October left us with a few tax treats, or perhaps tricks. As we have discussed in a recent blog, the IRS issued final regulations on broker withholding rules for sales of publicly traded partnership (PTP) interests. Legislators and industry representatives in New Jersey argued over a possible financial transactions tax in the state. And, in the nature of interim guidance, the IRS has provided relief for the adoption of certain fallback language related to the planned cessation of USD LIBOR. It has also provided clarification on a Form 1040 crypto tax question and draft Form 1042-S instructions for 2021, highlighting a reporting change that will need to be processed by broker withholding and reporting systems.
- What do the new publicly traded partnership withholding regulations mean for brokers?
- To make up for revenue shortfalls, New Jersey has been considering a financial transactions tax, and this may not be the last we hear about Financial Transaction Taxes (FTTs).
- IRS provides some interim updates on IBOR transition, the crypto tax question on the 2020 individual tax return form, and an exemption code change for 2021 Form 1042-S filings.
1. Final broker withholding regulations on PTP sales
For brokers, one of the big tax developments for October is the issuance by the IRS of final regulations under section 1446(f) of the Internal Revenue Code. Under the final regulations, section 1446(f) will generally require brokers to withhold at the rate of 10% on the amount realized on the sale of PTP interests by a non-U.S. account holder. The rules can also apply to transactions involving other brokers and thus will require proper documentation of broker counterparties as well as broker customers.
Unlike Form 1099-B reporting and backup withholding, there is no exception for delivery versus payment (DVP) transactions. Thus, industry participants fear that there could be increased potential for failed trades if withholding occurs.
There are new tax due diligence rules to determine which account holders and broker counterparties are subject to withholding under section 1446(f). Special rules, in particular, apply to intermediaries and foreign partnerships receiving payment. Non-qualified intermediaries will generally be subject to tax, and qualified intermediaries (QIs) can present the broker with one of several withholding possibilities at the QI’s election.
Moreover, the rules treat certain distributions from PTPs as deemed transfers subject to section 1446(f) withholding.
Exceptions to withholding are contained in the rules, including a provision that provides for exemption where the PTP certifies in a qualified notice that any effectively connected gain would be below 10% of total gain. The withholding rules are accompanied by their own set of reporting peculiarities.
The final regulations follow largely the framework of proposed regulations issued last year, and a number of requests from industry participants were not incorporated. These new tax developments will require substantial changes to broker due diligence, withholding and reporting systems.
The final regulations on PTP transfers are effective 1 January 2022. This means there is only about a year to design, test and implement new systems and procedures to accommodate section 1446(f) withholding on PTP trades.
2. New Jersey financial transactions tax
In October, tax developments discussions continued in New Jersey concerning a possible state-level financial transactions tax. The tax was originally proposed to be a flat rate tax of $0.0025 (quarter of a cent) on financial trades processed within New Jersey. The proposal was apparently later reduced to a hundredth of a cent tax, to be applied on each instrument (e.g., share) traded.
The NYSE and Nasdaq exchanges, which have data operations in New Jersey, were against the tax and threatened to move its data processing operations out of New Jersey if the tax were enacted.
On the legislators’ side, the state is eyeing the transactions tax with interest as a means to offset some of the revenue shortfall for the year. The tax was proposed to apply for a temporary two-year period.
Developments on this proposal should be monitored. Also, given the budget considerations across a number of states and nationally, this may not be the last time we hear of financial transactions taxes.
3. Crypto tax developments
At the end of September, the Treasury Inspector General for Tax Administration (TIGTA) released a report looking at IRS crypto tax enforcement and pointed out the lack of sufficient third-party information reporting in the area.
Issuing tax information reporting regulations continues to be a project on the IRS priority plan, and thus the IRS is in agreement with TIGTA in this respect. We should at some point be expecting regulations relating to Form 1099-B reporting for virtual currency sales.
However, with the increasing discussion and development of decentralized financing (DeFi) crypto platforms, it will be interesting to see if tax reporting regulations can catch up to the rapidly evolving technology. In the past, tax information reporting has relied on financial institutions that served as centralized intermediaries. DeFi platforms are premised on the idea of decentralized transactions that may not have such intermediaries.
The IRS continues also to emphasize the need for taxpayer compliance directly on the individual tax return form. It recently issued draft instructions for the 2020 Form 1040 tax return that clarified that the taxpayers did not need to indicate they have engaged in virtual currency transactions if they are only holding of virtual currency in a wallet or transferring virtual currency from an account they own or control to another that they own or control.
As we have previously noted, the 2020 Form 1040 is expected to have moved its question asking taxpayers whether they have received, sold, sent, exchanged, or otherwise acquired virtual currencies to the front page. The instructions are still not entirely clear if the question should be answered “yes” if a taxpayer has only purchased virtual currency during the year and has not disposed of any. Presumably that would not trigger a taxable transaction, but the question is broadly worded.
4. IRS relief for IBOR transition provisions
With USD LIBOR scheduled to be retired at end of 2021, industry participants in both the debt and derivatives market have been concerned about implications to existing contracts that undergo a modification of terms to allow for a fallback to a new reference rate.
In October 2019 tax developments, the IRS had issued proposed regulations in this area. But the Alternative Reference Rates Committee (ARRC), the group convened by the Federal Reserve Board and the New York Fed to assist in the transition from USD LIBOR, had requested more specific interim guidance.
Rev. Proc. 2020-44 issued in October 2020 provides interim guidance on additions/modifications to existing debt and derivative instruments relating to cessation of USD LIBOR.
The revenue procedure generally treats adoption of fallback language recommended by the ARRC and the International Swaps and Derivatives Association (ISDA) as not causing a deemed sale or exchange.
In addition, the revenue procedure would treat such modifications as not causing a “legging out” or termination of certain integrated transactions and hedges.
From a tax perspective, the relief would mean that adoption of such standard fallback provisions would present less risk of deemed sale events that could impact cost basis calculations.
5. New changes proposed for 2021 Form 1042-S
In further tax developments, draft instructions for the 2021 Form 1042-S was released in October. While this is the form for tax year 2021 to be filed in early 2022, it contains a change to an exemption code that brokers may wish to capture in their withholding and reporting systems during 2021.
The draft form indicates that there will be a new Chapter 3 exemption code: Code 24 – exempt under section 892. Section 892 of the Internal Revenue Code provides an exemption to certain payments to foreign governments and international organizations.
Due to the new code, brokers and other withholding agents will need to distinguish withholding exemptions provided to foreign government and international organizations separate from exemptions provided for other statutory reasons. For certain brokers, this may be easier to accomplish at the time of withholding during 2021 when payments are being made. Thus, some consideration of systems updates necessary to produce the new reporting code should be given well before the 2022 reporting season.
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