded options or equity futures, equity-linked notes, convertible bonds, and structured products, among others,” said Daftary. “Since withholding agents have generally not been required in the past to withhold or report on payments arising under these products, market participants need to put in place appropriate compliance systems as soon as possible, if they have not already done so.”
Under the new rules, brokers are responsible for determining whether a particular equity derivative is subject to 871(m), a judgement that is contingent on the underlying asset being a security that can give rise to a derivative and how closely the contract tracks that security.
“Tax was previously a back-office matter but these new rules make it the responsibility of the front office, which needs to understand the tax implications for non-US persons,” said Daftary. “Basically it’s a pre-trade concept with major tax implications.”
For “simple” contracts that reference a fixed number of shares of a US equity security, a contract will be taxable if it has a delta of 0.8 or greater with respect to the referenced security. Delta measures how closely securities and derivatives are correlated using the ratio of the change in the fair market value of the contract compared with a change in fair market value of the underlying security.
For more complicated contracts, such as structured products that stipulate different returns depending on the performance of the underlying asset, there is a “substantial equivalence” test. That requires financial modeling to create an artificial simple contract that can then compare the changes in value of the complex contract against a specified hedge for that contract and the changes in value of the benchmark contract against its hedge.
“There is also a reporting obligation on the broker to provide 871(m) information to other parties to the transaction, and the required amount to be withheld,” said Daftary. “Errors can lead to the IRS assessing tax liability against the determining party.”
In a letter to the US Department of the Treasury in March the Securities Industry and Financial Markets Association said the new rules could cause “significant disruption”, due to their complexity.
“We urge the government to … consider whether certain changes to the regulations are necessary in light of the complexity … the novel and ground-breaking withholding regime … and the impact that the regulations will have on the equity derivatives markets,” SIFMA said.