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The run-off from the global financial crisis saw any amount of regulatory weight-throwing-arounding — any pretence any regulator had to subscribe to Ronald Reagan’s idea that the government was the problem was well and truly jettisoned — and none more so than in the world of taxation. There was FATCA, of course, and then the HIRE Act, which didn’t seem to have anything much to do with equity derivatives, but sure as hell made itself have something to do with them, and then an amendment to Section 871(m) of the Internal Revenue Code.
What are these things, what to they do, and how are they related to each other?
Section 871(m) is part of the HIRE Act
Before Section 871(m) of the Internal Revenue Code was enacted, non-resident investors in US equities suffered 30% withholding on US-source taxable income — dividends, in other words. This was in practice mediated by double tax treaties in may jurisdictions, but that is the principle, and it remains the case. However previously, US dividend withholding did not apply to returns on notional principal contracts and instruments linked to underlying US equities. Equity derivatives, for example. It was therefore more efficient to invest in US equities through contracts for difference and equity swaps. You will never guess what tax-savvy offshore investors therefore tended to do.
Yes! You’re right! They invested in swaps all the time!
The HIRE Act, by amending Section 871(m) of the Inland Revenue Code, clamps down on naughty foreigners avoiding withholding tax for dividends on US equities and provides that everyone gets taxed at the same rate.
What counts as an in-scope equity derivative?
The thing about derivatives is they can easily be “funked up”. This was great fun in 2005 but honestly, in this day and age, they tend not to so much. It is all very formulaic and pass-through. But you can imagine naughty Johnny Foreigner making some tiny little, formalistic, funky change to a swap payoff and claiming it is no longer a derivative of a US equity.
US tax people are cleverer than that and decreed an option delta of more than 80% counts as an in-scope equity derivative. There are a wide range of products that fall into this camp including swaps, options, futures, convertible debt, structured notes and other customised derivatives — as long as the delta against the underlying stock is .08 or greater.
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. (Foiled, tricksy foreigners!)
There is an ISDA-sponsored Hire Act Protocol you can sign up to, and a standardised amendment to Section 2(d) of the ISDA to take account of the Hire Act and make sure all your reporting is right.