The Internal Revenue Service has released new guidance on how foreign financial institutions can enter into a Qualified Intermediary agreement with the U.S. under the Foreign Account Tax Compliance Act, or FATCA.

Notice 2016-42, released earlier this month, outlines the proposed QI agreement, which revises and updates the current agreement in Rev. Proc. 2014-39, released by the IRS in July 2014. The revised agreement details the procedures for how qualified intermediaries can meet their compliance review obligations. The notice also describes the terms and requirements for qualified intermediaries that want to act as qualified derivatives dealers, or QDDs, with respect to transactions subject to Section 871(m) of the Tax Code, which governs “dividend equivalent” payments. The proposed QI agreement, when it’s finalized, would be effective beginning Jan. 1, 2017, and the IRS is asking for comments by Aug. 31, 2016 on the proposal.

FATCA was included as part of the HIRE Act of 2010 and requires foreign financial institutions such as banks and hedge funds to provide the IRS with information on their U.S. taxpayers or else face stiff withholding penalties of up to 30 percent on their income from U.S. sources. The controversial law has prompted the Treasury Department to sign a series of intergovernmental agreements with other countries, most of them allowing their banks to provide the information first to their own local tax authority, which then passes the tax information along to the IRS.

Denise Hintzke, global FATCA leader with Deloitte Tax, predicts the guidance will be finalized later this year. Existing QI agreements will need to be renewed through the FATCA registration website before March 1, 2017. Most QIs will also need to undergo a compliance review in 2017 under the new rules, and the new Qualified Derivative Dealer regime will become part of the QI agreement going forward.

“This document actually does two things,” said Hintzke. “One, it provides the new proposed QI agreement. That QI agreement is supposed to go into effect on January 1, so I would expect they will be finalizing it at some point within the next couple of months because generally the renewal period for existing QIs will start in the last quarter of the year.”

The new revenue procedure covers the due diligence procedures for QIs and includes some new tweaks to the old rules. “The two key changes are they’ve provided a lot more detail and guidance around what the compliance program and the periodic reviews need to look like,” said Hintzke. “They’ve made it clear now that when the responsible officer for the qualified intermediary is going to have to do a periodic certification as to compliance that they can rely on a review that has been done by an external party. That party can be a law firm, an accounting firm, or any other type of organization that is capable of doing such a review. The responsible officer can then rely on that review for purposes of certifying back to the IRS that they’re in compliance.”

Another key change in the IRS’s new QI agreement allows banks to claim treaty benefits. “It’s in line with the changes that they’ve made to the new W-8 forms, where going forward anybody that’s going to claim a treaty benefit is going to need to provide a more detailed explanation of what limitations of benefits clause they are relying on within the particular treaty,” said Hintzke. “They also made it clear that the financial institutions—the QI in this particular situation—will have some responsibility for making sure that claim is reasonable. There will be certain cases where they actually are held to what’s called a ‘reason to know standard,’ meaning that unless a reasonable person would have knowledge based on the facts they have that this could not be correct that they would have to act on it. Then in some situations there’s an actual knowledge standard, meaning they actually know the person would not be entitled.”

Another important piece of the new QI agreement is the Qualified Derivative Dealer rules. “It allows certain types of entities that are QIs—generally regulated things like broker-dealers—to become a qualified derivative dealer,” said Hintzke. “This is a new status that allows them to avoid withholding under those 871(m) regulations that had to do with derivative transactions and substitute payments. It allows them, when they’re acting on a proprietary basis, to receive such payments without a withholding. Once they determine the actual taxation that is potentially required with respect to the dividend equivalent payment, they file a tax return with the IRS and they pay that directly.”

The QDD rules are supposed to address a situation known as “cascading withholding,” in which banks might be subject more than the 30 percent withholding penalty on their U.S. source income.

“If you had financial institutions that were entering into these derivative transactions that had equities underlying them—so the payments they made were being treated as if they were dividend equivalents—without these rules every single time a payment was made from one party to another along a chain, the 30 percent withholding would apply,” said Hintzke. “This allows entities within the chain, if they’re acting on a proprietary basis, to receive that payment free of withholding, and then finally at the end of the chain determine the appropriate taxes due to the U.S. government.”

In general, the new guidance should provide more clarity to foreign financial institutions so they can comply with FATCA, although it also introduces some added complexity.

“When you look at the QI agreement itself, I think we needed some more clarification around what this certification and review was going to be like, so that’s actually a good thing,” said Hintzke. “It gives more guidance. It gives a lot of flexibility to the financial institutions as to how they want to structure their compliance program and how they want to do the certifications to the IRS.”

However, she sees the part about the treaty benefits as a new complication. “It’s going to be more difficult for organizations to deal with providing treaty benefits, but that’s in line with what they’re doing outside of the QI as well,” said Hintzke. “All they’re doing there is amending the QI to make sure it’s consistent with what all withholding agents are going to need to do. The QDD is a pretty complicated regime, but in the absence of being able to be a QDD, these derivative dealers that are acting on a proprietary basis would not be able to do business with U.S. securities because there’s no other way to get out of the withholding. They’re getting rid of what they call the ‘credit forward rules’ and the ‘QSL [Qualified Securities Lenders] rules,’ which means that if you’re not a QDD you would be subject to withholding. That again would lead to this cascading withholding, and these transactions would not become workable. They just would not be good investments anymore. I think it’s a complicated regime, but very necessary for financial institutions that are eligible to sign onto it.”

The new rules promise to help the IRS with its goal of pressuring foreign banks to turn over more information on potential tax evaders.

“Both of these rules are meant to get more information into the hands of the IRS and give the IRS a better view into things,” said Hintzke. “With the qualified intermediary agreement in general, the institution is signing an agreement with the IRS to provide certain information and due diligence and undergo these reviews, which of course gives the IRS more insight into what’s going on. The same thing with these new what they call the ‘871 rules,’ the derivative rules. They are all focused on trying to get not only more information into the hands of the government but also make sure that they receive the appropriate tax. The concept of the QDD and QI is another way for the IRS to try to get that information in a more simplified manner. If they’re dealing with somebody that’s a QI, and this person has signed a contractual agreement with them to be governed by these QDD rules, then they’ve subjected themselves to review and providing certifications as to their compliance. This is a method of trying to ensure that they’re getting the information they should have.”

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