Proposed FATCA Regulations: impact on global lending ...
[Pages:9]March 2012
Proposed FATCA Regulations:
impact on global lending transactions
The potential extra-territorial nature of the foreign account rules originally proposed under the US Foreign Account Tax Compliance Act of 2009 ("FATCA"), and enacted under the US Hiring Incentives to Restore Employment Act of 2010, have been of particular interest to non-US financial institutions recently. However, much of the detail of how the rules would operate was uncertain pending publication of proposed regulations by the US Internal Revenue Service ("IRS"). Those regulations were published on 8 February 2012 and provide some additional visibility on how the rules will operate, though many aspects remain unclear.
Among other clarifications and changes, the proposed regulations extend the FATCA grandfathering period, postpone the effective date for withholding on "foreign passthru payments", provide a phase-in period for foreign financial institutions ("FFIs") to become FATCA-compliant and, in certain cases, relax due diligence requirements and expand the class of institutions deemed to be FATCA-compliant.
Additionally, on 8 February 2012 the US Treasury issued a joint statement with the governments of France, Germany, Spain, Italy and the UK stating that these countries have agreed to explore a common approach to FATCA implementation through domestic reporting and information exchange based on existing tax treaties. This intergovernmental approach is intended to address concerns that data protection and other local laws would prohibit FFIs from becoming FATCA-compliant.
New withholding tax
FATCA seeks to encourage FFIs to provide certain information to the IRS by imposing a 30 per cent. withholding tax on certain payments (including both principal and interest) made to FFIs and non-financial foreign entities unless, in the case of a FFI, the recipient enters into an agreement with the IRS ("FFI Agreement") pursuant to which the FFI:
> undertakes to report to the IRS information about its US financial account holders; and
> agrees to withhold on "passthru payments" it makes to "recalcitrant account holders" and FFIs that have not themselves entered into FFI Agreements.
Proposed FATCA Regulations: impact on global lending transactions
Contents
New withholding tax.......... 1 Proposed regulations........ 2
Extended grandfathering of obligations ................. 2 Material modifications ... 2 Passthru payments ....... 2 Meaning of financial account.......................... 4 Deemed-compliant FFIs 4 Compliance changes .... 5 Joint statement ................. 5 Transitional rules for FFI groups unable to comply with FATCA under applicable law ................... 6 Loan agreements: practical implications ....................... 6 Reliance on grandfathering provisions ...................................... 6 Position post grandfathering ? allocation of risk ............ 7 Practical management of FATCA risk.................... 8
1
FATCA withholding may apply not just to payments from US borrowers, but also to payments from borrowers that are themselves FFIs. Payments on loans made to non-US borrowers that are not FFIs are not generally expected to be affected by FATCA.
Proposed regulations
Extended grandfathering of obligations
Before the proposed regulations were published, obligations outstanding on 18 March 2012 were grandfathered and not subject to FATCA withholding. The proposed regulations extend this grandfathering period so that obligations outstanding on 1 January 2013 will not be subject to FATCA withholding.
For this purpose, the term "obligation" means any legal agreement that produces or could produce a payment subject to FATCA withholding. An obligation does not, however, include any legal agreement or instrument that is treated as equity for US tax purposes or any legal agreement that lacks a stated expiration or term, such as a savings deposit or a demand deposit.
It was previously unclear whether borrowings after the grandfathering deadline pursuant to a credit agreement entered into before that date would be subject to FATCA. It is now clear that executed credit agreements (and other debt financing agreements), even if undrawn, should be "obligations" for FATCA withholding purposes. Therefore, any such agreement entered into before 1 January 2013 should be grandfathered under the proposed regulations as should any drawdowns under those agreements after that date, provided the agreement is not modified as discussed below.
Material modifications
It is important to note that grandfathering protection will be lost if a "material modification" of an obligation is made on or after 1 January 2013. In the case of a debt obligation, a material modification is generally one that would constitute a "significant modification" under existing US regulations. In broad terms, changes to maturity, fees and pricing are more likely to be deemed significant modifications than changes to representations or covenants.
However, there is therefore a risk that grandfathered loan agreements could subsequently lose that protection and become subject to FATCA withholding as a result of amendments made on or after 1 January 2013. As a result, amendments on or after 1 January 2013 should be carefully evaluated to determine whether they are likely to result in a significant modification and, if so, it may be necessary to re-negotiate the allocation of FATCA withholding risk as part of such an amendment.
Passthru payments
One of the most significant areas of concern under FATCA has been the concept of passthru payments. Withholding on a passthru payment generally arises where a FFI that has signed a FFI Agreement (a "participating FFI") makes a payment to another FFI which has not entered into such an
Proposed FATCA Regulations: impact on global lending transactions
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agreement and is not otherwise deemed-compliant with, or exempt from, FATCA (a "non-compliant FFI").
In general, there are two types of passthru payments:
> passthru payments of "withholdable payments" (essentially payments by an agent to syndicate banks of interest or principal received from a US borrower). If the agent is a participating FFI, the payment to it by the US borrower would not be subject to withholding, but if a syndicate bank is a FFI which is not a participating FFI, the agent would be required to withhold on the onward payments it makes to that bank; and
> foreign passthru payments. A foreign passthru payment is one that is not a withholdable payment, but is "attributable to a withholdable payment".
Although the proposed regulations specifically state that the IRS will address the concept of foreign passthru payments in later guidance, the IRS has, in prior notices, indicated that a payment made by a FFI would be a passthru payment to the extent of the payor FFI's passthru payment percentage (or "PPP"), which very generally is based on the US assets of the FFI making the payment. However, in the case of a loan to a FFI borrower and a payment where another FFI acts as custodian or paying agent, the rate will generally be determined by reference to the borrower's PPP, not the agent's PPP.
The passthru payment regime means that the risk of withholding under FATCA applies not only to payments made from a US borrower to a noncompliant non-US agent or lender, but also to payments made by a participating FFI borrower to non-US agents or syndicate members if those entities are non-compliant FFIs. It is not necessary that payments be US sourced for the passthru regime to apply.
For example, on a syndicated loan with a participating FFI borrower and a non-compliant FFI agent, the borrower would be required under its FFI Agreement to withhold on payments to the agent. This withholding would be based on the borrower's PPP. So if half of the FFI borrower's assets were US assets, the rate at which the borrower would withhold would be 15 per cent. (i.e., 30 per cent. of 50 per cent.). In this case, the obligation for the borrower to withhold arises not as a result of applicable law, but under the contract between the borrower and the IRS.
Passthru payments are also relevant when the agent is a compliant FFI but the ultimate lender is a non-compliant FFI. For example, on a syndicated loan with a participating FFI borrower, a participating FFI agent and a non-US syndicate of lenders, the borrower would be able to make payments to the agent free of FATCA withholding. However, the agent generally would have to withhold on a portion of the payments it makes to FFIs in the syndicate (unless they are also participating FFIs) because the agent will have agreed to do that in its own FFI Agreement. In this case, the agent would withhold based on the borrower FFI's PPP; so if the borrower had a PPP of 50 per
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cent. the agent would be required to withhold 12 per cent. (30 per cent. of 50 per cent.).
In the preamble to the proposed regulations and various public announcements made on 8 February 2012, the IRS has stated that it received a significant number of comments on the passthru payment regime and is considering further alternatives to relieve the potential burden of this withholding on FFIs. The proposed regulations generally do not address the passthru payment regime, and in the meantime passthru payment withholding remains one of the principal areas of concern for lenders. Further clarification will be welcomed.
The proposed regulations provide that withholding will not be required with respect to foreign passthru payments made before 1 January 2017. Although the issue remains for longer dated loans entered into or modified on or after 1 January 2013 and will develop further when more is known about the alternatives being considered by the IRS, loans maturing before 2017 will not be subject to foreign passthru payment withholding. Unfortunately, because FATCA withholding on US source payments generally begins on 1 January 2014, FFIs will need to have signed up to FFI Agreements before then to avoid this withholding. Accordingly, they may be required to sign up to FFI Agreements without knowing exactly how foreign passthru payments will be dealt with.
Although foreign passthru payment withholding has been deferred until at least 2017, it is important to note that passthru payments of US source interest will be subject to withholding from 1 January 2014. This means nonUS participating-FFI agents on loans to US borrowers will need to be able to establish which, if any, of the syndicate members are non-compliant FFIs in order to determine whether any withholding may be required on payments to those lenders.
Meaning of financial account
The proposed regulations refine the definition of financial accounts that must be reported to the IRS. The definition now focuses on traditional bank, brokerage and money market accounts, and interests in investment vehicles, and excludes most debt and equity securities issued by banks and brokerage firms, subject to an anti-abuse rule. A financial account will generally include an equity or debt interest in a bank only if such interest is not regularly traded on an established securities market and the value of the interest is determined, directly or indirectly, primarily by reference to certain US assets. This narrowing of the definition of financial accounts means that many loans to non-US banks and insurance companies should not be considered financial accounts and information should not be required to be reported to the IRS, although passthru payment withholding may nevertheless apply if the lender is a non-compliant FFI.
Deemed-compliant FFIs
The proposed regulations expand the class of FFIs that are deemed to be compliant FFIs (and therefore exempt from FATCA reporting). The proposed
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regulations provide two types of deemed-compliant FFIs. Some classes of FFI will be "registered" deemed-compliant. These institutions must register to declare their deemed-compliant status and periodically certify that they meet certain procedural requirements. Certain other classes of institution will be "certified" deemed-compliant FFIs. They will not be required to register, but must certify that they meet certain requirements.
A lender that is deemed-compliant will need to identify itself as such to the agent or borrower, but would not be required to comply with the other FATCA obligations (i.e., reporting of financial accounts) in order to receive payments without deduction for FATCA withholding.
Compliance changes
Generally, to avoid withholding a participating FFI is required to report to the IRS information on its US account holders on an annual basis. A US account is a financial account held by a US person or by a non-financial foreign entity that has substantial US owners. The proposed regulations contain a number of helpful changes from a compliance perspective.
To ease the implementation of FATCA, the proposed regulations provide that reporting requirements will come into force in stages. Reporting the identity of holders of US accounts and account details (account number and account balance or value) will commence on 30 September 2014. From 2016, FFIs will be required to report on income paid to holders of US accounts (with respect to the 2015 calendar year). Reporting on gross proceeds will begin in 2017 (with respect to the 2016 calendar year).
Joint statement
Concerns have been expressed that FFIs would find themselves in breach of local data protection legislation if they were to comply with the obligations imposed under their FFI Agreements. In addition, the FFI Agreement is likely to include obligations in addition to information reporting (e.g., closing accounts of recalcitrant account holders) that may give rise to local law conflicts unrelated to data protection.
Contemporaneously with the release of the proposed regulations, the US Treasury issued a joint statement with the governments of France, Germany, Spain, Italy and the UK stating that these countries have agreed to explore a common approach to FATCA implementation through domestic reporting and reciprocal information exchange based on existing tax treaties.
Under this approach, a FFI established in one of those countries would still be required to perform certain due diligence to identify its US accounts. However, information regarding these accounts would then be reported to the authorities in the relevant jurisdiction, which would in turn share the information with the IRS. In exchange, the FFI would not need to comply with certain requirements that would otherwise be necessary to avoid FATCA withholding, including the need for the FFI to enter into a FFI Agreement.
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This approach may avoid the risk of FFIs in those jurisdictions breaching local data protection and other legislation. However, FFIs may still need to consider whether they are subject to any relevant contractual confidentiality obligations or other limitations on their ability to comply with the requirements of the relevant local legislation that will implement the FATCA requirements. In addition, FFIs outside France, Germany, Spain, Italy and the UK still face the issue in respect of both data protection and other legislation. Moreover, it is unclear how the intergovernmental approach would work in practice and there remains some uncertainty whether this approach to FATCA will resolve all of the potential conflicts with local law.
Transitional rules for FFI groups unable to comply with FATCA under applicable law
Under prior guidance, a FFI could not enter into a FFI Agreement unless all of its FFI affiliates did the same. Recognising that some jurisdictions have in place laws that would prohibit a FFI's compliance with certain requirements of its FFI Agreement, the proposed regulations provide that such affiliates have until 1 January 2016 to enter into FFI Agreements themselves. In the meantime, the existence of a FFI affiliate in a jurisdiction that prohibits the reporting or withholding required by FATCA will not prevent the other FFIs within the same expanded affiliated group from being permitted to enter into a FFI Agreement, provided that the FFI in the restrictive jurisdiction agrees to perform due diligence to identify its US accounts, maintain certain records, and meet certain other requirements. Similar rules apply to branches of FFIs that are subject to comparable legal prohibitions on compliance. Generally, for this "limited FFI" rule to apply, local law must prohibit the affiliate or branch from being able to (i) report US accounts to the IRS, (ii) close accounts of recalcitrant holders within a reasonable period of time, (iii) transfer such accounts to an affiliate or other FFI that may so report, or (iv) withhold on or block each such account.
Loan agreements: practical implications
Reliance on grandfathering provisions
The approach that has generally been followed in the European market so far has been not to allocate FATCA risk expressly on the basis that loan agreements entered into before the grandfathering deadline will fall outside the scope of FATCA withholding. The revised grandfathering date of 1 January 2013, combined with delays to aspects of FATCA coming into force (such as the passthru payment regime which does not come into force until 2017), means that this practice may continue, at least in the short term.
The disadvantage of this route from the borrower's perspective is the risk that grandfathering protection may be lost if amendments constituting material modifications are made on or after 1 January 2013. If grandfathering were to be lost, FATCA risk would fall on the borrower under a typical LMA-style tax indemnity.
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In addition, some agents have expressed a concern that they may be exposed to potential liability where loan agreements do not allocate FATCA risk expressly. Borrowers and lenders, rather than agents, determine whether amendments to loan agreements are made. If an amendment were made that resulted in a loan agreement no longer being grandfathered an agent may be required under the terms of its FFI Agreement to withhold on payments made to syndicate members who have not signed such agreements. Since the LMA form of loan agreement does not expressly allow the agent to withhold, those syndicate members may argue that they should be paid gross. To address this, some agents have explored including provisions to the effect that the agent is only bound to agree to changes that would result in the grandfathering protection being lost where provisions designed to address this risk are also included as part of the amendment.
Position post grandfathering ? allocation of risk
The grandfathering provisions only afford protection until 1 January 2013. Therefore, a practice dealing with FATCA risk will need to start to develop during the course of this year.
Under current LMA documentation, FATCA risk essentially falls on the borrower, in that the borrower should be required to gross-up or indemnify the lenders for any FATCA withholding under the general tax provisions of the loan agreement. However, as noted above, the current LMA wording does not cover the possibility that the agent may be required to withhold under FATCA on a passthru payment, and it likely that wording will start to be introduced accordingly. In addition, the LMA transfer provisions limit the amount a transferee lender can claim under the tax gross-up and indemnity provisions to the amount which the transferor lender could claim. Consequently, upon a transfer by a participating FFI to a non-participating FFI, that non-participating FFI may be restricted from obtaining a gross-up for any FATCA withholding that it is subject to. To deal with this (and also to make the allocation of FATCA risk more explicit), specific FATCA provisions may start to be introduced into loan agreements, rather than relying on the general tax provisions.
In this context, some borrowers have argued that they should not bear the cost of a FATCA withholding on the basis that whether the withholding arises is within the control of the lenders. However, the potential for lenders to be in breach of local data protection and other legislation if they do comply with FATCA means that this issue is not as straightforward as it may seem. The IRS has not yet published the form of FFI Agreement, so it is not entirely clear what FFIs will be required to do or exactly where conflicts with domestic legislation will arise. In some cases, this has led to an alternative approach where no gross up obligation is imposed on the borrower, but instead a mandatory prepayment event is triggered if a FATCA withholding arises, although this approach has not been broadly adopted.
The IRS expects to publish a draft form of FFI Agreement in early 2012, with a final form to be available in autumn 2012. This should help FFIs to understand the nature of the obligations that they will be expected to assume.
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In addition, the market position should develop as the IRS explores potential alternatives to passthru withholding and as the governments of France, Germany, Spain, Italy and the UK consider how their jointly announced domestic reporting regimes will operate in practice.
Practical management of FATCA risk
Whilst the allocation of FATCA risk will be an important issue, in practice it is likely that transactions will start to be structured and managed so that FATCA withholding should not arise because, regardless of how FATCA risk is allocated, in most cases it will simply not be commercially feasible for either the borrower or the lenders to be exposed to the cost of a 30 per cent. FATCA withholding.
This approach would also follow the practice for withholding taxes generally and, in particular, bespoke withholding tax rules such as the 10/20 rule in Switzerland. As with those rules, practices will develop, and restrictions will start to be included in loan documents, to minimise FATCA risk. For example:
> for loans where the borrower is not a US entity or a participating FFI, FATCA should not be applicable. If possible, therefore, lenders may seek to include day one representations and on-going undertakings requiring the borrowers to be, and to remain, non-US entities and nonFFIs, and also seek to prohibit the accession of any borrower which is a US entity or FFI without all-lender consent. Even if the borrower is taking FATCA risk, it would be in the interest of all parties to include such provisions to ensure that the financial cost and administrative inconvenience of FATCA does not arise; and
> where the borrower is or could be a US entity or a FFI (such that FATCA withholding could apply), the borrower may seek to control the identity of the lenders and the agent, both on day one and for the term of the facilities, to ensure that they are participating FFIs and therefore that no FATCA withholding should arise. This could be achieved by including restrictions on transfers by lenders to non-participating FFIs, and by requiring lenders to transfer their participations to other lenders if they cease to be participating FFIs, together with related notification requirements. Similar concepts could be used in relation to the facility agent.
Finally, it should be noted that, as a result of the uncertainty that still surrounds the exact scope of FATCA (and FFI Agreements in particular), it is likely that certain interim measures will be included in loan agreements as market practices develop. For example, since FFIs do not yet know whether they will be able to enter into FFI Agreements, it is not yet possible to be sure whether a FFI lender or a FFI acting as agent will be a participating FFI or not. If FATCA risk is to be addressed through controls on the parties to loan agreements, this uncertainly must be borne in mind (e.g., when drafting any representations or undertakings to be given by lenders and agents as to their
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