On August 15, 2012, the International Swaps and Derivatives Association ("ISDA") released a new Protocol relating to the effect on ISDA derivatives of taxes levied by the United States under the Foreign Account Tax Compliance Act ("FATCA"). FATCA was enacted in 2010 as part of the HIRE Act, and it has been the subject of other Jones Day updates. The Protocol proposes a standardized set of amendments to the ISDA Master Agreement that can be automatically adopted by a participant in the swap market. If both parties to a given ISDA Master Agreement adhere to the Protocol, the amendments it provides are automatically made to the agreement between them. Adherence to the Protocol, however, is unlikely to be universal in the market. If market participants want to amend their ISDA Master Agreements to deal with the application of FATCA to their over-the-counter derivatives trades, they may decide either to adhere to the Protocol, or alternatively, to amend their ISDA Master Agreements on a bilateral basis.
Relevant FATCA Rules
To recap FATCA itself, these rules require a U.S. withholding agent, which would include a U.S. counterparty to an ISDA derivatives transaction, to withhold 30 percent of any U.S. source payment made to a "foreign financial institution" unless the institution enters into an agreement with the IRS and satisfies significant reporting and disclosure requirements. All non-U.S. banks and swap dealers will be treated as foreign financial institutions for this purpose, as will many non-U.S. investment funds (including hedge funds, CDOs, private equity funds, and in some cases, real estate funds). As a result, beginning in 2014, any U.S. source payment on an ISDA derivative made to a foreign financial institution (as defined above) will be subject to a 30 percent U.S. withholding tax unless the financial institution (i) enters into an agreement with the Internal Revenue Service ("IRS") requiring it to obtain and report information regarding its U.S. investors and to meet other requirements and (ii) provides the counterparty with a form W-8BEN attesting to its agreement with the IRS and providing its FATCA ID number. Where such form is not provided, the swap counterparty must also withhold on proceeds of a disposition of an instrument providing for certain U.S. source payments, but this withholding of proceeds is required only beginning in 2015. All ISDA derivatives entered into in 2012 and previous years are exempt from FATCA withholding as "grandfathered" (unless they are subsequently modified in a manner that causes them to be treated as new obligations for tax purposes).
Even for derivatives entered into in 2013 and thereafter, only a limited number of derivatives payments will be U.S. source for purposes of the FATCA withholding tax. See, e.g., section 871(m) (treating certain equity derivatives payments as U.S. source dividends); Treas. Regs. § 1.446-3(g) (treating a swap with "significant nonperiodic payments" as, in part, a loan). The larger dollar impact on ISDA derivatives may be on payments on collateral posted by non-U.S. counterparties to U.S. counterparties. These payments are U.S. source and thus potentially subject to FATCA withholding, if the collateral posted is either cash or securities of U.S. obligors. And, as noted above, proceeds of dispositions of any of these instruments that give rise to U.S. source payments—e.g., a termination payment on a derivative or a payment of principal on collateral securities—may be subject to 30 percent FATCA withholding beginning in 2015.
Under the IRS agreement a foreign financial institution must enter into with the IRS in order to avoid the withholding tax, it must commit, beginning in 2014, to withhold on U.S. source "pass-through" payments to other foreign financial institutions that are not compliant with FATCA (i.e., that do not enter into and maintain the IRS agreement). Technically, it appears that certain derivatives payments (payments on equity derivatives that are recharacterized as U.S. source dividends under section 871(m)) and payments on securities of U.S. obligors posted as collateral will be subject to this rule. It is fair to say that not all financial institutions are prepared to collect U.S. withholding tax on payments they make to other non-U.S. counterparties.
The U.S. Treasury has also released a Joint Statement regarding potential bilateral agreements with certain countries to implement and mitigate the above FATCA rules. The countries named were the United Kingdom, Germany, France, Spain, and Italy, but it has been reported that the Treasury has been conducting negotiations aimed at bilateral agreements with other countries, including Switzerland and Japan. As yet, no such agreement has been finalized.
Turning now to the ISDA Protocol, probably its most important feature is that the payee will bear the risk of any FATCA withholding tax. Under the Protocol, where a non-U.S. counterparty fails either to enter into the above-described IRS agreement or fails to provide the required documentation to its counterparty, the 30 percent FATCA tax required to be withheld is not an "Indemnifiable Tax" for purposes of the ISDA Master Agreement. This treatment also applies to any taxes levied under one of the bilateral agreements to implement FATCA that are described above. Thus, the status of FATCA withholding under ISDA will be unique; it will be a withholding tax imposed by a major jurisdiction that will be withheld by the payer and actually borne by the counterparty, rather than being grossed up by the payer as an Indemnifiable Tax. The logic of the Protocol appears to be that a FATCA withholding tax, unlike a general statutory withholding tax, can be avoided if the payee enters into the IRS agreement and provides the required documentation to the payer.
The Protocol also defines "Tax" as used in Part 2(a) of the Schedule to the ISDA Master Agreement (Payer Tax Representations) to exclude any FATCA withholding tax. In most Schedules, the payer represents that it is not required to withhold any taxes. Thus, the Protocol provision allows this representation to be made without considering potential FATCA withholding. What is notably absent in the Protocol is any clarification of whether the imposition of a FATCA withholding tax is a "Tax Event" for purposes of section 5 of the ISDA Master Agreement, which would allow the payee a termination right (after reasonable efforts to transfer the contract under section 6 have not succeeded).
Deciding on Adherence
What are the considerations for foreign financial institutions in deciding whether or not to adhere to the Protocol or to agree to bilateral amendments to their ISDA Master Agreements? At this point, although the IRS still has to release the required FATCA agreement (and no bilateral agreements with foreign governments have been entered into), there is no reason to expect the procedure to be a bar to FATCA compliance in most cases. Addressing FATCA is important whether a foreign financial institution is concerned about being withheld on by a counterparty or is concerned that it will be obligated to withhold on a noncompliant foreign financial institution (under the above rules).
A foreign financial institution may be asked by its counterparty to adhere to the Protocol or to agree to a bilateral amendment to that ISDA Master Agreement so that the counterparty knows whether or not it has to withhold (i.e., to have clarity that a FATCA tax is not an Indemnifiable Tax and that a FATCA tax is not part of the Payer Tax Representations). Whether a foreign financial institution should agree to such a request depends, first, on whether the foreign financial institution intends to become FATCA compliant (i.e., to enter into the IRS agreement and be willing to provide its FATCA ID number to its counterparties). Agreement should depend, second, on whether the foreign financial institution is a party to ISDA Master Agreements with other foreign financial institutions, where it may want the protections with respect to the Indemnifiable Tax definition and Payer Tax Representations in its role as withholding agent (as described above). Another dilemma may be deciding whether or not a foreign financial institution will ever pay or receive a payment that may be subject to FATCA withholding. Since the types of trades and collateral posted may change under an ISDA Master Agreement, a counterparty's status as payer and recipient of FATCA-withholdable payments may change, and this should be considered carefully.
Once a foreign financial institution decides that it will address FATCA in its ISDA Master Agreements, it will need to determine whether it prefers to do so by adhering to the Protocol or by bilateral amendments. There are FATCA provisions that can be added to a bilateral amendment that are not in the Protocol.
Whether a foreign financial institution chooses adherence to the Protocol, bilateral amendments to its ISDA Master Agreements, or no action at all, a foreign financial institution has to consider the impact of FATCA—both from its perspective of payee on ISDA derivatives with other counterparties, which may request the foreign institution's adherence to the Protocol, as well as from the perspective of its relationships with other foreign financial institutions, when it will be the payer and withholding agent for potential FATCA tax.