Despite several delays, it seems almost certain that the “Foreign Account Tax Compliance Act”1 (FATCA) will finally go into effect on July 1, 2014. FATCA is a withholding tax regime designed to prevent U.S. taxpayers from hiding income offshore and avoiding U.S. taxes. FATCA’s impact will need to be considered in most cross-border transportation finance transactions. While the FATCA rules are complex and a thorough treatment of them is beyond the scope of this article, below are some key issues relating to the impending effectiveness of FATCA that are important to keep in mind.
When Do the FATCA Rules Go Into Effect?
After several delays and extensions, the FATCA rules are currently scheduled to become effective with respect to payments of interest, dividends and rentals and other similar payments made on or after July 1, 2014. While this deadline has been extended several times, the Internal Revenue Service (IRS) has repeatedly stated that no further delays are anticipated.2 Obligations outstanding on July 1, 2014 will be “grandfathered,” and the FATCA rules will not apply to payments made under these pre-existing obligations,3 unless such obligations are substantially modified after that date.4 Withholding on payments of “gross proceeds” is not set to begin until after December 31, 2016. Although FATCA withholding will not apply until July 1, 2014, parties who are currently negotiating transportation finance transactions are typically taking into account the possible application of FATCA withholding in the future and are documenting such transactions accordingly.
Overview of the Rules
In general, FATCA imposes a 30% withholding tax on “withholdable payments” to certain non-U.S. persons (foreigners). Withholdable payments broadly include any payment of: (a) U.S. source interest (including OID), dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments and other fixed and determinable annual or periodical gains, profits or income, or (b) U.S. source gross proceeds from the sale or other disposition of any property of a type that can produce U.S. source interest or dividends.5
Since it is the payor that is obligated to withhold from payments if withholding is required under FATCA, any payor making a payment to a foreigner should confirm that such payment is either (a) related to an obligation to which FATCA does not apply (such as a grandfathered obligation or a non-U.S. source obligation), or (b) made to a foreigner who can provide proof of exemption from FATCA withholding.
Determining U.S. Source
Determining the source of interest payments is usually straight forward, as the jurisdiction of the borrower generally determines the source.6 However, in the complex financing structures often utilized for transportation finance transactions, a deeper analysis may be required. For instance, in certain cross-border structured finance transactions a nominal U.S. borrower is used to “own” and “lease” the aircraft to a foreign airline lessee. However, for U.S. tax purposes this borrower is merely an agent, or conduit, for the lessee and the lessee would be treated as the owner of the aircraft. In these circumstances, notwithstanding the nominal U.S. borrower, the parties take the position that, since the true borrower is the foreign airline, the interest is not U.S. source and thus not subject to the FATCA rules.
While sourcing rental payments may seem straightforward at first glance, as you generally look to the jurisdiction where the asset is used, the analysis become trickier for transportation equipment like aircraft.7 As aircraft may be used in many jurisdictions, the Internal Revenue Code provides special rules treating as U.S. source: (a) 100% of the income attributable to flights that begin AND end in the U.S., and (b) 50% of the income attributable to flights not described in (a) which begin OR end in the U.S.8 Thus, even aircraft leased to a foreign carrier could generate U.S. source rental income if, for example such foreign carrier operates flights to the U.S. or has the ability to sublease the aircraft to a U.S. carrier. For these reasons, it is prudent to include FATCA provisions in aircraft leases with foreign carriers, even where such leases do not initially seem as though they will generate U.S. source income.9
Avoiding Withholding Under FATCA
A payor of U.S. source income will need to ensure that its payee is exempt from FATCA withholding. Payments to U.S. entities are generally exempt from FATCA withholding and a payor should collect a Form W-9 or other appropriate evidence of U.S. status when making a payment of U.S. source income to a U.S. entity in order to confirm FATCA withholding is not required.
FATCA is directed primarily at “foreign financial institutions” (FFIs), but also covers “non-financial foreign entities” (NFFEs). While there are various methods for FFIs and NFFEs to be exempt, several of the most common ones are discussed below.
An FFI may be exempt either by reason of the government of its home jurisdictions having entered into an intergovernmental agreement (IGA) with the U.S. or by entering into an agreement with the IRS to report U.S. account holders. There are two types of IGAs: (a) Model 1 IGAs, whereby the FFIs report to their local government, which shares the relevant information with the IRS, and (b) Model 2 IGAs, whereby the FFIs report directly to the IRS. The U.S. and numerous foreign jurisdictions have concluded IGAs10 and FFIs in a country with an IGA can obtain a “global intermediary identification number” (GIIN), which can be supplied to payees to evidence exemption.
NFFEs can obtain exemption from FATCA by confirming they are the beneficial owner of the payment and reporting their substantial (10% or more) U.S. owners, if any. Reporting information includes name, address and U.S. taxpayer identification number (TIN) of U.S. owners. Under certain circumstances the NFFE can report its ownership information to the IRS rather than the payee. In addition, certain classes of NFFEs are exempt, such as publicly traded companies or companies predominantly engaged in an active business. It remains to be seen whether a leasing company will be considered to be engaged in an active trade or business (and what tests will be applicable to qualify for this status).
When making a payment of U.S. source income to a foreigner, a payor should collect a Form W-8BEN-E to confirm the payee’s FATCA exemption status.11
Negotiating and Documenting FATCA Provisions
Bad news – you will probably need to get tax lawyers involved. Many, if not most, parties seem to be taking a cautious approach and are inserting FATCA provisions where there is any possibility that the payments could be U.S. source currently or in the future. The Loan Market Association has drafted a variety of “standard” provisions but cautions that there are no simple drafting solutions.
Approaches to the allocation of risk vary from a shared approach to an allocation of all of the risk to either the borrower or the lender, in the case of a secured financing, or the lessee or the lessor, in the case of a lease. Borrowers and lessees often make the argument their lender or lessor, as the case may be, should “come to the table” as FATCA compliant and be able to demonstrate such compliance or suffer withholding if they cannot. Lessors and lenders, on the other hand, often make the argument that they should not be at risk for changes in U.S. law. However, these perspectives should not be over emphasized as each transaction needs to be examined in the light of the particular parties and circumstances. In the short run, the negotiation and documentation of these provisions will continue to require time and effort. In the long run, the terms and allocations of risk will likely standardize in a manner similar to how U.S. withholding tax provisions have standardized over the years.
1 I.R.C. §§ 1471-1474.
2 “Final” FATCA regulations were published in the Federal Register on March 6, 2014 (Fed Reg Vol 79 No 44 p. 12812).
3 Technically the obligation needs to be issued before July 1, 2014 and outstanding on July 1, 2014 in order to be grandfathered, and an obligation issued on July 1, 2014 does not qualify for the exception.
4 A substantial modification may be triggered by, among other things, a change in interest rate, maturity or obligor.
5 Unlike traditional withholding rules, the FATCA regime will eventually apply to proceeds from the sale or other disposition of instruments producing U.S. source interest or dividends. The rules are broad enough to include principal payments on debt instruments.
6 I.R.C. § 861(a)(1).
7 I.R.C. § 861(a)(4) covering rentals generally.
8 I.R.C. § 863(c) covering transportation income which includes aircraft rentals (I.R.C. § 863(c)(3)(A)).
9 Where there is a foreign lessee with no other U.S. payor connection, it remains to be seen how the IRS will enforce the FATCA withholding obligation against the foreign lessee with minimal U.S. contacts (e.g., such as merely flying back and forth to and from the U.S.).
10 The U.S. has concluded Model 1 IGAs with: Canada (2-5-2014), Cayman Islands (11-29-2013), Costa Rica (11-26-2013), Denmark (11-19-2012), Finland (3-5-2014), France (11-14-2013), Germany (5-31-2013), Guernsey (12-13-2013), Hungary (2-4-2014), Ireland (1-23-2013), Isle of Man (12-13-2013), Italy (1-10-2014), Jersey (12-13-2013), Malta (12-16-2013), Mauritius (12-27-2013), Mexico (11-19-2012), Netherlands (12-18-2013), Norway (4-15-2013), Spain (5-14-2013) and the United Kingdom (9-12-2012); and Model 2 IGAs with: Bermuda (12-19-2013), Chile (3-5-2014), Japan (6-11-2013) and Switzerland (2-14-2013).
11 A new W-8BEN-E form will be used for foreign entities and will include the appropriate information to demonstrate FATCA compliance or an exemption from FATCA withholding. Note that a proper exemption from “regular” U.S. withholding will also need to be documented. It is possible that a payee may be exempt from FATCA withholding but not regular withholding.
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