August 15, 2012: ISDA Protocol to Tax FATCA Derivative Transactions
On August 15, 2012, the International Swaps and Derivatives Association, Inc. (ISDA) published the 2012 ISDA protocol that offers market participants an efficient way to amend the ISDA Master Agreement tax provisions to address the effects of Foreign Account Tax Compliance Act (FATCA). The impact of the Protocol is to place the FATCA withholding tax burden on the recipient of the payment by eliminating this tax from the definition of “Indemnifiable Tax” in the ISDA Master Agreement. ISDA’s 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 publishing date of this protocol also marked the opening of the Adherence Period. To amend an ISDA Master Agreement, please follow the directions on the ISDA Open Protocols Website.
In addition, ISDA held an educational webcast on FATCA and the adherence process on August 16, 2012. A copy of that presentation is attached, and you can access the ISDA FATCA Website for a link to their webcast (replay available through Sept. 6, 2012). Some notes from the webcast are also provided below.
- Starting 1/1/2013 derivatives transactions are no longer eligible for grandfathering and thus potentially subject to FATCA withholding (based upon proposed regulations).
- Protocol assigns responsibility for withholding tax to the recipient of the payment.
- Based upon the proposed regulations, counterparties to derivatives transactions are considered account holders.
Changes to Withholding
- Under current chapter 3 laws swap payments are generally sourced to the recipient and so in the case of a foreign counter-party would be foreign source and not subject to withholding tax. In cases where there is embedded interest withholding may apply to that portion of the payment unless it is reduced or eliminated under a double taxation treaty.
- Under FATCA, non-participating FFIs will be subject to withholding starting 2014 on interest. Beginning in 2017 withholding pay also apply to other swap payments in certain situations.
- Tax documentation will need to be collected from all counterparties to determine their status. This includes the need to collect Forms W-9 from counterparties that are U.S. financial institutions.
Pre-Existing Transactions (“Grandfathering Rule”)
- No withholding is required under FATCA on any payment with respect to a non-equity obligation outstanding on December 31, 2012 or from the gross proceeds from any disposition of such an obligation.
- Master agreements themselves don’t qualify for grandfathering relief since ISDA MAs do not typically have a fixed term, however the actual swap transactions entered into before December would be grandfathered provided there is not a material modification to the terms of the obligation.
FATCA Risk & ISDA MAs
- If both parties are FATCA compliant there is no risk of withholding even if the ISDA agreement with the FATCA protocol has not been signed.
Relevant Existing ISDA MA Language
- 2(d)(i) Gross Up states all payments under this Agreement will be made without any deduction or withholding for or on account of any tax unless such dedication or withholding is required by applicable law.
- Assumes payor is familiar with current withholding tax; payor bears risk of any withholding responsibility.
- Current law says payor may terminate transaction if withholding is required.
- Shifts risk to payee vs. payor and expands definition of passthru payments.
- If FATCA tax is imposed, the payor is not obligated to provide a gross up payment.
- Based upon fact that payor cannot assure they’ll receive necessary forms to eliminate withholding from payee.
- Risk that imposition of FATCA tax will not be considered change in law as it was signed into law in 2010.
- Open for adherence starting now
- No end date for signing
- Adherence letter allows for institution letterhead however no changes to the adherence letter are permitted other than name, date and signature.
- Names of adhering parties will be published on website and regularly updated.