The United States Internal Revenue Service (IRS) recently issued Announcement 2012-42 (the Announcement), changing the deadlines for meeting due diligence and other requirements under the Foreign Account Tax Compliance Act (FATCA). The Announcement also clarifies the scope of socalled “grandfathered obligations,” which are exempt from at least certain FATCA requirements. Awareness of the FATCA provisions is critical for investment fund sponsors and investors.

FATCA generally requires foreign financial institutions (FFIs), which, as defined, include most investment funds, to enter into an agreement with the IRS (FFI Agreement). FFIs that enter into an FFI Agreement are “participating FFIs.” Under the FFI Agreement, participating FFIs are required to (i) identify and report certain information about their US accounts to the IRS, and (ii) withhold on “withholdable payments” and “foreign passthru payments,” defined below, made to “nonparticipating FFIs” (FFIs that do not comply with FATCA) and “recalcitrant account holders” (certain account holders that do not furnish required information to FFIs or that fail to provide waivers of foreign laws that would prevent reporting by FFIs to the IRS).

The term “withholdable payments” includes (i) US-source interest, dividends, wages and similar (fixed and determinable annual or periodical) payments, and (ii) gross proceeds from the sale or other disposition of property that can produce US-source interest or dividends. The term “foreign passthru payments” refers to payments made by participating FFIs that are attributable to withholdable payments received by them.

FFIs that fail to satisfy the requirements of the FFI Agreement in a timely manner are subject to a 30 percent withholding tax on withholdable payments made to them. The tax is withheld by a “withholding agent.” The term “withholding agent” generally refers to US (or certain non-US) persons that have the control, receipt, custody, disposal or payment of a withholdable payment or foreign passthru payment.

On February 15, 2012, the IRS released proposed regulations (Proposed Regulations) that set forth rules to follow in satisfying requirements under FATCA. The IRS has also released several model intergovernmental agreements intended to provide FFIs in jurisdictions that enter into such agreements with alternative approaches to satisfy FATCA requirements. The Announcement modifies certain due diligence deadlines contained in the Proposed Regulations, thereby aligning such deadlines with the due diligence deadlines contained in the model intergovernmental agreements. 

I. Due Diligence Deadlines

A. Participating FFIs

The Proposed Regulations require participating FFIs to complete certain due diligence procedures by specified deadlines to (i) determine whether their account holders are US persons, subject to FATCA reporting, or recalcitrant account holders, subject to FATCA withholding, and (ii) determine whether any payees are nonparticipating FFIs, also subject to FATCA withholding. In the Announcement, the IRS modifies these deadlines, generally extending them.

The Proposed Regulations and Announcement both base the due diligence deadlines on the “effective date” of the FFI Agreement. Under the Announcement, an FFI Agreement entered into before January 1, 2014 has an “effective date” of January 1, 2014, while all other FFI Agreements are effective when entered into. The delayed effective date of an FFI Agreement under the Announcement (January 1, 2014 instead of July 1, 2013 under the Proposed Regulations) is significant because, as noted above, the due diligence deadlines are based on the FFI Agreement’s effective date.

In setting forth the due diligence deadlines for participating FFIs, the Proposed Regulations and Announcement distinguish between “preexisting obligations” and other obligations. The term “preexisting obligation” means accounts, instruments or contracts executed prior to the effective date of the participating FFI’s FFI Agreement (i.e., now January 1, 2014 under the Announcement). All other obligations are “new” obligations.

The applicable due diligence deadlines under the Announcement for participating FFIs are discussed below.

  • Preexisting obligations held by prima facie FFIs. A participating FFI is required to document payees and account holders of preexisting obligations that are “prima facie FFIs” (generally, entities as to which the participating FFI has certain information indicating their status as FFIs) by the later of June 30, 2014 or six months following the FFI Agreement’s effective date.
  • Preexisting obligations held by entities other than prima facie FFIs. A participating FFI is required to document payees and account holders of preexisting obligations held by entities other than prima facie FFIs by the later of December 31, 2015 or two years following the FFI Agreement’s effective date.
  • Preexisting high-value individual accounts. A participating FFI is required to document “highvalue” individual accounts (generally, accounts with a balance exceeding $1 million) by the later of December 31, 2014 or one year after the FFI Agreement’s effective date.
  • Preexisting individual accounts other than high-value accounts. A participating FFI is required to document individual accounts other than high-value accounts by the later of December 31, 2015 or two years after the FFI Agreement’s effective date.
  • New accounts. New accounts are accounts opened on or after the FFI Agreement’s effective date (i.e., January 1, 2014, under the Announcement). A participating FFI is required to implement due diligence procedures by such date. These due diligence procedures are to be used to document new accounts for FATCA purposes when such accounts are opened.

B. Withholding Agents That Are Not Participating FFIs

The Proposed Regulations also require withholding agents that are not participating FFIs (e.g., US withholding agents) to complete certain due diligence procedures by specified deadlines to determine whether their payees are nonparticipating FFIs subject to FATCA withholding. In the Announcement, the IRS modifies these deadlines, generally extending them.

In setting forth the due diligence deadlines for withholding agents, the Proposed Regulations and Announcement distinguish between “preexisting obligations” and other obligations. With respect to withholding agents aside from participating FFIs, the term “preexisting obligation” generally means accounts, instruments or contracts executed prior to a specified date, i.e., now January 1, 2014 under the Announcement. All other obligations are “new” obligations.

The applicable due diligence deadlines under the Announcement for withholding agents that are not participating FFIs are discussed below.

  • Preexisting obligations held by prima facie FFIs. A withholding agent that is not an FFI is required to document payees of “preexisting obligations” that are “prima facie FFIs” (generally, entities as to which the participating FFI has certain information indicating their status as FFIs) by June 30, 2014.
  • Preexisting obligations held by entities other than prima facie FFIs. A withholding agent that is not an FFI is required to document payees of preexisting obligations held by entities other than prima facie FFIs by December 31, 2015.
  • New accounts. New accounts mean accounts opened on or after a specified date, which, under the Announcement, is now January 1 2014. Withholding agents other than participating FFIs are required to implement due diligence procedures by such date. These due diligence procedures are to be used to document new accounts for FATCA purposes when such accounts are opened.

C. Additional Observations

The deadlines contained in the Announcement provide participating FFIs and other withholding agents with a reasonable period of time to document pre-existing obligations. It is important to note, however, that once participating FFIs and other withholding agents document an obligation, they must begin to withhold or report, as appropriate, with respect to that obligation, even if they have documented the obligation in advance of the applicable deadline.

The Announcement aligns the due diligence deadlines for (i) participating FFIs in countries without model intergovernmental agreements, (ii) participating FFIs in countries with model intergovernmental agreements, and (iii) withholding agents aside from participating FFIs (e.g., US withholding agents). This alignment of deadlines should serve to reduce the complexity of administrative compliance with the FATCA rules.

II. Other Deadlines

Under the Proposed Regulations, participating FFIs generally are required to report information to the IRS about their US accounts by March 31 of the year following the calendar year to which the reporting relates. Under the Announcement, participating FFIs are not required to report with respect to the 2013 and 2014 calendar years until March 31, 2015.

The Announcement also delays withholding on withholdable payments that are gross proceeds from the sale or other disposition of property that can produce US-source interest or dividends until January 1, 2017. The Announcement does not extend the deadline with respect to withholding on other withholdable payments, including US-source interest, dividends, wages and other (fixed and determinable annual or periodical) payments.

III. Grandfathered Obligations

Under the Proposed Regulations, an “obligation” outstanding on January 1, 2013, or any gross proceeds from the disposition of such an obligation, is not subject to withholding (i.e., is a “grandfathered obligation”). The term “obligation” generally means a legal agreement that produces or could produce a withholdable payment or foreign passthru payment, but does not include (i) stock or other equity interests, or (ii) agreements that lack a definitive expiration. Note that, under this definition, investor interests in investment funds are not grandfathered. The Announcement does not change this.

The Announcement does provide the following three provisions, designed to expand and clarify the scope of grandfathered obligations.

  • The scope of grandfathered obligations under the Proposed Regulations was unclear given that the Proposed Regulations did not define the term “foreign passthru payments.” The term generally means payments attributable to a withholdable payment, but under the Proposed Regulations, the IRS is still considering rules for when a payment will be treated as so attributable. To address this uncertainty, the Announcement provides that an obligation that produces or could produce a “foreign passthru payment,” and that cannot produce a withholdable payment, will be treated
  • as a grandfathered obligation, provided the obligation is outstanding six months after the final regulations defining the term “foreign passthru payment” are issued.
  • Under Section 871(m) of the US Internal Revenue Code (the Code), certain payments (dividend equivalents) specified in the Code and/or applicable proposed regulations that are determined by reference to the payment of USsource dividends are treated as US-source dividends and, as such, may be subject to FATCA withholding. The proposed regulations under Section 871(m) are not expected to be finalized until January 1, 2014. Thus, the scope of “dividend equivalents” currently is uncertain. To address this uncertainty, the Announcement provides that a grandfathered obligation will include any instrument that gives rise to a withholdable payment solely because the instrument is treated as giving rise to a dividend equivalent under Section 871(m) and the regulations thereunder, provided the instrument is outstanding six months after such instrument is first treated as giving rise to a dividend equivalent. Accordingly, instruments that give rise to dividend equivalents under Section 871(m) proposed regulations (as opposed to under the Code itself) will be grandfathered, assuming they are outstanding six months after the regulations are finalized. Presumably, however, instruments that give rise to dividend equivalents under Section 871(m) itself (i.e., the Code, rather than proposed regulations) are subject to the general grandfathering rule and, as such, are required to be outstanding on January 1, 2013 in order to qualify as a grandfathered obligation.
  • The Announcement expands the scope of “grandfathered obligations” to include an obligation to make a payment with respect to collateral posted to secure obligations under a notional principal contract, provided the notional principal contract is itself a grandfathered obligation.