On January 17 the Treasury Department and the Internal Revenue Service (IRS) promulgated their long-awaited final regulations (the “Final Regs”) to implement the Foreign Account Tax Compliance Act (“FATCA”), which is set forth in Sections 1471 through 1474 of the Internal Revenue Code. The Final Regs span some 500 pages, and differ in several important respects from the proposed regulations published in February 2012 (the “Proposed Regs”). In particular, the Final Regs respond to industry concerns about the extent of the regulatory burden imposed, and are designed to recognize and conform to the provisions of the Intergovernmental Agreements (IGAs) that the Treasury has entered into with seven foreign governments to date; Treasury has said it is in negotiations to enter into similar agreements with fifty or more other governments. This Client Alert summarizes the key provisions of FATCA as implemented in the Final Regs, with particular emphasis on changes from the Proposed Regs that may be relevant to clients engaged in bank finance, private equity and capital market transactions. The Appendix sets forth the key implementation deadlines for various aspects of FATCA under the Final Regs.

Background: What is FATCA?

Enacted in 2010, FATCA has as its stated purpose preventing use by US persons of foreign accounts for income tax evasion. Under FATCA, foreign financial institutions (FFIs) are generally required to enter into agreements with the IRS to identify any accounts held by US persons and to make annual reports regarding those accounts. In addition, both FFIs and domestic financial institutions must make reports regarding substantial US owners of nonfinancial foreign entities (NFFEs). Penalties for non-compliance are draconian: a noncompliant FFI or NFFE may be subject to a 30 percent withholding tax on certain US source payments that would not otherwise be subject to such tax (including, but not limited to, interest and dividends and gross proceeds of property that would ordinarily generate interest or dividends) and the payor of the item subject to such withholding tax may be held liable for any such tax that should have been withheld, including interest and penalties.

Because FATCA is aimed at foreign entities, it presented from the outset potentially serious conflict of laws issues with other jurisdictions. In particular, FFIs were faced with the prospect of violating home country laws by entering into the required agreements with the IRS. In addition, it imposed a potentially massive burden on FFIs to correctly identify and report accounts held by US persons. These two factors – potential conflict with the laws of foreign jurisdictions and compliance burden – resulted in considerable controversy when the Proposed Regs were issued nearly a year ago.

The Final Regs go a long way toward alleviating these concerns, although not all outstanding questions have been fully addressed. The remainder of this Alert highlights the key areas that have been addressed and some of the remaining open questions.

Intergovernmental Agreements

Shortly after the Proposed Regs were issued, the Treasury acknowledged the potentially serious conflict of laws issues that were raised and announced a framework for cooperation with other governments and their tax authorities to create intergovernmental agreements (IGAs) to implement FATCA. The result has been the creation of two models– IGA-1, which allows taxing authorities in the US and the signatory partner country to exchange information to determine whether residents of the either country are maintaining unreported financial accounts in the other. IGA-1 is thus bilateral and reciprocal in nature. The key point for FFIs is that it relieves them of the burden of entering into an agreement and reporting to the IRS; under the Final Regs they are deemed to be FATCA-compliant as long as they comply with their own country’s reporting requirements.

IGA-2, by contrast, is nonreciprocal, and does not relieve FFIs from entering into an agreement with the IRS and otherwise complying with FATCA, except to the extent that the IGA-2 agreement itself specifically modifies or alleviates the compliance burden. To date, seven countries – the United Kingdom, Mexico, Denmark, Ireland, Switzerland, Spain and Norway – have entered into IGA-1 type agreements; as yet there are no IGA-2 type agreements. Treasury has stated that it is currently negotiating with 50 or more other countries toward the creation of additional IGAs. However, the clock is running: FFIs in countries that have not signed IGAs must register with the IRS no later than October 25, 2013 to be included on the list of participating FFIs prior to the commencement of mandatory withholding on January 1, 2014.

Definition of “Investment Entity”

As noted, FATCA generally covers US source payments to “foreign financial institutions,” which generally includes banks, custodians, certain insurance companies, and investment entities. The Final Regs modified the definition of “financial institution” in several significant ways. Perhaps most importantly, the Final Regs adopt the definition of “investment entity” used in the IGAs negotiated to date. Thus, the term “investment entity” now excludes passive, noncommercial investment vehicles, including trusts that do not undertake investment activities on behalf of customers. Conforming with their treatment in the IGAs, an “investment entity” includes any entity that primarily conducts as a business on behalf of customers: (1) trading in an enumerated list of financial instruments; (2) individual or collective portfolio management; or (3) otherwise investing, administering, or managing funds, money, or certain financial assets on behalf of other persons (collectively referred to as “Investment Activities”). In addition, an investment entity includes any entity whose gross income is primarily attributable to investing or trading in financial assets and which is managed by an entity that conducts Investment Activities, whether or not it has “customers”.

Passive investment vehicles that do not fall within the definition of an investment entity are generally treated as non-financial foreign entities (“NFFEs”) rather than FFIs.

The Final Regs have eased the compliance burden for FFIs in a number of respects. For example, the Proposed Regs required maintenance of documents acquired in the due diligence process; the Final Regs allow the FFI to dispense with maintaining the actual documents (unless they are otherwise required, for example to meet anti-money laundering requirements).

Still, certain investment entities may not be able to comply with FATCA's registration and due diligence requirements due to restrictions in their organizational documents. The Final Regs permit these entities to qualify for “deemed compliant” treatment until December 31, 2016. This category is intended for investment vehicles that were created for the purpose of investing in a limited type of debt obligation and that have a fixed life span, with the intent to hold such obligations until maturity or until the liquidation of the vehicle. Under the Final Regs they are deemed to be compliant, but their deemed-compliant status terminates as of December 31, 2016 (although, it should be noted, withholding on principal payments and sales proceeds for non-compliant investment entities does not begin until January 1, 2017 in any event). Since these entities typically are organized under the laws of offshore jurisdictions such as the Cayman Islands, at the least this affords time for Treasury to enter into IGAs with such jurisdictions.

Grandfathering

To avoid retroactive application to instruments that were created prior to FATCA taking effect, FATCA grandfathers certain types of obligations. The Final Regs have liberalized the grandfather rules in several respects.

First, all obligations issued and outstanding before January 1, 2014 are generally exempt from FATCA withholding. For debt instruments, the date the obligation is deemed to be outstanding is generally the issue date. However, any material modification of the terms of the debt after January 1, 2014 – an increase of more than 25 basis points in the interest rate on a loan, for example – will destroy the grandfathering.

Second, a non-debt obligation, such as a swap or derivative, is considered outstanding as of the day a legally binding agreement is executed setting forth all material terms of the instrument. However, grandfathering does not apply to equity instruments.

Third, an obligation will not be deemed to give rise to a “foreign passthru payment” if it is executed on or before the date that is six months after the date this term is defined in subsequent amendments to the Final Regs. Treasury and IRS are continuing to grapple with the definition of this term.

Fourth, grandfathering will apply to any agreement that requires a secured party to repay, or make payments with respect to, collateral securing one or more grandfathered obligations (even if the collateral is not itself a grandfathered obligation).

Remaining to Be Done

Notwithstanding the massiveness of the Final Regs, a significant number of matters remain to be addressed. For example, the term “foreign passthru payments” remains undefined; the definition will be significant in terms of grandfathering of certain obligations (see above). Other outstanding items include final forms for entities and individuals; a form delineating the reporting requirements for FFIs and withholding agents; revised withholding forms (1042 and 1042-S); a new Revenue Procedure to define the terms of an FFI reporting agreement; and, not least, establishment of the FATCA Registration Portal, which will be the primary interface between the FFI and the IRS going forward.

FATCA – SCHEDULE OF EFFECTIVE DATES

The following Table shows the dates that various key provisions of FATCA become effective:

Click here to view table.