What are the unintended consequences of 871(m)?

In the third of this three-part article series on the effect of the 871(m), Daniel Carpenter, head of regulation at Meritsoft takes a look at some of the unintended consequences the finance industry may face once the ruling is fully enforced.

Speaking at the Vantage Melbourne rise of AI and automation conference last quarter, Telstra’s head of innovation, Stephen Elop, said that the “path to disruption is paved by unintended consequences.” This sound bite by no means only applies to the world of telecoms, it also relates to financial firms getting their houses in order for the impending 871(m) tax regulations.

Although it’s hard to imagine this looming change to the tax system having quite the same effect as the influence of AI, there will still be unintended consequences. The primary issue is whether 871(m) could reduce market participants interest in U.S equity derivatives products covered by the U.S Internal Revenue Service’s (IRS) rules.

It’s certainly a possibility, as confirmed by a senior tax specialist and Foreign Account Tax Compliance Act (FATCA) practitioner at an ‘871(m) lessons learnt in 2017 and what is around the corner for 2018’ seminar towards the end of last year. With the second part of 871(m) legislation, which is currently being finalised, scheduled to come into force in January 2019, 871(m) legislation is unlikely to be revoked.

But it isn’t as easy as simply deciding not to trade certain derivatives products covered by the 871(m) rules. One head of securities tax at a leading accountancy firm explained that they have found that clients have been unable to switch off U.S securities, in the context of securities lending, even if they wanted to. While firms might try to say that they don’t offer any service in U.S securities, they ultimately will because they’ll receive it in the form of collateral, for example.

Essentially, it’s near impossible to just tail-off U.S products, like an index or a basket of securities where an American company name pops up. While some of our attendees at the event explained how a number of their clients had made a conscious decision to disavow any kind of U.S strategy, they still end up with them. Although you can limit their exposure, you simply can’t exclude them altogether.

One expert revealed that his firm had also had discussions about whether, if you were on the ‘Long’ side, you could just use a U.S broker so that you would never have to withhold (i.e. through a ‘W9 form). However, he rightly pointed out that MiFID II and best execution requirements mean that it couldn’t be done either, aptly stating that “all of the sensible things one might think you could do just don’t work”.

While we should not, by any stretch of the imagination, be expecting the same sort of significant changes AI will bring to the telco industry, when it comes to 871(m), and many other new transaction taxes, we should definitely be considering them in whatever form they materialise, and addressing the potential inadvertent outcomes now is of the utmost importance.