This is the first of a two-part series. Part II will appear in the February issue of The Metropolitan Corporate Counsel.
On December 9, the House of Representatives passed the Tax Extenders Act of 2009 (the "Act"). The Act is notable because it incorporates the key provisions of the Foreign Account Tax Compliance Act of 2009 ("Fat Cat"). The Fat Cat bill was jointly introduced in both Houses of Congress on October 27, 2009. It was developed in consultation with the United States Treasury Department and enjoys the Obama administration's public support.
It is anticipated that the Act will be passed by the Senate before the end of the year. The Fat Cat provisions are one of two revenue raisers for the Act. The other revenue raiser, a change to the taxation of carried interests, may not be passed. However, it appears that there is strong support in both Houses of Congress to enact the Fat Cat proposals.
The Fat Cat provisions are not focused directly on tax evasion. The Act does not amend the criminal or civil penalties for tax evasion nor does it amend or expand the penalties applicable to those aiding and abetting understatements of tax or tax evasion. Instead the Act imposes significant reporting and information gathering obligations on individuals and third parties which are enforced through new withholding taxes and substantial penalties.
If enacted, the Act's Fat Cat provisions will have a significant effect well beyond U.S. persons engaging in tax evasion and their facilitators. The Act is likely to have more impact on the global financial system than any U.S. tax law change in more than a decade. It is unclear whether the Fat Cat Act's provisions will reduce offshore tax evasion, but it is certain that the Act will impose significant burdens upon the global financial system in an attempt to achieve this goal. Although touted as anti-offshore tax evasion legislation, the Act will affect, among others, investors in the U.S. capital markets, issuers of debt securities to non-U.S. investors, private equity and hedge funds, American expatriates and even foreign advisors with no direct United States connection.
The Fat Cat provisions of the Act can be divided into three core areas. The first area involves substantive changes to U.S. federal income tax law such as the repeal of the foreign targeted offering exemptions for bearer bonds. The second area increases reporting requirements for individuals with foreign investments. And the third area imposes disclosure and similar obligations on foreign financial institutions.
The obligations imposed upon third parties may cause non-U.S. persons to weigh carefully the benefits of doing business in the United States or with U.S. persons. Foreign parties may be reluctant to incur increased compliance costs and, more importantly, have potential exposure to U.S. tax penalties for inadvertent non-compliance with the new obligations the Act would impose. In particular, American expatriates may find foreign financial institutions and funds reluctant to have, or continue to have, individual American clients or investors.
1. Substantive Tax Law Changes
A. Repeal of the U.S. Bearer Bond Exception
The Act repeals the "foreign targeted" statutory exception to the denial of a deduction for interest on bonds not issued in registered form. Under the provision, a deduction for interest is disallowed with respect to any bearer debt of a type offered to the public with a maturity of more than one year. In addition, such obligations would be ineligible for the U.S. "portfolio interest" withholding tax exemption. The Act does not repeal the foreign targeted obligation exception with respect to the excise tax applicable to issuers of such obligations that do not issue their obligations in compliance with certain procedures commonly referred to as TEFRA C or TEFRA D.
The repeal of the bearer bond exception for U.S. issuers is very significant. This provision will place U.S. issuers at a disadvantage vis-à-vis foreign issuers. Local law favors bearer bonds in some jurisdictions. The bearer bond exception was originally introduced, in part, because Congress recognized that U.S. issuers needed to access foreign bond markets where bearer debt was the standard format.
If this exception is removed, U.S. issuers may only issue long-term debt that is treated as in "registered form" for U.S. federal tax purposes. In addition to any local law issues this may present to foreign investors, it also means that investors must provide certification of their status as non-United States persons ( i.e. , I.R.S. Form W-8 certification). This may make bonds issued by U.S. issuers less marketable. The Act also precludes the United States government from issuing bearer bonds.
The Act allows the Treasury to waive the certification requirements where the Treasury has determined that the certification is not required to carry out the anti-tax avoidance purpose of the rules. According to the Treasury's technical explanation of the Act, it is anticipated that the Treasury may exercise its authority under this rule to waive certification in circumstances where the Treasury has determined there is a low risk of tax evasion and there are adequate documentation standards within the country of tax residency of the beneficial owner of the obligations in question.
The provision also provides that a debt obligation held through a dematerialized book entry system is treated as eligible to be treated as in registered form even though under local law it may be formally treated as in bearer form. The Treasury's technical explanation of the Act states that this should be the case as long as the debt obligation may be transferred only by book entries and the holder of the obligation does not have the ability to withdraw the obligation from the book-entry system and obtain a physical certificate in bearer form in the ordinary course of business. This still leaves many questions unanswered as to what could qualify under this provision.
The provision applies to debt obligations issued after the date which is two years after the date of enactment.
B. Tax on Dividend-Equivalent Payments
The Act subjects payments of U.S. dividend equivalent amounts to a 30 percent gross basis withholding tax. This provision of the Act is targeted at "dividend washing" strategies designed to avoid U.S. dividend withholding tax. The tax imposed on "dividend equivalent amounts" is eligible for reduction under an applicable income tax treaty.
A U.S. dividend equivalent amount is any payment made pursuant to a notional principal contract (such as an equity swap) if the payment is contingent upon, or determined by reference to, the payment of a U.S. source dividend. Additionally, the amendment allows the Treasury to designate any other payment as a U.S. dividend equivalent amount if it is "substantially similar" to a U.S. dividend equivalent amount. The Act does not address the payment of similar dividend substitute payments under a securities lending transaction.
The Act gives the Treasury authority to exclude arrangements it concludes do not have the potential for tax avoidance. Unlike prior Senate proposals, the Act does not provide a safe harbour, but merely states that the Treasury "may take into account" factors listed in the amendment. These factors include the term of the contract, the amount of each party's investment and posted collateral, whether the price used to measure the parties' entitlements/obligations is objective, whether either party sells (directly or indirectly) to the other party shares of the underlying equity, whether terms address the hedge position of either party or other conditions which may compel either party to hold or acquire shares of the underlying equity.
Although the Treasury has authority to exclude certain types of transactions, it is unclear what types of transactions will be excluded. Senior Treasury officials have signaled that the current rules applicable to securities lending transactions over U.S. equities are likely to be withdrawn. Under current law, substitute payments under a foreign-to-foreign securities lending of U.S. equities are not subject to U.S. withholding tax provided the recipient was eligible for the same withholding tax rate as the payer for dividends paid on the lent equities. This avoids the "cascading" of withholding obligations. It is unclear what approach the Treasury would take with respect to dividend equivalent payments between two foreign persons acting completely outside the United States.
The tax is levied on the gross "dividend equivalent amount." In a typical equity swap, one party agrees to pay a specified return calculated by reference to a market interest rate such as LIBOR in exchange for the return on certain shares, and amounts due under the contract are typically netted. This provision treats any dividend-based amount as a payment even though any actual payment is netted against the interest-based leg of the contract. As a result, due to netting pursuant to the swap's terms, a party may be obligated to withhold and remit tax even when no actual payment is made to the foreign investor.
This provision would apply to payments made on or after the 90th day after enactment.
The Act amends several provisions relating to foreign trusts. The Act clarifies when a foreign trust has a U.S beneficiary for purposes of treating the trust as a "grantor trust," making it easier for the Service to treat a foreign trust as a grantor trust. Additionally, the uncompensated use of any trust property by a U.S. beneficiary, grantor or related person will be treated as a payment from the trust to the U.S. beneficiary or grantor. The Act also increases certain reporting obligations and imposes a minimum penalty for failure to comply with certain reporting requirements.
These provisions generally apply after the date of enactment. Increased reporting obligations will be imposed for tax years beginning after the date of enactment. Finally, the penalty provisions for failure to report on certain foreign trusts are effective for notices and returns required to be filed after December 31, 2009.
2. Increased Individual Reporting
The Act expands reporting obligations by requiring individual taxpayers to report certain foreign assets on their income tax returns. Reporting under this provision of the Act should be similar to the reporting required by the Report of Foreign Bank and Financial Account ("FBAR") rules.Although the information required by the Act's provisions is similar to the information disclosed on an FBAR, it is not identical. The Act does not replace or amend any provision relating to FBAR reporting. It is clear that taxpayers must separately comply with both sets of reporting obligations.
The Act's reporting obligations apply to individuals who hold an interest in a "specified foreign financial asset." Individuals holding such an interest during a taxable year must disclose certain information relating to those assets on their income tax return for the year if the aggregate value of their interest in such assets exceeds $50,000. It is not clear how or when taxpayers are meant to calculate the aggregate value. A "specified foreign financial asset" includes "financial accounts" (as defined below) maintained by a foreign financial institution and any of the following not held in an account maintained by a domestic or foreign financial institution: 1) shares or securities issued by a foreign person, 2) financial instruments or contracts with a foreign issuer or counterparty held for investment, and 3) any interest in a foreign entity. In addition, the Act increases reporting requirements for investments in entities treated as a passive foreign investment company for U.S. federal income tax purposes.
One of the Act's most significant changes from current law is its expansive definition of a "financial institution" to include most private investment funds. A foreign financial institution is defined by the Act to include: 1) a foreign bank, 2) a foreign custodian or depositary, 3) or a "foreign investment entity." A foreign investment entity includes any entity engaged primarily in investing or trading in securities, partnership interests, commodities or interests in any of the preceding. Hedge funds, private equity funds and almost any other type of investment fund formed outside of the United States should be a "foreign financial institution" under the Act's definition.
The Act imposes substantial penalties for non-compliance with the specified foreign financial asset reporting. Monetary penalties for failure to file are $10,000 for each year plus $10,000 per month (capped at $50,000 for a tax year) for failure to timely remedy such failure. Understatements of tax attributable to an undisclosed foreign financial asset can be subject to an additional penalty equal to 40 percent of the understatement. In addition, the statute of limitations for reporting income connected with the underreported assets is extended to six years in cases of substantial understatements of tax, and the statute of limitations does not begin to run until the taxpayer has disclosed the existence of the reportable foreign assets.
No penalty is imposed under the provision against an individual who can establish that the failure was due to reasonable cause and not willful neglect. Foreign law prohibitions against disclosure of the required information cannot be relied upon to establish reasonable cause.
This provision would apply for tax years beginning after the date of enactment.
Part II of this article, to appear in the February issue, will pick up with the third set of key provisions, increased third-party compliance and reporting.
L. Wayne Pressgrove Jr . and John Clay Taylor are U.S. tax lawyers with King & Spalding. Mr. Pressgrove is resident in the firm's Atlanta office, and Mr. Taylor is resident in the firm's London office.