Section 871(m):
pressing issues
in the asset
management space
EQ mr_es MS and non%MS fmnds
oith derivative epposmre to
MS eimities to tace action
to ensmre compdiance as the
effective date for new section
871(m) reimirements redated to
withhoddin_ rapiddy approaches&
Ohide recent pmZdic _overnment
statements impdy that the rmdes
may Ze made dess oneroms in
2017 throm_h transition _midance,
no comments have Zeen made
sm__estin_ an omtri_ht deferrad
of the new re_ime& Accordin_dy,
asset mana_ers shomdd assess their
overadd readiness and cdose any
remainin_ criticad _aps Zefore the
201. cadendar year%end&
Introduction
Section 871(m), enacted as part of the
HIRE Act in 2010, provides that payments
on certain Õnanciad instrmments that
_enerate a retmrn Zased on the payment
of a MS%somrce dividend are treated as
Édividend eimivadents&Ê Adthom_h the
scope of section 871(m) oas initiaddy
dimited to contracts that cdeardy passed
throm_h smZstitmte dividends, re_mdations
Õnadired in 201- _reatdy eppanded
its reach Ze_innin_ 1 Banmary 2017&
Startin_ on that date, dividend eimivadents
may arise in conbmnction oith a ran_e
of transactions over MS eimities,
incdmdin_ any of the foddooin_ iddmstrative
transactions2 secmrities doans or sade%
repmrchase a_reements, soaps, disted
1
or over%the%comnter options, foroards,
fmtmres, strmctmred notes or convertiZde
deZt instrmments& :ased on recent
comments made Zy an Internad Revenme
Service (IRS) ofÕciad si_niÕcantdy
invodved in draftin_ the re_mdations,1 it
is anticipated that _midance soon oidd Ze
issmed adoptin_ a phased%in approach for
potentiad section 871(m) transactions,
incdmdin_ ondy Édedta oneÊ prodmcts
(presmmaZdy prodmcts smch as totad retmrn
soaps, foroards, fmtmres and contracts for
difference) as in%scope in cadendar 2017
and add others in 2018& Lhis approach
is eppected to dessen cmrrent tappayer
Zmrden impdementation efforts associated
oith options and other prodmcts that are
traditionaddy non%dedta one&
SI>EAÌs ?doZad Lap Reportin_ Symposimm on 21 GctoZer 201.&
Select fundamental rules and
responsibilities
Ohen dividend eimivadents are considered paid to non%MS
investors on any in%scope transaction issmed or materiaddy modiÕed
in 2017 or dater, they widd Ze smZbect to _ross%Zasis tapation and
withhoddin_ mnder chapters three and fomr as if they were actmad
MS%somrce dividends& >or an instrmment to _enerate dividend
eimivadents, it mmst have smfÕcient corredation with the MS eimity
that it references, and the referenced eimity _eneraddy mmst pay
dividends& SmfÕcient corredation is estaZdished Zy a dedta2 of at
deast 0&8 at issmance in the case of simpde contracts (e&_&, most
options, swaps, forwards, fmtmres and convertiZde deZt) and Zy
an adternative test of ÉsmZstantiad eimivadenceÊ in the case of
more compdicated instrmments smch as strmctmred notes, where
dedta may not Ze determinaZde& Scopin_ is more compdicated for
so%cadded ÉcomZined transactionsÊ (e&_&, one don_ cadd and one
short pmt over the same MS eimity), where distinct dower%dedta
Õnanciad transactions issmed at different points may nonethedess
Ze treated as in scope if, when viewed to_ether, the separate
trades womdd reach the appdicaZde dedta or smZstantiad eimivadence
threshodds&
Mnder the re_mdations, Zrocers and deaders are _eneraddy
responsiZde for performin_ dedta and smZstantiad eimivadence
scopin_ cadcmdations and for withhoddin_ on dividend eimivadents
deemed paid to their non%MS cmstomers and comnterparties,
incdmdin_ fmnds with non%MS ZeneÕciad owners& Fotwithstandin_
the fmndamentad rode that Zrocers and deaders pday, fmnds and
their administrators adso have a si_niÕcant rode mnder these
rmdes, and they widd not Ze aZde to assmme a passive position in
2
the impdementation of section 871(m)& As discmssed Zedow, they
widd Ze responsiZde for commmnication and cnowded_e transfers,
certain compmtations, docmmentation and, in certain cases, even
withhoddin_& >mnds and their administrators widd encomnter fewer
operationad disrmptions and ne_ative impacts from the new rmdes
if they proactivedy coordinate with Zrocers and deaders now to
ensmre a mmtmaddy a_reeaZde roddomt of the section 871(m) rmde set&
Key section 871(m) issues in the
asset management industry
Some fmnds and fmnd administrators are mnaware of their section
871(m) oZdi_ations or have smZstantiad worc to do with dess than
two months remainin_ Zefore the effective date of many parts of
the re_mdations& Lhe foddowin_ are some epampdes of cey issmes for
the asset mana_ement indmstry&
Communication with brokers regarding
withholding obligations is critical
:rocers and deaders may not Ze fmddy prepared for section 871(m)
and may faid to perform the reimired withhoddin_ or appdy epcess
withhoddin_& If the Zrocer or deader faids to withhodd, the fmnd is
responsiZde for the withhoddin_& It is important for add fmnds to
conÕrm with their Zrocers and deaders now that each is prepared
to epecmte its withhoddin_ oZdi_ations startin_ on 1 Banmary 2017&
Eany fmnds are adso independentdy performin_ the section 871(m)
determinations to checc a_ainst information transmitted from the
Zrocer or deader and correct any errors&
?eneraddy speacin_, dedta measmres how cdosedy the pricin_ of an eimity derivative moves with that of the mnderdyin_ eimity it references& <erivatives that move in
tandem with their mnderdyin_ (e&_&, totad retmrn swaps) are often referred to as Édedta oneÊ instrmments and _eneraddy shomdd Ze in scope mnder these rmdes startin_ on
1 Banmary 2017, even mnder the eppected transition _midance& >mnds widd need to dooc to the forthcomin_ _midance to see which transactions widd Ze deÕned as Édedta oneÊ
and therefore Ze in scope for 2017&
2
| Section 871(m): pressing issues in the asset management space
Funds are responsible for full compliance with
combined transaction rules
871(m) tax liability will impact net asset value
(NAV) calculations
>inad responsiZidity for identifyin_ and performin_ cadcmdations
with respect to comZined transactions _eneraddy fadds on fmnds
Zecamse the Zrocer or deader may not have cnowded_e of the
comZined transaction (e&_&, where two transactions are hedd in
accomnts at different Õrms)& :ased on comments made dmrin_ the
?doZad Lap Reportin_ Symposimm, hedd Zy the Secmrities Indmstry
and >inanciad Earcets Association (SI>EA) forthcomin_ _midance
is eppected to modify the comZined transaction rmdes to redap
them or provide for a transition period& It is mncdear whether any
redapation or transition of these rmdes womdd appdy to the don_
party as wedd, or ondy to the short party, which cmrrentdy is aZde to
appdy presmmption rmdes that are dess oneroms than the aZsodmte
rmdes appdicaZde to the don_ party& In either case, as the comZined
transaction rmdes primaridy tar_et non%dedta one transactions
(e&_&, many options), eppected _midance providin_ that ondy dedta
one transactions widd Ze in scope in 2017 widd dessen near%term
tappayer Zmrdens when appdyin_ the comZined transaction rmdes&
A fmnd or fmnd administrator widd need to accomnt for section
871(m) tap when cadcmdatin_ FAN, even in cases where the Zrocer
or deader widd perform withhoddin_, as the fmnd is separatedy diaZde
for the tap& Lhe fmnd or administrator widd need to (i) ensmre that
the Zrocer or deader transmits accmrate information in a timedy
manner to permit FAN cadcmdations or (ii) independentdy perform
the section 871(m) determinations&
>mf\kk`gmd\[gfÔjeYf\ljY[cI<<klYlmkg^
non-US dealers
A fmnd payin_ a dividend eimivadent to a non%MS deader that has
not edected ÉimadiÕed derivatives deaderÊ (I<<) statms widd Ze
reimired to withhodd and report& In contrast, a fmnd macin_ a
dividend eimivadent payment to a I<< is not reimired to withhodd
or report& Any fmnd tradin_ short potentiad section 871(m)
>mnds shomdd consider creatin_ podicies and procedmres to raise
internad awareness and have docmmentation for amdit& >mrther,
they shomdd consider creatin_ operationad systems do_ic mpon
issmance of the modiÕed comZined transaction _midance to Ze
in a position to Öa_ as many comZined transactions as possiZde
when the rmdes appdy& Lhe fmnd adso may notify its Zrocer or deader
proactivedy of the comZined transaction to ensmre that any mpfront
withhoddin_ done Zy the Zrocer or deader is accmrate initiaddy
(thereZy redmcin_ any reimired additionad Õdin_s for the fmnd)&
US partnerships must withhold and report
on dividend equivalents paid to their non-US
investors
Adthom_h not as common these days, many de_acy fmnd of fmnds
are strmctmred with MS partnerships that have non%MS investors&
Fewer fmnd of fmnds _eneraddy are Éside%Zy%sideÊ strmctmres where
MS partners invest in the MS feeder fmnd and forei_n partners
invest in the offshore feeder fmnd& :mt even MS partnerships in
newer fmnd strmctmres often have non%MS investors as a resmdt of
epceptions made dmrin_ the onZoardin_ process&
MS partnerships widd Ze responsiZde for withhoddin_ on items
of section 871(m) income that they addocate to their non%MS
investors& Any MS fmnd that has non%MS investors mmst Ze
prepared to process section 871(m) information from its Zrocer or
deader comnterparty to perform the reimired withhoddin_& :rocers
or deaders may not reco_nire that certain MS persons, speciÕcaddy
partnerships and other Öow%throm_h vehicdes, are comnterparties
for which they mmst monitor section 871(m) data dme to the
potentiad for non%MS owners& Accordin_dy, the onms is on the MS
Öow%throm_h entities to inform the Zrocer or deader of their needs
in advance to ensmre timedy receipt of necessary information&
Section 871(m): pressing issues in the asset management space |
3
transactions throm_h non%MS deaders shomdd coddect a cmrrent >orm
O%8IEQ (which indicates I<< statms) from each deader and tracc
the I<< statms information& Eany deaders are in the process of
coddectin_ the necessary information for compdetin_ the appdication
to oZtain I<< statms with the IRS& However, pendin_ chan_es to
the draft II A_reement in Fotice 201.%,2, not add deader entities
widd Ze considered Éedi_iZdeÊ or have the reimired II desi_nation
to permit I<< statms&3 Asset mana_ers shomdd commmnicate with
their tradin_ comnterparties to ensmre each comnterparty widd have
I<< statms prior to 1 Banmary 2017&
Updating legal agreements
:rocers and deaders are mpdatin_ their de_ad a_reements
with cmstomers and comnterparties to remove references to
_ross%mp of withhedd amomnts or insistin_ on adherence to the
new IS<A protocod to this effect& >mnds shomdd eppect to Ze
inmndated Zy Zrocer reimests to enter into new a_reements Zy
31 <ecemZer 201.&
Software limitations
>mnds or their administrators may want software that, at a
minimmm, can store section 871(m) data transmitted from the
Zrocer or deader& Eany vendors of epistin_ software are not
pdannin_ to devedop sodmtions for section 871(m)&
Funds will need to track compliance with the
imYdaÔ]\af\]p]p[]hlagf
Lhe ÉimadiÕed indep epceptionÊ epcdmdes from the scope of section
871(m) transactions that reference a ÉimadiÕed indepÊ meetin_
certain criteria (e&_&, the SH -00) that epempt the transactions
from withhoddin_& ImadiÕed indices are _eneraddy msed Zy fmnd
mana_ers as portfodio hed_es& >mnd mana_ers may speciÕcaddy
reimest comnterparties to provide contracts that meet the
imadiÕed indep epception& However, a fmnd that shorts si_niÕcant
components of a imadiÕed indep may disimadify the indep (with
respect to the fmnd) from meetin_ the epception and camse the
indep to Ze in scope for section 871(m) and therefore smZbect to
withhoddin_& Asset mana_ement cdients need to have processes
in pdace to monitor shortin_ of imadiÕed indep components as a
pdannin_ tood and to commmnicate si_niÕcant shortin_ of an indep
to the Zrocer or deader&
3
4
Gn 2. GctoZer, 201., Information Reportin_ Hro_ram Advisory ;ommittee (IRHA;)
redeased a report (avaidaZde on the IRS weZsite) with cey recommendations for
the IRS in the area of information reportin_, incdmdin_ section 871(m)& Emdtipde
recommendations were made Zy IRHA; to eppand the mniverse of entities edi_iZde
for I<< statms& IRHA; is an advisory committee to the IRS on information reportin_
and withhoddin_ issmes and its memZers are persons from diverse parts of the
Zmsiness commmnity&
| Section 871(m): pressing issues in the asset management space
Transactions referencing MLP interests may be
\a^Ô[mdllg]nYdmYl]
Funds of funds face an additional hurdle on
compliance
A derivative transaction that references a partnership interest is
in scope if, amon_ other thin_s, the partnership hodds investments
in appdicaZde secmrities epceedin_ the desser of 2- of its assets
or 2- middion& Epistin_ _midance does not reimire a partnership
to share information aZomt its assets for the pmrposes of section
871(m), so Zrocers'fmnds may have to presmme 30 withhoddin_
on a transaction redatin_ to a derivative interest in a master dimited
partnership (EDH)& ;daims for refmnd of overwithhedd amomnts widd
Ze difÕcmdt to mace withomt adeimate smZstantiation&
Lhe regmdations do not provide an eppdicit mechanism for fmnds of
fmnds to compdy& ;onsider the typicad MS fmnd of fmnds strmctmre
depicted in the diagram Zedow& Lhe MS prime Zrocer in this
epampde is oZdigated to transmit information regarding potentiad
section 871(m) transactions to the ;ayman Easter >mnd DH, Zmt
the regmdations do not mandate that Investment Advisor 1 pass
this information on to the MS >mnd of >mnds DH& Lhms, the MS >mnd
of >mnds DH may not receive information smfÕcient to satisfy its
oZdigation to withhodd on dividend eimivadents addocated to its
non%MS investors, or to perform accmrate FAN cadcmdations&
EYl]jaYdeg\aÔ[Ylagfg^hj]%]paklaf_
transactions
>or this reason, fmnds of fmnds shomdd Ze proactive in
commmnicating with their fmnds to ensmre that they receive
reimired information& Hotentiad section 871(m) income addocations
comdd Ze incdmded on the fmnd of fmndsÌ Schedmde C%1 (perhaps
in a footnote if the IRS does not provide an appropriate dine) or
the investment advisor comdd provide any read%time information
that the fmnd of fmnds needs to cadcmdate accmrate FANs& >mnds
of fmnds may wish to address these issmes Zy mpdating their degad
agreements with the fmnds&
Oithhoddin_ may appdy with respect to a transaction issmed
or Émateriaddy modiÕedÊ on or after 1 Banmary 2017& Asset
mana_ement cdients may need a process in pdace to monitor
materiad modiÕcations, incdmdin_ certain contract eptensions,
occmrrin_ on or after 1 Banmary 2017 that womdd Zrin_
grandfathered derivative contracts within the scope of
section 871(m)&
Fund of funds example
Investment Advisor #2
Non-US
investors
1
US Fund of
Funds LP
871(m) transaction withholding and
reporting on dividend equivalent payments
US tax
exempt
investors
Forms W-8
Non-US
investors
Form W-9
US Feeder LP
1
Issue
Ź The unrelated US Fund of
Funds LP will need the
relevant 871(m) information
to properly withhold and
report on its non-US
investors.
Ź How will US Fund of
Funds obtain the relevant
871(m) information?
Form W-9
Investment Advisor #1
Cayman
Master Fund LP
(Long Party)
Form W-8IMY plus
Ź Form W-9 (US Feeder)
Ź Form W-8BEN-E
(Cayman Feeder) and
Ź Withholding statement
Form W-8BEN-E
Required per
Regs to provide
871(m)
information to
long party
2
US Prime Broker
(determining party/short party)
Cayman Feeder Corp
2
Ź Prime Broker will withhold
30% on the portion of the
dividend equivalent payment
allocated to the Cayman
Feeder and will Õle Form
1042-S on such payment
Ź Prime Broker has no 871(m)
withholding or reporting
responsibility with respect to
the US Feeder or its partners
Section 871(m): pressing issues in the asset management space |
5
Conclusion
The asset management industry will need to work together with
brokers, dealers and other parties to create certain functioning section
871(m) processes by 1 Banuary 2017. Now is the time for funds and
their administrators to assess the full extent of section 871(m) on
their operations and communicate with brokers and others to resolve
outstanding impediments to compliance. Failure to review the impact of
section 871(m) to the trading vehicles in your organiration and develop
appropriate policies, procedures and communication channels in
advance may cause your funds to suffer unintended consequences that
they are ill-prepared to address real-time. Please feel free to reach out
to discuss how we may assist you and your team in applying the current
guidance and in interpreting the impact of the expected additional
guidance.
6
| Section 871(m): pressing issues in the asset management space
For more information, please contact2
<Yf>Yjj]dd
Partner
T2 #44 20 77.0 9324
E2 dfarrell8uk.ey.com
Lauren Lovelace
Partner
T2 #1 212 773 8790
E2 lauren.lovelace8ey.com
Chris Morris
Senior Manager
T2 #44 20 79-1 1327
E2 cmorris8uk.ey.com
Kathy Vawter
Senior Manager
T2 #44 20 79-1 99..
E2 kvawter8uk.ey.com
Alison Hardin
Manager
T2 #44 20 79-1 0110
E2 ahardin8uk.ey.com
Nicholas Mowbray
Manager
T2 #44 20 79-1 -811
E2 nmowbray8uk.ey.com
Section 871(m): pressing issues in the asset management space |
7
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