TAX COMPLI AN C E T H O UG HT
LE A D E RS HI P
FATCA COMMENTARY: Why Withholding Agents
Must Monitor the Impact of Material Modifications
to Grandfathered Debt Instruments
By Jon Mosier, J.D., Associate Product Manager Capital Changes, Wolters Kluwer Financial Services
Introduction
for incorrect reporting of withheld amounts.3 Moreover, withholding
agents that do not correctly identify changes to grandfathered
instruments put themselves at a competitive risk against those that
correctly identify and begin withholding on these instruments.
The Foreign Account Tax Compliance Act (FATCA), enacted
in 2010, imposes an onerous new withholding obligation on
U.S. financial institutions and other withholding agents making
payments to certain foreign entities that do not document and
report on their U.S. account holders.
Exempt from this new withholding requirement are payments on
grandfathered obligations. A grandfathered obligation is generally
a U.S. debt instrument issued before the FATCA effective date
of July 1, 2014.1
A grandfathered obligation can lose its exempt status and
payments on it can become subject to FATCA withholding if a
material modification occurs. A material modification is defined
under FATCA as a significant modification as provided in the
regulations under Internal Revenue Code section 1001.
This paper will examine the challenges that grandfathered
obligations pose for withholding agents. As we will see, there are
two critical components: access to the necessary reference data
for grandfathered instruments and the systematic use of that
data to perform the specialized tax analysis required under FATCA.
Only a solution that leverages both security reference data
and specialized tax expertise can fully address the problem of
grandfathered debt instruments. Wolters Kluwer FATCA GFD
is that solution.
The Rules Have Changed -- But Challenges Remain
The regulations for material modifications originally imposed
a “reason to know” standard on withholding agents; that is, a
withholding agent was required to treat a modification as material
if it knew or had reason to know of the modification. During 2013,
the withholding agent community sent comment letters to the
IRS requesting a change to the standard of knowledge for material
modifications on grandfathered instruments. Citing the difficulty in
determining when a material modification occurs absent a notice
from the issuer, withholding agents requested that receipt of such
disclosure should be the only instance in which they would be
required to treat a modification as material.
Withholding agents were not given the safe harbor change they
requested. In response to the 2013 industry comments, on March
6, 2014 the IRS published amended regulations that eliminated
the “reason to know” standard for some (but not all) withholding
agents. Instead, a withholding agent must treat a modification as
material only if the agent has “actual knowledge” thereof. An issuer
disclosure is provided in the regulation as an example of such
actual knowledge. The following is the exact language from the
amended regulation:
The Clock Is Ticking
For purposes of paragraph (b)(2)(iv) of this section (defining material
modification), a withholding agent, other than the issuer of the
obligation (or an agent of the issuer), is required to treat a modification
of the obligation as material only if the withholding agent has actual
knowledge thereof, such as in the event the withholding agent receives
a disclosure indicating that there has been or will be a material
modification to such obligation. The issuer of the obligation (or an
agent of the issuer) that is a withholding agent is required to treat a
modification of the obligation as material if the withholding agent
knows or has reason to know that a material modification has occurred
with respect to the obligation (emphasis added).
Beginning July 1, 2014, withholding agents must begin to identify
and track grandfathered instruments that are initially exempt from
the new 30% withholding obligation on payments to certain foreign
financial institutions and other payees. The IRS has repeatedly said
the July 1, 2014 deadline is firm. FATCA will not be further delayed.2
As a withholding agent, how will you be sure your FATCA withholding
procedures accurately account for the relevant changes to all of the
grandfathered debt instruments for which you are responsible?
The risks are high: Withholding agents are generally liable dollar-fordollar for incorrect withholding amounts. Penalties may also apply
1
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What to make of this change? It clearly does not provide the issuer
notice safe harbor that withholding agents requested. Although
issuer disclosures are one example of actual knowledge, nowhere
do the amended regulations provide that the withholding
agent may rely “solely” on issuer notices to identify material
modifications. In other words, by providing issuer disclosure as
one example of actual knowledge, the implication is that there
are other ways, and the withholding agent is left to determine
what those other ways might be.
no change to the security identifier.4 At a minimum, a solution that
regularly monitors all consents and tender offers is essential for
FATCA grandfathering analysis.
However, monitoring and analysis of corporate action events alone is
not enough. To correctly identify changes and determine if they cause
material modifications, access to the complete set of security master
attributes for grandfathered debt instruments is essential. Some of
the relevant attributes that must be monitored include: options, calls
and other built-in rights; complete payment terms; recourse and nonrecourse status; and priority of the debt and payment expectations.
Equally problematic is the exemption carved out for withholding
agents that are agents of issuers. Agents of issuers are subject to
the same “reason to know” standard that applied before the rule
change. A large custodian bank is likely to have agreements in
place with hundreds of issuers. The terms of each such agreement
would need to be reviewed to determine if the withholding agent
is acting as the issuer’s agent. It is possible that a withholding agent
could be subject to the “actual knowledge” standard for some debt
instruments and the “reason to know” standard for others.
But Data Alone Is Not Enough –
Specialized Tax Analysis Is Required
As important as data is for FATCA grandfathering, it gets you
only part of the way to compliance. Your solution must have the
tax expertise and experience necessary to interpret the data and
perform complex calculations required under FATCA.
Keep in mind that many of the features of a debt instrument
that must be analyzed for material modifications are tax-specific
attributes that are derived from the reference data, but not
necessarily part of the security master reference attributes. For
example, to be eligible for grandfather status an instrument must
be debt for tax purposes; such determination is generally not an
attribute that is readily available in the reference data, but is rather
a tax determination derived from that data. Similarly, adjusted issue
price and unamortized bond premium are generally not reference
attributes but rather tax derivations that are essential to correct
grandfathering analysis.
Your solution must have the tax expertise
and experience necessary to interpret the
data and perform complex calculations
required under FATCA.
In practice, even taking the narrowest interpretation of the new
“actual knowledge” standard, some profound challenges remain
with respect to grandfathered instruments:
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■■
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FATCA grandfathering analysis requires regular, systematic
application of the significant modification rules found in Treasury
Regulation Sec. 1.1001-3. An in-depth examination of these rules
is beyond the scope of this paper. However, generally speaking,
these rules determine the extent to which a debt instrument can
be modified without causing a deemed exchange for tax purposes.
Among other tests, these rules include a yield test, which requires
analysis of changes in annual yield, and a payments test, which
looks to changes or deferrals in payments that rise to a specified
level. In considering a solution for FATCA grandfathering, here are a
few questions every withholding agent should be asking:
Workflow efficiency: How will you find, analyze and store issuer
notices for all of the grandfathered instruments in your system?
Early notification: Issuer notices may not be timely. Even when
available, they may be unclear or unreliable. How will you be
sure you are making timely decisions to begin withholding on
previously grandfathered instruments?
Standardization of results: A serious concern regularly
expressed by withholding agents is the competitive risk
associated with varying determinations on grandfathered
obligations. How will you be sure you are making the correct
grandfathering determinations to minimize this risk?
■■
The Right Data Is Essential
At any time during the life of a grandfathered instrument, a change
can occur that may cause the instrument to lose its grandfathered
status and become subject to withholding. The terms of each
instrument must be analyzed to determine (a) if grandfather eligible
and (b) if grandfathered status is lost.
■■
Some material modifications will be caused by corporate actions
where changes to terms are apparent. In other cases, a change
constituting a material modification may occur without any
outward signs: there may be no payment on the instrument and
Is your vendor capable of independently calculating changes
in annual yield? To comply with FATCA grandfathering, your
solution must identify changes to pre-existing yield (as of the
date of modification) by more than the greater of (a) 25 basis
points per full year of the term of the debt or (b) 5%.
Can your vendor identify specified changes in payments?
Your solution must also identify payment changes that are
lesser than a change resulting in (a) “material deferral” of
scheduled payments or (b) extension of original term more
than 5 years or 50% of original term.
If you can’t answer “yes” to these questions, you may not be fully
covered for FATCA grandfathering. Remember, these are just two of
the tests that must be regularly and systematically applied to each
grandfathered obligation until it reaches maturity.
2
Tax Compliance Thought Leadership
Issuer Disclosures May Be Unreliable
No other FATCA grandfathering solution can
offer the nationally-recognized tax expertise
behind Wolters Kluwer FATCA GFD.
As mentioned above, the amended regulations did not give
withholding agents permission to rely solely on issuer notices
to identify material modifications. Another change that the
withholding community requested, but did not receive, was a
requirement that issuers provide notices of material modifications.
That is, the issuer of an instrument that undergoes a change that
affects grandfathered status for FATCA is under no obligation to
notify holders of the tax implications of the change.5
No other FATCA grandfathering solution can offer the nationallyrecognized tax expertise behind Wolters Kluwer FATCA GFD.
Another problem with issuer notices is that they may not provide
clear answers in a timely way. Through Capital Changes’ years of
analyzing issuer tax information for debt and other instrument
types, we know all too well that issuer information may be
ambiguous, poorly worded, or take no position on the tax effect of
the event. Notices can also be difficult to obtain, and may not be
made available until well after the effective date of the event.
Conclusion
Monitoring and analyzing grandfathered obligations for FATCA
presents formidable challenges. A system that harnesses the
necessary reference data in order to systematically perform the tax
analysis required under the regulations must be in place ahead of
the July 1, 2014 effective date. Wolters Kluwer FATCA GFD has the
data, processes and tax expertise in place to provide a solution that
meets these challenges.
Given that notices are voluntary, and can be unreliable and
untimely, it simply is not realistic for a withholding agent relying
solely on issuer notices to identify changes to grandfathered
instruments – even if such reliance were permitted by the
regulations. The better practice would therefore seem to involve
the independent monitoring and tax analysis of grandfathered debt
instruments that includes an issuer notice validation process of such
independent determinations.
About the Author
Jon Mosier, J.D., is Associate Product Manager for Capital Changes,
a part of Wolters Kluwer Financial Services. Jon’s current product
focus includes CISR™ 8937, the Capital Changes IRS Form 8937 and
Return of Capital solution, and FATCA GFD, the new compliance
solution for FATCA Grandfathered Obligations.
Wolters Kluwer FATCA GFD
The Tax-Focused, Data-Leveraged FATCA
Grandfathering Solution
FATCA GFD solves the grandfathering compliance challenge with
a self-service web application that delivers customizable security
master updates to provide you with the alerts and attributes you
need for correct FATCA withholding.
Our dedicated team of experienced tax analysts leverage leading
reference and corporate actions data sources, combined with
the workflow efficiencies of our award-winning GainsKeeper™
brokerage products and applies tax rules developed under the
leadership of tax expert Stevie D. Conlon, to deliver a full set of
FATCA grandfathering attributes on the securities you hold.
1
Instruments that are treated as equity for U.S. tax purposes are excluded from the
definition of grandfathered obligations under Treas. Reg. §1.1471-2(b)(2)(ii)(B)(1).
2
t a tax conference on March 25, 2014, IRS Commissioner John Koskinsen said,
A
“We’ve held firm to the July 1 deadline because it’s already been extended.”
This echoes numerous other statements by IRS and Treasury officials.
S ee Draft IRS Form 1042, Annual Withholding Tax Return for U.S. Source Income
of Foreign Persons Section 2, Line 2c “Amount of Income paid with respect to
grandfathered obligations.”
3
The FATCA GFD workflow starts with the daily monitoring of
security master changes and event data from various sources to
identify events that may implicate grandfather status. Our earlynotification process triggers an issuer search, contact and followup process by which our analysts seek issuer confirmation of the
event and its tax effect. For each instrument in a user’s securitiesof-interest (SOI) file, FATCA GFD provides (a) an independent
determination of whether a material modification has occurred
and (b) whether such change is supported by an issuer disclosure.
Our process also includes continued monitoring of these events
after the effective date for any new or corrected issuer information.
This process is informed by Capital Changes’ years of experience in
research and reporting on the taxability of corporate actions.
3
4
ne example of a material modification with no payment and no change
O
to security identifier would be in the case of a non-participating holder in a
consent solicitation (which typically is not accompanied by a security identifier
change). If the issuer receives sufficient consents to amend the indenture, the
amendment may constitute a material modification even for the holder that
did not consent and therefore did not receive the consent payment. Needless
to say, correctly identifying the need to withhold on such an instrument will
be a particular challenge.
5
ontrast this with the Sec. 6045B issuer reporting rules that accompanied the
C
recent cost basis reporting regime under Sec. 6045. Withholding agents were
requesting essentially the equivalent of IRS Form 8937 for FATCA; that request
was not granted.
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