On February 8, 2012, the IRS released proposed regulations1 on the Foreign Account Tax Compliance Act ("FATCA"), which was enacted in 2010.2 FATCA imposes obligations on U.S. taxpayers and withholding agents, as well as certain foreign entities. Under the FATCA regime, U.S. taxpayers that hold foreign financial assets with an aggregate value of more than $50,000 will have to file a disclosure on Form 8938 with the IRS. Moreover, certain foreign financial institutions ("FFIs") will have to enter into an agreement with the IRS under which they will take on reporting and withholding obligations.

If an FFI is required to enter into an agreement with the IRS, it must do so prior to July 1, 2013 in order to avoid withholding on U.S.-source payments made in 2014 and thereafter, and must report information with respect to U.S. holders of accounts beginning in 2014.

FFIs for FATCA purposes include both foreign banks and investment vehicles such as hedge funds, private equity funds, CLOs, and CDOs. It is likely that these entities will meet the definition of an FFI despite some exceptions provided by the new proposed regulations that are discussed below. As a result, beginning in 2014, any U.S.-source payment made to an FFI on its assets—such as a payment of interest or original issue discount ("OID") on a U.S. debt obligation—will be subject to this 30 percent U.S. withholding tax unless the FFI enters into an agreement with the IRS. Withholding on gross proceeds of a sale or other disposition of these assets by an FFI is required starting in 2015.

No withholding is required on payments on obligations entered into before the FATCA regime's effectiveness. Perhaps the best news in the proposed regulations is the extension of such "grandfathered" treatment to U.S. obligations entered into prior to January 1, 2013 (previously this was March 18, 2012). This means that a payment made to an FFI on an instrument entered into in 2012 will never be subject to withholding under the FATCA rules. The only qualification is that if the instrument is subsequently modified in a manner that causes it to be treated as a new instrument for tax purposes, the grandfathered treatment is lost.3 The proposed regulations also provide a helpful clarification that payments on a derivative transaction entered into under an ISDA Master Agreement in 2012 or earlier are similarly grandfathered. In preparation for 2013, some parties have started to add FATCA provisions to their ISDA Master Agreements. Additionally, ISDA may publish a FATCA Protocol to address these requirements.

The required IRS agreement will obligate the FFI, among other things, to (i) obtain information necessary to determine which of the holders of its accounts or securities (including equity and debt) are U.S. persons, (ii) report annually to the IRS the name, Social Security number, or taxpayer identification number ("TIN"), and investment amount of each of these U.S. investors, and (iii) deduct and withhold 30 percent from any payment it makes either to U.S. investors or other FFIs that do not themselves comply with these provisions.

The proposed regulations reduce somewhat the amount of information that an FFI must report with respect to U.S. investors under the IRS agreement. For tax years 2014 and 2015 (i.e., reporting with respect to the 2013 and 2014 years), what must be reported is the U.S. investor's name, address, TIN, account number, and account balance. Starting in 2016 (with respect to the 2015 year), all of the statutory reporting requirements, including the income allocable to the U.S. investor from the FFI, become applicable. For determining who are the U.S. investors, the proposed regulations contain favorable rules as to the "due diligence" required by the FFI. For example, for existing accounts of individuals with a balance of $1 million or less, the FFI needs to review only electronically searchable data in order to find evidence of U.S. status. Existing accounts of entities with a balance of $250,000 or less are entirely exempt from review until the account balance exceeds $1 million, and above that, the FFI can generally rely on anti-money-laundering/know-your-customer ("AML/KYC") records and other existing account information for U.S. status. Although the rules for new accounts are more complex, the ability generally to rely on data already obtained by the FFI, including AML/KYC data, was a pleasant surprise to many tax practitioners.

Some relief is provided with respect to other deadlines as well. An FFI is required to withhold 30 percent on U.S.-source payments made to investors in two situations: (i) when an investor is determined to be a U.S. investor but refuses to give the FFI the required information, and (ii) when the investor is another FFI that has not entered into the required agreement with the IRS. With respect to U.S.-source amounts that the FFI pays to such investors, such as interest and OID on U.S. obligations, the withholding obligation starts on January 1, 2014 (and January 1, 2015 with respect to payments of gross proceeds). With respect to other "pass-through" payments—indirect U.S.-source payments to the investor resulting from the FFI's investment in other entities—the proposed regulations defer the withholding obligation until January 1, 2017. (This deferral comes as a relief to many FFIs because earlier IRS announcements had indicated that the withholding amount would be determined on a straight percentage basis according to the FFI's U.S. assets, direct and indirect.) The FFI must make an annual report to the IRS of the payments withheld.

Many in the investment fund community hoped that the proposed regulations might exclude certain types of non-U.S. funds entirely from the FATCA rules. Unfortunately, this turned out not to be the case. There are two exceptions that relate to non-U.S. funds. These exceptions have different requirements, but for each of them, the fund must be regulated as an investment fund in its country of organization. Thus, for many, if not most, non-U.S. funds, the FATCA rules above will be fully applicable, with the proposed regulations providing help only on the deadlines and other matters above.

Public comments on the proposed regulations may be submitted until April 30, 2012, and a hearing is scheduled for May 15, 2012. It seems unlikely that there will be major changes when the regulations are issued in final form, including with respect to the deadlines. Nevertheless, the market will know for sure only when the final regulations are published.

For a more detailed analysis of FATCA, please see our White Paper: "Treasury Issues Proposed Regulations on the Information Reporting and Withholding Tax Provisions of FATCA," available here.

Footnotes

1. Proposed Treasury Regulations § 1.1471-1 et seq.

2. Internal Revenue Code §§ 1471-1474, added by the Hiring Incentives to Restore Employment ("HIRE") Act of 2010, P.L. 111-147.

3. See Treas. Regs. § 1.1001-3.

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