United States: New ISDA Protocol Clarifies FATCA Withholding Responsibilities

Recently, the International Swaps and Derivatives Association, Inc. ("ISDA") published the ISDA 2012 FATCA Protocol (the "Protocol") to specify which party will bear the cost of the withholding tax that will be imposed under the Foreign Account Tax Compliance Act ("FATCA") on derivative transactions governed by ISDA Master Agreements.

Background

FATCA was enacted on March 18, 2010 as part of the Hiring Incentives to Restore Employment Act to assist the IRS in detecting and discouraging tax evasion by US taxpayers holding investments in foreign institutions. FATCA achieves this by imposing a 30% withholding tax on certain US source payments made to foreign financial institutions and non-financial foreign entities and on certain non-US source payments made by foreign financial institutions unless the recipients of such payments comply with FATCA (either under an Intergovernmental Agreement with a FATCA partner country or, if the recipient is not a resident of a FATCA partner country, by directly complying with the FATCA rules) or qualify for an exemption.

Starting in 2014, certain US source payments on derivative transactions will be subject to withholding under FATCA if the recipient does not comply with the FATCA rules. Under the current ISDA Master Agreement, if withholding under FATCA applies, the payor will be required to gross up the recipient for the withheld amount.

The Protocol

The Protocol excludes the FATCA withholding tax from the definition of "Indemnifiable Tax" of the ISDA Master Agreement resulting in the shift of the FATCA withholding tax burden to the recipient. This approach was adopted by the Loan Syndications and Trading Association ("LSTA") in its Model Credit Agreement in which the FATCA withholding tax burden is shifted to lenders by excluding the FATCA withholding tax from the taxes that must be grossed up by borrowers. ISDA explains that "the recipient is the sole party that has the ability to avoid the withholding tax by complying with the FATCA rules; therefore, the recipient should be the party burdened with the FATCA withholding tax if it chooses to not comply."

To adopt the Protocol each Protocol participant must complete and deliver online an adherence letter (which can be found in the Protocol Management section of the ISDA website at http://www2.isda.org/). ISDA reserves the right to designate a cut-off date after which ISDA would not accept any further adherence letters to the Protocol.

Grandfathering of derivatives transactions from FATCA withholding expires at the end of 2012 and transactions executed in 2013 will be subject to FATCA. ISDA strongly encourages parties to adhere to the Protocol as quickly as possible to provide their counterparties comfort in advance of 2013 in order to prevent market disruption due to the FATCA withholding tax.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.