A Closer Look at FATCA Grandfathering

Stevie_Conlon_updateGuest Contributor: Stevie Conlon, Senior Director & Tax Counsel, Wolters Kluwer Financial Services,with special thanks to support from Tax & Regulatory Specialists Anna Vayser and John Kareken.

On March 18, 2010, the Foreign Account Tax Compliance Act (FATCA) was passed into law as part of the Hiring Incentives to Restore Employment Act. Congress was concerned about U.S. taxpayers evading U.S. taxes by investing through Swiss banks and other offshore accounts. FATCA imposes significant new burdens on foreign banks and U.S. financial intermediaries making payments to foreign persons.

FATCA also has significant implications for brokers and operations staff responsible for withholding of U.S. taxes. As of July 1, 2014, FATCA will require 30% withholding tax on payments of U.S. source interest, dividends, and other fixed, determinable, annual, or periodic (FDAP) income, unless the payments can be reliably associated with documentation on which the withholding agent can rely to treat the payments as exempt from withholding. Withholding on gross proceeds from the sale or disposition of property which produces U.S. source interest or dividends will begin as of January 1, 2017. One complexity is coordinating FATCA withholding tax obligations with existing nonresident and backup withholding rules and IRS guidance is forthcoming.

FATCA withholding generally does not apply to payments on certain grandfathered obligations (defined below). Eligible debt instruments (which exclude debt without a stated maturity debt or instruments that are really not classified as debt for tax purposes) that are issued on or before July 1, 2014 are referred to as grandfathered debt. If a grandfathered debt instrument is “materially modified” for tax purposes after July 1, 2014, grandfathered status is lost and payments on the obligation are subject to FATCA withholding. U.S. Treasury Regulation §1.1001-3(e) defines material modifications as significant modifications that cause a change in yield, timing of payments, obligor or security, or the nature of a debt instrument.

There are certain exceptions to withholding in the regulations. FATCA withholding is not required if the withholding agent lacks control or custody of the money or property from which to withhold or lacks knowledge of the facts that give rise to the payment. Certain income “effectively connected” (ECI) with conduct of a U.S. trade or business is not a withholdable payment.

What is a grandfathered obligation?

Under the FATCA regulations, the definition of a grandfathered obligation includes obligations outstanding on July 1, 2014 of the following kind that are legally binding: a debt instrument (for example, a bond, guaranteed investment certificate, or term deposit); an agreement to extend credit for a fixed term (for example, a line of credit or a revolving credit facility), provided that the agreement as of its issue date fixes the material terms (including a stated maturity date) under which the credit will be provided; a derivatives transaction entered into between counterparties under an ISDA Master Agreement that is evidenced by a confirmation; a life insurance contract under which the entire contract value is payable no later than upon the death of the individual(s) insured under the contract; and an immediate annuity contract payable for a period certain or for the life of the annuitant.

What obligations cannot be grandfathered?

An obligation for purposes of FATCA grandfathering does not include any legal agreement or instrument that: is treated as equity for U.S. tax purposes; lacks a stated expiration or term (for example, a savings deposit or demand deposit, a deferred annuity contract, or a life insurance contract or annuity contract that permits a substitution of a new individual as the insured or as the annuitant under the contract); is a brokerage agreement, custodial agreement, investment linked insurance contract, investment linked annuity contract, or similar agreement to hold financial assets for the account of others and to make and receive payments of income and other amounts with respect to such assets; or is a master agreement that merely sets forth standard terms and conditions that are intended to apply to a series of transactions between parties but that does not set forth all of the specific terms necessary to conclude a particular transaction.

As these provisions illustrate, determining whether or not to withhold from a payment on a debt instrument can involve several layers of analysis, and the wrong decision has potentially costly consequences. Whether or not an instrument is a debt instrument determines if it can be grandfathered in the first place. Then analyzing corporate actions such as exchange offers, purchase offers, bankruptcies, and other events is necessary to determine the possible effects of material modification of the instrument resulting in loss of grandfathered status. These issues added to the overall complexity of the FATCA requirements and the systems needed for compliance result in one of the most challenging regulatory compliance tasks ever undertaken by banks, brokers and other financial firms.

How does a payor determine if an obligation is grandfathered?

A payor has two options to determine if an obligation is grandfathered. First, the payor can determine that the obligation held meets the requirements set forth above based on its own review of the facts and analysis (“actual knowledge”). Of course, under this approach the payor is liable for withholding tax and reporting risk and penalties if it makes an error in its determination. Second, the payor can rely on a written statement by the issuer to make the determination. However, it is unlikely that such written statements may be forthcoming for many outstanding obligations because the issuers did not know there was a written notice option at the time the obligations were issued (or entered into).

What is a material modification?

Determining what constitutes a material modification can be extremely challenging and brokers need an accurate, daily source of data alerting them to which debt instruments have been materially modified and whether they should withhold a portion of the payment. The penalties of under-withholding can be severe because the withholding agent is liable for any tax which was not properly withheld. Some withholding agents may try to minimize this this risk by withholding on all or a large portion of their debt holdings, but this course of action could lead to its own set of problems. For example, recipients could demand make-whole payments or transfer their investments to another firm that does not over-withhold. In both under- and over-withholding cases, there could be IRS penalties for reporting incorrect amounts on withholding forms filed with the IRS.

How does a payor determine if a material modification that causes a loss of grandfathered status has occurred?

Similar to the determination of whether an obligation is grandfathered, there are two ways that an obligation can lose its grandfathered status because a material modification is deemed to occur. First, a payor might receive a disclosure from the issuer of the obligation stating that there has been a material modification (an “Issuer Material Modification Notice”). Alternatively, a payor is required to treat a modification as material if the payor “has reason to know that a material modification has occurred” (the “Reason to Know Determination”). This alternative test is a big problem for the financial industry.

The inclusion in the final FATCA regulations of the Reason to Know Determination has troubled payors. Many, through industry associations and dialogue with the IRS, have asked that the Reason to Know Determination be deleted. Financial institutions are concerned that asking payors to make a determination that a material modification has occurred is difficult and burdensome. In spite of such concern, the IRS might have difficulty acquiescing to industry’s request because issuers of grandfathered obligations have no legal requirement or incentive (other than possibly pursuant to the Securities Exchange Commission’s Rule 10b-5 or as a matter of investor relations) to provide clear guidance of the occurrence of a material modification. Thus, the IRS may be concerned that the Reason to Know Determination is necessary to address possible gaps in issuer notification of material modifications.

Revised IRS Form 1042 Forces Specific Focus on This New Challenge

On April 17, 2013, the IRS released a new draft Form 1042. The form includes a new Line 2c in Section 2 of the Form that obligates payor and withholding agents to explicitly list the amount of income paid with respect to grandfathered obligations. Thus, the determinations of whether an obligation is grandfathered and whether a material modification causes the loss of grandfathered status will be implicitly reflected in the amount required to be included on this line of the Form. Accordingly, proper determinations directly impact both the payor’s underlying FATCA related withholding tax obligation (generally at 30% of the amount of interest paid after July 1, 2014 or 30% gross proceeds received on dispositions of such grandfathered debt occurring after January 1, 2017) and IRS form completion and reporting burden with associated penalty risks.


FATCA imposes a slew of significant set of challenges and burdens on financial institutions, large businesses and U.S. payors of payments relating to securities and investments. One small but painful aspect of the withholding tax burdens of FATCA relates to grandfathered obligations and material modifications. Payors should prepare for potential difficulties in determining both whether an obligation is grandfathered and if a material modification has occurred. The likely lack of issuer notice that an obligation is grandfathered and disclosure that a material modification has occurred, coupled with the Reason to Know Determination requirement of the FATCA regulations, forces payors to prepare to make material modification determinations themselves.

Check out FTF’s FATCA Breakfast on March 6, 2014 to learn how firms here and abroad need to optimize their operational infrastructures, workflows for KYC, governance and reporting, and documentation to stay ahead of the FATCA overhaul.

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