SwissBanking
The online magazine of the Swiss Bankers Association
June 21, 2017

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Section 871(m): significantly overshooting the objective

Section 871(m): significantly overshooting the objective

The motto of the US appears to be: more and more regulations, regardless of what their implementation costs others. Now, after QI and FATCA, comes Section 871(m), the next highly complex US regulation for which implementation is likely to cost the Swiss banks additional millions.

The US regulation IRC Section 871(m), hereinafter referred to as Section 871(m), came into force on 1 January 2017. Starting on 1 January 2018, its scope of application is to be further expanded in a second step. Section 871(m) is considered an extremely complex regulation. It requires banks to levy a withholding tax on so-called dividend equivalent payments for certain derivative financial instruments with underlying US equities. This tax is then transferred to the US tax authorities. Particularly impacted by Section 871(m) are banks that operate as issuers or custodians.

Circumstances outside the US not taken into consideration

One of the major challenges of Section 871(m) is that it primarily takes into account US financial market practices without consideration for the circumstances in financial markets outside the US. For example, among other instruments, structured products with a certain share of underlying US equities are within the scope of Section 871(m). In the US, such products are usually not intended for the secondary market, where these financial instruments can be traded freely, but rather only for the primary market. On the primary market, the information required for the proper fulfilment of the requirements flows directly between the issuer and the client. For unlisted products, the issuer generally knows who holds these products and can meet the identification and withholding tax requirements foreseen under Section 871(m) with relative ease.

The Section 871(m) primarily takes into account US financial market practices without consideration for the circumstances in financial markets outside the US.

In Switzerland, however, structured products are traded on the secondary market and therefore represent a mass market business. They are widespread in the retail segment and serve as important investment instruments. Structured products are held for customers by the bank at which they have their custody accounts. As a result of trading on the stock exchange, the holders of structured products change regularly and without the issuer having knowledge thereof. The information necessary for meeting the obligations set out under Section 871(m) is therefore often not available to the issuer. Such information is also not easy to obtain.

Regulation must be amended to facilitate proper implementation

Swiss banks must be able to process the mass market structured products business in a standardised manner. Against this backdrop, Section 871(m) in its present form poses almost unsurmountable hurdles for structured products traded on the secondary market. Proper implementation is practically impossible. The US should therefore be persuaded to amend its regulation, at least to the effect that structured products traded on the secondary market do not come within the scope of Section 871(m), or that the obligations to be met are subject to less stringent conditions.

A solution for the industry: financial infrastructure provider needed

The QI regime and FATCA already impose very far-reaching obligations on banks outside the US, which they must meet to the benefit of the US. But even measured against these regulations, Section 871(m) would appear completely disproportionate. Because of the significant complexity of implementation, many banks would in a first step like to see a viable solution for the industry, particularly as regards reporting. By virtue of its function, the financial infrastructure provider SIX would be predestined for such a solution.