NEED TO KNOW

The essence of these provisions is to ensure that, as between payer and payee, the burden of FATCA withholding rests with the payee.  This reflects the fact that a FATCA withholding requirement is primarily triggered by the attributes of the payee (namely, its non-compliance with FATCA) and not (as in the usual case of income tax imposed by the source country) by the attributes of the payer.  

  • FATCA and ISDA: New Zealand banks and corporates are now having to consider how FATCA should be addressed in their ISDA documentation.  FATCA's extraterritorial effect is such that New Zealand parties who dismiss FATCA as an irrelevant US requirement may not achieve the contractual protections they need in the event a FATCA withholding obligation arises.   
  • ISDA 2012 FATCA Protocol: ISDA has released a protocol that seeks to address the effects of FATCA.  For agreements to which it applies, the protocol would:
  1. clarify that FATCA withholding is a tax, the withholding or deduction of which is required by law, thereby entitling the payer to withhold;
  2. provide that the payer is not required to gross up the payee for a FATCA withholding; and 
  3. provide that the payer's representation in respect of taxes does not include a representation that no FATCA withholding will apply.

The essence of these provisions is to ensure that, as between payer and payee, the burden of FATCA withholding rests with the payee.  This reflects the fact that a FATCA withholding requirement is primarily triggered by the attributes of the payee (namely, its non-compliance with FATCA) and not (as in the usual case of income tax imposed by the source country) by the attributes of the payer.

  • "Dividend equivalent" payments:  Those negotiating ISDA documentation should also be aware of the United States HIRE Act provisions requiring withholding from dividend equivalent payments in respect of which the underlying instrument is a share in a United States tax resident corporation.  This reform is less pervasive than FATCA as it should apply only to equity derivatives.
  • ISDA Short Form HIRE Act Protocol for dividend equivalent payments: ISDA has also issued a protocol addressing this new withholding from dividend equivalent payments.  The general effect of the Short Form HIRE Act Protocol is that, as between payer and payee, the burden of the withholding rests with the payee, except in cases of a breach of representation by the payer.  This approach may be seen as consistent with the purpose of the new withholding regime, which is to prevent non-residents of the United States from avoiding dividend withholding tax by receiving dividend equivalent payments under a derivative instead of receiving the underlying dividend.

OVERVIEW

The HIRE Act and ISDA documentation

The Hiring Incentives to Restore Employment Act (or "HIRE Act") was enacted in the US in March 2010.  There has subsequently been extensive commentary and analysis in relation to the provisions of the HIRE Act known as the Foreign Account Tax Compliance Act (or "FATCA")1 in particular.

While the compliance aspects of FATCA have been the subject of widespread comment, one issue that has not received the same attention is how the risk of FATCA withholding should be addressed in commercial documentation.  Although industry bodies such as ISDA and the Loan Market Association have issued guidance and suggested drafting for certain issues, such work remains at a preliminary stage2.

This note focuses specifically on ISDA documentation given its prevalence throughout financial markets and the increasing frequency with which financial institutions and corporates in New Zealand and Australia are being asked to contemplate FATCA and the HIRE Act in such documentation.

Structure of note

This note addresses the following points:

  1. a recap on the FATCA and "dividend equivalent" payment aspects of the HIRE Act;
  2. the relevance of those aspects of the HIRE Act for ISDA documentation; and
  3. recommended strategies for New Zealand entities that are involved with the negotiation and drafting of ISDA documentation where the contemplation of FATCA and HIRE Act withholding is requested by foreign counterparties.

HIRE ACT - FATCA PROVISIONS

Overview of FATCA

The HIRE Act added the FATCA provisions as a new Chapter 4 to the US Internal Revenue Code of 1986 entitled "Taxes to Enforce Reporting on Certain Foreign Accounts".  The FATCA provisions are considered by the IRS to be an important development in efforts to combat US tax evasion by US persons holding investments in offshore accounts.  Although the FATCA aspects of the HIRE Act have been enacted, the detailed compliance requirements will be included in regulations to be issued by the IRS and the Department of the Treasury.  Proposed regulations were issued in February 2012 and finalised regulations are expected to be issued in the upcoming US autumn.    

In general terms, the three key components of the FATCA regime are as follows:

  1. Foreign financial institutions (or "FFIs") are required to report annually to the IRS and provide information about "US accounts" maintained with that FFI.  Subject to certain exceptions, these are financial accounts held by US taxpayers, or by non-US entities in which US taxpayers hold a "substantial" ownership interest (generally, greater than 10 percent).  This reporting is to be undertaken pursuant to an "FFI agreement" to be entered into between the relevant "participating FFI" and the IRS.3  FFIs party to an FFI Agreement in full force and effect are known as "participating FFIs".
  2. FFIs are also required to provide information regarding "recalcitrant account holders".  Recalcitrant account holders are defined to include any non-FFI that fails to comply with requests for information by the FFI in order to determine whether its account is a "US account".  
  3. Disclosure obligations are also imposed on certain non-financial foreign entities (or "NFFEs") that are regarded as involving a high risk of US tax evasion.  This excludes "excepted NFFEs" which include foreign government controlled entities, companies publicly traded on one or more established securities exchanges, non-financial holding companies4 and "active NFFEs" where less than 50% of the entity's income or assets are attributable to the derivation of "passive" income (such as dividends, interest, rents or royalties).  NFFEs receiving "withholdable payments" from the US are required either to provide certain information in respect of their substantial US owners or to certify that they are not substantially owned by US taxpayers.    

FATCA seeks to achieve enforcement of the reporting requirements summarised above by imposing a punitive withholding on all relevant "withholdable payments"5 sourced from the US.  Such US-sourced payments made to an FFI or NFFE that has not complied with its reporting and disclosure obligations, or that has not entered into an FFI agreement at all, may be subject to a 30% withholding.  Furthermore, it is proposed that a participating FFI itself may be required to withhold amounts from payments it makes to recalcitrant account holders or non-participating FFIs.  These payments are known as "foreign passthru payments", the definition of which has been reserved in the draft regulations.   

The first category of withholding (from US-sourced payments) is currently expected to apply to such payments made to FFIs and NFFEs after 31 December 2013, whereas the second category of withholding (on passthru payments) is not expected to take effect until 2017.  Grandfathering protection is expected to apply for all debt obligations outstanding on 1 January 2013, although any material modification to such obligations after that date could mean that such protection no longer applies.

Relevance for ISDA documentation

The FATCA regime is relevant in the context of ISDA documentation for two reasons.

First, parties need to contemplate the possibility that payments made under a derivative transaction may be subject to the new FATCA withholding if one of the parties does not comply with its FATCA obligations.  Although the withholding may not be relevant until 2014, an ISDA Master Agreement generally operates as an umbrella framework for derivative transactions entered into over a number of years.  The potential for FATCA withholding to apply in the future is therefore very relevant for the current negotiation of new agreements or amendments.

Second, US parties are likely to seek additional documentation from their New Zealand counterparties to address any potential FATCA withholding obligations on their behalf.  These forms are likely to be specified in Part 3 (Agreement to Deliver Documents) of the schedule to an ISDA Master Agreement. 

Many New Zealand taxpayers will be familiar with the US tax form "W-8BEN".  That form requires a non-US resident to certify to a US payer that it (i) is a resident of its particular country and not the US, (ii) is the beneficial owner of a particular item of income and (iii) is entitled to benefit under the double tax treaty between its country and the US.

As a consequence of FATCA, the IRS has recently published a draft "W-8BEN-E" form which is a modified and extended version of the existing W-8BEN form for non-individuals.  In addition to certifications relevant to tax, the new form requires the non-US payee to certify its status for FATCA purposes.  The W-8BEN-E form remains in draft and the IRS is yet to issue guidance instructions as is typically the case with other forms.  However, this form is likely to become more relevant in the coming months as parties seek certainty in relation to their FATCA obligations and the FATCA status of their counterparties. 

ISDA 2012 FATCA protocol

The FATCA working group of the ISDA North American tax committee has issued several versions of a suggested standard-form provision for ISDA Master Agreements to address the effect of FATCA on derivative transactions.  The most recent product of the working group is the ISDA 2012 FATCA protocol issued on 15 August 2012 (the "FATCA protocol").  Market participants are able to adhere to the FATCA protocol which means that the text of the FATCA protocol is then incorporated into all "Covered Master Agreements" of that participant.  As with all ISDA protocols, this alleviates the administrative burden of having to amend all ISDA Master Agreements to which a particular participant is a party.    

OPERATIVE TEXT OF ISDA FATCA PROTOCOL

Withholding Tax imposed on payments to non-US counterparties under the United States Foreign Account Tax Compliance Act.  "Tax" as used in Part 2(a) of this Schedule (Payer Tax Representation) and "Indemnifiable Tax" as defined in Section 14 of this Agreement shall not include any U.S. federal withholding tax imposed or collected pursuant to Sections 1471 through 1474 of the U.S. Internal Revenue Code of 1986, as amended (the "Code"), any current or future regulations or official interpretations thereof, any agreement entered into pursuant to Section 1471(b) of the Code, or any fiscal or regulatory legislation, rules or practices adopted pursuant to any intergovernmental agreement entered into in connection with the implementation of such Sections of the Code (a "FATCA Withholding Tax").  For the avoidance of doubt, a FATCA Withholding Tax is a Tax the deduction or withholding of which is required by applicable law for the purposes of Section 2(d) of this Agreement.

The most important aspect of the FATCA protocol relates to "Indemnifiable Tax".  The FATCA protocol excludes FATCA withholding from the definition of "Indemnifiable Tax" and therefore from the scope of the gross up provision in section 2(d) of the ISDA Master Agreement.  The result is that the burden of any FATCA withholding is placed on the recipient of the relevant payment under the derivative transaction.  The rationale for this approach is that the recipient is the sole party that has the ability to avoid the withholding by complying with the FATCA rules and therefore should be the party burdened with such withholding if it does not comply.

The other aspects of the FATCA protocol:

  1. exclude FATCA withholding from the payer tax representations provided in Part 2(a) of an ISDA Master schedule; and
  2. in relation to section 2(d) of the ISDA Master Agreement, which permits a party to make a deduction or withholding from a payment that is required by applicable law, records the agreement of the parties that the deduction or withholding of FATCA withholding is so required by applicable law.  

As at 21 August 2012, 23 parties had adhered to the FATCA protocol although many are different entities under the umbrella of a large financial institution such as Goldman Sachs or Merrill Lynch.  At this stage the FATCA protocol applies only to US federal withholding tax, but it will be interesting to see if this changes, particularly with respect to foreign passthru payments, as inter-governmental agreements are progressively entered into.

The New Zealand perspective

Recent experience has shown a general reluctance from Australasian banks and corporates to include FATCA provisions in their ISDA Master Agreements.  This approach is usually on the basis that FATCA is "US-centric" legislation and the detailed requirements in the draft regulations have yet to be finalised.  One can have some sympathy for that approach, particularly in the light of the extra-territorial nature of the FATCA provisions.  On the other hand, perhaps unsurprisingly, North American financial institutions seem more receptive to addressing FATCA issues in their ISDA Master Agreements. 

The reality is that FATCA is coming whether market participants outside the US like it or not.  Therefore to dismiss FATCA as irrelevant in the New Zealand context is not commercially realistic and could even be detrimental to New Zealand resident counterparties (eg, a New Zealand resident could find themselves obliged to gross up a counterparty for FATCA withholding if the risk of that withholding has not been contractually allocated between the parities).  However, in the absence of seeking specific US legal advice, the question is to what extent New Zealand taxpayers can or should include FATCA provisions in their ISDA Master Agreements without exposure to unacceptable legal risk.

The following contains a suggested set of guiding principles for New Zealand taxpayers when negotiating ISDA Agreements in the current FATCA environment in the absence of seeking US legal advice.

FATCA -  suggested set of guiding principles for New Zealand taxpayers when negotiating ISDA Agreements in the current environment:

  • If the starting position is that FATCA provisions should be resisted, one approach may be to oppose the inclusion of any FATCA provisions at all on the basis that the position remains uncertain pending finalisation of the applicable regulations.
  • Another approach in terms of resisting the inclusion of FATCA provisions may be to seek to oppose their inclusion on the basis of irrelevance if the New Zealand taxpayer is neither:
  1. a "foreign financial institution" (eg on the basis it is not a registered bank or other financial institution); nor
  2. a "non-financial foreign entity" (eg on the basis it is excepted due to being listed on the NZX or being a non-financial holding company).

This may be particularly relevant for large non-bank corporates that are listed.  It is likely that a US party would still require the provision of a W-8BEN-E form to confirm the New Zealand party's status for FATCA purposes.

  • Another approach may be for the New Zealand party to seek to restrict the scope of FATCA provisions to transactions in which the counterparty is acting out of its US head office or branch as those are the situations in which a "withholdable payment" from sources within the US is more likely to arise.  If the counterparty is not a US resident, and there is no possibility of payments originating from a US branch, there would again be a strong case for omitting FATCA provisions on the basis of irrelevance.
  • If there is strong insistence on including FATCA provisions in the ISDA Master, the FATCA protocol published by ISDA generally provides for a sensible result between the parties:
  1. A counterparty would suffer a withholding, and not reap the benefit of the gross up, only where that party has failed to comply with the FATCA requirements applicable to it.  As a matter of commercial negotiation, it would seem difficult to insist that your counterparty should provide a gross up for a potential withholding that will arise only due to your own non-compliance. 
  2. In terms of the other primary aspect of the FATCA protocol, a derivative counterparty cannot sensibly make a payer representation that no withholding will be required from derivative payments if there is the potential for FATCA withholding to apply. 
  • Any representations, covenants or other terms specific to US law over and above those included in the FATCA protocol will need to be worked through in the individual case and may require US legal advice in certain cases.  Parties should also think about including a termination right in the ISDA Master in the event that a FATCA withholding arises. 
  • An ISDA counterparty may seek a general undertaking from a New Zealand entity that it will provide any form or certification required to be delivered pursuant to Chapter 4 of the Internal Revenue Code of 1986.  Given that the FATCA regulations and associated documentation remain in draft, the response might be to resist such an obligation pending finalisation of the regulations.  However, if there is strong insistence on including a provision to deal with FATCA documentation, provided that the obligation is framed in reasonable terms and the New Zealand party has sufficient time to identify and provide those forms or certifications that are relevant, an undertaking framed in those terms seems commercially acceptable.

HIRE ACT - "DIVIDEND EQUIVALENT" PAYMENTS

Overview of "dividend equivalent" payment rules

In addition to FATCA, the HIRE Act also seeks to impose US withholding tax on certain payments referred to as “dividend equivalent" payments. 

Dividend equivalent payments are defined for these purposes as:

  1. any substitute dividend made under the terms of a securities lending transaction or repurchase ("repo") transaction;
  2. any payment made pursuant to a derivative transaction (or "specified notional principal contract") if the payment is contingent upon, or determined by reference to, the payment of a dividend from sources within the US; or
  3. any other payment determined by the Secretary of the Treasury to be substantially similar to those described in (a) and (b). 

By way of background, the US Treasury and the IRS had become aware that foreign entities could avoid withholding tax on US sourced dividends by entering into certain securities lending, repo or equity swap transactions which enabled an entity to receive amounts (including dividend equivalent amounts) that put it in a position equivalent to holding the share, but without actually holding the share and receiving actual dividends.  The "dividend equivalent" payments received as a result of those transactions were not dividends for tax purposes and therefore were not subject to US withholding tax on dividends.       

The effect of the HIRE Act is to treat these dividend equivalent payments as dividends from sources within the US for withholding tax purposes.  Withholding tax therefore applies at a rate of 30% to such payments made to non-US persons (subject to any applicable treaty relief).  The HIRE Act includes provisions to prevent over-withholding in the event that the same US share is the subject of multiple derivative transactions. 

Like the FATCA provisions, the dividend equivalent provisions are still in somewhat of a transitional phase in terms of their implementation.  For example, temporary and proposed regulations issued earlier this year deferred the date of application for amendments to the definition of "specified notional principal contract", being the key definition for the purposes of identifying relevant derivative transactions.  

The dividend equivalent provisions apply to payments made after 14 September 2010 (being 180 days after the date of enactment of the HIRE Act) regardless of when the relevant underlying transaction was entered into.  It should also be noted that the provisions may apply to derivative transactions entered into between non-US residents if the underlying securities are US equities meeting the relevant criteria.   

Relevance for ISDA Master Agreements - Short Form HIRE Act Protocol

The dividend equivalent provisions of the HIRE Act are relevant in the context of ISDA documentation because parties need to contemplate the possibility that payments made under a particular transaction may now be subject to US dividend withholding tax. 

ISDA has issued a "Short Form Hire Act Protocol" which is a suggested way for market participants to address the application of these provisions of the HIRE Act.6  (Note that there is also a longer form protocol but that the "short form" version is more recent and seems to be ISDA's preferred alternative in addressing these provisions of the HIRE Act.)

The effect of the Short Form Hire Act Protocol may be summarised as follows:

  1. Tax on dividend equivalent payments is excluded from the definition of "Indemnifiable Tax" and therefore is also excluded from the scope of the gross up in section 2(d) of the ISDA Master Agreement.
  2. The Short Form Hire Act Protocol adds a new section 2(d)(iii) to section 2(d) of the ISDA Master Agreement.  Section 2(d) provides that a deduction or withholding on account of tax is permitted to be made from a payment under a derivative transaction where that deduction or withholding is required by applicable law.  The new section 2(d)(iii) seeks to allocate responsibilities for the payment of dividend equivalent tax where it is imposed on a party in respect of a payment under a derivative transaction.  It essentially applies as follows:
    1. A party is entitled to deduct dividend equivalent tax from payments it makes under a derivative transaction, even if that tax is not assessed on the basis of a withholding and is instead assessed against the payer as an amount to be remitted to the tax authorities.
    2. If Party X is required to remit to the tax authorities any amount of dividend equivalent tax in respect of a payment Party X makes to Party Y then:
      1. Party X is entitled to be indemnified by Party Y for the amount of that tax (to the extent the tax has not already been deducted from that payment).
      2. If that tax arose as a result of a breach by Party X of a payer tax representation, then no such indemnity applies.
    3. If Party Y is required to remit to the tax authorities any amount of Dividend Equivalent Tax in respect of a payment Party X makes to Party Y, then Party Y is entitled to be indemnified by Party X for the amount of that tax if that tax arose as a result of a breach by Party X of a payer tax representation.
  3. Additional tax payer and payee representations and undertakings are given to the effect that the parties have not taken, and undertake that they will not take, certain specified trading actions that could cause a transaction to be subject to the dividend equivalent provisions of the HIRE Act.  

    For example, an additional payee representation is provided by a "long party" (ie the party receiving the dividend equivalent payment) that is not a US person and that does not carry on a trade or business in the US with which the payment is effectively connected.  The additional representation is to the effect that the long party: (i) has not transferred and will not transfer the underlying security to the other party in connection with entry into the relevant derivative transaction and (ii) will not acquire the underlying security from the other party in connection with the termination of the relevant derivative transaction.

    The representation is directed at the definition of "specified notional principal contract" in the HIRE Act.  It provides comfort to the counterparty that the derivative transaction concerned will fall outside the scope of that definition as there is no transfer between the parties of the underlying instrument on either side of the dividend date.  

The New Zealand perspective

The dividend equivalent payment aspects of the HIRE Act have not been as widely discussed as the FATCA aspects, but more New Zealand ISDA counterparties are being asked to contemplate their application in their ISDA documents.  In particular, where a New Zealand party has not adhered to the Short Form HIRE Act Protocol, it may be asked to incorporate the provisions of that Protocol in an ISDA Master Agreement by reference.  As at 31 August 2012, the only Australasian entities that had taken the step of adhering to the Short Form HIRE Act Protocol, as listed on the ISDA website, were: Macquarie Bank and First Prudential Markets. 

In practice, the dividend equivalent payment aspects of the HIRE Act will only be relevant in very specific circumstances.  That said, the HIRE Act provisions apply on their face to transactions entered into between non-US parties, so the fact that neither party to an ISDA Master Agreement has a US connection is not a complete answer to a counterparty's request to include contractual provisions addressing the HIRE Act.

One practical way to push back on the inclusion of these provisions would be on the basis of irrelevance where no equity derivatives are to be entered into under the ISDA Master concerned.  In particular, if no derivative transactions are to be entered into with respect to US equity securities there is no sensible basis for requiring the Short Form HIRE Act Protocol to apply. 

In many cases, a New Zealand party will be entering into an ISDA Master to hedge its currency and interest rate exposure with respect to its debt arrangements and so will have a principled basis for resisting the Short Form HIRE Act Protocol.  A suggested example of a covenant to be included in the Schedule to an ISDA Master Agreement to address this issue is set out below:

SUGGESTED COVENANT FOR USE IN RELATION TO US EQUITIES

Party A and Party B agree and acknowledge that no Transaction shall be entered into pursuant to this Agreement in respect of equity securities issued by a corporation tax resident in the United States or that may give rise to the payment of a dividend from sources within the United States (including, for the avoidance of doubt, any Option Transaction, Forward Transaction or Equity Swap Transaction in respect of such securities, as those terms are defined in the 2002 ISDA Equity Derivatives Definitions).

If derivative transactions in relation to US equities may be entered into under the ISDA Master concerned, the relevant provisions will need to be considered and worked through in each individual case.  However, if the underlying securities are not being physically traded in connection with a corresponding derivative transaction, the risk of the dividend equivalent withholding tax applying should be minimal.