With the introduction of QDD, will tax compliance get even more taxing?
Just when banks may have thought they have met all of their fiscal and regulatory obligations for the New Year (including the hotly debated IRS 871(m) requirements governing financial derivatives), yet a new one arises.
Cue QDD—a new set of requirements for broker dealers and banks that want to become Qualified Derivatives Dealers. The idea is great, as QDD status prevents the cascading of withholding taxes on implied and actual equity-linked income events. Becoming a QDD breaks the chain, as when a QDD is paying income to a fellow QDD, it can do so gross, whereas if it is paying a non-QDD it must do so net.
But QDD status means the company must perform a self-assessment of what tax it must pay to the IRS. This may result in assessing hundreds or even thousands of U.S.-related derivative contracts, as well as the implied dividend on the underlying shares embedded in the contract where they will get taxed on the underlying income events. All of which could create substantial potential tax withholding processing issues.
Luckily, the IRS has recognized the potential complexity involved in QDD and granted a concession stating that firms can use risk system reporting to understand if their implied dividends on derivatives were fully offset by the tax due on a standard cash income event in a QDD self-assessment calculation. As a QDD, the company in question will need to report and pay tax on these events. This all sounds reasonably straightforward, right?
This is where things start to get even more complicated. The QDD regime acts so that, in return for complying with the requirements of the regime, the bank or broker dealer receives 100 percent of the dividend and can pass it on to other QDDs at that rate. Although when it is paying to a non-QDD, that party is taxed based upon their associated tax documentation. This scenario seems like it could be easily supported—but, multiply the transactions, positions and dividend events into hundreds of thousands of flows, and it is clear that attempting to comply with this regime manually without leveraging automation will lead to a plethora of problems.
Similarly, QDD requires the comparison of the tax embedded on the underlying event, typically based on linking derivative share equivalents to dividend events, to the tax calculated on the cash income earned on the same dividend event so that only a “net” amount should be paid. With a myriad of complexities that will spill out, the implementation of QDD being delayed is not stopping firms from looking for solutions to these inevitable problems now. After all, every bank will need to work out the different entities they want to register as QDD status for and, as a result, will have to go through the painful process of registration. They will also need to work out a mechanism for centrally tracking situations that are QDD eligible and decide what feeds need to be interfaced into the central system, what tax needs to be calculated, when, by whom and submitted into what returns.
QDD regulations will of course require a much more sophisticated monitoring of a range of data elements—including who is receiving changes, updates and cancellations. While QDD is currently front of mind, it is not the first and certainly will not be the last tax initiative. Firms that ignore the problem instead of looking for a long-term solution run the risk of accruing fines and ultimately reputational damage. On the flip side, those that take advantage of the latest compliance technology like data automation and smart processing will not only keep the relevant U.S regulators happy, but also drive efficiency savings across the business.