IRS and Treasury Release Massive Set of Proposed Regulations on FATCA

The Internal Revenue Service (the “IRS”) and Treasury have released a comprehensive set of proposed regulations relating to the implementation of the Foreign Account Tax Compliance Act (“FATCA”). The most significant changes made by the proposed regulations are to delay the implementation of certain FATCA provisions, as described below.

FATCA Generally

The FATCA provisions generally impose gross-basis withholding at a 30 percent rate on the U.S.-source income (including the gross proceeds from the sale of, or a return of capital or principal from, investments that generate U.S.-source income) of certain foreign financial institutions (“FFIs”) unless the relevant FFI enters into an agreement (an “FFI Agreement”) with the IRS pursuant to which the FFI agrees to determine which of its accounts is directly or indirectly owned by U.S. individuals or entities (“U.S. holders”), and ultimately, to provide information on such U.S. holders and their account balances, income and withdrawals, to the IRS. Similar withholding is imposed on “non-financial foreign entities” (“NFFEs”) unless the NFFE makes certain certifications regarding its U.S. holders.

The definition of an “FFI” includes not only banks and broker dealers, but also entities whose principal business is investing in securities, commodities and partnership interests (including derivatives of such interests). Therefore, the FATCA provisions are applicable to many investment entities organized outside the U.S. (e.g., mutual funds, hedge funds, private equity funds and CLOs, among others).

Payments of U.S.-source income (and payments of proceeds or principal from investments generating such income) to an FFI that has entered into an FFI Agreement (a “Participating FFI”) will generally not be subject to 30 percent withholding. Rather, the Participating FFI will itself perform withholding on any payments that are attributable to withholdable payments that it makes to its accountholders (such payments, “Passthru Payments”), if the account holders either have not provided the requisite information to determine whether they are U.S. holders, or are themselves FFIs that have not entered into an FFI Agreement (“Non-Participating FFIs”).

Changes Made in Proposed Regulations

FATCA, sections 1471 through 1474 of the Internal Revenue Code of 1986, as amended (the “Code”) was enacted in 2010. The IRS provided preliminary guidance on implementing the FATCA provisions in the form of Notice 2010-60, Notice 2011-34 and Notice 2011-53 (together, the “Notices”).

The Notices provided a fair amount of detail regarding the types of FFIs that would be subject to the FATCA provisions, the due diligence requirements imposed on a Participating FFI, the types of instruments that would be subject to the FATCA provisions and the type of information to be reported by a Participating FFI with respect to its U.S. holders. The proposed regulations, which ultimately will replace the guidance contained in the Notices, expand upon that earlier guidance and in particular provide welcome transitional relief regarding the implementation of certain of the FATCA provisions.

The principal significant changes made by the proposed regulations include:

• Under the FATCA provisions, payments with respect to instruments that were outstanding as of March 18, 2012, would not be subject to the FATCA provisions. Under the proposed regulations, this “grandfathering” provision has been extended to Jan. 1, 2013. Accordingly, payments made on debt instruments, derivatives and other types of instruments entered into prior to Jan. 1, 2013 generally should not be subject to the FATCA provisions, unless materially modified after such date;
• The IRS has committed to releasing a proposed model FFI Agreement in early 2012 and a final model FFI Agreement by late 2012. The IRS has also stated that there will be an online registration process available no later than Jan. 1, 2013;
• FATCA withholding will begin with respect to U.S. source payments (i.e., of interest, dividends, etc.) on Jan. 1, 2014, and withholding with respect to the gross proceeds from the sale of, or payments of principal or capital with respect to, U.S. investments will begin Jan. 1, 2015;
• Participating FFIs will be required to perform information reporting regarding the amount of income realized by U.S. holders by 2016 (with respect to the 2015 taxable year), and will be required to perform information reporting regarding the amount of gross proceeds realized by U.S. holders by 2017 (with respect to the 2016 taxable year);
• Certain Passthru Payments will be subject to information reporting by Participating FFIs no earlier than Jan. 1, 2015, and will be subject to withholding no earlier than Jan. 1, 2017;
• Describing the due diligence required to determine which of a Participating FFI’s account holders were U.S. holders, with the account balance thresholds that trigger increased diligence raised; and
• Limited transitional relief is proposed for affiliates of a Participating FFI in a jurisdiction that prohibits providing certain of the information called for under the FATCA provision and certain additional categories of FFIs would be “deemed compliant” with the FATCA provisions without entering into an FFI Agreement are established.

The proposed regulations are fairly complex, and no assurance can be given that the final regulations will be substantially the same. However, given the statutory requirements of the FATCA provisions and the manner in which the IRS is proposing to implement these requirements, any entity that is an FFI will need to adopt substantial procedures to ensure compliance. 

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