Section 871(m) amendment - ISDA Provision
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Section 871(m) of the Internal Revenue Code clamps down on dirty foreigners avoiding withholding tax for dividends on US equities. Previously, US dividend withholding did not apply to returns on notional principal contracts and instruments linked to underlying US equities.
That’s all changed now.
The new regulations will establish up to a 30% withholding tax on foreign investors on dividend-equivalent payments under equity derivatives. There are a wide range of products that fall into this camp including swaps, options, futures, convertible debt, structured notes and other customised derivative where the ...
Beware of Greeks
... delta (see what I did there?) against the underlying stock is .08 or greater.
Delta
A delta of 1 gives a one-for-one correlation with the return of the underlying. A delta of -1 does the exact opposite of what the underlier is doing: If underlier goes up, swap necessarily goes down by the same amount. A delta of 0 means the return on the two products is completely unconnected.
The calculation is cumulative so even if the delta threshold isn’t met in one transaction, it may be as a result a connected transaction.
It applies from 1 January 2017.
So does that mean I can bin all this hypothetical broker-dealer nonsense?
There’s no bright line test, obviously.
What “hypothetical broker-dealer nonsense”?
In some jurisdictions, derivatives are taxed differently — more favourably — than cash equities (for example stamp duty reserve tax, and in the US, for certain types of underlier, under 871(m)) so it is important that your synthetic position doesn’t look like a tax play. Tax attorneys — especially American ones — fret mightily that high-delta equity derivatives do.
One of the key indicators, they intuit, is the degree to which the contract permits a swap counterparty influence or control its prime broker’s hedge. A swap counterparty should care not one whit about its broker’s hedge — other than its cost. If it does takes an unhealthy interest, the swap position may be — dramatic look gopher — recharacterised as a disguised custody arrangement of shares the swap counterparty has in reality bought, and on which it should pay tax, stamp duty and so on. Depending on which tax specialist you ask, an “unhealthy interest” might extend even to the execution price the broker-dealer achieves on its hedge. (This seems potty to us, by the way, but such is the interior world of the US tax attorney). US tax attorneys are greatly calmed by the suggestion that a hedge execution price is imaginary, and not real, even though it happens to be identical to the real one. Thus, you will see much chatter about prices a “hypothetical broker-dealer” might achieve selling fungible securities, and volume-weighted average prices and so on.
What is a hypothetical broker-dealer anyway?
So who, why, which or what is this much-talked-about, seldom-seen “hypothetical broker-dealer”?
Well, it’s an investment banker’s imaginary friend. A fellow just like the actual broker-dealer — in the same jurisdiction, having the same taxation status, earning the same income, executing the same hedge transactions, eating at the same restaurants, having the same GSOH and watching the same stuff on Netflix — but not the actual broker-dealer. He’s like actual broker-dealer’s “sober me”, only he gets drunk too. Now this might strike you, as it strikes the JC, as just too cute – too much of a playground argument to hold water. (“I didn’t break the window, sir, honest, sir, it was a boy who looked exactly like me who arrived from out of nowhere and is gone now”). But US tax attorneys seem to be taken in by it, even if they won’t buy arguments on actual economic substance.
But do synthetic equity swaps resemble disguised custody arrangements?
Um — no. About the economic substance: synthetic equity swaps don’t resemble disguised custody arrangements at all:
- (i) a prime broker will hedge delta-one across its whole client portfolio — some of which will be short, and some long — so there is no one-to-one relationship between each client’s long position and the prime broker’s net physical hedge in the first place — that is to say, there is no assurance that the prime broker is holding anything in custody at any time; and
- (ii) even if there were, the prime broker will almost certainly finance the net long portion of its delta anyway, to reduce its funding costs, by lending it out, title transfer, for cash, so even if the prime broker has a corresponding exposure, it won’t be hedging it with holding a physical hedge at all, let alone one it is covertly holding on custody for its clients.
But US tax attorneys wilfully ignore all this dispiriting logical talk and insist the only thing that can save you are some magic words about you hedge costs being incurred by a hypothetical broker dealer exactly like you, but who isn’t you.
Okay. So ...?
Since 871(m) means that WHT is now applied on high-delta equity derivatives in the same way it applies to physical cash trades, the recharacterisation risk is surely less fraught now, isn’t it? do we really care whether the counterparty controls the hedge? Can we therefore get rid of that tiresome “hypothetical broker-dealer” language, which so mightily confuses many counterparties, and just reference the actual hedge liquidation price as the closing price of the derivative?
No, because 871(m) does not apply to all underliers that might feature in a synthetic equity transaction. and also because there are WHT and stamp duty regimes in other jurisdictions (SDRT on UK equities for example) where a derivative acheives preferential tax treatment over a cash equity trade.
But you’re right: the hypothetical broker-dealer business is ridiculous.