FATCA: Foreign Funds Lending into the US and Investing in US Indebtedness Should Take Heed
The recent enactment of the Foreign Account Tax Compliance Act (“FATCA”) has greatly expanded the tax reporting obligations of foreign persons investing in the US. Ostensibly targeted by the drafters of this legislation, private equity funds and hedge funds investing in the US (through either debt or equity investments) should be particularly concerned with the FATCA regime. The 30 percent withholding tax, which may apply to the receipt of certain US source payments, will certainly gain the attention of foreign investors. Thus, a foreign fund which receives payments of interest, original issue discount, or dividends (as well as other streams of revenue which are not attributable to an active business of the fund within the US) may incur a new incremental tax cost as a result of FATCA.
Unfortunately, the broad provisions of FATCA go even further also imposing a 30 percent withholding tax on the gross proceeds from a foreign person’s disposition of property interests which ordinarily give rise to US source payments of interest (i.e., indebtedness of a US debtor) or dividends (i.e., shares of a US corporation). This withholding tax liability is determined based on the gross amount of the payment (i.e., whether or not the foreign investor enjoys economic gain as a result of the payment). Accordingly, a foreign person who suffers a loss upon exit from a US investment (equity or debt) may be further disappointed at settlement when the proceeds from the sale are shy of 70 percent of the sales price. With few exceptions, foreign investment funds investing in the US should consider executing a reporting agreement in order to avoid the 30 percent withholding tax.
For an industry which has historically remained reluctant to disclose information concerning its investors, these new US reporting requirements will likely give investment funds pause upon considering prospective investments within the US. For old and cold debt obligations of US borrowers held by foreign persons as of January 1, 2014, the US Internal Revenue Service has granted a small but meaningful reprieve. Payments of interest and original issue discount on “grandfathered obligations” are exempt from FATCA withholding tax. Furthermore, upon the sale or redemption of a grandfathered note (of a US debtor), a foreign holder can rest assured that the proceeds will also be free of FATCA withholding tax.
However, due to peculiarities in US tax law, debtors and creditors should be wary not to materially disturb or amend the terms of a grandfathered obligation. In practice, where the economic circumstances of the parties to a lending arrangement have changed, the parties may seek to modify the terms of borrowing (e.g., modifying the applicable rate of interest on the loans or deferring payments due on the indebtedness). Under US tax law, even where a note holder does not actually dispose of a debtor’s note, modifying the terms of an existing lending arrangement may give rise to a deemed debt-for-debt exchange. Regarded as a significant modification for US tax purposes, the outstanding note is deemed to be retired with the holder surrendering the old note in exchange for a new, modified note.
Not only are these “deemed exchange” rules deceptively easy to trigger, they can cause a grandfathered obligation (otherwise exempt from FATCA) to spoil. Where material modifications are made to the terms of a grandfathered obligation after January 1, 2014, and such amendments give rise to a significant modification under US tax law, the grandfathered obligation would be deemed retired with a new modified note deemed to be issued in satisfaction thereof. The unfortunate consequence of such a deemed exchange would be that the foreign lender in this arrangement would thereafter hold an interest in US debt which is no longer exempt from FATCA withholding tax. For an unwitting lender that has executed amendments to the governing credit agreement of outstanding US inbound loans, it is entirely conceivable that, having the bona fide belief that the note had been a grandfathered obligation, the lender remains oblivious to the 30 percent withholding tax liability suddenly owed on the receipt of subsequent payments of interest on the note. As well, gross proceeds from a subsequent disposition of the note could also be subject to 30 percent withholding tax. Accordingly, foreign funds holding US indebtedness qualifying as grandfathered obligations should take heed when modifying the terms of the lending arrangement.
As for US debt obligations not bearing grandfathered status, a potentially significant hidden tax cost may result upon modification of the terms of lending. As discussed above, parties which make one or more material alterations to outstanding indebtedness may unintentionally bring about a deemed debt-for-debt exchange. Under US tax law, the note of a debtor is generally regarded as property in the hands of a holder-creditor. Accordingly, a deemed debt-for-debt exchange is regarded for US federal tax purposes as a taxable exchange of property with the holder surrendering the old note for a new modified note. Hence, even where a holder does not actually dispose of the note, the drafters of FATCA viewed a deemed disposition of the note as a fitting occasion to impose a 30 percent withholding tax upon the gross proceeds of the note – in most cases either the fair market value of the note or the stated principal amount, as the case may be. This latter withholding tax will become effective upon full implementation of FATCA beginning January 1, 2017.