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FATCA: Risk allocation in the European syndicated loan market


07 March 2012

FATCA withholding risk continues to be a concern for participants in the European syndicated loan market, despite recently issued proposed regulations and a joint statement about an intergovernmental approach to FATCA implementation.  

In this note, we look at how to limit FATCA withholding risk in the context of a European syndicated loan, and possible approaches to allocating that risk.

For more about the proposed regulations and the joint statement, see our recent bulletin "Proposed Regulations Issued Under FATCA".

A brief reminder about FATCA withholding

Broadly, FATCA will impose withholding on certain payments to foreign (i.e. non-U.S.) financial institutions (FFIs) unless they participate in a U.S. reporting and withholding regime (a participating FFI), or qualify for an exemption.

The payments subject to withholding include various U.S. source payments and all "passthru payments". Passthru payment withholding applies to payments made by participating FFIs. Based on current guidance, almost any payment made by a participating FFI which owns U.S. assets to a non-participating FFI could be subject to passthru payment withholding (although this may change when additional guidance is issued).

FATCA withholding risk can therefore arise in relation to a variety of payments made to non-participating FFIs by U.S. entities, non-U.S. entities whose payments have a U.S. source, and participating FFIs.

FFI is very broadly defined and includes banks, building societies, certain funds and SPVs, and other entities holding, investing or trading in financial assets.

Withholding on U.S. source payments starts on 1 January 2014, and withholding on passthru payments starts on 1 January 2017.

When FATCA withholding risk arises in a European syndicated loan

It is a common misconception that FATCA withholding risk arises only in syndicated loan transactions involving U.S. obligors. In fact, FATCA withholding risk can arise in a syndicated loan transaction regardless of the nature of the obligors. This is because current guidance on passthru payment withholding gives it a very broad potential application.

Unusually, FATCA withholding can apply not only to payments by obligors, but also to payments by facility agents, lenders and other finance parties. In addition, its application is not limited to interest payments. It can apply to other types of payment (including principal payments in some circumstances), again because of current guidance on passthru payment withholding. FATCA withholding therefore poses risks for all parties to a syndicated loan transaction.

Whether FATCA withholding risk actually arises in a deal (and the level of risk) depends on a number of factors. As a result, every deal has to be considered on a case by case basis.

Why it is not safe to rely on existing credit agreement provisions

FATCA withholding is simply not contemplated by existing standard credit agreement provisions. As a result, the withholding risk may not be properly allocated on those deals where it arises. Facility agents, lenders and other finance parties may not be entitled to make FATCA withholdings from their payments. Tax gross-ups typically only apply to payments made by obligors and so may not pick up all payments that can be subject to FATCA withholding. Similarly, tax indemnities may not be broad enough to compensate affected finance parties.

At a more practical level, standard credit agreements do not include provisions to facilitate FATCA compliance where appropriate (such as a provision requiring parties to give other parties information about their FATCA status).

Why it may not be safe to rely on grandfathering

The proposed regulations helpfully extended the grandfathering deadline to 1 January 2013, and confirmed that payments under credit agreements entered into before that date generally will be grandfathered.

However, the grandfathering rules continue to have some limitations. Most importantly for the syndicated loan market, grandfathering may be lost if a credit agreement is materially amended on or after the grandfathering deadline.

As a result, there may be problems if a credit agreement entered into before the grandfathering deadline that is affected by FATCA does not address FATCA withholding risk. The most obvious problem is that the parties may simply forget to add FATCA provisions to the credit agreement the first time it is materially amended after the deadline (or may not even realise an amendment is material). Parties may therefore wish to consider including FATCA provisions in affected credit agreements entered into before the grandfathering deadline. Doing so has the added benefit of avoiding discussions about whether amendments made after the deadline are material, and who should bear the costs of negotiating the FATCA provisions.

How to limit FATCA withholding risk

As we have already noted, currently FATCA withholding risk can arise in a syndicated loan transaction regardless of the nature of the obligors. However, there are provisions parties can include in a credit agreement that may be affected by FATCA to limit the risk.

Lenders may want to include provisions to ensure no obligor is a U.S. entity, a non-U.S. entity whose payments are taken to be U.S. source, or an FFI. Alternatively, lenders may want to have the right to require such obligors to resign or to be replaced before any FATCA withholding arises.

Lenders and obligors may want to have the right to replace any facility agent or other administrative finance party that is a non-participating FFI before any FATCA withholding arises.

Obligors may want to have the right to prepay or replace any lender that is a non-participating FFI before any FATCA withholding arises.

All of these provisions may help to limit the risk of FATCA withholding arising.

Allocating FATCA withholding risk in the European market

The approach to allocating FATCA withholding risk in the U.S. market is relatively settled. Typically, the finance parties take the risk. This is reflected in the current model credit agreement provisions published by the Loan Syndications and Trading Association (LSTA) in the U.S.

In contrast, the approach in the European market is not settled. Deals are negotiated on a case by case basis. European lenders are very reluctant to take FATCA withholding risk. This is primarily (but not solely) because of conflicts between FATCA reporting requirements and local laws applying to European lenders. These conflicts (which do not arise for most lenders in the U.S. market) mean European lenders are not certain that they can become participating FFIs. Whilst the recent joint statement about intergovernmental cooperation provides a possible solution, it is no more than a statement of intention at this stage. As a result, the U.S. market approach, as reflected in the LSTA's model provisions, is likely to remain generally unacceptable to lenders in the European market for the time being.

Regardless of how FATCA withholding risk is allocated, it is important to ensure that obligors and finance parties are permitted to make any required FATCA withholdings on affected deals. This is to ensure that no party is in technical default as a result of making a required withholding. In addition, each party should have the right to request information about the FATCA status of any other party to the extent necessary to comply with its FATCA obligations.

If the obligors are to bear FATCA withholding risk, the usual tax gross up will need to be expanded to apply to payments by facility agents, and (if agreed) lenders and other finance parties. Alternatively, the tax indemnity may need to be expanded. If the finance parties are to bear FATCA withholding risk, a provision will need to be included making it clear that the obligors are not required to compensate the finance parties for any withholding whether under the tax gross up, tax indemnity or any other provision. That provision should also make it clear that no finance party is required to gross up any payment or otherwise compensate any other party for any withholding.

Last week, the Loan Market Association (LMA) published a detailed note addressing the impact of FATCA on the European syndicated loan market. In the note, the LMA indicates that it intends to produce some suggested FATCA credit agreement provisions. LMA members can find a copy of the note on the LMA's website.


Circular 230
Circular 230 disclosure: To ensure compliance with requirements imposed by the Internal Revenue Service, we inform you that the U.S. federal tax discussion contained in this note (1) was not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal tax-related penalties under the Internal Revenue Code and (2) was not written to support the promotion or marketing of any transaction. Taxpayers should seek the advice of their own independent tax advisers based on their own particular circumstances.

Please call your usual Allen & Overy contact if you want to discuss any of the matters covered by this note.


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