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ISDA Publishes Section 871(m) Protocol

On 2 November 2015, ISDA published the ISDA 2015 Section 871(m) Protocol (the “Protocol”), designed to enable parties to amend the terms of ISDA Master Agreements to reflect the requirements of Section 871(m) of the U.S. Internal Revenue Code.  Broadly, from 1 January 2016, Section 871(m) will impose a 30% withholding tax on “dividend equivalent” payments made to non-US investors in relation to a variety of derivative transactions linked to US equities which have a ‘high delta’ i.e. a delta value of 0.8 or more.

In substance, the Protocol does three things.  Firstly, it carves out “Dividend Equivalent Tax” (i.e. tax imposed on payments treated as dividends from sources within the US under Section 871(m)) from the definition of “Indemnifiable Tax” under the ISDA Master Agreement.  This means that a party (the payor) which is required to withhold in relation to Dividend Equivalent Tax is not required to gross-up the payment due to its counterparty (the payee).  Secondly, the Protocol addresses the possibility that a payor may be required to withhold under Section 871(m) even in circumstances where no payment is being made to the payee or where the amount of any payment being made is less than the amount required to be withheld.  It does this by inserting a new Section 2(d)(iii) into the form of the ISDA Master Agreement to ensure that the payor is not left out of pocket, being compensated by the payee.  Finally, the Protocol amends both payer and payee tax representations in order to clarify that Dividend Equivalent Tax is excluded from the representations which state that no withholding is required.

Section 871(m) involves transitional implementation.  The Protocol deals with this aspect of the new rules by reference to “Prior Section 871(m) Provisions” (i.e. provisions that are intended to address the impact of Section 871(m)).  If an ISDA Master Agreement which is to be amended by the Protocol already contains “Prior Section 871(m) Provisions” (whether by way of adherence to the 2010 HIRE Act Protocol, the 2010 Short Form HIRE Act Protocol, or otherwise), then the “Prior Section 871(m) Provisions” are considered to provide sufficient protection with respect to transactions executed in the period between 1 January 2016 and 1 January 2017.  “Prior Section 871(m) Provisions” will only cease to apply in relation to any transaction executed on or after 1 January 2017 and, at that point, will be replaced by the new provisions of the Protocol.  In contrast, Master agreements which do not include “Prior Section 871(m) Provisions” are amended with respect to any transactions executed on or after 1 January 2016 (the earliest date on which a transaction may be impacted by the new regulations).

As is usually the case, the Protocol is intended for use without negotiation.  The act of adherence is irrevocable, except that an “Adhering Party” may give notice between 1 October and 31 October in any year that, as of 31 December that year, it will not accept any further adherences to the Protocol.  Whilst an excellent tool, the Protocol relies on widespread market adoption which – as a one-size-fits-all solution which may not be appropriate to the needs of all market participants – is not guaranteed.  As such, a significant degree of repapering may still be required.  However, of at least as much concern as the legal effort is the operational challenge.  Section 871(m) will capture many transaction types, including listed options and futures, equity swaps and structured notes.  Obvious difficulties exist regarding the way in which firms will calculate whether a transaction is subject to the rules and, if so, the amount to be withheld.  Two calculation methodologies currently exist – one for simple instruments, which involves a straightforward delta test, and one for complex instruments, pursuant to which it is necessary to assess whether the product is “substantially equivalent” to the underlying shares it references.  This will undoubtedly involve a significant degree of re-plumbing of existing systems in order to facilitate the calculation, capture and reporting of this information at the point of trade execution.  Whichever way you look at it, Section 871(m) is nearly upon us and is going to require a huge compliance effort by many firms.

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