SIFMA Comments on Proposed QI Agreement

The Securities Industry and Financial Markets Association ("SIFMA")¹ appreciates the opportunity to submit comments on the proposed Qualified Intermediary (QI) Agreement published in Notice 2016-42² (herein, "Notice" or "proposed QI Agreement"), which includes the requirements for qualified derivatives dealers ("QDDs") pursuant to regulations issued under section 871(m) of the Internal Revenue Code (the "Code").

SIFMA has continuously engaged the Treasury Department (Treasury) and the Internal Revenue Service ("IRS") in an effort to provide constructive recommendations that are operationally administrable. In that same spirit, the members of SIFMA provide the following comments in response to the Notice:

Moreover, there are critical process issues beyond SIFMA members' control that remain in flux. For instance, the IRS has not published the QDD application form, which will take time to complete and be approved, especially since it is a paper application process. It also currently takes entities and branches two to three months to set up an account with the IRS to make withholding tax deposits. With an influx of entities applying for QI status to qualify as QDDs by January 1, 2017, we are concerned that this process may take even more time. Further, the Form W-8IMY has not been finalized; nor have the Form W-8 requestor instructions been updated. Withholding agents need time to program systems to intake the new form, build systems and processes for validation, and collect updated documentation. Revising documentation for specific accounts of legal entities based on the multiple capacities in which they may act requires coordination across the business, the tax department, and other operational areas.

Even without the significant new complexities added by the recently issued proposed QDD rules, SIFMA members will not be able to build automated systems in time to be compliant by January 1, 2017, with all of the requirements in the section 871(m) regulations. SIFMA members are spending significant resources to be prepared for compliance, but there are fundamental open issues related to technical and industry data availability for both delta one and non-delta one transactions that must be resolved before finalizing the withholding process. SIFMA's letter dated June 24, 2016 lists a number of issues that SIFMA members believe require additional guidance. Examples of open areas for concern in the delta one space are structured notes and certain other securities held in custody, where there is a chain of institutions involved,⁴ and swaps on potentially covered partnerships, where timely and sufficient data are not available. In the non-delta one space, examples of open areas of concern include withholding for nonqualified indices, obtaining deltas globally for listed options, and implementing the combination rule. Absent additional or final guidance on these issues, the members of SIFMA will not be in a position to implement the regulations in their current form on January 1, 2017.

Accordingly, SIFMA requests a delay of the final and temporary regulations issued under section 871(m) for at least one year from the date of the finalization of the temporary regulations under section 871(m) and QI Agreement. The current QI Agreement would therefore stay in effect until December 31, 2017, with the requirements of the compliance procedure (including the waiver provisions and appendices) under the final QI Agreement being applicable to the certification period ending December 31, 2017.

The QDD tax liability introduced in the Notice is comprised of three elements: (i) the "section 871(m) amount" arising in connection with the dealer book; (ii) US-source dividends that are not on underlying securities associated with potential section 871(m) transactions and dividend equivalents from non-dealer activities, including investing and proprietary trading; and (iii) other non-dividend, fixed, determinable, annual or periodic income (e.g., interest) associated with potential section 871(m) transactions.⁶ The "section 871(m) amount" is computed by determining, for each dividend on each underlying security, the excess (if any) of (A) the amounts the QDD receives in its dealer capacity that are dividend equivalent payments and dividends on underlying securities associated with potential section 871(m) transactions over (B) the dividend equivalent payments and the "qualifying dividend equivalent offsetting payments"⁷ that the QDD makes or is contractually obligated to make in its dealer capacity with respect to the same underlying dividend.⁸ A "qualifying dividend equivalent offsetting payment" is a dividend equivalent embedded in a client trade with a sufficiently high delta to be in scope for section 871(m) purposes but for the fact the trade was executed with a US person or is effectively connected income to a foreign counterparty.⁹ With regard to the section 871(m) amount, as currently drafted, the precise inputs for qualifying dividend equivalent offsetting payments do not take into account members' hedging strategies which often net positions across books (e.g., a delta one single stock book, an options book, and an index book) within a single entity and could result in a tax liability that does not reflect the true economic position of the dealer.

Dealers generally do not take a directional view on an underlying asset, but rather, seek to profit from fees and on the spreads captured between their hedges and client trades. Profit margins are typically slim. To be profitable, dealers must pursue effective hedging strategies as inefficient hedges may be capital intensive and cost-prohibitive. For example, hedging on a gross basis may lead to higher margin and collateral requirements under Financial Industry Regulatory Authority (FINRA) Rule 4210.¹⁰ Even intercompany hedges require the posting of collateral under these rules; it therefore would be inefficient to hedge on a gross basis and post more collateral than would be necessary if hedging were done on a net basis. Effective equity derivative hedging strategies include those done at a macro-level that consolidate overall exposure to a given equity across client trades within one net offsetting position. This strategy is often more efficient than a hedging strategy that requires a back-to-back hedge to be created for every individual client trade, especially after accounting for the personnel time and costs associated with booking each intercompany hedge. Although there are instances when back-to-back micro-hedging is appropriate, there are significant transaction and balance sheet usage costs associated with micro-hedging on a large scale.

When a dealer properly offsets client positions, there should be no (or de minimis) long exposure left to subject to tax, but the section 871(m) amount results in uneconomic tax consequences when, for example --

The withholding tax rule under the final regulations provides certainty for long party clients as to the amount of withholding that they will suffer; however, under the proposed QI Agreement QDDs will have uncertainty as to how much tax liability they will incur with respect to trades that are fully hedged from an economic perspective.¹¹ Even in-scope, non-delta one client trades, which are treated as having static deltas (i.e., fixed at issuance per Treas. Reg. § 1.871-15(g)(2)), could give rise to section 871(m) tax amounts because these will be hedged with positions that may need to offset an increased delta over time. This is because economically the client's delta, and therefore the delta of the associated hedge, change over time based on factors such as volatility and time to maturity of the derivative. Dealers subject to the Volcker Rule¹² are required to set limits on the amount, types, and risks of their market-making activities and related risk management and to maintain their portfolios within those limits.

Consider an example where a client approaches a QDD to engage in a section 871(m) transaction involving a 0.8 delta option over 100 shares of IBM. The QDD initially hedges this client transaction by buying 80 shares of IBM but then subsequently adjusts its hedge to 90 shares as the delta of the client position increases to 0.9. IBM pays a $1 dividend. Under these facts, the section 871(m) amount would be $10, computed as follows: $90 in dividends received on the physical shares in the dealer book less $80 deemed paid out of the dealer book. This is not an appropriate result because the net $10 of exposure is solely the result of the fixed delta required to calculate the dividend equivalent payments treated as made out of the dealer book.

For determining the section 871(m) amount on a transaction-level basis, SIFMA requests that the offsetting payments be expanded to encompass all client transactions that are potential section 871(m) transactions. Offsets should be allowed to the extent that the client transaction references one or more dividend-paying US equities, regardless of whether the transaction is in scope. Thus, amounts paid with respect to grandfathered trades, trades with a delta of less than 0.8 at issuance, and trades involving qualified indices should all be included as offsets. A conforming expansion should be made on the incoming side of the dealer book -- i.e., amounts received in the dealer book from potential section 871(m) transactions, in addition to dividends and dividend equivalent payments received. The QDD would essentially treat a potential section 871(m) transaction as if it were a section 871(m) transaction. For each potential section 871(m) transaction (including a section 871(m) transaction), the QDD would compute a dividend-related payment by multiplying the live delta¹⁵ as of the close of the day before ex-date of each underlying security by the per share dividend. The section 871(m) amount would be the amount by which (1) the dividends on underlying securities associated with potential section 871(m) transactions and dividend related payments exceed (2) dividend related payments the QDD makes or is contractually obligated to make with respect to the same dividend in its dealer capacity.

Instead of calculating dividend equivalents paid and received on a transaction -- level basis, a QDD should be permitted, at its option, to determine its section 871(m) amount by calculating: (1) the net delta exposure (measured in number of shares) of the QDD (aggregated across all US equity and equity derivative transactions entered into in a dealer capacity (whether client or hedge transactions) as of the close of the day before ex-date of each underlying security, multiplied by (2) the relevant dividend amount per share. A sample of the calculation method is detailed in the Attachment to this letter. SIFMA members believe that using the net delta methodology captures the true residual exposure in the hands of the QDD and allows the QDD to leverage a calculation already performed for the following non-tax regulatory purposes:

For bank holding companies and many regulated dealer entities that would serve as QDDs, the calculation of risk-weighted assets (RWA) takes into account net delta per equity -- any net long or short exposure to an equity attracts RWA -- which in turn requires an allocation of capital to support the exposure and thus has a direct cost to the parent firm. At the end of each quarter, net delta per security is calculated and checked carefully by front office personnel and control functions as it feeds directly into the firm's published results and financial statements.

SIFMA also requests that an option should be provided for QDDs either to treat indices and exchange traded funds (ETFs) as an underlying security or to assess each component separately.

As explained above, the QDD tax liability related to the section 871(m) amount is complex operationally. For administrative ease, SIFMA requests that the QDD be required to calculate its section 871(m) amount on a quarterly basis and deposit accordingly. Further, for dividend equivalent payments received by QDDs in a non-dealer capacity, QDDs should not have to pay their QDD tax liability for such amounts prior to the time the withholding agent would have otherwise been required to withhold. SIFMA requests that the IRS and Treasury allow a QDD to elect to self-assess the QDD tax liability for dividend equivalent payments received in its non-dealer capacity when either the dividend equivalent payment is considered made under Treas. Reg. § 1.1441-2(e)(8) or the dividend payment date for the underlying security that is referenced by the section 871(m) transaction.

SIFMA members will not have automated systems to calculate and self-assess the QDD tax liability by January 1, 2017, and it is likely that members will not have automated systems to withhold tax under section 871(m) with respect to all client transactions. As a result, members will struggle to do manual withholding in the timeframe required by the regulations. Moreover, many non-US firms are performing US withholding for the first time as part of the section 871(m) regime. Given these facts, SIFMA further requests that the QDD not be liable for any penalties related to failure to pay or deposit if the QDD pays the client's US withholding tax and its QDD tax liability by the due date for filing Form 1042, without extensions. US withholding agents should be provided similar penalty relief. The extraordinary complexity of this withholding regime warrants providing taxpayers with this extra time to comply should a withholding agent need it.

Treas. Reg. § 1.1441-1T(e)(6)(ii) provides that an "eligible entity" is a QI that is:

As detailed in the SIFMA comment letter on the proposed regulations under IRC Sec. 385 dated July 6, 2016, financial groups that include banks, bank holding companies and dealers in securities, including derivatives, are subject to a number of wide-ranging regulatory regimes and rules that constrain or affect virtually every aspect of their businesses. While these regulatory regimes and rules apply with the greatest force to banks and other fully regulated members of the group, they apply in significant part to or affect all of a regulated financial group's members. For example, bank holding companies with total consolidated assets of $50 billion or more are required to comply with capital planning and stress testing requirements as an enhanced prudential standard. Regulatory rules also require such a bank holding company to adhere to enhanced risk-management and liquidity risk-management standards, conduct liquidity stress tests, and hold a buffer of highly liquid assets based on projected funding needs during a 30-day stress event. In addition, a publicly traded bank holding company that exceeds $10 billion in assets is required to comply with certain provisions of the Federal Reserve's enhanced prudential standards, which impose a number of detailed requirements concerning risk management and governance. In many cases, even where there is not a specific regulation or guidance that applies to a transaction, regulators have broad powers, under their consolidated supervisory authority, to encourage or require, or discourage or prohibit, various actions and transactions that the regulator believes may adversely affect the financial position of the parent and/or various members of the group.

Accordingly, SIFMA requests on behalf of our members that an "eligible entity" include subsidiaries of regulated securities dealers and bank holding companies provided that the entity at issue is regularly engaged in issuing potential section 871(m) transactions to customers and receives dividends or dividend equivalent payments pursuant to potential section 871(m) transactions to hedge the transactions issued to customers. Such expansion (or clarification of current applicability) is consistent with the intent of the rule because such entities are generally part of larger financial groups that are heavily regulated.

Further, by becoming QDDs, entities are subject to IRS review through the required compliance procedures. The fact that these entities are certifying directly to the IRS that they are in compliance with the QDD rules and are subject to an IRS correspondence review should provide additional assurance to the IRS that appropriate measures will be undertaken to ensure that withholding and reporting are properly done. Indeed, it may be appropriate to expand the eligible entity definition further to include entities that are not owned by a regulated entity but that regularly enter into 871(m) transactions, such as a structured note issuer that is a special purpose vehicle¹⁷ owned by a third party that is not regulated.

A disregarded entity is generally not considered to be a person under section 7701(a)(1) ("the term 'person' shall be construed to mean and include an individual, a trust, estate, partnership, association, company or corporation"). This would mean that a disregarded entity might not meet the regulatory requirements for QI status. However, in its discretion, the IRS has granted QI status to entities that do not strictly meet the regulatory definition. Notwithstanding the technicalities of being eligible to attain QI/QDD status, SIFMA recommends that Treasury and IRS clarify that an entity engaging in dealer activities involving potential section 871(m) transactions may become a QI/QDD, even if such entity is a disregarded entity. Alternatively, if the regulations require that the single member owner (as opposed to the disregarded entity itself) apply for QI/QDD status, the activities and regulation of the disregarded entity should be sufficient to qualify the single member owner because the disregarded entity should be treated like a branch of the single member owner for U.S. tax purposes.

In an effort to comply by January 1, 2017, the members of SIFMA have been developing their systems based on the requirements in the final regulations. They have spent significant time working on systems that will treat the dividend equivalent amount as paid when a "payment" occurs pursuant to Treas. Reg. § 1.1441-2(e)(8). The divergent rules for QDDs would require beginning anew with different systems builds. The members of SIFMA leverage the same withholding system and process for both their US and non-US operations. SIFMA members do not have sufficient time or IT capabilities to build multiple systems or program their systems with different logic for different entities and the appropriate level of associated controls.

More importantly, and consistent with previous comments, SIFMA requests that withholding agents (including QDDs) be allowed to elect to treat a dividend equivalent amount as paid either when a payment occurs under Treas. Reg. § 1.1441-2(e)(8) or on the dividend payment date for the underlying security that is referenced by the section 871(m) transaction. The current rules in the final regulations should remain the default approach as many withholding agents believe that building systems based on payments, as defined in the regulations, remains the most time and cost efficient build. However, for certain transactions, such as structured notes, some withholding agents believe that it will be easier to build systems based on the time of the payment of actual dividends on the underlying security.

SIFMA requests that the reconciliation schedule support only the computation of the section 871(m) amount. If the QDD elects to calculate the section 871(m) using a net delta approach described above, SIFMA requests that instead of the reconciliation, a QDD have record-keeping responsibilities to substantiate the calculation of the section 871(m) amount and can also separately substantiate how the net delta was determined for each dividend payment.²⁰

Amounts received in a non-dealer capacity or amounts received that are not with respect to an underlying security associated with potential section 871(m) transactions should not be included in any record-keeping or reconciliation schedule because a QDD's tax liability for these amounts is based on the gross payments received. Unlike the section 871(m) amount, these amounts do not require a netting computation.

The preamble to the section 871(m) regulations states that the IRS has had difficulty verifying that prior withholding in a chain of securities loans had in fact occurred in order to justify the crediting of prior withholding to a subsequent payment.²¹ However, the members of SIFMA believe that the revisions that have been made to the Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, and Form 1042-S, Foreign Person's U.S. Source Income Subject to Withholding, in recent years allow the IRS to verify the prior withholding and that the credit forward system therefore should be allowed to continue. In addition, SIFMA requests an expansion of the credit forward system for delta one section 871(m) transactions for this same reason.

The Form 1042 now requires an entity to attach the Form 1042-S that it received from another withholding agent to verify the credit amounts claimed for withholding. The Form 1042-S also now includes the primary withholding agent box which requires a withholding agent reporting amounts withheld by another withholding agent to report the name and EIN of the withholding agent that withheld. The addition of this box allows the IRS to confirm the initial withholding agent in a chain of transactions and verify the deposit.

U.S. withholding agents already have the infrastructure in place to withhold on these payments and QDDs should not have to develop systems to track and assess tax on these payments. SIFMA requests that a QDD not be required to assume withholding responsibility for payments other than dividend and dividend equivalent payments. Accordingly, the QI Agreement should be revised consistent with the regulations.

The members of SIFMA recognize that this request will require a withholding agent to document a potential section 871(m) transaction with multiple withholding certificates, which is challenging to implement from an operational perspective, and further request that the QDD certification be included on the Form W-8BEN-E, Certificate of Status of Beneficial Owner for United States Tax Withholding and Reporting (Entities), to eliminate the need to provide multiple withholding certificates.

Further, SIFMA requests that the QDD rules be amended to provide that a QDD solely engaging in securities lending and sale-repurchase transactions covered by section 871(m) should not be required to compute a QDD tax liability (including the section 871(m) amount) since there is always a requirement that the full amount of any dividends received be passed on as substitute dividends. No concept of delta even exists for these transactions in the context of the section 871(m) regulations as they will be fully in scope to the extent they involve a dividend-paying US equity since the transaction requires the complete transfer of an actual dividend payment stream. Accordingly, an identifiable audit trail already exists to prove there is no net exposure for these transaction types without the necessity of introducing additional rigor and complexity into the process.

Section 10.03 of the proposed QI Agreement requires that ROs of QIs certify the QI's internal controls by July 1 of the calendar year following the end of the three-year certification period. The RO can "rely on any reasonable procedure, process, or review that enables the responsible officer to make the certification." Section 10.04 states that the RO must, at the same time, provide the factual information described in Appendix I of the QI Agreement, which includes information about the required periodic review (unless QI qualifies for a waiver of the periodic review). Thus, any periodic review, and any other procedures, processes or reviews to be relied upon by the RO in making the certification of internal controls, would need to be completed within six months of the end of the certification period.

QIs with initial certification periods that end on December 31, 2017 and that act as QDDs are required by section 10.05 to use 2017 as the periodic review year. Even in the absence of this requirement, many QIs would prefer to use 2017, the third and final year of the certification period, as the year of the periodic review. The Forms 1042 and 1042-S for 2017, which must be included in any periodic review of that year, are not due until March 15, 2018. (Indeed, many institutions request an automatic 30-day extension to file Form 1042-S and an automatic six-month extension to file Form 1042, and thus will not complete the filings that would be the subject of the periodic review until September 15.) The effect of the deadlines above and other requirements, assuming all filings are made on an unextended timeline, will be to compress demand for both internal and external resources to verify internal controls and otherwise conduct periodic reviews into the three-and-a-half month period from March 15, 2018, to June 30, 2018. Taking extensions into account, the July 1, 2018 deadline makes even less sense.

SIFMA members believe that it is in the IRS's interest to extend the certification and factual information deadlines. Doing so should result in higher quality submissions by spreading out demand for qualified external resources and by not disrupting QIs' normal filing schedule. SIFMA proposes, on behalf of our members, that the deadline for RO certifications and the submission of factual information be changed permanently to December 31 of the year following the end of the certification period. QIs should also be able to obtain a six-month extension upon a showing of reasonable cause. For reviews of 2017, however, the extension should be automatic in light of the very substantial new requirements.

Our members also note that Part IV.E of Appendix I requires a QI to provide a reconciliation of amounts reported paid to the QI and amounts reported paid by the QI to determine the amount of any unreconciled variance which is to be reported on line 14 of the reconciliation. It appears that line 14 should be the difference, if any, between the total of amounts reported paid to the QI (i.e., the amount reported on line 3) and the aggregate of amounts reported paid by the QI (i.e., the amount reported on line 13). However, the reconciliation in Part IV.E currently excludes the amounts reported on line 15 from the total amounts paid and reported by the QI on line 13. As a result, any amount on line 15 will be incorrectly included in the variance. Therefore, SIFMA members believe that the amounts to be reported on line 15 should be included in the total reported on line 13 and that the reconciliation should be adjusted accordingly.

The issue that section 10.04(A) raises is that it seemingly prevents any person or firm involved in developing a QI's procedures, systems, or policies from taking part in the review. This standard is unobtainable, particularly in light of the requirement that the reviewer be competent regarding the requirements of the QI Agreement. The number of employees within a QI that have the requisite knowledge to perform a periodic review is very limited. Employees with requisite knowledge necessarily will be involved in helping management make decisions regarding the implementation of the QI Agreement and, to the extent that the QI uses internal reviewers, they necessarily will have to provide guidance regarding the rules of the agreement. The same problem applies to the use of external reviewers. Many QIs seek the involvement of external advisors to implement the QI Agreement and in many cases they will use multiple advisory firms. The use of the term "independence" in describing the objectivity requirement also raises issues for external advisors, particularly accounting firms, since that term has very specific meanings under the various regulations that apply to such firms.

SIFMA members agree that objectivity by any person or firm involved in the periodic review is a critical element to ensuring the reliability of the periodic review. The members of SIFMA believe the goal of objectivity can be met by providing that any individual that had management responsibility for implementation of the QI Agreement should not be significantly involved in the periodic review. Further, parties primarily responsible for: (1) reviewing client tax forms; (2) performing the withholding on clients; and (3) calculating the amounts required to be reported should not be a reviewer. On the other hand, internal and external parties that do the following should be allowed to do the QI review: (1) provide advice on what the FATCA/QI rules are and how they are applied to a particular client situation/tax form; (2) provide advice on how the withholding rules apply to a particular client situation or fact pattern, (3) assist in reporting by doing the physical submission of client data to the IRS or local tax authority but without being responsible for the correctness of the underlying data; and (4) provide quality assurance review services to the QI. While the members of SIFMA recognize that such a standard is somewhat imprecise, they believe the interest of the IRS can be protected by providing the IRS with general information regarding the persons or firm involved in the periodic review and whether they had any managerial involvement in the implementation of the QI Agreement. Further, SIFMA recommends on behalf of our members that in describing the objectivity standard, the term "independence" not be used to avoid any inference that professional standards implemented by other regulatory authorities are applicable to the periodic review.

The members of SIFMA believe that this sufficiency standard will result in an unintended overreporting of "material failures." Any time there is an error, it is arguably because something was not sufficient. Instead, the standard should be whether there was a "failure to establish a policy, procedure, or control . . ." and that result in a material amount of underwithholding, understatement of the QDD tax liability, or underreporting.

"Events of default" require the RO to make the qualified certification regardless of whether corrected as of the date of the certification and permit the IRS to terminate a QI's agreement under section 11.01 if, in its sole discretion, the IRS determines that termination is warranted. Given the potentially catastrophic consequences of an event of default, the term must be defined by materiality. For example, section 11.06 lists the events of default, including section 11.06(A): "QI fails to implement adequate procedures, accounting systems, and internal controls to ensure compliance with this Agreement." The word "adequate" is a vague standard, and given the dire consequences, a vague standard should not be imposed. SIFMA recommends that the events of default impose of measurement of materiality as it is a standard that is familiar to industry and more in line with the consequences of an event of default. Further, an event of default should only occur in this instance if the QI fails to implement any procedures, accounting systems, and internal controls for compliance with the QI Agreement.

Section 10.06(A) states that the factual information required by Appendix I "should report the results upon initial review (i.e., not reflecting the results after curing) and the curing process should not delay certification of internal controls or factual information required in Appendix I to this Agreement." That section goes on to state that "to the extent necessary," the report should include information about curative documentation and revised withholding calculations. The members of SIFMA agree with the IRS's sentiment that efforts to cure documentation failures should not delay the periodic review report. However, a report of the liability prior to cures will not show the QI's actual liability, which is calculated as if valid curative documentation was timely received. Accordingly, SIFMA recommends amending section 10.06(A) to provide that any withholding liability included in the report may take into account cures received prior to the date of the report.

The spot check approach is completely missing from the Safe-Harbor Method without explanation. All procedures in the Safe-Harbor Method are performed on all sample accounts. Moreover, the Safe-Harbor Method generally requires a minimum of 50 accounts per stratum (or all accounts in a stratum if there are less than 50).

SIFMA recommends that the IRS incorporate spot checks for pooling, withholding and reporting compliance into the Safe-Harbor Method. The spot check method outlined in Rev. Proc. 2002-55 can guarantee that documentation of a statistically valid sample is subject to the full slate of tests, in recognition of the fact that documentation errors tend to cause other errors. At the same time, the spot check method strikes the proper balance of cost and benefit with respect to other errors -- neither ignoring them nor requiring a full-blown statistically valid testing regimen. The IRS could, if it identifies issues that require more complete investigation in the factual disclosures made by a QI, make follow-up inquiries.

Stratum (5) refers to accounts held by indirect account holders "not included in any previously defined strata."

The members of SIFMA believe that the intention of Stratum (5) is to test underlying indirect account holders of the QI's direct accounts that are flow-through entities and non-QIs documented with W-8IMYs, consistent with the third stratum identified in the audit guidance set out Revenue Procedure 2002-55, which was described as a "stratum of all indirect account holders covered by the QI Agreement."³⁷ Under this approach, the account for the direct account holder (i.e., the flow-through entity or NQI) would be included in Stratum (3) and the individual indirect account holders of these entities each would be identified individually in Stratum (5). If this is in fact the intention, we recommend that Stratum (5) be amended to read a "stratum of all indirect account holders." The reference to "not included in any previously defined strata" should also be removed.

Further, SIFMA requests clarification on the purposes of paragraph (G) of Section 1. The first paragraph of paragraph (G) provides a seemingly duplicate rule for stratum with less than 50 sample units. There is a rule provided in paragraph (D) of Section 1 for such instances. The second paragraph makes reference to strata with less than 20 accounts in the sample. However, it is unclear when these comments would apply given separate comments requiring minimum sample sizes of 50 per stratum. It is unclear what is added in paragraph (G).

The lack of any specific rules about what constitutes "actual knowledge" places QIs at risk for invalid documentation. A QI is unlikely to have the necessary information to determine the applicability of an LOB provision. Moreover, LOB provisions can be complicated even for tax professionals and those responsible for obtaining account opening documentation and validation, who are not tax professionals, cannot be expected to evaluate the applicability of LOB provisions. SIFMA requests that the IRS define "actual knowledge" using the same standard applicable to treaty claims in general; that is, a QI has actual knowledge that an LOB representation is incorrect only if the beneficial owner is claiming benefits under a treaty that does not exist or is not in force.

Further, the application of the Annex 1 due diligence procedures and local guidance in many Model 1 jurisdictions will generally result in an undocumented entity account being classified as a U.S. Reportable Account or non-consenting US Account. Under the Annex I due diligence procedures nonparticipating FFI status applies only when there is information indicating that the account holder is a financial institution. A QI, including a QI branch of a U.S. financial institution, should be permitted to establish an account holder's FATCA status using the standards of an applicable IGA. The QI should be able to couple that approach with documentary evidence to establish that the entity is a foreign beneficial owner, and should not be required to apply the presumption rules in a way that is contrary to the IGA.

In addition, the proposed QI Agreement would add to section 5.01(A)(1):

If an account holder receiving the payment is not the payee, QI is also required to establish the chapter 4 status of the payee or payees to determine whether withholding applies under chapter 4. See section 5.13(B)(1) of this Agreement for the requirements for QI to reliably associate a withholdable payment with a Form W-8IMY for chapter 4 purposes.

The first sentence does not explain what kind of "payment" it applies to, and if it were applied literally it would go well beyond what is required by the regulations with respect to payments that are not withholdable payments. The second sentence could be read as clarifying the first and limiting its scope to withholdable payments, but this should not be left open to interpretation. The beginning of the first sentence should be changed to read "If an account holder receives a withholdable payment but is not the payee . . ."

Under section 4.05(B)(3) of the current QI Agreement, it is specifically permitted for a QI to report in its chapter 3 pools payments to direct account holders to which the QI applies the joint account rule:

(3) QI may include payments made to the partnership or trust in its chapter 3 reporting pools for direct account holders of QI for Form 1042-S purposes under section 8.03(B) of this Agreement. Indeed, a major incentive to apply the joint account rule, despite possible overwithholding, is to be able to use pooled reporting, which otherwise would not apply because of the requirement under current section 8.02(G) for a QI to file recipient specific forms for interest holders of flow-through entities.

Moreover, the revised version of section 4.05(B)(3) states:

QI may pool report amounts distributed to, or included in the distributive share of, the partnership's or trust's direct partners, beneficiaries, or owners in chapter 3 reporting pools on Form 1042-S as described in section 8.03(B) of this Agreement.

Thus, sections 8.02(E) and 4.05(B)(3) of the proposed QI Agreement seem to be in conflict. Pooled reporting is nominally permitted by section 4.05(B)(3), but it is not clear that a QI would really know whether the amounts were distributed or included in the distributive share of direct interest holders. It may not matter, because section 8.02(E) requires recipient specific reporting. The requirement for recipient specific information will greatly reduce the utility of the joint account option. SIFMA recommends that new section 8.02(E) not be adopted, and that the current version of section 4.05(B)(3) be retained.

Please do not hesitate to contact me at (202) 962-7300 or ppeabody@sifma.org, or our outside consultants John Staples or Jeff Levey at Ernst & Young. John can be reached at (202) 337-5662 or john.staples@ey.com and Jeff can be reached at (202) 467-4813 or jeff.levey@wc.ey.com.

• It is the day before Apple goes ex with a dividend of $0.57 per share.

• The QDD has 3 Apple-related transactions on its dealer book --

•  

  1. Short 'in-scope' client option with live delta of -250 shares

  2. Long 'out-of-scope' client option with live delta of +50 shares

  3. Long 210 AAPL shares to hedge

 - $142.5  (-250 shares * $0.57/share)

² I.R.S. Notice 2016-42, 2016-29 I.R.B. 67.

³ Prohibitions against technological system updates typically begin in early December and are meant to maximize system stability during periods of peak transaction volume and lower personnel availability due to the year-end holidays.

⁴ Products held in custody require the implementation of a very complex chain of data transmission, from the issuers to the custodians, through a series of intermediaries, to bring together the knowledge of the product and that of the client tax status. Despite significant coordination efforts, the industry has not agreed upon a target operating model for all stakeholders in all countries (issuers, data providers, custodians, etc.). The rules will require consistent application and international coordination that cannot be effectively addressed until the section 871(m) regulations and QI Agreement are finalized.

⁵ Prop. Treas. Reg. § 1.871-15(j), 48 Fed. Reg. 73128-01 (December 5, 2013).

⁶ Prop. QI Agreement, section 2.67.

⁷ Prop. QI Agreement, section 2.79.

⁸ Prop. QI Agreement, section 2.80.

⁹ Prop. QI Agreement, section 8.03(C).

¹⁰ FINRA Rule 4210 describes margin requirements for various equity and fixed income security and derivative transactions with the goal to minimize counterparty credit risk. Among other things, the rule provides details regarding maintenance of margin and variation margin requirements, risk limit determinations, and concentrated exposures.

¹¹ The members of SIFMA are also uncertain as to whether they will be able to claim a foreign tax credit in their country of tax residence for U.S. taxes paid with respect to the QDD tax liability.

¹² The so-called "Volcker Rule" is section 619 of the 2010 Dodd-Frank Act and the implementing regulations thereunder. Entities subject to the Volcker Rule are prohibited from engaging in "proprietary trading" or owning or sponsoring "covered funds"(each as defined in the rule), except as otherwise permitted under the rule. The rule includes an exemption for market-making activity on behalf of clients and related hedging activities.

¹³ I.R.C section 871(m)(6) states: "In the case of any chain of dividend equivalents one or more of which is subject to tax under subsection (a) or section 881, the Secretary may reduce such tax, but only to the extent that the taxpayer can establish that such tax has been paid with respect to another dividend equivalent in such chain, or is not otherwise due, or as the Secretary determines is appropriate to address the role of financial intermediaries in such chain."

¹⁴ For this purpose, the term "potential section 871(m) transaction" should be interpreted in a manner that is agnostic to the tax status of the counterparty, consistent with the current draft guidance.

¹⁵ The live delta is the number of shares hedging the potential section 871(m) transaction.

¹⁶ Treas. Reg. § 1.871-15(p).

¹⁷ It should be noted that the use of special purpose vehicles in these situations is not tax-motivated, but rather, to reduce or eliminate credit risk exposure to the banking chain. Other third parties that are not special purpose vehicles and that issue potential section 871(m) structured notes may also be excluded from the definition of eligible entity. A third party may be used in these cases for non-tax business reasons, including diversification of credit risk. From the issuer's perspective, it receives compensation for the use of its balance sheet through less expensive funding.

¹⁸ Prop QI Agreement, section 3.03(B).

¹⁹ Prop. QI Agreement, section 7.01(C).

²⁰ As described above, net delta is computed in a "commercially reasonable" manner and the QDD maintains records to support the net delta calculation for a business or non-tax regulatory purpose.

²¹ T.D. 9734, 2015-41 I.R.B. 500.

²² Prop. QI Agreement, section 4.05(A).

²³ Prop. QI Agreement, section 4.06.

²⁴ Treas. Reg. § 1.1441-1T(e)(6).

²⁵ Prop. QI Agreement, sections 3.01(B) and 6.01.

²⁶ QI Agreement, section 8.01.

²⁷ I.R.S. Notice 2010-46, 2010-24 I.R.B. 757.

²⁸ Prop. QI Agreement, preamble section 2.01(F).

²⁹ Prop. QI Agreement, preamble section 2.01(B).

³⁰ A PAI is a "private arrangement intermediary." An intermediary is a PAI only if the conditions in Prop. QI Agreement section 4.01(A)-(H) are met.

³¹ Rev. Proc. 2002-55, 2002-2 C.B. 435.

³² Prop. QI Agreement, Appendix II, Section 3.D.

³³ Treas. Reg. § 1.1441-1T(b)(7)(ii).

³⁴ Prop. QI Agreement, Appendix II section 2(A).

³⁵ Rev. Proc. 2002-55, 2002-2 C.B. 435.

³⁶Compare, e.g., Rev. Proc. 2002-55, Sec. 2.02(ii), 2002-2 C.B. 43, section 10.03(A)(4) (full sample review of treaty statements) with 10.03(B)(4)(spot check of withholding rate pools).

³⁷See section 10.04.4 of Rev. Proc. 2002-55.

³⁸ Prop. QI Agreement, section 12.02.

³⁹ Referring to Section I.A.1 of this letter.