By Daniel Carpenter, Head of Regulation at Meritsoft
The latest derivatives headache of getting taxed on the implied dividends embedded in the proceeds you may or may not receive, the foundation of the hotly debated 871(m), is just one aspect of an increasingly perplexing transaction tax system that needs to be managed.
Cue QDD – a new set of requirements for dealers and banks that want to become Qualified Derivatives Dealers (QDD) to facilitate prevention of cascading of withholding tax. 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 pay net of tax.
Sounds great, but this QDD status means that the company must perform a self-assessment of what tax it must pay to the IRS. This may result in assessing hundreds or thousands of U.S. related derivative contracts and 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.
Handily, the IRS recognised the potential complexity involved here and granted a concession that firms can use risk system reporting to understand if their implied dividends on derivative 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. Sounds reasonably straightforward!
However, his is where things start to get more complicated. The QDD regime acts so that, in return for complying with the requirements of the regime, you receive 100% of the dividend and can pass it on to other QDD’s at that rate. Although when you are paying to a non QDD, that party is taxed based on 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 pretty clear that attempting to do this without automation leads to a plethora of problems.
Similarly, the regime 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, QDD being delayed is not stopping firms from looking for solutions now. After all, every bank needs 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 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. The point is that those who continue to paper over the cracks, instead of looking for a long-term solution, run the risk of big fines and ultimately, reputational damage. On the flip side, those that find a way not only to keep the relevant authorities happy, but also to help drive efficiency savings, will be best placed to navigate themselves through these taxing times.