On August 15, 2012, the International Swaps and Derivatives Association ("ISDA") released a new Protocol relating to the effect on ISDA derivatives of taxes levied by the United States under the Foreign Account Tax Compliance Act ("FATCA"). FATCA was enacted in 2010 as part of the HIRE Act, and it has been the subject of other Jones Day updates.1 The Protocol proposes a standardized set of amendments to the ISDA Master Agreement that can be automatically adopted by a participant in the swap market. If both parties to a given ISDA Master Agreement adhere to the Protocol, the amendments it provides are automatically made to the agreement between them.2 Adherence to the Protocol, however, is unlikely to be universal in the market. If market participants want to amend their ISDA Master Agreements to deal with the application of FATCA to their over-the-counter derivatives trades, they may decide either to adhere to the Protocol, or alternatively, to amend their ISDA Master Agreements on a bilateral basis.3
Relevant FATCA Rules
To recap FATCA itself, these rules require a U.S. withholding
agent, which would include a U.S. counterparty to an ISDA
derivatives transaction, to withhold 30 percent of any U.S. source
payment made to a "foreign financial institution" unless
the institution enters into an agreement with the IRS and satisfies
significant reporting and disclosure requirements. All non-U.S.
banks and swap dealers will be treated as foreign financial
institutions for this purpose, as will many non-U.S. investment
funds (including hedge funds, CDOs, private equity funds, and in
some cases, real estate funds). As a result, beginning in 2014, any
U.S. source payment on an ISDA derivative made to a foreign
financial institution (as defined above) will be subject to a 30
percent U.S. withholding tax unless the financial institution (i)
enters into an agreement with the Internal Revenue Service
("IRS") requiring it to obtain and report information
regarding its U.S. investors and to meet other
requirements4 and (ii) provides the counterparty with a
form W-8BEN attesting to its agreement with the IRS and providing
its FATCA ID number. Where such form is not provided, the swap
counterparty must also withhold on proceeds of a disposition of an
instrument providing for certain U.S. source payments, but this
withholding of proceeds is required only beginning in 2015. All
ISDA derivatives entered into in 2012 and previous years are exempt
from FATCA withholding as "grandfathered" (unless they
are subsequently modified in a manner that causes them to be
treated as new obligations for tax purposes).
Even for derivatives entered into in 2013 and thereafter, only a limited number of derivatives payments will be U.S. source for purposes of the FATCA withholding tax. See, e.g., section 871(m)5 (treating certain equity derivatives payments as U.S. source dividends); Treas. Regs. § 1.446-3(g) (treating a swap with "significant nonperiodic payments" as, in part, a loan).6 The larger dollar impact on ISDA derivatives may be on payments on collateral posted by non-U.S. counterparties to U.S. counterparties. These payments are U.S. source and thus potentially subject to FATCA withholding, if the collateral posted is either cash or securities of U.S. obligors. And, as noted above, proceeds of dispositions of any of these instruments that give rise to U.S. source payments e.g., a termination payment on a derivative or a payment of principal on collateral securities may be subject to 30 percent FATCA withholding beginning in 2015.
Under the IRS agreement a foreign financial institution must enter into with the IRS in order to avoid the withholding tax, it must commit, beginning in 2014, to withhold on U.S. source "pass-through" payments to other foreign financial institutions that are not compliant with FATCA (i.e., that do not enter into and maintain the IRS agreement).7 Technically, it appears that certain derivatives payments (payments on equity derivatives that are recharacterized as U.S. source dividends under section 871(m)) and payments on securities of U.S. obligors posted as collateral will be subject to this rule.8 It is fair to say that not all financial institutions are prepared to collect U.S. withholding tax on payments they make to other non-U.S. counterparties.
The U.S. Treasury has also released a Joint Statement regarding potential bilateral agreements with certain countries to implement and mitigate the above FATCA rules. The countries named were the United Kingdom, Germany, France, Spain, and Italy, but it has been reported that the Treasury has been conducting negotiations aimed at bilateral agreements with other countries, including Switzerland and Japan. As yet, no such agreement has been finalized.9
Turning now to the ISDA Protocol, probably its most important
feature is that the payee will bear the risk of any FATCA
withholding tax. Under the Protocol, where a non-U.S. counterparty
fails either to enter into the above-described IRS agreement or
fails to provide the required documentation to its counterparty,
the 30 percent FATCA tax required to be withheld is not an
"Indemnifiable Tax" for purposes of the ISDA Master
Agreement. This treatment also applies to any taxes levied under
one of the bilateral agreements to implement FATCA that are
described above. Thus, the status of FATCA withholding under ISDA
will be unique; it will be a withholding tax imposed by a major
jurisdiction that will be withheld by the payer and actually borne
by the counterparty, rather than being grossed up by the payer as
an Indemnifiable Tax. The logic of the Protocol appears to be that
a FATCA withholding tax, unlike a general statutory withholding
tax, can be avoided if the payee enters into the IRS agreement and
provides the required documentation to the payer.
The Protocol also defines "Tax" as used in Part 2(a) of the Schedule to the ISDA Master Agreement (Payer Tax Representations) to exclude any FATCA withholding tax. In most Schedules, the payer represents that it is not required to withhold any taxes. Thus, the Protocol provision allows this representation to be made without considering potential FATCA withholding. What is notably absent in the Protocol is any clarification of whether the imposition of a FATCA withholding tax is a "Tax Event" for purposes of section 5 of the ISDA Master Agreement, which would allow the payee a termination right (after reasonable efforts to transfer the contract under section 6 have not succeeded).
Deciding on Adherence
What are the considerations for foreign financial institutions
in deciding whether or not to adhere to the Protocol or to agree to
bilateral amendments to their ISDA Master Agreements? At this
point, although the IRS still has to release the required FATCA
agreement (and no bilateral agreements with foreign governments
have been entered into), there is no reason to expect the procedure
to be a bar to FATCA compliance in most cases. Addressing FATCA is
important whether a foreign financial institution is concerned
about being withheld on by a counterparty or is concerned that it
will be obligated to withhold on a noncompliant foreign financial
institution (under the above rules).
A foreign financial institution may be asked by its counterparty to adhere to the Protocol or to agree to a bilateral amendment to that ISDA Master Agreement so that the counterparty knows whether or not it has to withhold (i.e., to have clarity that a FATCA tax is not an Indemnifiable Tax and that a FATCA tax is not part of the Payer Tax Representations). Whether a foreign financial institution should agree to such a request depends, first, on whether the foreign financial institution intends to become FATCA compliant (i.e., to enter into the IRS agreement and be willing to provide its FATCA ID number to its counterparties). Agreement should depend, second, on whether the foreign financial institution is a party to ISDA Master Agreements with other foreign financial institutions, where it may want the protections with respect to the Indemnifiable Tax definition and Payer Tax Representations in its role as withholding agent (as described above). Another dilemma may be deciding whether or not a foreign financial institution will ever pay or receive a payment that may be subject to FATCA withholding. Since the types of trades and collateral posted may change under an ISDA Master Agreement, a counterparty's status as payer and recipient of FATCA-withholdable payments may change, and this should be considered carefully.
Once a foreign financial institution decides that it will address FATCA in its ISDA Master Agreements, it will need to determine whether it prefers to do so by adhering to the Protocol or by bilateral amendments. There are FATCA provisions that can be added to a bilateral amendment that are not in the Protocol.
Whether a foreign financial institution chooses adherence to the Protocol, bilateral amendments to its ISDA Master Agreements, or no action at all, a foreign financial institution has to consider the impact of FATCA both from its perspective of payee on ISDA derivatives with other counterparties, which may request the foreign institution's adherence to the Protocol, as well as from the perspective of its relationships with other foreign financial institutions, when it will be the payer and withholding agent for potential FATCA tax.
1. See "
Treasury Issues Proposed Regulations on the Information Reporting
and Withholding Tax Provisions of FATCA," Jones
Day White Paper, April 2012; "
New FATCA Proposed Regulations; the System Moves Forward for
Funds," Jones Day Commentary, February
2. The ISDA had previously released two sets of proposed amendments to the ISDA Master Agreement one in November 2011 and one in May 2012 to deal with the issues raised for derivatives by FATCA. The May amendments were very similar in substance to the Protocol. But, as amendments to the ISDA Master Agreement, the earlier proposals would have had to be adopted bilaterally between the counterparties.
3. This Commentary focuses on non-U.S. counterparties who, potentially at least, face withholding under FATCA and need to take this into account for their ISDA agreements. A separate Commentary will focus on the concerns of U.S. counterparties as potential withholding agents under FATCA.
4. The required IRS agreement will obligate the foreign financial institution to (i) obtain information necessary to determine which of its account holders are U.S. persons; (ii) report annually to the IRS the name, Social Security or taxpayer identification number, and investment amount of each of these U.S. holders; and (iii) deduct and withhold 30 percent from any payment it makes either to a U.S. investor or a foreign financial institution that does not itself comply with these provisions. The IRS is expected to release its model agreement very soon.
5. Unless otherwise specified, all references to "sections" are to sections of the Internal Revenue Code of 1986, as amended.
6. Most derivatives payments made to non-U.S. counterparties are foreign source because derivative payments are generally sourced according to the residence of the recipient. See Treas. Regs. § 1.863-7(b) (dealing with notional principal contracts); section 865 (dealing with disposition payments).
7. See endnote 4.
8. Starting in 2017, the amount of payments on ISDA derivative contracts made between non-U.S. financial institutions that could be subject to FATCA withholding could rise dramatically. In the proposed Treasury regulations implementing FATCA, the Treasury has reserved on the definition of "foreign pass-through payments" that are subject to withholding beginning in that year. If the approach of earlier IRS guidance is followed, a portion of each derivatives payment made by a FATCA-compliant foreign financial institution to a noncompliant one would be subject to withholding; the portion would be the same as the portion of the payer's assets that generates U.S. source income. See Notice 2011-34.
9. The Treasury released two model bilateral agreements one imposing obligations on the U.S. government that are reciprocal to those of the foreign government and one not on July 26.
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.