Qualified Intermediaries and “Dividend Equivalent” Withholding: IRS Publishes New Proposed QI Agreement, Providing New Details on the “Qualified Derivatives Dealer” Program

Sullivan & Cromwell LLP - July 19, 2016

The IRS recently released a new draft “qualified intermediary” (“QI”) agreement (the “Proposed QI Agreement”) in Notice 2016-42 (the “Notice”).  All existing QI agreements expire on December 31, 2016.  The Proposed QI Agreement is accordingly proposed to be effective starting on January 1, 2017.
Among other modifications, the Proposed QI Agreement implements the “qualified derivatives dealer” (“QDD”) regime that is designed to mitigate “cascading withholding tax” with respect to transactions that are subject to withholding under Section 871(m).  Noteworthy features of the Proposed QI Agreement’s treatment of QDDs include the following:

  • An entity will only be eligible for QDD status if it is a QI that is: (i) a bank, (ii) a subsidiary of a bank or (iii) a dealer, in each case that satisfies the requirements described below.  Bank holding companies and subsidiaries of broker-dealers will not be eligible to be QDDs under the Proposed QI Agreement.
  • The Notice extends the QDD exemption from Section 871 withholding tax to all dividends and dividend equivalents that a QDD receives in a principal capacity, even if a QDD does not receive ‎such amounts in a dealer capacity.
  • A QDD will, however, be required to self-assess Section 871 tax with respect to dividends and dividend equivalents that it receives in a principal capacity to the extent such amounts exceed the dividend equivalent payments (and comparable amounts paid to U.S. persons) that the QDD makes with respect to offsetting positions in a dealer capacity. 
  • The Proposed QI Agreement does not incorporate the “credit forward” regime that, as discussed below, is currently in effect with respect to cascading substitute payments under securities loans.  Accordingly, the “credit forward” approach will likely not be available after 2016 to mitigate cascading withholding unless the government issues additional guidance in the interim to the contrary.
In addition to the above, the Proposed QI Agreement makes various amendments to the current QI agreement, including a new provision that allows QIs to be “withholding QIs” in respect of substitute interest payments and changes to the compliance and certification requirements that QIs must satisfy.