INSIGHT FATCA documentation requirements in capital and lending transactions

INSIGHT FATCA documentation requirements in capital and lending transactions Stefka Kavaldjieva and Matthew Peckosh Allen &Overy, London This is the first in atwo-part series of articles aimed at addressing FATCA requirements in documentation in international capital and lending transactions. Stefka Kavaldjieva and Matthew Peckosh are tax associates at Allen &Overy in London. I. Background The United States enacted the so-called Foreign Account TaxCompliance Act ( FATCA ) in 2010 to combat tax evasion by US persons hiding their income through non-us financial institutions. FATCA generally imposes a new reporting regime and potentially requires US and certain non-us entities to withhold up to 30 percent tax on certain payments to: (i) any non-us financial institution (a foreign financial institution, or FFI (as defined by FATCA)) that does not become a participating FFI byentering into an agreement with the US Internal Revenue Service ( IRS ) to provide the IRS with 4 01/14 Copyright 2014 by The Bureau of National Affairs, Inc. TPETS ISSN 1754-1646

certain information in respect of its account holders and investors or is not otherwise exempt from or in deemed compliance with FATCA; and (ii) any investor or creditor (unless otherwise exempt from FATCA) that does not provide information sufficient to determine whether the investor or creditor is a US person or should otherwise be treated as holding a United States account ofthe issuer or debtor. Because of the broad scope of FATCA (including the broad definition of the term FFI ), compliance requires many entities and groups within and outside the financial sector to re-evaluate and adjust their internal compliance processes. 1 The impact of FATCA does not end, however, with compliance concerns such as new customer onboarding procedures, information collection, or reporting. In addition to these concerns, transaction documentation must be drafted to ensure that market participants are contractually permitted to perform the information gathering and reporting required by FATCA, and that the allocation of risk of any withholding due to non-compliance represents a commercial decision. This article describes common approaches to addressing FATCA in international debt capital market offerings and lending documentation. In a forthcoming article, documentation approaches to asset management documentation will be addressed. In this piece, we assume a general familiarity with the basic rules of FATCA, which have been discussed previously in the series of articles on FATCA compliance for non-financial US companies published in past issues of European Tax Service. II. Debt capital market transactions Since the introduction of FATCA in 2010, market participants in debt capital markets, and their trade association, the International Capital Markets Association ( ICMA ) have accepted almost universally that FATCA withholding is an investor s risk. Allocating withholding risk to investors generally makes sense, since apayee is in aposition to avoid FATCA withholding by complying with FATCA. In addition, payees may often be in a position to obtain a refund for FATCA withholding if they have no underlying tax obligation. Although withholding triggered by certain non-compliant intermediaries in the payment chain may be beyond the investor scontrol, the general view is that commercial pressures would prompt all parties to take adequate steps to pre-empt FATCA withholding. Consequently, payments in a debt capital market transaction generally are subject to any applicable FATCA withholding with no obligation on part of the payor to gross up the payee for any FATCA withholding. This practice contrasts with the general practice in capital markets with respect to source-country withholding, which allocates this risk to the issuer, who is generally required to pay the investor gross. 2. The exception There is one limited exception to this general practice of allocating FATCA withholding risk to the payee, advocated by many European practitioners. The exception relates to the remote possibility of FATCA withholding being triggered by local law, for example, if FATCA withholding is required pursuant to the implementing legislation of an intergovernmental agreement ( IGA ). In such circumstances, FATCA withholding would be considered a local, rather than US tax. It is therefore argued that, as with most other local taxes, the issuer should gross up payments to the clearing systems. This position generally is not accepted by US advisers, for whom FATCA withholding Allocating withholding risk to investors generally makes sense, since apayee is in aposition to avoid FATCA withholding by complying with FATCA remains universally apayee s risk, subject to commercial agreement otherwise. A. Risk allocation 1. The rule 3. Risk mitigation While market practice is to allocate FATCA withholding to investors, it is almost universally accepted that issuers have an obligation to mitigate the risk of FATCA withholding by ensuring their choice of agents does not trigger FATCA withholding on payments received by such agents. The justification for this mitigation obligation is that the issuer appoints its agents, and is therefore in the best position to ensure that such entities do not themselves trigger FATCA withholding on payments they receive. An issuer may accomplish this in various ways, none of which are accepted universally at present since the International Capital Market Association ( ICMA ) and other industry bodies continue to deliberate the most appropriate, and logistically feasible, mechanic. The following three approaches are commonly used, often as acombination of at least two thereof: 01/14 Tax Planning International European Tax Service Bloomberg BNA ISSN 1754-1646 5

a. termination of the agent by the issuer with no notice or on short notice if the agent cannot receive payments free of FATCA withholding; b. re-direction or re-organisation of such payments by the issuer if the agent cannot receive payments free of FATCA withholding; and c. a representation by the agent to the issuer that the agent is or will be in compliance with FATCA prior to the earliest relevant effective date of FATCA withholding. B. Documenting the right to withhold for FATCA Currently there are two alternative ways of documenting the right of the issuer to make payments free of FATCA withholding with no corresponding obligation to gross up for such withholding. The right may be documented under either the payment condition of the securities or the taxation condition. 1. Payment condition ICMA, along with its European membership, recommend and prefer documenting the withholding risk by stating under the payment condition that payments are subject to all fiscal and other laws in the place of payment and to withholding or deduction under FATCA. A key reason for addressing withholding in the payment condition rather than the taxation condition is that for non-us issuers, the taxation condition generally is limited to taxes imposed by the jurisdiction of incorporation of the issuer and/or its guarantors. Therefore, FATCA withholding, as a tax imposed by the United States, should not be addressed by the taxation condition. 2. Taxation condition Practitioners who advocate documenting the risk allocation under the taxation condition, on the other hand, argue that the taxation condition most suitably informs investors of the relevant withholding which may apply to payments on the securities, regardless of the jurisdiction which imposes the withholding. In their opinion, addressing withholding in the payment condition buries information key to the investment decision of investors in a condition that on its face is unrelated to tax. Since the taxation condition generally is limited only to taxes imposed by the jurisdiction of incorporation of the issuer and/or its guarantors, the FATCA provisions in this condition would need to: s include FATCA withholding among the taxes covered by the taxation condition; and s carve out FATCA withholding from the gross up obligation of the issuer and/or its guarantors. C. Disclosing the risk of FATCA withholding Since the earliest effective date for FATCA withholding (currently July 1, 2014) has been postponed several times, the definition of foreign passthru payment isstill pending, and many issuers are uncertain of their future FATCA status, it has become market practice to cater for the possibility of FATCA withholding in capital market transactions by amending the terms and conditions of the securities in note programmes irrespective of the nature of the issuer (with limited exceptions) and the likelihood of the application of FATCA withholding to payments on the securities. This sweeping approach to addressing FATCA was triggered mostly by a desire to save costs in conducting legal analyses, achieve efficiencies in documenting programme updates, and eliminate the risk of an inadvertent FATCA gross up applying in the future should FATCA ultimately apply in a way not currently anticipated. As FATCA develops and becomes better understood, this generalised approach may be scaled back. In the meantime, it has become generally routine to disclose the possible risk of FATCA withholding to investors in all programme updates. Market participants are, however, typically, though not universally, willing to rely on grandfathering meaning, the exemption from FATCA withholding generally applicable to debt obligations issued prior to July 1, 2014 (or later, inthe case of certain non-us issuers) in standalone debt issuances, and therefore do not require amendment to the terms and conditions of the securities or acorresponding disclosure of FATCA withholding risk. 1. Risk factor One way to alert investors of the possible impact of FATCA withholding on the pay-out of the securities is to include a FATCA risk factor in the offering documentation. ICMA has recommended standard language which deals generally with the risk of FATCA withholding in the payment chain after the clearing systems, and apprises investors of their responsibility to choose with care the brokers through whom they invest. These recommendations have not yet been made public. Not all market participants agree with using this standard language. It is most widely used amongst European issuers advised by non-us advisers. US advisers typically prefer a more detailed risk factor providing background and explanation to FATCA and its workings, with less mitigating language, akin to FATCA disclosure, which is discussed next. 2. FATCA disclosure FATCA disclosure may be included in the taxation section of an offering document as a separate subsection. The FATCA disclosure should not be part of a US tax section in the offering document of anon-us issuer because such disclosure is relevant not only to US taxable investors, but to all investors, whether or not they are subject to US tax. The FATCA sub-section should address both the withholding aspects of FATCA and its information reporting requirements, so that investors are informed that information about themselves may be disclosed to the United States or foreign governments. The range of accepted wording for such disclosure is very broad. One paragraph thereof, specifically recommended by ICMA, addresses the risk of FATCA withholding in the payment chain from the issuer to the clearing systems. The con- 6 01/14 Copyright 2014 by The Bureau of National Affairs, Inc. TPETS ISSN 1754-1646

tent of the rest of the FATCA disclosure generally is left to the discretion of issuer s counsel. III. Lending transactions A. Risk allocation and documentation The international loan market has not yet reached consensus as to which party (lender or borrower) should bear the risk of FATCA withholding. Some argue that lenders should bear the risk, because it is within their power to avoid FATCA withholding by complying with FATCA. Others counter that too much uncertainty remains (for example as to whether and to what extent an FFI borrower may be required to withhold under the as yet unreleased passthru payment rules) and that therefore, the lender should not suffer withholding because of an obligor s decision to shoulder the withholding obligations entailed by FATCA compliance. This lack of consensus is reflected in the response of the Loan Market Association ( LMA ). Rather than provide a normative approach to FATCA, the LMA has produced a set of riders, which are not publicly available, which provide a series of options for allocating FATCA withholding risk. The LMA has issued three sets of FATCA riders, as well as a set of Common Provisions to be used regardless of which set of riders is chosen. The Common Provisions contain definitions of terms used in the riders, a provision allowing all parties to request such information as may be required for FATCA compliance, and the ability to remove the facility agent if its non-compliance results in FATCA withholding. Rider 1 places the risk of FATCA withholding on the borrower. The rider is divided into Rider 1A and Rider 1B, which can be used separately or together. Rider 1A is, essentially, a representation and an undertaking from the borrower that payments it makes under the agreement will not be subject to FATCA withholding because: (i) they will not be from sources within the United States (i.e., they will not be withholdable payments as defined by FATCA); and (ii) the borrower is not anon-us financial institution, which would potentially be required to withhold on foreign passthru payments. Rider 1B, in contrast, offers no direct comfort that FATCA will not apply, but instead requires the borrower to gross up and indemnify the finance parties for any FATCA withholding that arises. Rider 2 adopts acompromise approach by relying on the grandfathering rules mentioned above to ensure that the credit facility will not be subject to FATCA. This protection is accomplished by providing each lender with the ability to veto any amendment, including a change in obligor that it reasonably believes will result in loss of grandfathering and subsequent withholding. The borrower may override this veto by agreeing in advance to prepay the lender before the date FATCA withholding commences. The Rider 2 compromise will become obsolete for obligations issued after grandfathering expires. Rider 3 shifts the risk of FATCA withholding entirely to the lenders by allowing all parties to withhold as required. B. Variations and amendments to the LMA Riders The Rider 2compromise will become obsolete for obligations issued after grandfathering expires. Although the LMA riders provide a starting point for documenting the allocation of FATCA withholding risk in lending transactions and many market participants prefer to use the LMA riders as drafted the riders are designed as guidelines and some degree of amendment is common. The definition of US TaxObligor warrants special attention, because whether FATCA withholding may apply turns in large part on whether the borrower will be making payments from sources within the United States. The definition of US Tax Obligor includes two prongs, the first addressing tax residence and the second addressing source of payments. The resi- dence prong is intended to give parties that are unfamiliar with US tax principles some guidance as to which type of borrowers may fall within the definition. It may also cause additional confusion, however, since the concept of residence for US tax purposes is determined quite differently than it is in many other jurisdictions. The source prong of the definition is the operative provision, as it corresponds to the statutory parameters of what might be considered a withholdable payment for FATCA purposes. The source prong of the US TaxObligor definition references payments under all finance documents, not just the credit facility. Use of such abroad definition creates other complications. For example, if the credit facility has associated hedging arrangements, and the hedging agreements are included within the definition of Finance Document, a non-us borrower could be treated as making US source payments to US swap counterparties, technically breaching the Rider 1A representation and undertaking. Furthermore, borrowers with no internal US tax expertise often hesitate to provide US tax representations and undertakings without seeking external US tax advice, which can be costly and time consuming. 01/14 Tax Planning International European Tax Service Bloomberg BNA ISSN 1754-1646 7

In these circumstances, some parties agree to an alternative definition that seeks to comprehensively list the factual scenarios that may give rise to US source payments. Where acredit facility involves (or potentially involves) a US Tax Obligor, different complications arise, primarily with respect to the FATCA information clause of the Common Provisions of the LMA riders. For instance, these provisions specifically allow for agent-driven information requests where a US Tax Obligor may be present. Where a borrower is in fact austax Obligor, however, additional tax provisions addressing general US withholding would typically be included in the facility agreement. These provisions historically have not used the US TaxObligor definition but instead amore narrowly defined US Borrower. Given the attempts by the IRS to align traditional US information reporting and withholding requirements with those introduced by FATCA, the use of off-the-shelf FATCA provisions in combination with traditional US tax provisions may lead to unnecessarily duplicative or inconsistent contractual information reporting requirements. Issues surrounding the definition of US Tax Obligor, however, are not the only concerns that may lead to deviations from the LMA riders. Some borrowers will agree to the gross-up provisions of Rider 1B, but only to the extent that any FATCA withholding that would have occurred regardless of the nature or FATCA status of the borrower is excluded from the gross up. Some parties prefer to remove references to passthru payment percentage inthe FATCA information clause of the Common Provisions because the guidance establishing the concept of passthru payment percentage was made obsolete by the final FATCA regulations. Others, however, prefer to retain this language because the IRS may revive this concept when it ultimately defines foreign passthru payment. Where this language is retained, some borrowers may seek to expressly carve out the undertaking to provide passthru payment percentage information from the events of default. Facility agents have their own concerns, with some insisting on a FATCA-specific indemnity from the lenders (often with a secondary indemnity from the borrower) to protect themselves from the impact FATCA may have on them should one or more lenders be non-compliant. Perhaps most significantly, many parties relying on the grandfathering protections of Rider 2are dissatisfied with the mechanics involved. Amendments to Rider 2 may involve fairly significant drafting changes. C. Evolving market practice US borrowers, and to a large extent US lenders, generally accept the allocation of FATCA withholding risk to the lenders. Internationally, however, lenders uncertain of their ability to comply with FATCA have strongly resisted accepting such risk, and the original LMA riders, released in July 2012, did not include Rider 3 as an option. Since the release of the original riders, however, FATCA implementation has evolved, market practice has shifted, and the LMA riders have been updated several times to account for many of these changes. More major banks are gaining confidence in their ability to comply with FATCA, largely as a result of the growing network of IGAs, and accordingly, the use of Rider 3 has become relatively standard in Europe. The occasional lender resistance based either on concerns of tainting by noncompliant branches or subsidiaries or on the ability to sell the loan in the secondary market islikely to continue to recede as FATCA becomes better understood and the IGA network continues to expand. This shift is less true outside of Europe, however, as many lenders in non-european jurisdictions still have very real concerns about their ability to comply with FATCA. IV. Conclusion While many institutions, within and outside the financial sector, are expending significant resources on internal FATCA compliance, the implications of FATCA for transaction documentation must also be considered. Industry bodies in the debt capital markets and financing spheres have attempted to bring some degree of efficiency and consistency to this process by providing recommendations and draft clauses to address FATCA, ensuring that both the information gathering and withholding concerns are appropriately accommodated. Counterparties that consider these recommendations carefully, and establish internal policies and protocols on FATCA documentation, will have an edge at the negotiating table in protecting themselves from unnecessary negotiation costs, compliance expense or inthe worst case FATCA penalties. Stefka Kavaldjieva is Senior Associate and Matthew Peckosh is Associate in the tax department at Allen &Overy in London and they may be contacted by emails at stefka.kavaldjieva@allenovery.com and matthew.peckosh@allenovery.com respectively. NOTES 1 Documentation gathering in FATCA compliance published in the September 2013 issue of European TaxService, Volume 15 Issue 09 and can be found at http://internationaltax.bna.com/itax/display/story_ list.adp?mode=ep&frag_id=35958390&item=topic7&prod=euon and FATCA: A pragmatic approach to the payee classification rules for MNCs published in November 2013 issue of European TaxService, Volume 15 issue 11 and can be found at http:// internationaltax.bna.com/itax/display/story_list.adp?mode=ep&frag_ id=38329999&item=topic7&prod=euon 8 01/14 Copyright 2014 by The Bureau of National Affairs, Inc. TPETS ISSN 1754-1646