To address the effects of FATCA on derivatives transactions, on August 15, 2012 ISDA published a Protocol to allow market participants to amend the tax provisions of their ISDA Master Agreements. The amendments contained in the Protocol place the FATCA withholding tax burden on the recipient of the payment. The rationale is that the recipient is the sole party that has the ability to avoid the withholding tax by complying with the FATCA rules; therefore, the recipient should be the party burdened with the FATCA withholding tax if it chooses to not comply.
The following are responses to frequently-asked questions that ISDA has received in connection with the application of the Foreign Account Tax Compliance Act (FATCA) to derivative transactions. The following does not constitute legal advice. Parties should consult with their legal and tax advisers and any other adviser they deem appropriate prior to using the ISDA FATCA provision.
IRS Circular 230 Disclosure: ISDA does not provide tax advice. Any discussion of US tax matters on this website cannot be used for the purpose of avoiding tax penalties.
What is FATCA?
The Foreign Account Tax Compliance Act (FATCA) refers to US Internal Revenue Code sections 1471 through 1474, which were enacted by the Hiring Incentives to Restore Employment Act of March 2010. The original effective date has been delayed and is now scheduled for July 1, 2014. The intent behind FATCA is to help the US Internal Revenue Service (IRS) is to “target tax non-compliance by U.S. taxpayers with foreign accounts.”
What is the impact of FATCA on non-US financial institutions?
Broadly speaking, FATCA requires foreign financial institutions (“FFIs”) that are either residents in FATCA Partner Countries via an Intergovernmental Agreement (“IGA”) or opt in to the FATCA reporting regime (“participating FFIs”) to report information to either their home government or directly to the IRS regarding their US account holders in order to assist the IRS in enforcing US taxpayer compliance and to potentially withhold 30% US tax on payments made to account holders or other FFIs. Initally, any entity which makes a payment of US source income (or items considered US source for FATCA purposes) must consider whether the payment is subject to FATCA withholding.
What is the impact of FATCA on US financial institutions?
US entities, both financial and non-financial, that make payments of most types of US source income to non-US persons will be impacted as they may now be required to withhold a 30% tax on the payments to those non-US persons. This will require the US entities to collect and maintain documentation on those non-US persons and also track whether those persons are classified as subject to withholding under FATCA.
What are the effects of FATCA on derivatives transactions?
FATCA imposes a 30% withholding tax on an expansive list of payments, including payments of gross proceeds to non-participating FFIs and other payees that are not FATCA compliant starting in 2017 and potentially foreign pass through payments at some point after 2016.
What is ISDA doing to address the effects of FATCA on derivatives transactions?
ISDA has published the 2012 FATCA Protocol. The FATCA provision in the Protocol carves out FATCA withholding tax from the definition of “Indemnifiable Tax” in the ISDA Master Agreement. The impact of the proposed language is to place the FATCA withholding tax burden on the recipient of the payment. The rationale is that the recipient is the sole party that has the ability to avoid the withholding tax by complying with the FATCA rules; therefore, the recipient should be the party burdened with the FATCA withholding tax if it chooses to not comply.
PARTIES SHOULD CONSULT WITH THEIR LEGAL AND TAX ADVISERS AND ANY OTHER ADVISER THEY DEEM APPROPRIATE PRIOR TO USING THE ISDA FATCA PROVISION.
Why should parties consider incorporating the ISDA language prior to the January 1, 2014 effective date?
Under current law, grandfathering of derivatives transactions from FATCA withholding expires June 30, 2014. Since transactions executed July 1, 2014 could potentially be subject to FATCA withholding immediately, there is some urgency to amending agreements to address FATCA withholding prior to that July 1, 2014 date. Many counterparties in the market have expressed concerns with trading under ISDA Master Agreements that require the Payor to gross-up for the FATCA non-compliance of the Payee. In order to prevent market disruption, parties are strongly encouraged to adhere to the Protocol as quickly as possible to provide their counterparties comfort in advance of the effective date.
Are any additional materials available?
Yes, but they are dated. On August 16, 2012 ISDA held a market education call on FATCA, which can be streamed by clicking below. Also available is the accompanying presentation.
ISDA FATCA Protocol Market Education Call – Audio Recording and Presentation (PDF).
Also available are the ISDA FATCA market education note and an audio recording of the November 2011 FATCA market education call (ISDA member login required). These provide more on FATCA's effect on derivatives transactions and the proposed ISDA language that market participants may wish to consider incorporating in their ISDA documentation. Again, these materials are now dated.