Gearing Up for FATCA and Dodd-Frank: Next Steps for Trade Finance

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1 Gearing Up for FATCA and Dodd-Frank: Next Steps for Trade Finance City of London Club, London 25 February 2014 Douglas S. Stransky

2 Agenda Repeal of FATCA Background of FATCA and Implementation Timeline FATCA Fundamentals Intergovernmental Agreements, including the U.K.-U.S. Agreement Registration for Foreign Financial Institutions New FATCA Reporting Forms Impact of FATCA on Trade Finance Allocating Risk in Financing Transactions Models for Allocating Risk 2

3 Republican Party Backs FATCA Repeal Resolution The Republican National Committee approved a resolution on 24 January 2014 that called for the repeal of the Foreign Account Tax Compliance Act of 2009, or FATCA. The Republican National Committee... urges the U.S. Congress to repeal FATCA, the resolution says. 3

4 Background of FATCA History March 2010: FATCA became law as part of the Hiring Incentives to Restore Employment Act : U.S. Treasury and IRS issue Notices with preliminary guidance. 2012: Proposed regulations issued. Joint Statement issued by five EU countries and U.S. IRS announcement delays effective dates. Nine Intergovernmental Agreements ( IGAs ) signed or initialed. Approximately fifty more are expected. January 2013: Final regulations issued. Intent Law is aimed an ensuring that U.S. persons with financial assets outside the U.S. are paying U.S. tax by enhancing documentation and due diligence with an emphasis on increased reporting on U.S. persons. FATCA does not replace existing U.S. withholding tax rules, i.e., Chapters 3 and 61. 4

5 Notice : Current FATCA Implementation Timeline Withholding on withholdable payments Generally for payments after 30 June Grandfathered obligations: outstanding as of 1 July New account opening procedures Generally must be implemented by 1 July Later of 1 July 2014 or date of a Foreign Financial Institution ( FFI ) agreement. Pre-existing accounts Generally must be open as of 1 July Confirming changes will be made to IGAs. 5

6 Notice : Current FATCA Implementation Timeline Due date for first FFI report regarding U.S. Accounts. No later than 31 March 2015 for Timeline for registration Portal open as of 19 August Key due dates extended by six months. 6

7 FATCA Fundamentals FATCA imposes additional documentation, withholding, and reporting rules on U.S. financial institutions and FFIs. FATCA requires a withholding agent (U.S. or foreign) to withhold 30% U.S. tax on any withholdable payment made to a foreign entity that is: An FFI, unless the FFI satisfies certain requirements related to the identification and reporting of U.S. accounts or the payment is exempt; or A non-financial foreign entity ( NFFE ) that does not disclose certain U.S. owners or that does not certify that it has no U.S. owners. FATCA also requires an FFI to withhold on recalcitrant individual accounts. The withholding agent making a payment must determine who the payee is and the FATCA status of such payee. Loans advanced or committed prior to 1 January 2014 are grandfathered and fall outside the scope of FATCA, but care will be needed if they are materially amended (as a matter of U.S. tax law) after that date, since that might result in the benefit of grandfathering being lost. 7

8 Withholdable Payments Withholdable payments include: Any payment of U.S. source Fixed or Determinable Annual or Periodical ( FDAP ) gains, profits and income; and For any sales or other dispositions occurring after 31 December 2016, any gross proceeds from the sale or other disposition of any property of a type which can produce interest or dividends that are U.S. source. FATCA applies to the gross amount of the income payment (i.e., it is not reduced by any offsets or deductions). Significantly, the U.S. Treasury Regulations state that a withholding agent who is unable to determine the payment source at the time of payment is required to treat the payment as U.S. source income. Reg (a)(5) It is important to recognize that FATCA generally overrides the normal withholding exceptions allowed for U.S. source FDAP income under other Internal Revenue Code sections. For example, portfolio interest or U.S. bank interest are both exempt from withholding under the normal rules, but are subject to FATCA withholding. 8

9 Examples of FDAP Income The following items are a few examples of FDAP income: Compensation for personal services Dividends Interest Original issue discount Pensions and annuities Alimony Real property income, such as rents, other than gains from the sale of real property Royalties Scholarships and fellowship grants Other grants, prizes and awards A sales commission paid for a single transaction The distributable net income of an estate or trust that is FDAP income, and that must be distributed currently, or has been paid or credited during the tax year, to a nonresident alien beneficiary 9

10 Intergovernmental Agreements ( IGAs ) Foreign law may prevent an FFI from reporting directly to the IRS or withholding U.S. tax as required by FATCA, thereby preventing the FFI from complying with a participating FFI ( PFFI ) agreement. To overcome these legal impediments, U.S. Treasury is collaborating with foreign governments to develop an alternative approach to FATCA implementation under IGAs that leverages existing tax treaties and information sharing agreements. 10

11 Intergovernmental Agreements (continued) Treasury has published two Model IGAs that require: FFIs to register with the IRS. The identification and reporting of U.S. accounts, recalcitrant accounts and non- PFFIs (similar to the rules under the PFFI agreement). Due diligence and documentation with respect to client identification and withholding, in certain cases. FFIs located in Model 1 IGA jurisdictions (e.g., U.K.) that comply with the terms of that IGA will be treated as satisfying FATCA and will not be required to comply with the final U.S. regulations. These FFIs will report to their own government, which will then share the information with the U.S. FFIs located in Model 2 jurisdictions will comply with the terms of that IGA by complying with the PFFI agreement. These FFIs will report on U.S. accounts directly to the IRS consistent with the final regulations. 11

12 U.K.-U.S. IGA - Overview The U.K. entered into a Model 1 IGA with the U.S. on 12 September HMRC issued regulations (the Regulations ) on 31 May 2013 allowing U.K. FFIs to comply with their due diligence and reporting obligations under FATCA and the U.K.-U.S. IGA. Under the U.K.-U.S. IGA and the Regulations, direct reporting to the U.S. has been replaced with a mechanism whereby U.K. tax resident financial institutions (and U.K. branches of non-resident financial institutions) will register with the U.S. Internal Revenue Service ( IRS ), but provide information to HMRC, which will forward the information to the IRS. This regime will allow U.K. financial institutions to comply with their FATCA obligations without breaching U.K. data protection (and other) laws. 12

13 U.K.-U.S. IGA - Regulations The Regulations will apply to U.K. Financial Institutions ( UKFIs ). UKFIs generally include custodial institutions, depository institutions, investment entities, specified insurance companies, relevant holding companies and treasury companies that are resident in the U.K. for tax purposes, excluding branches and subsidiaries located outside the U.K. U.K. branches of non-resident financial institutions will be UKFIs as they are obliged to report to HMRC, whereas the branches and subsidiaries located outside the U.K. of UKFIs are excluded because they do not report to HMRC. Given the U.K. tax residence requirement, the U.K.-U.S. IGA will not be of great application to many investment entities, as the majority are structured to avoid being U.K. tax resident. The U.K. tax residency requirement may not be straightforward to determine where U.K. fiscally transparent entities, such as partnerships or limited partnerships, are used. 13

14 U.K.-U.S. IGA - Regulations (continued) Having said that, the U.S. has entered into IGAs with a number of jurisdictions that are commonly used for investment entities, including the Cayman Islands, Guernsey and Jersey. All UKFIs will be Reporting UKFIs unless they are deemed-compliant FFIs, exempt beneficial owners or excepted FFIs under the U.S. FATCA implementing regulations or they are otherwise identified as Non- Reporting UKFIs under Annex II of the IGA - these are, broadly, governmental or international organizations or certain specified forms of financial institutions that are generally solely U.K.-focused. All Reporting UKFIs will be subject to due diligence and reporting obligations, the details of which are set out in the Regulations. However, notwithstanding the Regulations, UKFIs will still need to register through an online FATCA registration portal established by the IRS. 14

15 FFI Registration IRS announced on 10 August 2013 the opening of its online registration system for FFIs, including UKFIs. FFIs can now register online by creating an account and providing required information. Financial institutions will also be able to provide required information for their branches of operation and other members of their expanded affiliate groups in which the financial institution is the lead organization. The registration system, designed to enable secure account management, is a web-based application with around-the-clock availability. As registrations are finalized and approved in 2014, registering FFIs will receive a notice of registration acceptance and will be issued a global intermediary identification number ( GIIN ). The IRS will electronically post the first IRS Foreign Financial Institution List in June 2014, and will update the list monthly. To ensure inclusion in the June 2014 IRS FFI List, financial institutions will need to finalize their registrations by 25 April

16 New Reporting Forms Form 8966, FATCA Report To be used by FFIs and withholding agents. Will allow reporting of all required information that is required of financial accounts: Including, substantial U.S. owners of passive NFFEs and owner documented FFIs; Aggregate recalcitrant account information. Revised Forms 1042 and 1042-S Will allow reporting required under Chapter 4 and Chapter 3. New Forms W-8. XML schemas to be used by withholding agents for electronic filing of these forms. 16

17 Impact of FATCA on Trade Finance The impact of FATCA on trade finance is of concern. Trade finance transactions, including: import/export letters of credit, documentary bankers acceptances, trade acceptances and open-account payments resulting in payments to a party other than an FFI, either directly, or through an FFI, may be subject to FATCA requirements. These transactions are of particular concern when payments are made through non-pffis, which may often be the case with emerging-markets transactions. 17

18 Impact of FATCA on Trade Finance This is also of particular concern for trade finance groups with affiliates in many countries. This unintentional, but potential disruptive impact on global trade should be considered, and trade finance transactions should be exempted from FATCA reporting and withholding. Such transactions are not very likely to raise the underlying concerns of FATCA. Further, imposing complex FATCA compliance requirements is likely to make it less likely that major-market banks will be willing to continue such low-margin business, especially given the other new burdens on such transactions arising in other regulatory regimes. Considering the goals of FATCA, financing activities generally should be explicitly excluded from the definition of financial accounts under FATCA. The same should apply for any collateral provided. 18

19 Allocating Risk in Financing Transactions An urgent issue for international finance professionals is to determine how to allocate the risk of 30% U.S. tax withholding under FATCA. One of the key FATCA risks in financial transactions is the possibility that PFFIs will be required to withhold on offshore payments made to non- PFFIs and account holders that have not properly identified themselves ( recalcitrant accountholders ). The 30% withholding obligation under FATCA can arise in several ways. Common circumstances that can require imposition of a FATCA withholding tax in financing transactions include the following: The borrower is a U.S. entity, or (in certain circumstances) has its obligations guaranteed by a U.S. entity, so that interest payments are U.S.-source and subject to FATCA withholding if paid to a noncompliant lender. 19

20 Allocating Risk in Financing Transactions (continued) The borrower is an FFI that earns some U.S.-source income, and rules are issued during the term of the loan requiring withholding on Foreign Passthru Payments. Payments on a loan that otherwise would avoid withholding because the loan is a grandfathered obligation could become subject to withholding if the loan loses that status. An existing agreement with a standard gross-up provision tied to taxes imposed by law may not apply to FATCA withholding on Foreign Passthru Payments if this withholding is imposed pursuant to an agreement with the IRS (and not under non-u.s. legislation implementing an IGA). 20

21 Models for Allocating Risk For transactions with borrowers that are U.S. persons, the consensus position in the U.S. loan market is to allocate the risk of FATCA withholding to the lender because compliance is within the lender s control. This position is reflected in Section 2(g)(i)(D) of the 2012 Model Credit Agreement Provisions published by the Loan Syndications and Trading Association (the LSTA ). Outside the United States, the lending market has not yet coalesced around a single approach to FATCA withholding for loan agreements. The Loan Market Association (the LMA ) has suggested this model wording: Rider 1 is referred to as borrower risk and it contains wording that effectively makes the application of FATCA withholding to the particular loan financing the borrower s risk. This is achieved by either the borrower(s) representing that they are outside the scope of FATCA and/or by extending the scope of the actual gross-up and indemnity to cover FATCA tax risks. 21

22 Models for Allocating Risk (continued) Rider 2 is referred to as lender risk but it effectively seeks to facilitate the application of the grandfathering rules to the loan financing in question by giving lenders the right to veto any amendment or change of borrower(s) that would result in the financing losing grandfathering. Lenders, however, carry the risk of FATCA withholding arising if, for whatever reasons, grandfathering provisions were not to apply in circumstances where there has been no material modification or change of borrower(s). As is clear from the above, the LMA proposals do not really provide an answer in that they do not establish a market standard whereby the risk of FATCA withholding is placed on one or the other party as the standard/usual position. Therefore, who assumes the contractual risk of FATCA is largely down to relative commercial bargaining power of the parties. 22

23 Models for Allocating Risk (continued) In addition to loan documentation, the LSTA and LMA coordinate documentation for secondary trading of loan participations and claims. The tax provisions in that documentation focus on the allocation of tax withholding risk not between a borrower and a lender but between a participant and a lead bank where the lead bank may be responsible for passing on proceeds or other payments it has received. Secondary transactions in which the participant is a non-pffi face the risk that payments of the settlement amount for purchased assets, as well as interest, fees, breakage amounts and delayed settlement compensation or payments by the seller/grantor to the participant, could be subject to FATCA withholding tax. 23

24 Models for Allocating Risk (continued) It is challenging to assess the precise effects of FATCA on secondary debt trading, not only because of the complexity of the topic and the absence of clear determination of certain issues, but also because the implications of FATCA in any particular case will depend on a complex set of factors, including not only the identity and status of the parties to the trade but also the terms of the underlying loan and the nature and status of the underlying obligors. As with the LMA riders for loan transactions, LMA has also proposed riders for the allocation of FATCA withholding risk in secondary transactions. These riders are based on worst-case scenarios and allocate FATCA withholding risk to the payee. They provide that each party is entitled to withhold on account of FATCA if required to do so and need not pay a grossed-up amount. The riders also contain contractual language entitling each party to request information from the other party concerning its status under FATCA. 24

25 Gearing Up for FATCA and Dodd-Frank: Next Steps for Trade Finance City of London Club, London 25 February 2014 Harry E. Ekblom

26 Overview - Dodd-Frank Wall Street Reform and Consumer Protection Act Hugely ambitious in scope 848 pages long - regulators left to flesh out the details Signed into law July 21, 2010 To date, about 200 of the rules required by DFA have now been adopted in final form - a little over half of all the rulemaking required under DFA Extraterritoriality issues in abundance Focus on two components of DFA New, final Federal Reserve rules - enhanced prudential standards for US operations of foreign banking organizations ( FBOs ) Final Volcker Rule 2

27 Regulation of FBOs - current rules FBO Any foreign bank that has a banking presence in the US (by operating a branch or agency, or a commercial lending company subsidiary, or controlling a bank in the US); or any company of which the foreign bank is a subsidiary Limited FBO capital requirements The Board of Governors of the Federal Reserve Bank, the primary regulator of Bank Holding Companies ("BHCs") does not require FBOs, or their US subs, to comply with the capital standards otherwise applicable to US BHCs The top tier US sub of FBO not subject to FRB capital requirements so long as considered "well capitalized and well managed" under the laws of its home jurisdiction FRB reliance on o home country supervisor to supervise an FBO on a global basis consistent with international standards o the FBO to support its U.S. operations under both normal and stressed conditions 3

28 Regulation of FBOs - current rules (cont d) Rules established in era when US operations of FBOs were principally engaged in lending to home country and US clients, and were net recipients of funding from offshore parents. FBOs may readily move capital in and out of their US operations Changes in role of US operations in years prior to DFA US operations become a source of funding for offshore affiliates - from a lending branch model to a funding branch model Most of the funding short term in nature (funding longer term assets held in home jurisdiction) FBO's more concentrated, and more complex o 5 of top ten US broker dealer are owned by FBOs Effect of financial crisis FBOs disproportionate users of Fed liquidity facilities Some home jurisdictions became a capital trap, not a source of strength Home jurisdiction ring-fencing proposal 4

29 Recent FRB FBO rules - "enhanced prudential standards and early remediation requirements" Proposed December 2012; final rules issued February 18, 2014 Section 165 of DFA- FRB to establish "enhanced prudential standards" for BHCs - including FBOs - with total consolidated global assets of >$50 billion "Large FBOs" - total consolidated global assets of >$50 billion Section 166 of DFA - FRB to establish "regulatory framework for early remediation of financial weakness" Section 171 of DFA ( Collins Amendment ) - top tier US banking subsidiary of FBO must meet minimum capital requirements applicable to US BHCs - effective July 21,

30 Recent FRB FBO rules (cont d) Intermediate holding company ( IHC ) requirement All US bank and non-bank subsidiaries to be moved underneath a top-tier intermediate US holding company FBO branches and agencies not affected Application - to any large FBO with >$50 billion in its US based subsidiaries (excluding assets in US branches or agencies) Risk based capital and leverage rules IHCs: Capital standards generally same rules as for US BHCs Large IHCs (>$50 billion of consolidated assets) also required to submit annual capital plans to FRB o Consequences of failing to submit an acceptable capital plan Large FBOs: must meet home country capital adequacy standards that are consistent with Basel no separate tests for US branches or agencies 6

31 Recent FRB FBO rules (cont d) Liquidity requirements Applicable to large FBOs with combined US assets (including assets in branches or agencies) >$50 billion Requirements: Liquidity stress tests: o for US operations - reported monthly to FRB o FBO liquidity stress test results provided to home country regulator Enhanced liquidity requirements: o 30-day liquidity buffer, consisting of highly liquid assets o Apply separately to FBO branches & agencies and IHCs IHC -- all liquid assets need to be held in the US FBO branches & agencies - only 14 days buffer required to be held in US 7

32 Recent FRB FBO rules (cont d) Single counterparty credit limits Rule not yet final Risk management governance For large FBOs and FBOs with public stock and >$10 billion of consolidated assets: Must maintain a committee to oversee risk management of US operations For large FBOs with >$50 billion of combined US assets US chief risk officer

33 Recent FRB FBO rules (cont d) Capital stress test requirements: Testing: IHCs, subject to same stress testing as US BHCs o o For IHCs with >$10 billion but < $50 billion of consolidated assets - annual "company run" stress test For IHCs with >$50 billion of consolidated assets: semi-annual "company run" stress test annual "supervisory" stress tests For FBOs with combined US assets of >$50 billion o o Must be subject to annual supervisory stress test by conducted by home country regulator, or evaluation and review of internal test by home country regulator Results of stress testing (and additional info) to be provided to FRB 9

34 Recent FRB FBO rules (cont d) Consequences of FBO failure to comply with stress testing requirements For FBOs with combined US assets of >$50 billion o maintain eligible assets at US branches & agencies equal to 108% of third party liabilities o at discretion of FRB, impose on US branches & agencies: intragroup funding restrictions liquidity buffer Any FBO with >$10 billion but < $50 billion of combined US assets o US branches & agencies required to maintain eligible assets on their books not less than 105% of their liabilities Debt to equity limits Early remediation of financial weakness Compliance dates - originally proposed July 1, 2015 Backed off a year to July 1, 2016 but implementation plan to be submitted by January 1, 2015 IHC leverage capital requirements January 1,

35 Recent FRB FBO rules (cont d) Proposed FRB FBO Rules - Takeaways 11

36 Volcker Rule & FBOs Volcker rule generally Section 619 of DFA (new section 13 to Bank Holding Company Act) A "banking entity" may not o "engage in proprietary trading" or o "acquire or retain any equity, partnership or other ownership interest in or sponsor a hedge fund or a private equity fund" Variety of statutory exemptions from rule History Proposed regulations issued October 2011 Final regulation adopted December 10, 2013 Overall purpose of Volcker Rule Enhance financial stability by limiting risk Limit inappropriate transfer of federal subsidies and liquidity guarantees Reduce conflicts of interest between banking entities and their customers 12

37 Volcker Rule & FBOs (cont d) Proprietary trading ban -- what's covered? "proprietary trading" -- "engaging as a principal for the trading account of the banking entity in any purchase and sale of one or more financial instruments" Three elements: "trading account" - an account used for acquiring or taking positions in financial instruments principally for selling in the near term (or otherwise to profit from short term price movements) "banking entities o Includes -- A foreign bank with a US branch, agency or US commercial lending subsidiary A parent company of such a foreign bank Any affiliate or subsidiary of foregoing o Not limited geographically! "financial instruments" o Includes securities derivatives futures contracts Options on any of the foregoing 13

38 Volcker Rule & FBOs (cont d) o Excludes: a "loan" - a loan, lease, extension of credit, or secured or unsecured receivable that is not a security or derivative SEC and CFTC have (finally) clarified that LMA loan participations are not derivatives A commodity that is not an interest rate or other "financial commodity" a derivative a futures contract Foreign exchange or currency 14

39 Volcker Rule & FBOs (cont d) Among exclusions from the proprietary trading ban -- Trading in non-us government obligations by US affiliates of foreign banking entities, foreign banking entities and certain foreign affiliates of US banking entities o government obligations issued or guaranteed by foreign sovereign under which foreign banking entity or foreign affiliate is organized o Trading in obligations of US or agency - that's OK Narrow exclusion for trading activities conducted solely outside of the US -- o No involvement by US affiliates of banking entity, or any personnel of banking entity or its affiliates located in US o The majority of the trading entity's business must be derived from outside the US o trade can't be conducted "with or through" a "US entity" -- an entity that is, or is controlled by, an entity located or organized in the US But - trades with foreign operations of a US entity are permitted (so long as no personnel of the US entity are involved in the trade) trades with unaffiliated market intermediaries also permitted as principal (so long as trade is promptly cleared and settled) or as agent (so long as conducted anonymously on an exchange, and promptly cleared and settled) 15

40 Volcker Rule & FBOs (cont d) Exclusions also subject to No material conflict of interest between the banking entity and its clients, customers and counterparties o Where banking entity s interests are materially adverse to the interests of client and either No disclosure to client that would permit the client to meaningfully understand the conflict, or disclosure is not made in a manner that would permit the client to mitigate the conflict; and/or No information barrier in place that is reasonably designed to prevent the conflict of interest from having a material adverse effect on the client No material exposure by banking entity to a high risk asset or trading strategy Trade does not pose a threat to the safety and soundness of the banking entity or to the financial stability of the US 16

41 Volcker Rule & FBOs (cont d) Ban on investments in hedge funds or a private equity funds DFA defines hedge fund or private equity fund as any issuer that would be an "investment company" under Investment Company Act of 1940, if not for 100 investor and qualified purchaser exceptions Under the final rule, a "covered fund" unless an exemption applies No banking entity allowed to own an interest in, or sponsor, a covered fund The breadth of covered fund definition highly troublesome 17

42 Volcker Rule & FBOs (cont d) Among exclusions from ban on investments in covered funds -- Foreign public funds issuers outside the United States Offering and selling ownership interests on a retail basis in the issuer's home jurisdiction Predominately (85%) through public offerings outside the US Where activities of covered fund conducted solely outside of United States Conditions include no ownership interest being offered for sale or sold to a resident of the United States Compliance Dates Final conformance required - July 21, 2015 Two one-year extensions available upon request Volcker Rule Takeaways 18

43 Questions? 19