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Update on FATCA (May 2013)

14 May 2013

As reported in several recent Risk Notes, there is continuing concern about the introduction of the U.S. Foreign Account Tax Compliance Act (FATCA). FATCA added a new component to the U.S. tax withholding and information reporting regime.

The law effectively makes foreign financial institutions (FFIs) information gathering and withholding agents of the U.S. Internal Revenue Service (the IRS) by threatening an FFI's own U.S. source income and gross proceeds of sale of U.S. securities with a 30% withholding tax (30% Withholding). 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 U.S. persons (as well as certain non-U.S. entities which have a 10% U.S. owner), or complies with prescribed procedures to ensure that the FFI does not maintain any financial accounts held by such persons or entities. In addition, such an FFI may need to withhold on "passthru payments" it makes to other FFIs. The expansive definition of FFI provided by the law means that these changes are of concern not only to banks, but also to investment funds, hedge funds, private equity funds, securitization vehicles, and many other forms of financial intermediary.

We have prepared detailed guidance notes on this initiative, which we are happy to send to clients. We highlight below two important recent developments.

Final FATCA regulations issued

Final regulations issued by the IRS in January 2013 confirmed that withholding on U.S. source income, eg payments on securities issued by U.S. issuers made to FFIs, will begin on 1 January 2014. The final regulations also confirmed the date for withholding on the gross proceeds of sale of U.S. debt and equity securities will be 1 January 2017.

The commencement date for withholding on "passthru payments" is also 1 January 2017. Regulations regarding the latter two forms of withholding are still awaited.

Grandfathering and collateral in derivatives trades

The final regulations altered the so-called "grandfathering" provisions, so that obligations that produce foreign source "passthru payments" will be exempt from FATCA withholding in respect of such payments if issued up to six months after the date the U.S. defines the term "foreign passthru payment" in further regulations. This creates, in effect, a "floating" grandfathering date for obligations which have no immediate U.S. connection.

All obligations entered into prior to 1 January 2014 (even those producing U.S. source withholdable payments) are also grandfathered.

Only obligations which have a definitive term and are not classified as "equity" for U.S. tax purposes can benefit from grandfathering. A significant consequence of this rule is that collateral support agreements entered into in connection with derivatives transactions will almost never qualify for grandfathering.

The final regulations contain a special rule which allows collateral arrangements associated with derivatives trades entered into prior to 1 January 2014 to benefit from grandfathering. Collateral arrangements associated with trades entered into after that date will not be grandfathered. As a consequence, payments on c ollateral can be subject to FATCA withholding even when the associated derivative trade is itself exempt.

For example, a derivative contract between two non-U.S. parties entered into in 2014 may itself benefit from the "floating" grandfathering date described above. If one party posts U.S. Treasury securities as collateral for that contract, however, payments on the collateral will be subject to FATCA withholding if the recipient is not exempt. Unless specially addressed in the documentation, this withholding will need to be grossed up by the collateral poster. Clients should consider amending master agreements and schedules to address this concern.

Clients wishing to discuss the implications of this legislation upon their businesses should contact Stephen Fiamma or another tax specialist in the U.S. Law group at Allen & Overy LLP.