On February 8, 2012, the IRS released proposed regulations1 on the Foreign Account Tax Compliance Act ("FATCA"), which was enacted in 2010.2 FATCA imposes obligations on U.S. taxpayers and withholding agents, as well as certain foreign entities. Under the FATCA regime, U.S. taxpayers that hold foreign financial assets with an aggregate value of more than $50,000 will have to file a disclosure on Form 8938 with the IRS. Moreover, certain foreign financial institutions ("FFIs") will have to enter into an agreement with the IRS under which they will take on reporting and withholding obligations.
If an FFI is required to enter into an agreement with the IRS, it must do so prior to July 1, 2013 in order to avoid withholding on U.S.-source payments made in 2014 and thereafter, and must report information with respect to U.S. holders of accounts beginning in 2014.
FFIs for FATCA purposes include both foreign banks and
investment vehicles such as hedge funds, private equity funds,
CLOs, and CDOs. It is likely that these entities will meet the
definition of an FFI despite some exceptions provided by the new
proposed regulations that are discussed below. As a result,
beginning in 2014, any U.S.-source payment made to an FFI on its
assets—such as a payment of interest or original issue
discount ("OID") on a U.S. debt obligation—will
be subject to this 30 percent U.S. withholding tax unless the FFI
enters into an agreement with the IRS. Withholding on gross
proceeds of a sale or other disposition of these assets by an FFI
is required starting in 2015.
No withholding is required on payments on obligations entered into
before the FATCA regime's effectiveness. Perhaps the best news
in the proposed regulations is the extension of such
"grandfathered" treatment to U.S. obligations entered
into prior to January 1, 2013 (previously this was March 18, 2012).
This means that a payment made to an FFI on an instrument entered
into in 2012 will never be subject to withholding under the FATCA
rules. The only qualification is that if the instrument is
subsequently modified in a manner that causes it to be treated as a
new instrument for tax purposes, the grandfathered treatment is
lost.3 The proposed regulations also provide a helpful
clarification that payments on a derivative transaction entered
into under an ISDA Master Agreement in 2012 or earlier are
similarly grandfathered. In preparation for 2013, some parties have
started to add FATCA provisions to their ISDA Master Agreements.
Additionally, ISDA may publish a FATCA Protocol to address these
requirements.
The required IRS agreement will obligate the FFI, among other
things, to (i) obtain information necessary to determine which of
the holders of its accounts or securities (including equity and
debt) are U.S. persons, (ii) report annually to the IRS the name,
Social Security number, or taxpayer identification number
("TIN"), and investment amount of each of these U.S.
investors, and (iii) deduct and withhold 30 percent from any
payment it makes either to U.S. investors or other FFIs that do not
themselves comply with these provisions.
The proposed regulations reduce somewhat the amount of information
that an FFI must report with respect to U.S. investors under the
IRS agreement. For tax years 2014 and 2015 (i.e., reporting with
respect to the 2013 and 2014 years), what must be reported is the
U.S. investor's name, address, TIN, account number, and account
balance. Starting in 2016 (with respect to the 2015 year), all of
the statutory reporting requirements, including the income
allocable to the U.S. investor from the FFI, become applicable. For
determining who are the U.S. investors, the proposed regulations
contain favorable rules as to the "due diligence"
required by the FFI. For example, for existing accounts of
individuals with a balance of $1 million or less, the FFI needs to
review only electronically searchable data in order to find
evidence of U.S. status. Existing accounts of entities with a
balance of $250,000 or less are entirely exempt from review until
the account balance exceeds $1 million, and above that, the FFI can
generally rely on anti-money-laundering/know-your-customer
("AML/KYC") records and other existing account
information for U.S. status. Although the rules for new accounts
are more complex, the ability generally to rely on data already
obtained by the FFI, including AML/KYC data, was a pleasant
surprise to many tax practitioners.
Some relief is provided with respect to other deadlines as well.
An FFI is required to withhold 30 percent on U.S.-source payments
made to investors in two situations: (i) when an investor is
determined to be a U.S. investor but refuses to give the FFI the
required information, and (ii) when the investor is another FFI
that has not entered into the required agreement with the IRS. With
respect to U.S.-source amounts that the FFI pays to such investors,
such as interest and OID on U.S. obligations, the withholding
obligation starts on January 1, 2014 (and January 1, 2015 with
respect to payments of gross proceeds). With respect to other
"pass-through" payments—indirect U.S.-source
payments to the investor resulting from the FFI's investment in
other entities—the proposed regulations defer the
withholding obligation until January 1, 2017. (This deferral comes
as a relief to many FFIs because earlier IRS announcements had
indicated that the withholding amount would be determined on a
straight percentage basis according to the FFI's U.S. assets,
direct and indirect.) The FFI must make an annual report to the IRS
of the payments withheld.
Many in the investment fund community hoped that the proposed
regulations might exclude certain types of non-U.S. funds entirely
from the FATCA rules. Unfortunately, this turned out not to be the
case. There are two exceptions that relate to non-U.S. funds. These
exceptions have different requirements, but for each of them, the
fund must be regulated as an investment fund in its country of
organization. Thus, for many, if not most, non-U.S. funds, the
FATCA rules above will be fully applicable, with the proposed
regulations providing help only on the deadlines and other matters
above.
Public comments on the proposed regulations may be submitted until
April 30, 2012, and a hearing is scheduled for May 15, 2012. It
seems unlikely that there will be major changes when the
regulations are issued in final form, including with respect to the
deadlines. Nevertheless, the market will know for sure only when
the final regulations are published.
For a more detailed analysis of FATCA, please see our White
Paper: "Treasury Issues Proposed Regulations on the
Information Reporting and Withholding Tax Provisions of
FATCA," available
here.
Footnotes
1. Proposed Treasury Regulations § 1.1471-1 et seq.
2. Internal Revenue Code §§ 1471-1474, added by the Hiring Incentives to Restore Employment ("HIRE") Act of 2010, P.L. 111-147.
3. See Treas. Regs. § 1.1001-3.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.