IRS Form 1042-S is used by withholding agents to report income subject to withholding tax paid to foreign persons, including nonresident individuals, partnerships, corporations, and other foreign entities. The form plays a vital role in U.S. withholding tax compliance and reporting. For the 2025 tax year, the IRS has issued updated guidance that specifically addresses payments made to Qualified Derivative Dealers (QDDs). These updates clarify how withholding and reporting obligations apply to QDDs, especially in the context of dividend equivalent payments under Section 871(m).
This blog explores in detail the changes to Form 1042-S reporting involving QDDs, the nature of QDD transactions, key withholding and documentation obligations, and how entities engaged in derivatives trading must now adjust their compliance processes in light of the updated IRS guidance.
What Is IRS Form 1042-S?
Form 1042-S, titled “Foreign Person’s U.S. Source Income Subject to Withholding,” is filed by U.S. withholding agents—including financial institutions, brokers, and corporations—to report various types of U.S.-source payments to nonresident individuals or foreign entities. These payments may include:
- Interest and dividends
- Royalties
- U.S. source services income
- Gross proceeds subject to FIRPTA (real estate transactions)
- Dividend equivalent payments under Section 871(m)
Form 1042-S must also identify the recipient’s chapter 3 and chapter 4 statuses under FATCA and include proper withholding rates, income codes, and exemption codes. The form is filed with the IRS and a copy is furnished to the foreign recipient.
Understanding Qualified Derivative Dealers (QDDs)
A Qualified Derivative Dealer (QDD) is a foreign financial institution that has agreed, as part of its Qualified Intermediary (QI) agreement with the IRS, to act as a principal in equity derivative transactions. QDDs are allowed to avoid withholding on certain U.S. source payments—particularly dividend equivalent amounts under Section 871(m)—when acting in their capacity as dealers.
The concept of QDDs was introduced to streamline the treatment of derivatives and to prevent cascading withholding taxes when a financial intermediary is involved in structured finance or equity derivative arrangements. However, QDDs still have complex responsibilities, especially when receiving or making payments that may give rise to U.S.-source dividend equivalents.
What Changed in 2025: Updated IRS Guidance on QDDs
In 2025, the IRS released updated instructions and clarifications for Form 1042-S reporting specific to QDDs. The revisions primarily address:
- How withholding agents must document QDD status
- Clarification on when QDDs are exempt from withholding on dividend equivalents
- Reinforcement of reporting requirements even when no withholding is applied
- Expanded coding instructions for Box 1 (Income Code) and Box 3a (Chapter 3 Status) to account for QDD-specific entries
The IRS also issued guidance reinforcing that QDDs remain responsible for their own tax liability on payments received in the QDD capacity, even if no tax is withheld. This is to prevent abusive arrangements where dealers improperly avoid tax under the guise of QDD status.
Key Points from the IRS 2025 Update
1. Enhanced Documentation Requirements
Withholding agents must confirm and retain evidence that the recipient is a QDD in good standing under a valid QI agreement. This includes verifying that:
- The recipient has provided a valid Form W-8IMY with QDD status indicated
- The QI agreement is still in effect and covers the type of derivative activity conducted
- Dividend equivalents are clearly identified and separated from other U.S.-source payments
Failure to obtain this documentation may result in the withholding agent being liable for backup withholding, penalties, or interest.
2. Continued Exemption for QDD Payments—but With Limits
The IRS confirmed that QDDs acting in their capacity as dealers are generally exempt from withholding on dividend equivalent payments under Section 871(m). However, this exemption only applies to transactions where the QDD is acting as a principal, not an agent or intermediary for another party. If the QDD is receiving payment in a non-dealer capacity, standard withholding rules apply.
Moreover, the QDD’s exemption does not apply to other U.S.-source income types such as direct dividends or interest not tied to a derivative transaction.
3. Mandatory Reporting of QDD Payments on Form 1042-S
Even when no withholding is applied, QDD-related payments must be reported on Form 1042-S using the appropriate codes:
- Income Code 40: Dividend equivalent payments
- Exemption Code 06: Exempt under income tax treaty or other IRS guidance (in QDD context)
- Chapter 3 Status Code 13: Qualified Derivative Dealer
This ensures that the IRS can track QDD-related payments and ensure accurate self-assessment of any tax due by the QDD itself under its QI agreement.
4. Responsibility for QDD Self-Assessment
QDDs are expected to compute and pay their own liability on dividend equivalents received in the dealer capacity. This responsibility is distinct from the withholding agent’s duty and must be documented in the QDD’s annual reporting, including on Form 1120-F and the QI periodic certification.
QDDs must ensure accurate internal systems for tracking dividend equivalents and may be required to submit a QDD Schedule with their U.S. tax return to disclose the volume and character of such payments.
Practical Considerations for Withholding Agents
Withholding agents involved in equity derivatives or structured finance must take several steps to comply with the 2025 updates:
- Update internal procedures and IRS validation tools to identify QDD recipients
- Train personnel on the appropriate income and status codes related to QDDs
- Retain and validate W-8IMY forms with QDD indicators
- Monitor expiration of QI agreements and re-validate status periodically
- Include all QDD-related payments on Form 1042-S, even if exempt from withholding
Penalties for Noncompliance
Failing to properly report payments to QDDs—or misapplying exemptions—can result in significant penalties, including:
- Failure-to-file penalties: For each incorrect or omitted Form 1042-S
- Failure-to-withhold penalties: For underwithholding on non-qualifying QDD transactions
- Interest charges: On unremitted withholding taxes
- Loss of QI status: If QDDs are found to be noncompliant under their agreement
Conclusion
The 2025 updates to Form 1042-S guidance related to Qualified Derivative Dealers (QDDs) signal the IRS’s commitment to closing gaps in withholding tax enforcement for complex financial instruments. While QDDs continue to benefit from exemptions on dividend equivalents when acting as principals, they—and the withholding agents who pay them—must strictly adhere to updated reporting, documentation, and compliance requirements.
Financial institutions, broker-dealers, and fund administrators should review their derivative transaction protocols and ensure accurate and timely Form 1042-S filings that reflect the IRS’s clarified position on QDD treatment. Early planning, system updates, and proactive documentation will help minimize risk and ensure full compliance in 2025 and beyond.
