Guest Contributor: Kristin Swenton Hochstein, Co-Chair of ISITC Regulatory Working Group and Americas Head of Entity Risk for Thomson Reuters
Ask most people to think of M&M’s and they probably would recall something colorful and sweet. Ask someone close to FATCA (Foreign Account Tax Compliance Act) and they would have a slightly different perspective on M&M’s, also known as Material Modifications. Unlike one of America’s favorite treats, FATCA is far from America’s favorite regulation, and Material Modifications complicate things even further.
With a goal of locating hidden U.S. assets abroad to recoup tax revenues, FATCA seems straightforward – it comprises identification, documentation, and withholding, but dig into the regulation and you find anything but that. At around 540 pages filled with complex requirements, FATCA is longer than most versions of Homer’s The Odyssey, feeling like a much tougher and less fulfilling journey than Odysseus experienced.
To highlight one of the major challenges, the security master workflow around Grandfathered Obligations requires three steps. The first is to determine the universe of instruments eligible for FATCA withholdings. FDAP, or Fixed, Determinable, Annual, Period Income affects many instrument types, including equities, debt instruments, and securitized products. There is great ambiguity in the treatment of derivatives, warrants, and funds, and the nuances across all asset classes demand tax expertise. Once the universe of FATCA eligible instruments has been established, the next step is to figure out which can be “grandfathered” and therefore, not subject to FATCA, by identifying any debt obligation outstanding prior to January 1, 2014. Those with a shorter maturity duration (<183 days) automatically would be grandfathered.
While the first two steps require significant data scrubbing efforts, they pale in comparison to the final Material Modifications step, or determining which instruments lose their grandfathered status once there has been a ‘material modification.’ Let’s take a bond whose yield changes 25 basis points. Is that material or not? What if the obligor changes?
As of today, the IRS has provided some guidance in defining what significant modifications are, but like many other tax provisions, there are elements open to interpretation by tax advisors. Unfortunately, FATCA provides no further clarity:
A modification of a debt instrument results in an exchange for purposes of § 1.1001-1(a) if the modification is significant.
The regulation does cite that a withholding agent must have a ‘reason to know’ that the modification was material, so a number of industry groups are lobbying for an issuer mandate (similar to Cost Basis Reporting) rather than the guesswork of what will or will not change the status of the instrument, including change in yield, payments, and obligor. In the meantime, with January 2014 approaching, the necessity for an industry standard is stronger than ever.
Even if issuers are mandated, they will need to interpret what is material, as will the IRS in determining whether the withholding agents were or were not compliant. Just as ISITC has driven consensus and standards in trade communications, the global custodians, data vendors, and entire community affected will have to come together to convince the IRS that we all need greater direction on M&M’s. In the absence of that prescriptive guidance, we as a group will lead the way and make that determination on our own – providing sweeter clarity to all.