On January 17, the U.S. Internal Revenue Service (the "IRS") released final regulations (the "Final Regulations") under the so-called "FATCA" provisions found in Section 1471 through 1474 of the U.S. Internal Revenue Code (the "Code"). The Final Regulations provide helpful guidance in many respects, but also leave a number of questions unanswered. Our previous March 2, 2012 Client Alert (click HERE to view), addressed how, as a general matter, the implementation of FATCA raises concerns for offshore securitization vehicles such as collateralized loan obligation and collateralized debt obligation issuers (which we refer to collectively in this Client Alert as "CLO issuers"). This Client Alert addresses how the Final Regulations will affect CLO issuers and their managers.
Recap of Issues Raised By Previously Proposed FATCA Regulations
In our prior Client Alert we highlighted several issues in the proposed regulations published February 8, 2012 (the "Proposed Regulations"). The Final Regulations do provide additional guidance and transitional relief but are lacking in some areas.
We previously discussed the joint statement released along with the Proposed Regulations announcing that France, Germany, Italy, Spain and the United Kingdom were working with the U.S. Treasury Department on an intergovernmental approach to FATCA. These initial discussions have led to the intergovernmental agreements discussed below under "Intergovernmental Agreements."
We discussed the limitations on the categories of deemed compliant institutions in the Proposed Regulations and how those limitations offered little relief to CLO issuers. As discussed below under "Rules for Legacy CLO Issuers," the Final Regulations provide additional transitional relief for "limited life debt investment entities." As discussed more fully below, this addition in the Final Regulations likely offers little relief to existing CLO issuers.
We discussed how the Proposed Regulations generally reserved on detailed rules regarding the imposition of FATCA withholding tax on "foreign passthru payments" but provided a delayed effective date for withholding on such payments. As discussed below under "Transitional Guidance on Foreign Passthru Payments," in lieu of providing detailed rules, the Final Regulations continue to reserve on the definition of a "foreign passthru payments." The Final Regulations instead provide special grandfathering rules for obligations that might produce "foreign passthru payments" but are not otherwise subject to FATCA withholding.
Finally, we discussed how the presence of foreign financial institutions in the chain of payments can affect both the withholding and information reporting obligations of CLO issuers. These issues persist in the Final Regulations, as the Final Regulations generally continue to treat a "payee" rather than the beneficial owner as the recipient of a payment, even specifically reserving on how to treat a payment to a clearing organization with fully FATCA compliant membership.1 Although the Final Regulations provide no guidance on how a foreign financial institution can report information with respect any non-certificated debt and equity interests that are "financial accounts" under the Final Regulations, the Final Regulations do provide for an extension of grandfathering, discussed below under "Expansion of Grandfathered Obligations," that may provide relief as non-U.S. clearing organizations determine whether they will comply with FATCA and update their systems and procedures accordingly.
Intergovernmental Agreements
Industry groups and affected organizations had raised concerns that bank secrecy or other privacy requirements under foreign law may prevent a foreign financial institution (an "FFI") from entering into an agreement with the IRS as required by FATCA to avoid withholding under FATCA. In response, the U.S. Treasury Department has begun negotiating and has in fact completed several Intergovernmental Agreements ("IGAs") that will have a significant impact on the manner in which FATCA is implemented by each foreign partner jurisdiction. In general concept, IGAs will tailor FATCA to reflect the reporting regime in a particular country if it has been deemed satisfactory for this purpose.
There are currently two model IGAs. An FFI in a jurisdiction which entered into a "Model 1 IGA" would be deemed to comply with FATCA if it complies with reporting requirements imposed under its relevant local law. The Model 1 IGA provides that information reported to a partner jurisdiction by an FFI is followed by automatic information reporting by the partner jurisdiction to the IRS. There are two versions of the Model 1 IGA, one requiring reciprocal reporting by the United States to the partner jurisdiction and one only requiring reporting from the partner jurisdiction to the IRS. The "reciprocal" Model 1 IGA is only available to jurisdictions with which the United States has an existing tax information exchange agreement.
The "Model 2 IGA," in contrast, requires partner jurisdictions to direct and enable FFIs in that jurisdiction to report information to the IRS unless the IGA otherwise exempts the FFI from FATCA. FFIs in a partner jurisdiction that entered into a Model 2 IGA are subject to withholding under FATCA unless they enter into and comply with an agreement with the IRS directly to report information on their U.S. accounts, except as such obligations are modified by the Model 2 IGA.
The Final Regulations coordinate the application of FATCA with the current or future presence of an IGA. In general, an FFI in a jurisdiction which entered into a Model 1 IGA will not be required to implement the due diligence and reporting procedures in the Final Regulations with respect to U.S. accounts maintained by the FFI or its branches that are covered by the Model 1 IGA in order to avoid being subject to withholding under FATCA. Although an FFI in a jurisdiction which entered into a Model 2 IGA will be required to register with the IRS and agree to comply with FATCA, the Final Regulations specifically provide that any agreement with the IRS entered into by an FFI in a jurisdiction which entered into a Model 2 IGA will incorporate any modifications to the ordinary FATCA reporting and withholding obligations set forth in the IGA.2
The jurisdiction in which a CLO issuer is organized in may therefore have an impact on the FATCA requirements with which such issuer must comply. Most U.S. managed CLO issuers are organized in the Cayman Islands, while foreign managed CLO issuers tend to be organized in Luxembourg, the Netherlands, Ireland, Jersey or, occasionally, in the United Kingdom. The U.S. Treasury Department has finalized IGAs with Ireland and the United Kingdom and has announced that it is close to finalizing IGAs with the Netherlands and Jersey. The U.S. Treasury Department has also announced that it is actively engaged with the Cayman Islands in the process of entering into an IGA and is exploring options for an IGA with Luxembourg. Continual monitoring will be necessary to determine how the jurisdiction of organization of a CLO issuer, and any IGAs entered into by such jurisdiction, will impact the FATCA requirements applicable to such issuer.
Expansion of Grandfathered Obligations
The Final Regulations extend the scope of "obligations" grandfathered under FATCA. Under the statutory provisions, payments with respect to obligations that are outstanding on or before March 18, 2012 were permanently exempt from the FATCA withholding regime. Transitional guidance had extended the grandfathering date to December 31, 2012. The Final Regulations provide that obligations outstanding on or before January 1, 2014 (and not materially modified thereafter) will be permanently exempt from the FATCA withholding regime.3 As was the case under the prior grandfathering rules, certain material modifications to an otherwise grandfathered obligation after 2013 may result in the obligation losing grandfathered status.4 Thus, amendments to loans held by a CLO or debt instruments issued by a CLO issuer could result in FATCA withholding tax problems if the CLO issuer is not a participating or deemed compliant FFI.
While the extension of grandfathering is a welcome change, this is merely a transition rule. With the Final Regulations now in place, CLO issuers and their managers should not rely on further extensions of grandfathering. CLO issuers and managers cannot delay coming to grips with implementing FATCA any longer.
Delay of Withholding on Gross Proceeds
FATCA provides that FFIs that do not agree to comply with FATCA ("nonparticipating FFIs") are subject to withholding on any "withholdable payments" received.5 Withholdable payments generally include any U.S. source interest, dividends, rent or royalties (or other fixed or determinable annual or periodic income) and, for any disposition occurring after December 31, 2016, the gross proceeds from a sale or other disposition of any property of a type which can produce U.S. source interest or dividends.6
Although the delay in imposing FATCA withholding on gross proceeds may be helpful in other contexts, CLO issuers of interests with a final maturity date occurring after December 31, 2016, would, absent FATCA compliance, still be subject to FATCA withholding on the receipt of gross proceeds following the sale of any loans that are not grandfathered.
Transitional Guidance on Foreign Passthru Payments
As described in our prior Client Alert, an FFI that enters into an agreement with the IRS to report information with respect to its U.S. accounts (a "participating FFI") will be required to agree to withhold on "passthru payments" made to recalcitrant account holders and to non participating FFIs. The Final Regulations define a "passthru payment" as "any withholdable payment and any foreign passthru payment."7
Although concerned parties have anxiously awaited the definition of what constitutes a "foreign passthru payment," the Final Regulations provide no additional guidance.8 However, the Final Regulations do provide two transition rules. First, a participating FFI will not be required to withhold on any foreign passthru payment that is paid prior to the later of January 1, 2017 or the date that final regulations defining the term "foreign passthru payment" are published.9 Second, a special grandfathering rule provides that obligations that produce foreign passthru payments, but do not otherwise produce withholdable payments, will be exempt from the FATCA withholding regime if outstanding on or before the date that is six months after the date that final regulations defining the term "foreign passthru payment" are published.10
As discussed in our prior Client Alert, debt or equity interests issued by a CLO issuer constitute a "financial account," and a CLO issuer that is a participating FFI will be required to withhold on payments made on such interests to recalcitrant account holders or nonparticipating FFIs.11 Although the extended grandfathering rules, absent a material modification, will mean that CLO issuers that are participating FFIs will not be required to withhold on payments on classes of interests issued by the CLO issuer that are characterized as debt for U.S. tax purposes and that are outstanding on January 1, 2014, any class of interest characterized as equity for U.S. tax purposes will not be grandfathered and will be subject to FATCA withholding to the extent of any "foreign passthru payments." Ongoing monitoring of regulatory changes will be necessary to determine the scope of a CLO issuer's withholding obligations under FATCA and CLO issuers will need to ensure that operative documents permit and properly allocate any such withholding tax. Because these requirements apply to any participating FFI, absent modification of such requirements by an applicable IGA, the pending requirement to withhold on foreign passthru payments is relevant both to existing CLO issuers and new CLO issuers. In determining whether an existing CLO issuer can become a participating FFI, CLO issuers and their managers will need to determine whether the CLO issuer, the indenture trustee or any other applicable paying agent will be permitted to withhold on account of any applicable FATCA withholding tax under the CLO issuer's operative documents. In addition, CLO issuers and their managers will need to determine whether the CLO issuer's operative documents require the investors in the CLO issuer to deliver such information as may be necessary for the CLO issuer to determine whether any such investors are nonparticipating FFIs or whether, after a period of noncompliance with information requests from the CLO issuer, such investors must be classified as recalcitrant account holders. Amendments to existing CLO issuers' indentures may prove difficult given noteholder consent requirements, but should be reviewed on a case-by-case basis. Passthru payments also should remain of concern to CLO issuers and their managers when structuring new transactions.
In addition, although the grandfathering rules provide transitional guidance on FATCA withholding with respect foreign passthru payments, the grandfathering rules are not specifically incorporated into the diligence and information reporting requirements of a participating FFI. Therefore, because reporting this information may remain a necessary condition for a CLO issuer to become a participating FFI and avoid withholding on its income a CLO issuer's operative documents must be drafted to require, to the greatest extent permitted under applicable law, certifications and information regarding the identity of the owners of debt and equity interests issued by the CLO issuer.
Rules for Legacy CLO Issuers
We noted in our prior Client Alert that, ideally, legacy CLO issuers would be able to revise their operative documents to include FATCA-related provisions, including covenants by investors to provide identifying information, acknowledgment by investors that a failure to provide such information (or, in the case of an investor that is an FFI, a failure to demonstrate that such investor is a participating FFI or otherwise exempt) may result in withholding under FATCA and indemnities or forced sale arrangements to avoid adverse consequences as a result of a breach of these obligations. We noted then that seeking such revisions may be difficult, particularly in the case of CLO issuers that issued multiple classes of interests.
In response to concerns that certain FFI investment vehicles might not be able to comply with the FATCA registration and diligence requirements (including because an applicable operative documents provided the trustee of the vehicle with limited authority), the Final Regulations provide a transition rule for "limited life debt investment entities."12 The Final Regulations provide that a "limited life debt investment entity" will be treated as a "certified deemedcompliant FFI" for periods prior to January 1, 2017.13 Certified deemed-compliant FFIs are deemed to comply with the reporting requirements of FATCA and, unlike the category of "registered deemed-compliant FFIs", are not required to register with the IRS. Rather, a certified deemed compliant FFI need only provide a certification of their status to a payor.
Unfortunately, the category of entities for which relief is available is very narrow. Even if a CLO issuer can qualify for this exception, its limited temporal nature means that legacy CLO issuers will need to find a permanent solution prior to January 1, 2017 or they will become subject to FATCA withholding. In addition, significant limitations apply to CLO issuers hoping to avail themselves of this exception.
Importantly, this relief is limited to CLO issuers that were in existence as of December 31, 2011 and whose "organizational documents require that the [CLO issuer] liquidate on or prior to a set date, and do not permit amendments to the organizational documents . . . without the agreement of all of the [CLO issuer's] investors."14 This limitation highlights the transitional nature of the exception for "limited life debt investment entities," as it will not be applicable to any vehicle not already in existence. Further, the Final Regulations appear to apply this exception only in the case of a CLO issuer that requires unanimous investor consent to make any amendments to its indenture, which in our experience is rare.
The Final Regulations also require that "all payments made to the investors of the [limited life debt investment entity be] cleared through a clearing organization that is a participating FFI, reporting Model 1 FFI, or U.S. financial institution or made through a trustee that is a participating FFI, reporting Model 1 FFI, or U.S. financial institution."15 It is not uncommon for at least some of the most subordinated classes of notes issued by a CLO issuer to be held directly by investors in certificated form, in which case payments are not made not through a clearing organization or trustee but by a third party (which may include the trustee acting in a different capacity) pursuant to a fiscal agency agreement or other similar arrangement.
While it is clear that the IRS and the U.S. Treasury Department intended to provide relief for at least a large segment legacy CLOs that would legitimately have great difficulty complying with the requirements to become a participating FFI, the issues highlighted above and the various other requirements of the exception for "limited life debt investment entities" highlight the difficult issues facing legacy CLO issuers and their managers as a result of FATCA implementation, which are largely unchanged from the Proposed Regulations.
FATCA Agreement Procedure
Although not discussed in the Final Regulations themselves, the preamble to the Final Regulations indicates that the primary method by which an FFI, including a CLO issuer, will interact with the IRS in regards to FATCA compliance will be the "FATCA Registration Portal" (the "Portal"). The IRS expects to have the Portal available for FFIs to register and agree to comply with the reporting and withholding provisions of FATCA (as modified by an applicable IGA) by July 15, 2013. Once an FFI's registration is effective, the IRS will issue the FFI a "Global Intermediary Identification Number" (a "GIIN"). The GIIN will be used by the FFI to identify its status for FATCA purposes to payors.
The IRS anticipates issuing GIINs to registered FFIs beginning no later than October 15, 2013. The IRS anticipates electronically posting a list of registered FFIs (the "IRS FFI List") on December 2, 2013 and updating that list on a monthly basis thereafter. Notably, the preamble to the Final Regulations states that "the last date by which a financial institution can register with the IRS to ensure its inclusion on the December 2013 IRS FFI List is October 25, 2013." Registering through the Portal prior to October 25, 2013 is therefore critical as the Final Regulations generally require payors to verify any claim of status by an FFI (including, for example, that an FFI is a participating FFI or a registered deemed-compliant FFI) against the published IRS FFI List,16 and an FFI payee that delays its registration would be relying on the IRS to continue to publish the IRS FFI List on a timely basis.
Prior to the Portal opening for registration, the U.S. Treasury Department and the IRS expect to publish a Revenue Procedure detailing the terms and conditions applicable to FFIs for FATCA purposes.
Updated FATCA Timeline
2013
June 15, 2013
FATCA Registration Portal opens.
October 25, 2013
Last day for FFIs to register with the IRS and be included on the January IRS FFI List.
2014
January 1, 2014
FATCA withholding on U.S.-source FDAP payments begins.
Obligations that are already outstanding on this date are grandfathered and will not be subject to FATCA withholding. Any obligations issued (including a deemed issuance as a result of a material modification) on or after this date will be subject to FATCA withholding.17
2017
January 1, 2017
FATCA withholding on gross proceeds begins.
Footnotes
1 Treas. Reg. § 1.1471-2(a)(4)(vii).
2 Treas. Reg. § 1.1471-4(a).
3 Treas. Reg. § 1.1471-2(b)(2)(i)(A).
4 Treas. Reg. § 1.1471-2(b)(2)(4).
5 I.R.C. §1471(a). In addition, as discussed more fully below and in our prior Client Alert, in order to enter into an agreement to avoid FATCA withholding, an FFI (other than an FFI in a jurisdiction with a Model 1 IGA) will generally be required to agree to withhold on passthru payments made to recalcitrant account holders and nonparticipating FFIs.
6 Treas. Reg. § 1.1473-1(a).
7 Treas. Reg. § 1.1471-5(h).
8 Treas. Reg. § 1.1471-5(h)(2).
9 Treas. Reg. § 1.1471-4(b)(4).\
10 Treas. Reg. § 1.1473-1(b)(2)(i)(B). The use of the term "obligation" in the grandfathering rules is subject to the same issues addressed in our prior Client Alert. For example, the term "obligation" does not include any instrument that lacks a definitive term or that is equity for tax purposes. In addition, an amendment after that grandfathering date that results in a material modification of the obligation for U.S. tax purposes may result in a deemed exchange for a new obligation that is not grandfathered.
11 Treas. Reg. § 1.1471-4(b).
12 Treas. Reg. § 1.1471-5(f )(2)(iv).
13 Treas. Reg. § 1.1471-5(f )(2).
14 Treas. Reg. § 1.1471-5(f )(2)(iv)(B). 15 Treas. Reg. § 1.1471-5(f )(2)(iv)(D).
16 See Treas. Reg. § 1.1471-3(d)(4)(v).
17 As discussed above, obligations that produce foreign passthru payments, but that do not otherwise produce withholdable payments, will be grandfathered if outstanding on or before the date that is six months after the date on which final regulations define the term "foreign passthru payment."
18 This date may be extended as the final regulations provide that participating FFIs will not be required to withhold on any foreign passthru payments prior to the date regulations defining the term "foreign passthru payment" are published. Treas. Reg. § 1.1471-4(b)(4).
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.
