Withholding on US source income under FATCA started on 1 July 2014.  The withholding will apply to gross "proceeds of sale" of securities bearing US source income (which includes repayment of principal on a loan to a US borrower) and, potentially, to "foreign passthru payments" from January 2017.

Now that most European jurisdictions have signed Intergovernmental Agreements (IGAs) with the US (or in some cases are deemed so to have signed for US tax purposes), documenting FATCA risk in European facilities agreements is pretty straightforward.  Most parties are happy to include the LMA's standard wording (based on their initial "Rider 3" approach) which makes FATCA a lender risk subject to some protections, such as the ability to force a Facility Agent who would cause a FATCA withholding to resign.

Before the IGAs were signed, many deals were completed where the parties agreed to rely on the FATCA "grandfathering" provisions. The grandfathering protection is in place for those transactions where a committed facility agreement which would be regarded as debt for US tax purposes was executed prior to 1 July 2014. If unaltered, such facilities remain outside of the FATCA withholding rules for their life.  Where there are unusual economic or other factors which might cause the loan to be treated as equity for US tax purposes (for example profit participating loans) grandfathering was never available.

Losing grandfathered status

The grandfathering protection will be lost on any transaction which suffers a "material modification" after 1 July 2014.

There are detailed US tax rules regarding what amounts to a "material modification". In the case of an obligation that is treated as a debt instrument for US tax purposes, a material modification means a “significant modification” as defined pursuant to Treasury Regulations.

Generally, a modification is considered “significant” only if, based on all of the facts and circumstances, the legal rights or obligations that are altered, and the degree to which they are altered, are economically significant.  A change to or waiver of customary accounting or financial covenants typically will not be deemed a significant modification.  An alteration of a legal right or obligation that occurs by operation of the terms of a debt instrument is also generally not a significant modification (e.g. an annual resetting of the interest rate based on the value of an index or a specified increase in the interest rate if the value of the collateral declines from a specified level.) This is the case whether or not such alterations occur automatically or arise from the exercise of an option to change a term of the debt instrument provided to a borrower. 

Certain alterations, however, will be considered significant modifications regardless of whether or not they arise by operation of the terms of the debt instrument, including alterations that result in:

  • the substitution of a new obligor on a recourse obligation; 
  • the addition or deletion of a co-obligor if the alteration changes the payment expectations, (routine accessions to Facilities Agreements whereby a new guarantor or borrower accedes to the Facilities Agreement with no change in the payment expectations is unlikely to be considered a significant modification);
  • a change (in whole or in part) in the recourse nature of the instrument to non-recourse, or non-recourse to recourse; or 
  • the creation of an instrument that is not treated as debt for U.S. federal income tax purposes (other than the conversion of the debt instrument by the holder into equity of the issuer). 

Alterations occurring as a result of the exercise of an option that is not “unilateral” are generally considered significant modifications.

For this purpose "unilateral" means where:

  1. there does not exist at the time the option is exercised, or as a result of the exercise, a right of the other party to alter or terminate the instrument or put the instrument to a person who is related to the issuer;
  2. the exercise does not require the consent or approval of (A) the other party, (B) a person who is related to that party, whether or not that person is a party to the instrument, or (C) a court or arbitrator; and
  3. the exercise of the option does not require consideration (other than incidental costs and expenses relating to the exercise of the option) unless, on the issue date of the instrument, the consideration is a de minimis amount, a specified amount, or an amount that is based on a formula that uses objective financial information.

If a modification causes the above (i) through (iii) to be true, the exercise of the option would not be considered “unilateral” and would, therefore, need to be analysed to confirm that a significant modification has occurred. If an option results in deferral of, or reduction in, any scheduled or expected payment on the debt, an alteration of the instrument as a result of the exercise of that option is a modification. 

Additionally, a change in yield results in a significant modification if the annual yield of the modified instrument differs from the annual yield on the unmodified instrument by more than the greater of 25 basis points or five per cent of the annual yield of the unmodified instrument. 

A change in timing of payments, including any resulting change in the amount of payments, is significant if the change results in a “material deferral” of scheduled payments (e.g. certain extensions of the tenor of a loan).  Whether an extension of the tenor of a loan will be considered a “material deferral” depends on a weighing of the facts and circumstances, including the length of the deferral, the original term of the debt, the amounts of the payments deferred, and the amount of time between the modification and the actual deferral of payments.     

Items not specifically covered by the Treasury Regulations must also be considered taking into account all of the facts and circumstances.  Such alterations would include (i) adding additional new facilities to an existing facility agreement (e.g. to fund a new acquisition), (ii) changes to the margin and/or fees payable, and (iii) redesignating existing tranches of debt in work-outs. 

Accordion facilities generally should be viewed as separate loans, even though they are provided for in the original loan documents. There is a question as to whether an accordion loan could be grandfathered.  This might be the case if the accordion loan has exactly the same terms as the original loan and is considered a “qualified reopening” of the original loan (which has a complex definition requiring one of three narrow tests to be met).  This issue has not been squarely addressed by the FATCA guidance to date, but the argument is that in a qualified reopening the new debt has the same issue date (and issue price) as the old debt for tax purposes – the two issuances are completely fungible. 

Many transactions which chose to rely on grandfathering may not contain any FATCA language, on the basis that the finance parties accepted the LMA's view at the time that the LMA's standard tax gross-up clause would require any FATCA withholding to be grossed up should the loan lose its grandfathered status.

Other transactions do acknowledge FATCA by adding protection to allow the finance parties to veto any amendments which would cause the grandfathered status of the facility to be lost.  This was the approach taken in "Rider 2” of the LMA's FATCA riders published at the time.

Does it really matter if grandfathered status is lost?

Documents which are silent on FATCA could usefully be updated at the same time that the relevant material modification which causes them to lose grandfathered status is made.

In the case where there is a US borrower and the UK lender has not otherwise registered with the IRS (and obtained a Global Intermediary Identification Number or “GIIN”) it will be required to do so in order to continue receiving payments from the US borrower without risk of FATCA withholding.  Moreover, the UK lender will be required to furnish the US borrower with an IRS Form W-8BEN-E, or if it already had provided such form to the US borrower, an updated Form W-8BEN-E, as applicable.

In the absence of a US borrower, the impact of a loss of grandfathering depends on whether the individual lenders now have the benefit of a Model 1 IGA (and have complied with their reporting obligations under it).

For instance, the Model 1 IGA between the US and UK should have the effect that UK financial institutions do not, in most circumstances, have to withhold under FATCA and should not be withheld upon and so loss of grandfathering should not generally be an issue. The main circumstance in which withholding could still apply is where the financial institution fails to comply with its reporting requirements under UK law (and fails to rectify that non-compliance within 18 months of being given notice of such failure). 

Accordingly, loss of grandfathering is more of an issue when the lenders do not have the benefit of a Model 1 IGA. Whilst FATCA is mainly about information sharing, it is the threat of a party having to withhold payments under the finance documents as a result of FATCA which impacts on the documentation.

To summarise, there will be a 30% withholding required on any "withholdable payment" or "passthru payment" made by a US-based party or by a Participating Foreign Financial Institution (PFFI) to:

  • a foreign financial institution (FFI) (unless that FFI is a PFFI); or
  • a non-financial foreign entity (NFFE) (unless that NFFE discloses all its substantial US owners or attests that there are none).

Note that "withholdable payments" include the gross proceeds of sale of property which produces US source income, as well as US source income payments themselves.  Gross proceeds includes the repayment of loan principal.

To consider whether or not there is any risk of a FATCA withholding on a particular loan transaction, it is necessary to analyse the nature of both the borrowers and other obligors as well as the various finance parties to that transaction and to work out which parties have the benefit of an IGA. For syndicated loans or transactions where obligors can change during the life of the loan, the analysis needs to include the identity of future parties to the transaction too. So the ideal approach if grandfathered documentation needs to be revisited anyway is to incorporate FATCA wording to anticipate such future changes in order to maintain flexibility.