Taxing times: is the market ready for a new tax on US equity derivatives?

clock • 4 min read

From the Big Bang of ‘86 to the dotcom bubble of the early 2000’s, finance, perhaps more than any other industry, is defined by a series of eras. Some eras, have far greater significance than others: who could forget 2007-2008?

But you have to rack your brains to think of another period that has lasted quite as long as the current global battle to stamp out tax evasion. Back in 2010, then president Obama passed a law to ensure all US persons were tax compliant, including those with a tax domicile outside the US. The law, known as the Foreign Account Tax Compliance Act (Fatca), meant all foreign financial institutions had to withhold and report any US-sourced assets held by US individuals. Then, four years later, the Automatic Exchange of Information (AEOI) took the fight against tax evasion global.

Now, the American government is continuing its crackdown by enforcing a 30% withholding tax for non-US investors on dividend payments under derivatives in which the underlying instruments are US equities. This has left firms scrambling to establish the appropriate monitoring, withholding and reporting processes for financial institutions falling under the jurisdiction of this new regulation, more commonly known as 871(m). In effect from 1 January 2018, it applies to situations where the ratio of change in value of the instrument vs. the value of the underlying security is equal or greater than 0.8.

Financial institutions need to have the right processes and systems in place to carry out appropriate calculations and work out which products are affected by the regulation. For investment firms with heavily weighted 871(m) relevant instruments in their portfolios all this adds up to an intricate operational puzzle to solve.

Compliance with 871(m) demands a vast degree of data coverage, research, record-keeping, monitoring, and calculations. To ease reporting and withholding during the phase-in period, the IRS recently raised the delta criteria for affected derivatives to 1.0. Due to the sheer scale and complexity of the task, the IRS will take into account whether a firm has done its best to comply with the combined transaction rule. In 2018, the ruling will be reverted back to the 0.8 delta criteria.

Nevertheless, how exactly should financial institutions go about complying with this latest tax complexity? Clearly, with so much detail to get on top of, firms will need to provide investors with comprehensive and timely information concerning their investment – in the EU, as of 2018 – and also the tax implications. Even before a transaction is carried out, investment managers must be able to tell their clients during the advisory process which instruments fall in-scope of 871(m). Having this level of insight is also key to ensuring that data is shared widely and in a timely manner, and that reporting and withholding requirements are upheld.

Being compliant with 871(m) is, however, just one piece of the puzzle. After all, investors don’t just want to avoid fines; they’re most interested in maximizing their returns. While it may initially seem like a minor and obscure rule amongst a sea of other tax laws, a deluge of detail on the derivatives affected will enable investment managers to detect potential savings and risks. The net beneficiary of this will be clients receiving a better quality of service. As a case in point, Esma (European Securities and Markets Authority) guidelines for the “assessment of knowledge and competence” from 3 January 2017, force advisers to clearly outline the nature of complex products sold to investors. This includes, crucially, the tax implications related to the product in question.

Advisers and investors can access this tax information from 871(m)-related information provided by the major data providers which should empower them to make investing decisions more easily. The savviest firms will be the ones turning the tax compliance to their advantage.

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 the other side first. After all, as soon as these firms meet their obligations and comply with the various tax directives, they will also be able to deliver benefits to their investors and ultimately, live to see the next financial era that isn’t consumed by the drive to eliminate tax evasion.


Phil Lynch is head of Markets, Products, and Strategy at SIX Financial Information