The 2010 Hire Act Protocol (the "Protocol") was published by the International Swap and Derivatives Association, Inc. ("ISDA") on August 23, 2010. The Protocol offers market participants a means to amend existing ISDA Master Agreements to incorporate changes to the U.S. federal tax law included in the recently enacted Hiring Incentives to Restore Employment Act (the "HIRE Act").
A party that has entered into a Covered Master Agreement may adhere to the Protocol and be bound by its terms (an "Adhering Party"). "Covered Master Agreements" include: (1) any 1992 or 2002 ISDA Master Agreement executed by two Adhering Parties; (2) any 1992 or 2002 ISDA Master Agreement deemed to be executed by two Adhering Parties by execution of a confirmation; and (3) any 1992 ISDA Master Agreement or 2002 ISDA Master Agreement signed as an umbrella agreement by an entity on behalf of and as agent for one or more clients, investors, funds or other principals (collectively, an "Agreement").
A party that wishes to amend the terms of an Agreement to incorporate the terms set forth in the Protocol must send in conformed and executed copies of the "Adherence Letter" via email to email@example.com. The Adherence Letter should be provided on a company's letterhead without modification using the form available on ISDA's website, other than the company's name, date and signature block. Enrollment for the Protocol commenced on August 23, 2010. A closing date for the Protocol has not been published. ISDA, however, has the ability to designate a cut-off date by providing thirty (30) days' notice on the ISDA website.
The HIRE Act
The HIRE Act was signed into law on March 18, 2010, and includes a provision imposing United States ("U.S.") withholding taxes on certain payments referred to as "dividend equivalent payments," effective for payments made in connection with any swap entered into on or after September 14, 2010 (the "Effective Date"). Dividend equivalent payments include payments made in connection with equity swaps that are, at least in part, determined by reference to dividends on underlying U.S. equity securities. Thus, if a non-U.S. counterparty buys or sells the underlying equity security from its counterparty, taxes will be withheld on the dividend payment. Further, withholding taxes will be imposed on the gross amount of any dividend equivalent payments. Consequently, the counterparty to an equity swap may be obligated to withhold at a rate of up to 30% and remit taxes on the gross amount of a dividend equivalent even though no payment is submitted to a foreign entity.
Dividend equivalents generally include, among other things:
- any substitute dividend made pursuant to a securities lending or a sale-repurchase transaction that (directly or indirectly) is contingent upon, or determined by reference to, the payment of a dividend from sources within the U.S.; and
- any payment made pursuant to a "specified notional principal contract" that (directly or indirectly) is contingent upon, or determined by reference to, the payment of a dividend from sources within the U.S.
A "specified notional principal contract" includes any notional principal contract if, among other things:
- in connection with entering into the contract, any long party1 to the contract transfers the underlying security to any short party2 to the contract;
- any short party to the contract transfers the underlying security to any long party to the contract;
- in connection with entering into the contract, the underlying security is not readily tradable on an established securities market; or
- the underlying security is posted as collateral by any short party to the contract with any long party to the contract.
In the case of payments made after March 18, 2012, a "specified notional principal contract" includes any notional principal contract, unless the Internal Revenue Service ("IRS") determines that such contract is of a type that does not have the potential for tax avoidance.
Summary of the Proposed Changes in the ISDA 2010 HIRE Act Protocol
(1) An Adhering Party required to withhold taxes under the HIRE Act will not be required to gross-up dividend equivalent payments.
Under the HIRE Act, a party to an equity swap may be obligated to withhold and remit tax on the gross amount of a dividend equivalent payment even though, as a result of netting of payments due under the swap, the party is not required to make an actual payment. Under the Protocol, "withholding tax" includes the taxes on dividend equivalent payments that might be remitted directly to the IRS. The amount of such taxes deemed to be withheld is added to the calculation of the net payment for the period in which the amount arises. If taxes are in fact withheld, (1) the amount of such taxes will not be included when calculating a net payment under the Agreement and (2) a party may not ask for Indemnity under Section 2(d)(ii) of the Agreement for the same amount.
(2) The Protocol adds Payee Representations.
The Protocol adds payee representations in which the party that would be a recipient of a dividend equivalent payment represents that an equity derivative transaction under the Agreement is not one that would be subject to withholding under the HIRE Act, nor will the payee take actions that it believes may cause the transaction to be subject to such withholding.
In addition, the Protocol adds payee representations in which the parties represent that they meet the yet-to-be defined enhanced reporting requirements set forth in the HIRE Act. Failure to satisfy these U.S. information reporting requirements generally will result in 30% withholding tax. These representations make it clear that the payee will be responsible for any U.S. withholding tax imposed under the new reporting requirements.
Finally, if a party has made a payee representation in the Agreement, such representation also shall apply to the "Dividends" provision of the "Specified Treaty." This ensures that if the withholding tax rate can be reduced under a double tax treaty, the party will benefit under such treaty.
(3) The Protocol clarifies the definition of "Tax Event."
Under the Protocol, the definition of Tax Event would include a circumstance in which a U.S. payor, which could be a non-US person, such as a hedge fund, is found by the IRS to have failed to withhold properly on a U.S. dividend equivalent payment under an equity derivative transaction. Such U.S. payor would be liable to the IRS for the amount of taxes that it failed to withhold and would have to gross up for any similar payments going forward. Under this circumstance, the U.S. payor would be allowed to terminate a swap if "an action taken by a taxing authority" creates a "substantial likelihood" that the U.S. payor would be obligated to gross up on the next scheduled swap payment date. "An action taken by a taxing authority" specifically includes written notice from the IRS of "an assessment of Tax" or "an intention to make an assessment of Tax."
(4) The Protocol gives both parties to an Agreement the right to terminate the related transaction if such transaction becomes subject to withholding on dividend equivalent payments under the HIRE Act.
According to ISDA, the main purpose of the provision is to allow a party that is unable, due to system or operational reasons, to comply with the withholding provisions of the HIRE Act to terminate the transaction. The rationale is that the parties entered into these Agreements with an understanding of the tax risk prior to the enactment of the HIRE Act and such parties may not be able to sustain the additional risk added by these provisions.
Under the Protocol, parties that do not have a "Mutual Early Termination" provision or an optional early termination provision in a "Confirmation" or an Agreement may terminate a transaction if payments are subject to withholding and are not being grossed-up.
If the relevant taxing authority takes an action that would cause withholding on dividend equivalent payments to be incurred, a party must exercise the optional early termination right: (1) within eighteen (18) months, if such taxing authority's action occurs before March 18, 2012; or (2) within three (3) months, if such taxing authority's action occurs on or after March 18, 2012.
It should be noted that an action by a taxing authority that gives rise to such optional early termination is deemed to occur (1) on September 13, 2010, because the HIRE Act becomes effective on September 14, 2010, and (2) on March 18, 2012, because, in the event the IRS fails to enact further regulations as of that date, such additional transactions will be subject to the provisions of the HIRE Act.
A party that exercises this optional early termination provision is generally required to give at least ten (10) "Exchange Business Days'" notice unless the relevant taxing authority takes an action that causes withholding on dividend equivalent payments within the ten (10) "Exchange Business Days" period.
(5) The Protocol becomes effective at the time two parties become Adhering Parties.
Except for the new Tax Event and payee representation provisions, the provisions of the Protocol will become effective after both parties to an Agreement become Adhering Parties and will apply to all outstanding and future transactions. The Tax Event provisions will apply to transactions entered into by the parties after they become Adhering Parties. The payee representations will apply to transactions entered into or outstanding after September 14, 2010.