Issues With FATCA Grandfathered Obligations

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Issues With FATCA Grandfathered

Obligations

October 7, 2014 Washington DC

Stevie D. Conlon, Senior Director & Tax Counsel Wolters Kluwer Financial Services

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• FATCA withholding tax rules went into effect on July 2, 2014 • Notice 2014-33 does not delay withholding tax rules or special

rules for grandfathered obligations

• Understanding the FATCA grandfathering rules for debt and the impact of the February 2014 Amendments to the FATCA

Regulations

• Understanding the Rules of Treas. Reg. Sec. 1.1001-3 to determine if debt is materially modified

Agenda

determine if debt is materially modified

• Concerns regarding modifications of non-debt grandfathered obligations

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Reporting Grandfathered

Obligations

IRS Form 1042 (2014) Annual Withholding Tax Return for U.S.

Source Income of Foreign Persons

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Treas. Reg. 1.1471-2(b): FATCA

Grandfathering

• “… a withholdable payment does not include any payment made under a grandfathered obligation described in paragraph (b)(2)(i)(A) of this section, or any gross proceeds from the disposition of such an obligation.”

• Grandfathered obligation:

– “…giving rise to a dividend equivalent pursuant to section 871(m)…, provided that the obligation is executed on or before the date that is six months after the date on which obligations of its type are first treated as

months after the date on which obligations of its type are first treated as giving rise to dividend equivalents…”

– “…any agreement requiring a secured party to make a payment with respect to, or to repay, collateral posted to secure a grandfathered obligation.”

• Obligation:

– Debt instrument or agreement to extend credit

– A derivatives transaction confirmed under an ISDA master

– Annuity contract payable for set period or for the life of annuitant – Life insurance payable no later than death of insured individual(s)

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FATCA Grandfathering Exclusions

• Does not include agreement or instrument:

– Equity for US tax purposes

– Lacks a stated expiration or term (Temp. Reg. 1.1471-2T(b)) – Brokerage agreement, custodial agreement, investment linked

insurance contract, investment linked annuity contract, or similar agreement to hold financial assets for the account of others

– Master agreement that merely sets forth standard terms and conditions that are intended to apply to a series of transactions – Master agreement that merely sets forth standard terms and

conditions that are intended to apply to a series of transactions between parties but that does not set forth all of the specific terms necessary to conclude a particular transaction

• Date outstanding:

– Issue date for debt

– If not debt, if a legally binding agreement establishing the

obligation was executed between the parties to the agreement before such date

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Notice 2014-33: The FATCA May

2014 Relief Notice

• The Notice includes repeated use of the term

“obligation”. At issue is the extent to which the use of

the term obligation in the Notice has significance in the

context of a withholding agent’s responsibilities relating

to grandfathered obligations pursuant to Treas. Reg.

Sec. 1.1471-2(b).

• The underlying FATCA regulations do not appear to

provide determinative guidance. “Obligation” appears

to have an extremely broad meaning for purposes of

Section 1471 and the FATCA rules.

• “Obligation” has a narrower, prescribed definition for

purposes of defining grandfathered obligations that

differs from the use of the term “obligation” in other

FATCA contexts.

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The FATCA May 2014 Relief Notice

• The notice does not include any reference to grandfathered obligations or the related grandfathered obligations FATCA regulation provisions.

– Without explicit reference, withholding agents face a risk that the Notice could be construed as not providing any relief for a withholding agent’s obligations with regard to grandfathered obligations that begin on July 1, 2014.

– This conclusion appears consistent with the Notice’s explicit statement that “…the IRS will not provide transitional relief with respect to its enforcement regarding a withholding agent’s determinations of the character and source of payments for withholding agent’s determinations of the character and source of payments for withholding and reporting purposes.”

• Alternatively, even if the term “obligation” as used in the Notice was broadly construed to include grandfathered obligations, it appears that the relief would only relate to the IRS Notice’s shorter six month relief period for obtaining and reviewing Forms W-8BEN-E, W-8IMY, etc. from entities. The Notice does not appear to support any relief beyond July 1, 2014 relating to obtaining and reviewing Forms W-8BEN from individuals.

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Summary of 2-20-2014 Amendments to

Grandfathered Obligations Regs.

• 2-20-2014 amendments removed the “reason to know” standard of

knowledge for material modifications for withholding agents that are not agents of issuer

• The standard for non-issuer agent withholding agents is now “actual knowledge” – the withholding agent must have actual knowledge that a modification is material in order for a grandfathered obligation to lose

modification is material in order for a grandfathered obligation to lose grandfathered status

• Issuer agents are still subject to know/reason to know standard (note: custodians and trustees may be agents of issuers)

• “Actual knowledge” is not a defined term in the Code/Regs.

• Issuer disclosure is one way, but not the only way, that a withholding agent may have actual knowledge (issuer disclosure is provided as an example of actual knowledge, which implies other forms of actual knowledge are

possible)

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• Determination of material modification. For purposes of paragraph (b)(2)(iv) of this section (defining material modification), a withholding agent, other than the issuer of the obligation (or an agent of the

issuer), is required to treat a modification of the obligation as material only if the withholding agent has actual knowledge thereof, such as in the event the withholding agent receives a disclosure indicating

Amended Rule for Material

Modifications:

§1.1471-2(b)(4)(iv)

in the event the withholding agent receives a disclosure indicating that there has been or will be a material modification to such

obligation. The issuer of the obligation (or an agent of the issuer) that is a withholding agent is required to treat a modification of the

obligation as material if the withholding agent knows or has reason to know that a material modification has occurred with respect to the obligation.

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Treas. Reg. §1.1471-2(b)(4)(ii)

Knowledge Standards

Withholding Agent Issuer/ Agent of Issuer? Knows/Has Reason To Know Issuer disclosures

YES _{Actual knowledge other}

than issuer disclosure

Reason to know

Issuer?

Actual Knowledge

Issuer disclosures

Actual knowledge other than issuer disclosure

NO

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Observations Re:

“Actual Knowledge” Standard

• Receipt of issuer disclosure is clearly “actual knowledge”

– But, what if unclear, or incorrect?

• What is (and is not) an issuer disclosure? Not defined

• New regulations do not provide that an issuer disclosure is

the only way to have actual knowledge

• What if…

– You receive issuer disclosure from client or competitor? – You receive issuer disclosure from client or competitor? – Issuer posts tax information on its web site?

• What if your internal tax counsel knows facts sufficient to

determine that a material modification has occurred?

• Could the “actual knowledge” standard actually put you at a

disadvantage if your level of tax expertise is superior to that

of your competitors?

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FATCA Grandfathering Overview

• Focus in this presentation is on rules for debt

• FATCA regulations require that security must be debt

for tax purposes

• Tax analysis independent of issuer notices may be

required

• Tax calculations—as of the date of the change in

terms under analysis, of adjusted issue price and

• Tax calculations—as of the date of the change in

terms under analysis, of adjusted issue price and

amortized bond premium are required in order to

apply the change in yield test

• Legal analysis is also required due to many rules of

the regulation, including for determining if a change

is a modification or a change in payment terms

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FATCA and Grandfathered Obligations

Step 1

Determine if obligation is grandfather-eligible Was obligation issued on/before 7/1/2014 Is obligation of requisite kind: debt for tax purposes, insurance or annuity, derivative collateral

Step 2

U.S. Withholding Agent FATCA Grandfathering Analysis

Step 2

Determine if a material modification occurs that causes obligation to lose grandfather status & become subject to withholding

Check for issuer disclosure indicating material modification

Determine if you have actual knowledge (or reason to if agent of issuer) that a material modification occurred, based on:

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Material Modification Standard Is

Existing Law

• “In the case of an obligation that constitutes

indebtedness for U.S. tax purposes, a material

modification is any significant modification of the debt

instrument as defined in §1.1001-3(e).”

• This is a tax law determination under existing law and

regulations that were originally finalized in 1996 (and

updated in 2011 and 2013).

• Testified on the proposed 1.1001-3 regulation in 1993.

Wrote an article on the final regulation in 1996. Wrote

opinions.

• IS FATCA material modification standard special or

different than the general tax rule for determining if

debt is materially modified? NO

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Issuer Notices Are Not Enough

• Regulatory/legal interpretation:

– Issuer notice is not the exclusive manner by which a withholding agent has a “actual knowledge” that a material modification has occurred.

• Issuer notice is ONLY ONE WAY that a withholding agent has actual knowledge

• The regulations do not say “only if issuer notifies agent.” • Industry asked the IRS to say this in comments on proposed • Industry asked the IRS to say this in comments on proposed

regulations and the final regulations did not do so. [FIF Comment Letter 6-21-2013; Treas. Reg. 1.1471-2(b)(4)(ii)]

• RESULT: Withholding Agents have a new regulatory burden that requires consideration of whether they have actual knowledge based on facts that are not provided in an issuer notice

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Analyzing the Tests Requires Legal & Tax

Analysis

• A material modification of a debt instrument for FATCA

grandfathered status depends on whether modifications result in a “significant modification” under Reg. 1.1001-3(e).

• Reg. 1.1001-3(b) provides that a change in the terms of a debt instrument must be a “modification” in order for it to be

necessary to assess whether it is a significant modification. • Reg. 1.1001-3(c) sets for the rules for assessing whether

changes to the terms of debt instruments constitute a

Reg. 1.1001-3(c) sets for the rules for assessing whether changes to the terms of debt instruments constitute a

modification. These are legal tests, rather than simply data tests. See, e.g., Reg. 1.1001-3(c)(1)(ii) regarding alteration by operation of terms. These are also tax law tests. See, e.g., Reg. 1.1001-3(c)(2)(ii) regarding property that is not debt for tax purposes.

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Material Modification – Significant

Modification Tests

1. Collective modifications are significant ((e)(1))

2. Change in annual yield greater than pre-existing yield (as of date of modification) of: (A) 25 basis points per full year of term of debt OR (B) 5% ((e)(2))

3. Change in payments greater than a material change in payments that is lesser than a change that (A) results in material deferral of scheduled payments OR (B) extends original term more than 5 years or 50% of original term ((e)(3))

scheduled payments OR (B) extends original term more than 5 years or 50% of original term ((e)(3))

4. Change in obligor (or co-obligor) on recourse debt ((e)(4)) (special rule for tax-exempt debt & certain other transactions) 5. Change in collateral on nonrecourse debt ((e)(4)(iv))

6. Change in nature (to non-debt) or recourse to non-recourse (except for defeased tax-exempt bonds) ((e)(6))

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Detailed Tax Analysis Can Be Required

• Yield test (tax law

based): adjusted issue

price & bond premium

• Material deferral prong

of payment test

?

Tax Analysis

of payment test

• Change in payment

expectations under

priority test

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FATCA Grandfathered Debt - Decision Matrix

U.S. Debt Instrument Issue Date? After 7-1-2014 Before 7-1-2014 Grandfathered Debt (GFD) Withhold on Payments to No Yes Material Modification? Yes No Actual knowledge/reason to know

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Material Modifications for Non-Debt

• Life insurance contracts: “…a material modification

includes any substitution of the insured under the

contract.” Temp. Reg. 1.1471-2T(b)(2)(iv).

• No clear rules for material modification for

non-debt/non-life insurance contracts: “…whether a

modification of an obligation is material is determined

based on the facts and circumstances.”

• Rev. Rul. 90-109 and the “fundamental change”

standard: key employee life insurance. Preamble to

1.1001-3 regulations explains that Rev. Rul. 90-109 and

existing law applies to non-debt, NOT 1.1001-3.

• Extremely narrow scope of Treas. Reg. 1.1001-4

regarding dealer/clearinghouse assignments of

derivative contracts.

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Modifications of Non-Debt: Rev. Rul.

90-109

• Preamble to debt mod regs (1.1001-3) says you can’t rely on the rules for non-debt (Preamble, T.D. 8675 (1996)):

– “For equity instruments in particular, the IRS and Treasury believe that the application of certain rules in these regulations would be inappropriate.”

– “Similarly, for contracts that are not debt instruments, the final regulations do not limit or otherwise affect the application of the “fundamental change” concept articulated in Rev. Rul. 90-109… .”

• Rev. Rul. 90-109 states: “A change in contractual terms effected through an • Rev. Rul. 90-109 states: “A change in contractual terms effected through an

option provided in the original contract is treated as an exchange under section 1001 if there is a sufficiently fundamental or material change that the

substance of the original contract is altered… .” • What is a “fundamental or material change”?

– “X exercised an option … to change the insured from A, the original insured under the policy, to B, ... This resulted in a change in the fundamental substance of the original contract because the essence of a life insurance contract is the life that is insured under the contract.”

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Notional Principal Contracts,

Options, Forwards & Short Sales

• Limited and narrow guidance:

– 1.1001-4 regarding dealer assignments of NPCs meeting certain conditions

– James S. Reily v. Comm. (extension of option was not a

continuation of original option—term is an essential aspect)

– Rev. Rul. 80-134 (extension of option), obsoleted by Rev. Rul. 86-9 – Rev. Rul. 78-408 (exchange of warrants on Y stock for warrants on – Rev. Rul. 78-408 (exchange of warrants on Y stock for warrants on

X stock), modified by Rev. Rul. 98-10

– GCM 38285 (Feb. 22, 1980) (call options with same terms except strike prices: substantially identical for wash sale purposes)

– Notice 2003-81 (assumption of option obligation), modified by Notice 2007-71

– TAM 2011402020 (July 12, 2011) (analysis of 1001 consequences of modification of settlement, strike and term provisions of

several different options)

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Limitations and Disclaimers

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