In late October, Senator Max Baucus (D-Montana) and Representative Charles Rangel (D-New York), chairmen of the Congressional tax writing committees, unveiled the Foreign Account Tax Compliance Act of 2009 (“FATCA”). The FATCA provisions, introducing a new 30% U.S. withholding tax on “withholdable payments” made to foreign financial institutions that fail to comply with specified reporting requirements, and proposing to repeal the U.S. bearer bond exception, had significant ripple effects in the global capital markets. On December 7, 2009, Representative Rangel introduced H.R. 4213, the Tax Extenders Act of 2009 (the “Bill”) which was passed by the House on December 9. As its name suggests, the Bill is aimed at extending certain tax provisions set to expire at the end of the year. Importantly, the Bill also includes the FATCA, with certain modifications, many of which are intended to address issues raised by market participants relating to provisions of the original FATCA. The FATCA provisions stem from Congressional concerns about U.S. tax avoidance apparently triggered by the recent disclosures about substantial numbers of U.S. taxpayers with “undisclosed” foreign accounts. At least so far, Congress is apparently less concerned about possible negative impacts on foreign investors’ willingness to buy U.S. securities or about foreign countries imposing similar requirements on U.S. financial institutions. We summarize below the Bill’s provisions that are of importance to capital markets transactions.
Proposed Repeal of U.S. Bearer Bond Exception
In 1982, Congress passed the Tax Equity and Fiscal Responsibility Act (“TEFRA”) which restricts the issuance of debt instruments in bearer form. Under TEFRA, issuers of debt instruments in bearer form generally are denied deductions for U.S. federal income tax purposes for interest paid with respect to such debt instruments and are subject to an excise tax. Various sanctions also apply to holders. The aforementioned sanctions, however, do not apply with respect to bearer debt instruments that are issued under circumstances in which they are unlikely to be sold to U.S. persons. These circumstances include an issuance of foreign-targeted bearer debt instruments that complies with U.S. Treasury Department (“Treasury”) regulations referred to as “TEFRA C” and “TEFRA D.”
The U.S. imposes a 30% withholding tax on all U.S. source interest paid to non-resident aliens and foreign corporations. In 1984, Congress exempted “portfolio interest” from the U.S. withholding tax in order to encourage investment in U.S. debt. Portfolio interest is any U.S. source interest other than interest received from certain related parties or interest earned by a bank on an extension of credit in the ordinary course of its lending business. When it repealed the 30% withholding tax on “portfolio interest” Congress provided that debt instruments in bearer form do not qualify for the portfolio interest exemption unless such instruments are issued in compliance with the foreign-targeted requirements imposed by TEFRA.
Many U.S. issuers have European medium-term note or other foreigntargeted programs under which they issue bearer notes to non-U.S. investors. These issuances comply with the TEFRA regulations and, as such, the instruments are not subject to the sanctions described above or to U.S. withholding tax. In addition, many non-U.S. issuers include TEFRA restrictions in their debt offerings outside the U.S. to ensure that these offerings are not subject to the TEFRA excise tax.
- The Bill would end the practice of selling bearer bonds to foreign investors under TEFRA C and TEFRA D. Thus, with respect to issuers of foreign targeted bearer bonds, the Bill would deny an interest deduction for interest on bearer bonds. In addition, interest paid on such bonds would no longer qualify for treatment as portfolio interest, thereby subjecting such interest to a 30% U.S. withholding tax, and any gain realized by a holder of such bonds would be treated as ordinary income. In an odd twist, the Bill would effectively retain TEFRA restrictions for foreign issuers. Thus, issuers of debt in purely foreign-to-foreign transactions could avoid any excise tax risk by complying with existing TEFRA procedures.
- The Bill proposes to codify IRS Notice 2006-99. Accordingly, debt obligations held in dematerialized book-entry systems (such as JASDEC in Japan) would be treated as being issued in registered form. U.S. issuers using such a system would be required to comply with the certification provisions applicable to registered debt (e.g., by obtaining IRS Form W-8s from holders) in order to tap the portfolio interest exception for their debt issuances.
- The Bill includes a provision giving Treasury the authority to determine that certification (required under current law) as to non-U.S. beneficial ownership (e.g., IRS Form W-8BEN) is not required to qualify for the portfolio interest exemption from withholding tax on payments of interest on certain registered debt obligations. It is not clear under what circumstances Treasury would use this authority.
- Under the Bill, the repeal of the bearer bond exception would apply to debt obligations issued after the date which is two years after the enactment of the Bill. This grandfather provision, eighteen months longer than originally proposed, would give issuers substantial time to adapt to the new rules.
Proposed 30% U.S. Withholding Tax On “Withholdable Payments”
The Bill would introduce a new 30% withholding tax on any “withholdable payment” made to a foreign financial institution (“FFI”) (whether or not beneficially owned by such institution), unless the FFI agrees, pursuant to an agreement entered into with the Treasury, to provide information (including U.S. accountholder identification information and annual account activity information) with respect to each “financial account” held by “specified U.S. persons” and “U.S.- owned foreign entities.” The new disclosure requirements would be in addition to requirements imposed by a “Qualified Intermediary” agreement.
Rather than agreeing with Treasury to act as a withholding agent in respect of reportable payments, an FFI may wash its hands of any withholding responsibility by electing to give the withholding agents from which it receives payments the information necessary for the “upstream” withholding agent to implement the new withholding tax (generally, information that discloses the extent to which payments made to the electing FFI are allocable to accounts subject to the 30% U.S. withholding tax).
The term “financial institution” would include banks, brokers and investment funds, including private equity funds and hedge funds. A “withholdable payment” generally would include any payment of interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations,
emoluments, and other fixed or determinable annual or periodical gains, profits, and income from sources within the U.S. It also includes gross proceeds from the sale of property that is of a type which can produce U.S. source dividends or interest, such as stock or debt issued by domestic corporations. A “financial account” would include bank accounts, brokerage accounts and other custodial accounts. A “specified U.S. person” is any U.S. person other than certain categories of entities such as publicly-traded corporations and their affiliates, banks, mutual funds, real estate investment trusts and charitable trusts. A “U.S.-owned foreign entity” for this purpose would be any entity that has one or more “substantial U.S. owners,” which generally means (i) in the case of a corporation, if a specified U.S. person, directly or indirectly, owns more than 10% of the stock, by vote or value, (ii) in the case of a partnership, if a specified U.S. person, directly or indirectly, owns more than 10% of the profits or capital interests, or (iii) in the case of a trust, if a specified U.S. person is treated as an owner of any portion of the trust under the grantor trust rules.
Impact on Foreign Non-Financial Institutions
The Bill would also impose a 30% withholding tax on any withholdable payment made to a non-financial foreign entity, unless the non-financial foreign entity provides the withholding agent with either (i) a certification that it does not have a substantial U.S. owner, or (ii) the name, address, and taxpayer identification number of each substantial U.S. owner. This provision would not apply to payments made to a publicly-traded non-financial foreign entity, or any of its affiliates.
Treaty Relief, Credits and Refunds
If the beneficial owner of a payment is entitled to treaty benefits, the withholding tax rate imposed on any withholdable payment may be reduced or eliminated by the provisions of an applicable tax treaty and such beneficial owner would be entitled to a partial or full refund or credit. In addition, even if a treaty is not available, the beneficial owner of a withholdable payment on which the 30% tax is withheld may otherwise be entitled to a full refund or credit of the tax (e.g., because payments are eligible for the portfolio interest exemption or represent gross proceeds from the sale of a capital asset). In such a case, a non- U.S. person would have to file a U.S. tax return to obtain a full or partial refund or credit. Similarly, a U.S. person with a foreign bank account on which it receives payments that are withheld on, presumably would have to claim a refund or credit on its U.S. tax return.
These provisions generally would apply to payments made after December 31, 2012. However, the provisions would not apply to payments made on debt obligations outstanding on the date which is two years after enactment of the Bill. This latter grandfather should serve to calm foreign markets, which in early December were shut to U.S. issuers of debt over concern about the earlier version of the provision.
Unfortunately, the impact of the FATCA bearer bond and withholdable payment provisions on the purchase of U.S. securities by foreign investors will not be known until they take effect (if they are enacted), and then it may be too late to do anything. The U.S. Senate has not yet acted on the Bill.
Under current law, the source of any payments made pursuant to a notional principal contract (or swap) is determined by reference to the residence of the person receiving the payment. Accordingly, payments (including any amounts determined by reference to dividends) received by a foreign person that enters into a swap with respect to an underlying U.S. stock are treated as foreign source payments not subject to U.S. tax. By contrast, a direct distribution to the foreign person of a dividend generally would be subject to a 30% withholding tax (unless reduced by an applicable treaty). Further, although substitute dividend payments made under a stock lending agreement are sourced in the same manner as the dividends with respect to the underlying stock (and would therefore be U.S. source if made with respect to stock of a U.S. corporation), transactions involving stock lending rely on a decade old IRS Notice to avoid U.S. dividend withholding tax.2
Beginning in 2007, Congress investigated certain transactions where brokers would enter into swaps on U.S. equities for foreign customers. After a Wall Street Journal article3 and a Congressional hearing4, it was apparent that “dividend washing” was in the Congressional sights even after one of the perceived culprits, Lehman Brothers, Inc., went bankrupt. The Bill would treat as a U.S.-source dividend any “dividend equivalent” for purposes of U.S. withholding tax provisions. A “dividend equivalent” would be (i) any substitute dividend, (ii) any amount paid pursuant to a “specified notional principal contract” and that is contingent on, or determined by reference to, the payment of a U.S.-source dividend, and (iii) any amount that the Treasury determines is substantially similar to a payment described in (i) and (ii).
A specified notional principal contract is any notional principal contract if (i) in connection with entering into the contract, any long party (i.e., the party entitled to receive the dividend related payment) transfers the underlying security, (ii) in connection with the termination of the contract, any short party (i.e., any party that is not a long party) transfers the underlying securities to any long party, (iii) the underlying security is not readily tradable on an established securities market, (iv) in connection with entering into the contract, any short party to the contract posts the underlying security as collateral, or (v) the Treasury identifies the contract as a specified notional principal contact. In addition, unless the Treasury determines that a notional principal contract is of a type that does not have the potential for tax avoidance, any notional principal contract pursuant to which payments are made more than two years after the date of enactment will be a specified notional principal contract.
To address the concern with respect to the cascading effect of such a dividend withholding tax, the Bill includes a provision pursuant to which the Treasury may reduce the tax if one or more of the dividend equivalents is subject to tax and to the extent the taxpayer establishes that the tax has been paid on another dividend equivalent in the chain. For purposes of this provision, an actual dividend payment is treated as a dividend equivalent.
This provision would apply to payments made on or after the 90th day after enactment of the Bill. Therefore, if enacted, it would apply to existing swaps. The provision would have no effect, positive or negative, on payments before said date.