IRS Relaxes Timeline for Due Diligence and Withholding and Expands Grandfathered Obligations under FATCA

On October 24, the Internal Revenue Service (IRS) released Announcement 2012-42, outlining new, extended timelines for due diligence requirements and withholding under the Foreign Account Tax Compliance Act (FATCA) and including additional types of payments with respect to pre-existing investors as grandfathered obligations exempt from FATCA withholding. The IRS will incorporate these new rules into the final FATCA regulations.

Observation:  The IRS still intends to release final FATCA regulations – as well as an FFI Agreement and Forms W8 as noted below – by the end of this year. 


FATCA generally provides that a Foreign Financial Institution (FFI) – including not only a foreign bank but a foreign hedge fund, private equity fund, etc. – will need to be registered as a Participating FFI (PFFI) (or a Deemed-Compliant FFI) in order to avoid a 30% withholding tax on withholdable payments – generally U.S. source passive income (FDAP) and gross proceeds from the sale of U.S. securities.  FATCA also imposes certain documentation, due diligence, and reporting requirements on U.S. withholding agents and PFFIs, in respect of which the Treasury Department issued proposed regulations last February 8, 2012, that set forth a staggered timeline beginning in 2013 for the implementation of these rules.

Since then, the IRS has proceeded to draft revised Forms W8, etc. (with which the FATCA status of foreign persons will be documented), work on drafting an FFI Agreement for PFFIs, and work on developing an online registration system, all of which were intended to be finalized, along with the proposed regulations, by the end of 2012.

At the same time, the U.S. Treasury Department has been conducting negotiations with the tax authorities of other countries who are interested in pursuing an alternative framework to achieve FATCA’s policy objectives, under which FFIs would report instead to their own local tax authority which would then exchange the information with the IRS on an automatic basis, under a so-called Intergovernmental Agreement or IGA.  A foreign entity covered by an IGA is largely subject to similar due diligence, withholding, and reporting as a PFFI is, except it performs these procedures under the laws of its local tax authority. The Treasury released, on July 26, 2012, a model agreement as the basis for concluding agreements with each country; has signed such an agreement with the United Kingdom on September 12, 2012; and continues its discussions with various countries to conclude IGAs.  

The timeline set forth in the proposed regulations presented several challenges. For example, U.S. withholding agents (including U.S. investment funds) were required to implement new account opening procedures documenting FATCA status by January 1, 2013. However, the ability to enter into an FFI Agreement was to commence at the same time, resulting in the possibility that the documentation would have to be updated as the entity opening the account registered with the IRS during 2013.  Furthermore, the timeline set forth in the model IGA for a foreign entity to comply with FATCA is different from that for a U.S. withholding agent and a PFFI. The Treasury recognized the desirability of aligning the timelines for U.S. withholding agents (including U.S. funds), PFFIs, and FFIs in countries that have (or will have during 2013) IGAs.

New Timelines 

We note below some important timelines which have been extended by comparison to the proposed regulations (p/r) (for a complete list, please see the IRS Announcement and Table to which links are provided above):

Implementation of New Account Opening Procedures 

  • U.S. withholding agents (including U.S. funds) – by January 1, 2014 (one year later than  under the p/r)
  • PFFIs (including foreign funds) – by the later of January 1, 2014 (6 months later than under the p/r) or the effective date of FFI Agreement
  • FFIs pursuant to an IGA – by January 1, 2014

The final regulations will define a pre-existing obligation (i.e., account) by reference to the above dates, which, in turn, will determine the date on which FATCA withholding on FDAP begins, as noted below.

FATCA Withholding on FDAP (U.S. source interest, dividends, etc., but not gross proceeds from sale of U.S. securities) 

  • New accounts opened on or after the dates noted above – January 1, 2014
  • Pre-existing accounts of undocumented Prima Facie FFIs (as defined) – July 1, 2014 (6 months later than  under the p/r)
  • Pre-existing accounts of all other undocumented foreign entities – January 1, 2016 (one year later than under the p/r)

Observation:  This timeline is intended to dovetail with the new timeline for the date by which due diligence on existing accounts must be completed.  However, once a particular account has been documented, for example as a Non-Participating FFI, withholding or reporting as appropriate must begin with respect to that account even though the time period for documenting the FATCA status of such account may not have expired.  This may provide a disincentive for a foreign entity that is not FATCA compliant to provide – or for a fund to request from such an investor – formal documentation of such status on the new Forms W8 (expected by the end of 2012) before these extended dates. 

Effective Date of FFI Agreement 

An FFI Agreement entered into prior to 2014 will have an effective date of January 1, 2014 (6 months later than under the p/r).

Gross Proceeds Withholding 

Gross proceeds from the sale or other disposition of any property that could produce U.S. source interest or dividends (e.g., a debt or equity instrument issued by a U.S. person) will first be subject to FATCA withholding on January 1, 2017 (two years later than under the p/r).

Observation:  Withholding on gross proceeds – not just on capital gains – is probably the “sharpest teeth” that FATCA uses toenforce its objectives of transparency and reporting. The model IGA, as well as the U.K. IGA, does not provide for withholding on gross proceeds, although this could change in the future. Deferral of gross proceeds withholding under FATCA is consistent with the apparent attempt to align with IGAs which for the time being do not provide for withholding on gross proceeds. 

Expansion of Grandfathered Obligations 

FATCA imposes a 30% withholding tax on various types of passive income from U.S. sources. It also imposes the 30% withholding tax on so-called “foreign passthru payments” – payments which are not themselves from U.S. sources but are deemed “attributable to” U.S. source income subject to FATCA withholding. Absent this provision, foreign entities that were not FATCA compliant would be able to effectively hide behind FATCA compliant entities, thus circumventing FATCA’s objective of transparency. Just how to determine the portion of a payment “attributable to” U.S. source income subject to FATCA withholding received from a foreign entity that earns income from both U.S. and foreign sources is the subject of much controversy.

Accordingly, the IRS has not yet decided on the definition of a foreign passthru payment and has stated that such payments will be subject to withholding no earlier than January 1, 2017.  The IRS announced that, under the final regulations to be issued, a foreign passthru payment in respect of an obligation that is outstanding (i.e., an account that has already been opened) as of 6 months after the IRS publishes the definition of a foreign passthru payment will be treated as a “grandfathered obligation” which is not subject to FATCA.

Observation:  U.S. withholding agents are not required to withhold on foreign passthru payments.  In addition, there is no withholding on foreign passthru payments under the model IGA or the U.K. IGA. Limiting FATCA withholding on such foreign passthru payments is consistent with the apparent attempt to align with IGAs.  

The IRS Announcement also stated that final regulations will also treat as a grandfathered obligation exempt from FATCA any instrument that (a) would otherwise be subject to FATCA withholding solely because it gives rise to a so-called dividend equivalent (pursuant to Internal Revenue Code Section 871(m) and the regulations thereunder) and (b) is outstanding 6 months after the date on which such instruments become subject to such treatment.  Moreover, obligations to make a payment with respect to, or to repay, collateral posted to secure obligations under a notional principal contract that is a grandfathered obligation will also be treated as a grandfathered obligation exempt from FATCA. These provisions are particularly beneficial to the hedge fund industry.


As financial institutions – including investment funds – have worked on implementing a global strategy for FATCA compliance, they have expressed concerns about being subject to different rules and timelines in the varying jurisdictions in which they operate. This Alert demonstrates that the IRS continues to work to alleviate these concerns, and in doing so coordinates and aligns (to the extent possible) the rules that are applicable to U.S. investment funds, foreign investment funds and investors that will become PFFIs, and foreign investment funds and investors that will be governed by IGAs. 

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