Alternative asset management firms need to address the impact of final Section 871(m) regulations

Alternative investment funds need to evaluate the impact of recently issued Section 871(m) final regulations on a wide range of notional principal contracts, derivatives and other “equity-linked instruments” with payments that reference (or are deemed to reference) dividends on US equity securities. The analysis will have to focus on understanding the pre-trade, execution, withholding and reporting requirements of the final rules with respect to the affected product as well as the potential impact on internal business areas (tax, accounting, trading, reporting) and external counterparties (brokers, administrators, trading counterparties). Although some of the effective dates are phased in over a two-year period, certain provisions require action to be taken effective from 1 January 2016.

Section 871(m) is currently in effect, and withholding is currently required for a narrow set of notional principal contracts (NPCs) as well as repos and securities lending transactions. In-scope NPCs are those with payments that are contingent upon, or determined by reference to, the payment of dividends on US equities and that have one of the following features: underlying security crosses in; underlying security crosses out; underlying security is not readily tradable on an established securities market; or underlying security is posted as collateral by the short party.

Section 871(m) – in-scope transactions

Introduction

Section 871(m) – combined transactions

Section 871(m) – exceptions and additional key elements

Definition: When (i) a long party (or a related person) enters into two or more transactions that reference the same underlying US security; (ii) two transactions replicate the economics of a single section 871(m) transaction; and (iii) the transactions are entered into “in connection” with each other, then the deltas of the two transactions will need to be combined to see if the 0.8 delta threshold is reached. • Presumptions: For a short party, the

regulations state where a broker may presume that transactions are not entered into in connection with each other if the long party holds the transactions in separate accounts, or if the transactions were entered into two or more business days apart

• Neither presumption is applicable if the broker (i.e., short party) has actual knowledge

• Similar presumptions apply to the IRS Commissioner

• In addition, neither presumption is applicable to the long party, which is required to treat two

or more transactions as combined regardless of when the transaction was entered into

• The Commissioner may rebut the first presumption with facts and circumstances showing that separate trading books were created or used to avoid Section 871(m), and may rebut either presumption with facts and circumstances showing that the transactions in question were entered into in connection with each other

Ernst & Young LLP observations: • The effect of the rule generally shifts

identification responsibility and consequences of non-compliance to the long party. Hedge funds and asset managers should consider creating:• Policies and procedures to raise internal

awareness and have documentation for audit

• Operational systems logic to flag as many combined transactions as possible

• Qualified Derivatives Dealer (QDD) exception: expands the existing qualified intermediary regime for non-US banks and brokers that receive dividends as intermediaries for the account of customers

• Foreign Withholding Partnership: certain types of foreign persons may receive US source payments free of withholding and assume primary withholding/reporting responsibility with respect to FDAP2 income that is subject to chapter 3 withholding by becoming qualified intermediaries, foreign withholding partnerships or withholding foreign trusts

• Corporate acquisition exception: applies to transactions that obligate the long party to

acquire ownership of the underlying security as part of a plan pursuant to which one or more persons are obligated to acquire more than 50% of the issuing entity’s value

• Qualified index exception: provides a safe harbor for transactions that reference certain passive indices that are based on a diverse basket of publicly traded securities (> 25 securities) and that are widely used by numerous market participants

• Partnerships: certain derivatives over partnership may be pulled in if the partnerships carry on a securities trading/dealing business, hold significant investments in securities (25% or more of the value of the partnership’s assets

consist of underlying securities or potential Section 871(m) transaction) or have an interest in a lower-tier partnership that does either

• Contingent interest: if the delta threshold or substantial equivalence test is met in an instrument with contingent interest, then the interest will not be eligible for the portfolio interest exemption and will be treated as a dividend equivalent; it is not anticipated that many debt instruments will reach the threshold requirements

• Convertible debt and 305(c) coordination: conversion price or ratio changes in these instruments may be treated as dividends subject to withholding

The following criteria are used to assess the status on a given transaction: whether it is an in-scope product,1 if the referenced security is a US equity, the type of contract (simple or complex based on availability of delta) and if the value of the delta is more than or equal to 0.8 or the substantial equivalence test for complex transactions.

1. Section 871(m) imposes 30% US withholding on dividend equivalent amounts (DEAs), which potentially arise in the following products, any substitute dividend that references a US source dividend made pursuant to a securities lending or sale-repurchase transaction; 2. any payment that references a US source dividend made pursuant to a specified NPC; 3. any payment that

references a US source dividend made pursuant to a specified equity linked instrument (ELI); or 4. any other substantially similar payment. A payment references a US source dividend if the payment is directly or indirectly contingent upon a US source dividend or determined by reference to such a dividend.

2 | Alternative asset management firms need to address the impact of final Section 871(m) regulations

1 Examples of typical in-scope products include, but are not limited to: swaps, futures, convertible debt, structured notes, options (listed and OTC), securities lending, derivatives over equity-linked indices, certain compensation arrangements, forwards, repurchase agreements, other equity-linked contracts, contracts for differences. 2 Fixed, Determinable, Annual, or Periodical (FDAP) income is all income, except gains derived from the sale of real or personal property (including market discount and option premiums, but not including original issue discount) and items of income excluded from gross income, without regard to the U.S. or foreign status of the owner of the income, such as tax-exempt municipal bond interest and qualified scholarship income.

Alternative funds that use multiple prime and executing brokers need to carefully consider the potential fund level withholding and reporting obligations on in-scope transactions from the recently issued Section 871(m) final regulations

Ernst & Young LLP | 3

• Do you know who is the determining party in the trade? Who is the withholding agent?

• Are you storing the delta calculation at the time the contract was issued?

• Can you notify the counterparty that the trade is subject to withholding under Section 871(m)?• Are you able to provide an

estimate of the withholding amounts?

• Can you explain to the counterparty or client how the disposition of the contract may affect its tax treatment?

• What information do you need to send to prime brokers or fund administrators?

• Does the front office have the data available to make a determination of scope prior to the trade?• Type of contract (simple vs

complex)

• Tax status of the recipient (non-US vs US)

• Tax-appropriate delta risk of simple contracts (above, at or below .80 at issuance)

• Substantial Equivalence Test for complex contracts

• Source of the dividend income on the referenced securities (US vs non-US)

Pre-

trad

e

Execution Withhilding an

d reporting

Monitor

An 871(m) assessment from the perspective of technology and operations

• How do you calculate and store DEA for both simple and complex contracts?

• How do you accrue dividend amounts?• Can you apply the delta to calculate the DEA?• Can you apply a treaty withholding rate?• What is the NAV impact of the DEA?

How can Ernst & Young LLP help?Our approach and key activities Readiness assessment outputs Benefits

• Agree on the in-scope products relative to your fund for this assessment

• Develop data and process requirements based on the agreed product

• Hold targeted walkthroughs with the middle office operations and front-office contacts

• Create a workflow diagram and data requirement table incorporating your current operational landscape and the information obtained from the scenario walkthroughs

• Review observations with key stakeholders and refine

• Present final assessment and propose next steps

• Trade process flow and accounting flows • Summary of process, system and data

challenges observed• Review of vendor and service provider

readiness• Plan for efficiently performing a deeper

gap analysis and implementation of 871(m) recommendations

• Provides an inexpensive and expeditious way for our clients to get a high-level understanding of the challenges they’ll face with 871(m)

• Facilitates our clients’ 2016 budget conversations

• Provides our clients with educational awareness of 871(m) and demonstrates our knowledge in this space

EY | Assurance | Tax | Transactions | Advisory

About EYEY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities

EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com.

EY is a leader in serving the global financial services marketplaceNearly 46,000 EY financial services professionals around the world provide integrated assurance, tax, transaction and advisory services to our asset management, banking, capital markets and insurance clients. In the Americas, EY is the only public accounting organization with a separate business unit dedicated to the financial services marketplace. Created in 2000, the Americas Financial Services Office today includes more than 9,000 professionals at member firms in over 50 locations throughout the US, the Caribbean and Latin America.

EY professionals in our financial services practices worldwide align with key global industry groups, including EY’s Global Wealth & Asset Management Center, Global Banking & Capital Markets Center, Global Insurance Center and Global Private Equity Center, which act as hubs for sharing industry-focused knowledge on current and emerging trends and regulations in order to help our clients address key issues. Our practitioners span many disciplines and provide a well-rounded understanding of business issues and challenges, as well as integrated services to our clients.

With a global presence and industry-focused advice, EY’s financial services professionals provide high-quality assurance, tax, transaction and advisory services, including operations, process improvement, risk and technology, to financial services companies worldwide.

© 2015 Ernst & Young LLP. All Rights Reserved.

SCORE no. CK0999

ED None

This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice.

Timeline

2015 2016 2017 2018

1 January 2016Start of transition year for identifying in-scope transactions that meet the 0.8 delta criterion issued in 2016. These transactions will have an effective withholding date of 1 January 2018. Contemporaneous documentation needs to be maintained within 10 days after transaction close.

1 January 2017Go-live date for withholding on DEA associated with in-scope contracts that meet the 0.8 delta criterion issued 1 January 2017 onward.

1 January 2018Withhold on DEA associated with contracts identified as in-scope that were issued in 2016 and meet the 0.8 delta criterion.

18 September 2015 IRS finalized Section 871(m) regulations.

Present day

Withhold on contracts that satisfy the four-part test: 1. cross-in; 2. cross-out; 3. not readily tradable; 4. underlying contract is posted as collateral.

Ernst & Young LLP key contactsJun LiWealth & Asset Management Taxjun.li@ey.com+1 212 773 6522

Dmitri V. SemenovInternational Tax Servicesdmitri.semenov@ey.com+1 212 773 2552

Maria MurphyInformation Reporting and Withholding maria.murphy@ey.com+1 202 327 6059

Justin O’BrienGlobal Information Reporting and Withholdingjustin.obrien@ey.com+1 212 773 4767

Jim KickhamWealth & Asset Management Advisoryjim.kickham@ey.com+1 212 773 7032

Zsuzsanna KadarInternational Tax Serviceszsuzsanna.kadar@ey.com+1 212 773 5453

Madhuri RaviInformation Reporting and Withholding madhuri.ravi@ey.com+1 212 773 3348

Matthew StevensNational Tax – Financial Productsmatthew.stevens@ey.com+1 202 327 6846

Scott C. OdahlWestWealth & Asset ManagementTaxscott.odahl@ey.com+1 612 371 6840

Kevin J. GlenCentralInternational Tax Serviceskevin.glen@ey.com+1 312 879 6257