january 2012 analysis - the worldwide reach of fatca reach of facta... 2 summary of the fatca rules...

Stefka Kavaldjieva Senior Associate U.S. Tax, London

Contact Tel +44 (0)20 3088 2663 [email protected]

Stephen Fiamma Partner U.S. Tax, London

Contact Tel +44 (0)20 3088 3657 [email protected]

SPEED READRecent US legislation effectively makes non-US banks and non-US financial institutions, investment funds, and others information gathering agents of the US tax authorities by threatening their own US source income with 30% withholding. The recently released definition of ‘passthru payments’ further expands the universe of non-US financial entities which will need to comply with the new legislation. Capital market participants, investment vehicles and derivatives counterparties will have to do cost-benefit analysis for becoming compliant with the new legislation, and correspondingly engage in a comprehensive review not only of their business operations, but also of their standard documentation.

Recent US legislation is beginning to send ripples through the markets, with non-US banks and governments mounting a push against the law, and capital markets threatening to divest US assets. The Foreign Account Tax Compliance Act (FATCA), part of the Hiring Incentives to Restore Employment Act of 2010 (the HIRE Act), overhauls the US withholding regime. The law effectively makes foreign financial institutions (FFIs) information gathering agents of the US Internal Revenue Service (the IRS) by threatening an FFI’s own US source income with withholding. This new regime is not intended to be a revenue raiser for the US government, but rather to provide a mechanism to identify US investors in FFIs.

www.allenovery.com 1

Analysis - the worldwide reach of FATCA

January 2012

This article was first published in the Tax Journal in July 2011

DP12010012 - DPR177771 Tax Journal FATCA Article (PRINT).indd 1 24/01/2012 16:02


Summary of the FATCA rulesINFORMATION REPORTING AND WITHHOLDING

An FFI will be subject to a new withholding tax of 30% (30% Withholding):

– from 1 January 2014 in respect of US source investment income and ‘passthru payments’; and

– from 1 January 2015 in respect of the gross proceeds from the sale or other disposition of any property of a type which can produce interest or dividends from sources within the United States and ‘passthru payments’.

The effective date for the commencement of withholding have only recently been delayed from the originally scheduled 1 January 2013. The 30% withholding applies to investment income and gross proceeds which the FFI receives either for its own account or with respect to any ‘financial account’ it maintains for others. Investment income in this context means interest, dividends, and other fixed or determinable annual or periodical gains, profits, and income, if such payment is from sources within the United States.

PASSTHRU PAYMENTS

The recently released definition of passthru payments dramatically expands the number of FFIs which will need to comply with FATCA. According to such definition, a portion of any payment made by an FFI will be treated as a passthru payment, and therefore subject to 30% withholding, in proportion to the ratio of the FFI’s US assets to its total assets (the passthru percentage). As most FFIs are likely to hold some US assets, such as US Treasuries or US equities, most FFIs will have a positive passthru percentage. Thus, a passthru payment subject to 30% Withholding need not relate in any direct way to US-source income of the FFI.

The definition of passthru payment is currently so expansive that it would cover not only payments by an FFI on its securities, but also its non-financial payments. For example, the payment of wages by Megabank (an FFI) to cleaners in its Leeds branch by direct debit to the cleaners’ bank account in a local building society would be treated as a passthru payment, subject to 30% withholding, to the extent of Megabank’s passthru percentage, unless the building society is a compliant FFI. This expansive definition of passthru payment is intended by the United States to expand the number of FFIs which become FATCA-compliant to include those which may have little or no direct contact with the United States (eg, the building society in the example above).

FFI

The definition of FFI includes not only banks but also entities engaged primarily in the business of investing, such as hedge funds, private equity funds, and securitisation vehicles. The HIRE Act permits the

US Treasury to designate classes of financial institutions (such as purely local banks) which will not be subject to HIRE Act compliance.


Analysis - the worldwide reach of FATCA - January 2012


FINANCIAL ACCOUNTS

The term financial account includes not only depository accounts, such as savings, current, brokerage and custodial accounts, but also debt or equity interests in an FFI which are not regularly traded on an established securities market.

Thus, equity investments in hedge funds and private equity funds, and non-traded notes issued by securitisation vehicles, are all likely to be financial accounts.

AGREEMENTS WITH THE IRS

The 30% withholding does not apply if the relevant FFI:

– enters into an agreement with the IRS to report certain information in respect of financial accounts maintained by it which are held by US persons (as well as certain non-US entities which have a 10% US owner); or

– complies with prescribed procedures to ensure that the FFI does not maintain any financial accounts held by such persons or entities.

Among other things, the agreement with the IRS will require the FFI to:

– identify which of its financial accounts is a ‘United States account’;

– report information to the IRS concerning, eg, the owner, value, and income of such accounts; and either

– deduct 30% withholding with respect to a financial account if the owner of such account does not co-operate in providing the required information (a recalcitrant account holder); or

– arrange for 30% withholding to occur at source with respect to income and gross proceeds of sale attributable to such recalcitrant account holder.

CONFLICTS WITH NON-US LAWS

If non-US law prevents the reporting of the information required under the HIRE Act, the FFI must attempt to obtain a waiver of such law from the recalcitrant account holder, and if a waiver is not obtained within a reasonable period of time, the FFI must close such account. Many non-US laws will prevent an FFI from closing a customer’s account in these circumstances. Further, in the case of an ‘account’ which is an investment in, say, a private equity fund, it is unlikely that existing fund documentation will permit the forced redemption of an investor’s interest for

this reason alone. It is unclear whether an FFI will be in breach of its agreement with the IRS if non-US law or fund agreements prohibit it from closing the account.



CHAINS OF FFIS

US source payments made via a series of FFIs will oblige each FFI in the chain to comply with these rules to avoid the imposition of the 30% withholding. Given the inability of the final recipient of a withholdable payment to monitor

or control the compliance of an entire chain of financial intermediaries, in the absence of further guidance from the US Treasury, the HIRE Act rules introduce significant tax risk in such circumstances.

Principal categories of taxpayers affected by the HIRE ActCAPITAL MARKETS PARTICIPANTS

In the case of US issuers, 30% withholding will be imposed on payments of dividends and interest on their securities if the FFIs to, or through, which payments are made do not comply with the reporting requirements of FATCA. A major concern relates to the risk that FATCA imposes on investors, ie, that they may suffer withholding due to an intermediary’s failure to comply. For example, in a chain of FFIs (as is often present in a capital market transaction), if one intermediary is non-compliant it could trigger 30% withholding irrespective of the status of the

other FFIs in the chain or that of the ultimate holder. Until the US authorities publish Treasury Regulations, it remains unclear how this risk will be allocated among issuers, financial intermediaries and investors. Market practice is starting to develop whereby such risk is allocated to investors. Once a definitive position is established by market practice, consistent changes will need to be made to standard form documentation, most probably through additional risk factors and carve-outs to tax gross-up provisions.

INVESTMENT VEHICLES

As previously mentioned, institutions caught by FATCA include a wide range of investment entities, including funds and securitisation vehicles. Many which have no direct US investments will nevertheless need to be concerned about FATCA compliance. For example, a private equity fund with a deposit account with Megabank will be subject to FATCA reporting, and possible 30% withholding, on payments received on its deposit account which are treated as passthru payments (based

on Megabank’s passthru percentage). Unless the fund can certify that it is a compliant FFI, it will be subject to 30% withholding.

The ability of existing investment vehicles to comply with FATCA will often depend on the cooperation of their investors, who, in the absence of specific relief in Treasury Regulations, will generally be regarded as financial account holders. Not all investors will be willing voluntarily to provide the investment vehicle with the relevant information and any necessary certifications




of non-US status. The relevant fund agreements and disclosures will therefore need to be reviewed and amended to address this with respect both to existing and future investors.

Some investment vehicles will find it difficult even to attempt to comply. Many, such as securitisation vehicles, are special purpose entities set up without an independent operations function. In addition, such vehicles would generally not be able to allocate the cost of any withholding to the recalcitrant investors which may have triggered the withholding in the first place.

DERIVATIVES

The current definition of passthru payment is so broad as to include payments on derivatives. This would mean that payments on a foreign exchange swap, for example, between Megabank and a small Swiss bank would be

treated as a passthru payment, subject to 30% Withholding, on the amount attributable to Megabank’s US assets, unless the small Swiss bank is a compliant FFI.



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© Allen & Overy LLP 2012. This document is for general guidance only and does not constitute definitive advice. | DP12010012


january 2012 analysis - the worldwide reach of fatca reach of facta... 2 summary of the fatca rules...

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