On October 24, 2012, the Internal Revenue Service (the “IRS”) and the United States Treasury Department released Announcement 2012-42, which provides additional guidance on the provisions of the Internal Revenue Code (the “Code”) commonly referred to as “FATCA.” The announcement (i) extends certain timelines for withholding agents and foreign financial institutions (including foreign investment entities such as hedge funds and private equity funds) (“FFIs”) to complete the due diligence required under FATCA, (ii) delays the date by which a participating FFI must file its first information report under FATCA, (iii) delays the start of FATCA withholding on gross proceeds and (iv) expands the scope of “grandfathered” obligations that will not be subject to withholding under FATCA if outstanding as of a specified date. Proposed FATCA regulations, which will be modified to conform with the announcement, were released in February 2012. For a detailed summary of the proposed FATCA regulations, please see the March 7, 2012 Davis Polk Client Memorandum, Summary of the Proposed FATCA Regulations.

Timelines. In order to avoid being subject to FATCA withholding, an FFI must either qualify for an exemption or become a “participating FFI” by entering into an FFI agreement with the IRS pursuant to which it agrees to perform certain due diligence, reporting and withholding functions. The announcement provides that the earliest effective date of an FFI agreement will be January 1, 2014. The announcement also generally extends the timelines within which U.S. withholding agents and participating FFIs must implement new account opening procedures and complete due diligence on pre-existing accounts. The new schedule matches the corresponding deadlines applicable to FFIs in countries that have intergovernmental agreements with the United States for the implementation of FATCA. The announcement contains a summary table of the dates by which each type of person must implement new account opening procedures and complete its review of pre-existing accounts. The announcement also delays the date by which a participating FFI must begin to file its information reports with respect to U.S. accounts to March 31, 2015 (from September 30, 2014).  

Gross Proceeds Withholding. Under FATCA, the payment of gross proceeds from a disposition of any property of a type that can produce U.S.-source interest or dividends is a “withholdable payment” that may be subject to FATCA withholding. The announcement delays the date on which FATCA withholding will begin to apply to gross proceeds to January 1, 2017 (from January 1, 2015).

Grandfathered Obligations. The proposed FATCA regulations provide that payments made under an obligation that is outstanding on January 1, 2013 will not constitute withholdable payments and will therefore not be subject to FATCA withholding. The announcement provides that there will be three additional categories of obligations that are grandfathered:  

  • Any obligation that produces or could produce a foreign passthru payment and that cannot produce a withholdable payment (e.g., a debt security issued by a participating FFI) and is outstanding as of the date that is six months after the date on which final regulations defining the term “foreign passthru payment” are released. Notably, this additional category of grandfathered obligations does not, as written, include equity securities that could produce foreign passthru payments. 
  • Any obligation to make a payment with respect to, or to repay, collateral posted to secure obligations under a notional principal contract that is a grandfathered obligation. The proposed FATCA regulations provide that a derivatives transaction under an ISDA master agreement will be a grandfathered obligation if the transaction is evidenced by a confirmation executed before January 1, 2013. Many market participants believed that payments with respect to collateral for these contracts were grandfathered under this general rule. The announcement’s inclusion of this new category of grandfathered obligations implies that payments with respect to collateral posted to secure grandfathered derivatives transactions other than notional principal contracts (e.g., securities loans) may not be covered by the grandfathering rule. 
  • Any instrument that gives rise to a withholdable payment solely because it gives rise to a dividend equivalent pursuant to Section 871(m) of the Code if such instrument is outstanding six months after the date on which instruments of its type first become subject to the provisions of Section 871(m). Absent a change in law, certain instruments will be grandfathered under this provision if they are outstanding on January 1, 2013, while other instruments (covered by proposed regulations under Section 871(m)) will be grandfathered if they are outstanding on July 1, 2014. For a summary of the proposed regulations under Section 871(m), please see the January 20, 2012 Davis Polk Client Newsflash, New Regulations Address Withholding on “Dividend Equivalents.”1