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What FIs Can Expect in 2017 and Beyond

In the months since the new tax rule IRS 871(m) came into force, many financial institutions are still struggling to find the best approach to manage the complex tangle of data required for compliance. Phillip Lynch, Global Head of Markets, Products & Strategy at SIX Financial Information, explores the challenges and counsels that compliance isn’t the only issue at play.

For some time, one of the most persistent problems bedeviling U.S. tax officials has been the collection of tax from overseas income. Inevitably, corporations and individuals have complex and disparate financial pictures, with assets often held outside the U.S. for a variety of reasons, including to minimize income tax liabilities. In its quest to get its hands on the billions of dollars’ worth of revenue lost abroad, the U.S. government has trained its focus on regulation specifically designed to capture these foreign earnings.

The government’s first move on this front came in the form of the Foreign Account Tax Compliance Act (FATCA), which was signed into law by President Obama in 2010 and came into force on July 1, 2014. FATCA requires U.S. persons, including those living abroad, to file annual reports on any foreign financial accounts. It also requires foreign financial institutions to report any U.S.-sourced assets held by U.S. persons to the U.S. government. Now, the American government is continuing its efforts in the area of tax compliance by homing in on “dividend equivalent” payments from derivative transactions involving U.S. equities through an IRS regulation known as 871(m), the implementation of which began in January 2017.

It will come as little surprise that the implementation of 871(m) has created an array of compliance headaches for financial institutions. Firms are scrambling to establish the appropriate withholding and reporting processes for the financial instruments falling under the jurisdiction of the new regulation. For instance, 871(m) applies to equity-linked instruments (ELIs) where the delta (ratio of change in the value of the instrument vs. the value of the underlying security) of the underlying instrument is 0.8 or greater. In order to determine which instruments are affected, firms must make these often complicated calculations on their own.

In short, to ensure effective compliance with 871(m) without specialist support involves a herculean degree of research, recordkeeping, monitoring and calculations from already overburdened designated teams. The IRS, recognizing the complexity of the regulation’s implementation, relaxed compliance mandates for the first year (2017), raising the delta requirement for affected securities to 1.0 from 0.8 and announcing that for the first year of implementation they would take into account whether a firm made a “good faith” effort to comply with the law when assessing penalties. This simplified standard only applies to withholding agents, however, and does not cover taxpayers that are long parties (the buyers), meaning the hardest burden may fall on foreign investors.

Regardless, any foreign investors that trade in U.S.-backed ELIs will need to take concrete steps to prove that they are complying with the reporting provisions of the new law. In order to comply with 871(m), firms will need up-to-date and comprehensive information provided to investors on the financial instruments affected by the rule.

Having this information will be vital if firms expect to accurately determine which products fall under 871(m)’s scope and which do not, to ensure that the appropriate sharing of necessary data has been undertaken and to successfully execute withholding and reporting requirements.

Compliance is only the beginning, though. After all, investors are not simply interested in avoiding fines; they’re interested in optimizing their portfolios and strategies in order to maximize returns. In order to do this, advisors and investors need to have a clear picture of how the IRS rules affect all investment decisions they might make. Every new regulation represents not just another potential stumbling block, but an opportunity for intelligent, savvy and well-informed investors to gain a leg up on their peers.

The same principle holds true for 871(m). While it may seem like a minor, obscure rule amongst a sea of tax regulations, financial institutions’ responses will shed light on the quality of their operations. Complete information on the affected instruments will enable firms to improve their business strategies, alerting them to potential savings and risks and allowing them to better counsel clients. For example, advisors are required to disclose the characteristics of products offered to investors – like the instruments’ type, risks and costs, along with the tax implications related to the investments in question, as required under ESMA “Knowledge and Competence Guidelines.” 871(m)-related data will provide advisors and investors this information regarding the tax implications of particular products, empowering them to make better-informed decisions and helping to make investing easier and more efficient.

While unprepared firms struggle to compile the data necessary for compliance, and most firms settle for a minimum good-faith compliance effort, a select few of the savviest firms will be turning the compliance burden posed by the regulation to their advantage. Even though the IRS has relaxed its compliance standards as firms have stumbled through the early stages of 871(m)’s implementation, the most prepared firms – those that have put themselves ahead of the pack – are already ready to go.

Perhaps the question shouldn’t be whether financial institutions can navigate the maze of 871(m) compliance, but rather which institutions are going to come out on the other side first, to the benefit of their clients.


Phillip Lynch

Phillip Lynch is the Global Head of Markets, Products & Strategy at SIX Financial Information, where he oversees the development and management of SIX’s product suite. His focus is to enhance the client experience by reshaping the overall product vision and strategy from a customer and market perspective.

Lynch has many years of expertise in the financial information industry from a business, technology, and client perspective. Prior to joining SIX, he was Head of Global Accounts for the Asset Management Division of SunGard. For over five years, he served as CEO for Asset Control, where he doubled the revenue and client base. He was also a Venture Partner at Fidelity Ventures. Before that, Phillip Lynch was the CEO for Reuters America for over five years.

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