The Intersection of FATCA and M&A: Buyer Beware

Several years after its passage by Congress, companies continue to address the Foreign Account Tax Compliance Act ¹Chapter 4 of Subtitle A of the Internal Revenue Code of 1986, as amended (the Code), §1471 through §1474. (FATCA) with different pace and purpose; the goal of each FATCA project, however, is generally the same—to achieve compliant status with minimal cost and disruption to operations.

While companies continue to struggle with fundamental FATCA requirements, another FATCA-related concern is developing on the horizon—the need and ability for FATCA-based diligence and considerations in merger and acquisition transactions. This will be no easy task.

Time lines are seemingly in a constant state of flux and final rules, forms and many intergovernmental agreements remain outstanding. So how can a buyer determine whether a target’s FATCA preparedness is adequate? How should it quantify potential exposures and protect itself when FATCA liability may not crystallize until after the deal is closed? And with so many companies lacking resources to understand and address their own FATCA issues, how can they efficiently analyze and integrate the FATCA program(s) of a target and integrate them with their own FATCA programs?

Of course, transactions will continue as we move through FATCA’s various effective dates and greater clarity should develop in the coming months and years. In the meantime, deal teams will need to address FATCA in the context of deals as best they can. In this article, we consider the potential impact of FATCA on merger and acquisition (M&A) transactions, identify areas of potential exposure for an acquirer and target, and consider what, if anything, clients and tax counsel can do now to address the potential future impact of these rules.

Background

FATCA was enacted in 2010 to address certain offshore tax evasion methods being effectuated by U.S. taxpayers. ²FATCA was enacted as part of the Hiring Incentives to Restore Employment Act of 2010, P.L. 111-147, 124 Stat. 71 (HIRE). FATCA is a new chapter to the ever expanding Internal Revenue Code (§1471-§1474) and very generally seeks to ensure that information regarding certain cross-border payment types, as well as the payees who receive them, is provided to the Internal Revenue Service.

The rules obtain this result by effectively conscripting payors of in-scope payments as withholding agents. As withholding agents, these payors have the responsibility of classifying their payments, collecting documentation from payees (including disclosures regarding the payees’ substantial U.S. owners or account holders, and/or certifications regarding FATCA status and compliance) and reporting such information to the IRS.

The objective is to provide additional information to the IRS regarding U.S. investors, so the IRS can confirm that such investors are adequately reporting their foreign assets and income.

The specifics of which payors are conscripted, which payments are in scope and the detailed payee obligations are beyond the scope of this article. What is important for the purposes of this article is an appreciation that these obligations exist, and that the efforts necessary to satisfy these requirements in the context of specific business, system, operational and contractual arrangements can be substantial and unique to each withholding agent and payee.

The Stakes

The signature feature of the FATCA rules is the 30% withholding tax, intended to ensure that foreign entities and their withholding agents comply with the rules. Withholding is applied on certain types of payments made to foreign entities as a sort of negative reinforcement: If adequate documentation is provided/collected, no withholding tax should generally be applicable. If inadequate documentation is provided/collected (or the documentation indicates that the payee isn’t itself complying with its FATCA obligations), then the withholding tax can be imposed.

Withholding agents also have reporting and (when amounts are withheld) deposit obligations.

As further insurance of compliance, the rules provide that when a withholding agent fails to appropriately withhold, the withholding agent is itself liable for the under-withheld tax. ³Reg. §1.1474-1(a)(4)(i). Further, if a withholding agent fails to correctly report, reporting penalties apply. ⁴Id.

On the other side of an in-scope payment, the -U.S. payees must determine their FATCA status and provide appropriate documentation to the payor reflecting their status or be subject to the 30% withholding tax on the gross amount of certain payments. This determination can be complicated and, depending upon the identified FATCA status of the payee (e.g., as a foreign financial institution or a passive non-financial foreign entity), can result in significant additional FATCA burdens being imposed.

Diligence Considerations

What this will mean in the context of many merger and acquisition transactions is that when a target group includes a FATCA-relevant withholding agent or payee (which will be the case in virtually every deal involving multinational companies) due diligence procedures will need to be expanded to review, identify and quantify potential FATCA exposures. This will prove challenging for a number of reasons.

As an initial matter, the FATCA requirements are (currently) phased in through 2017. The phased approach is good news for companies that face the daunting challenge of changing procedures and systems to achieve FATCA compliance, but will create difficulties from a diligence perspective. For instance, under the current timeline, new account on-boarding procedures are required as of July 1, 2014. ⁵Notice 2013-43, 2013-31 I.R.B. 113. The rules grant additional time to review and remediate pre-existing accounts and obligations. ⁶Id.

Additional requirements under the FATCA regulations, such as expanded U.S. Form 1042-S reporting, withholding and the application of the rules to certain gross proceeds payments, are scheduled to come online over the course of the coming months and years. ⁷Reg. §1.1473-1(a)(1)(ii). Further, taxpayers operating in jurisdictions with intergovernmental agreements (IGAs) may encounter additional wrinkles; though largely standardized, separate IGAs can contain different requirements and exceptions, and will involve different local country implementing legislation processes and timelines. ⁸Briefly, IGAs are bilateral agreements between the U.S. and third-party countries. There are various iterations of model IGAs. Generally, IGAs are intended to address certain local country legal impediments to implementing FATCA and to ease certain compliance related burdens. Absent an IGA, taxpayers generally must apply the FATCA regulations. As and when IGAs are adopted companies will migrate from the provisions of the regulations to the provisions of the applicable IGA.

An acquirer, therefore, must not only determine the target group’s level of preparedness with each currently effective FATCA obligation (a list that will expand with time), but also must confirm the in-flight efforts relating to rules that are scheduled to become effective: What are the requirements? When are they scheduled to become effective? How much heavy lifting is required to bring the target into compliance?

In answering these questions, acquirers will need to consider not only the U.S. domestic FATCA tax rules, but will also need to understand whether and how various current and future IGAs might apply. ⁹While largely standardized and broadly consistent with the regulations, each IGA will contain different requirements, contain country-specific carve-outs and exceptions, and have different local country implementing legislation. From an integration perspective, an acquirer must consider and compare the target’s FATCA program with the acquirer’s own FATCA efforts to successfully combine procedures and systems for existing and future requirements. The acquirer must also confirm that the target’s interpretation of the evolving rules doesn’t conflict with its own interpretation.

Thus, diligence regarding a target group’s FATCA status will need to be considered from a number of perspectives:

• current/past compliance (i.e., does the target’s FATCA program address all currently effective requirements to ensure acquirer isn’t assuming material secondary withholding liabilities?);

• future compliance (i.e., has the target group taken steps toward addressing new FATCA requirements such that future state compliance can be reasonably achieved? For instance, has the target group collected adequate pre-deal payment/payee information so that the acquirer can comply with post-closing reporting obligations?); and

• integration (i.e., have the target’s FATCA relevant systems and procedures been identified and considered as part of a successful post-integration program?).

Areas of Particular Focus

As described, all aspects of a target group’s FATCA program generally should be considered in the context of transaction due diligence. There are, however, certain areas companies find particularly challenging with respect to FATCA readiness, and it may therefore be prudent for acquirers to focus on those same areas during diligence reviews.

Identification of FATCA-Relevant
Payment Centers

FATCA’s withholding and reporting requirements are both keyed off of the fundamental definition of “withholdable payments.” ¹⁰‘‘Withholdable payments’’ under the FATCA rules consist of (a) payments of U.S.-source fixed or determinable annual or periodical (FDAP) income, as defined in Reg. §1.1441-2(b)(1) or Reg. §1.1441-2(c), but without exceptions allowed by that regulation; and (b) after Dec. 31, 2016, gross proceeds from dispositions of property that could produce interest or dividends that would be U.S.-source FDAP income. Reg. §1.1473-1(a)(1). Sometime after Dec. 31, 2016, foreign financial institutions will also have to contend with ‘‘foreign passthru payments,’’ which are presently undefined. Reg. §1.1471-4(b)(4). Withholdable payments can be made by any entity/business unit within an organization that has control of a checkbook. In the context of FATCA, companies often focus narrowly, perhaps exclusively, on payments made by their accounts payable groups and shared service centers; however, other groups within an organization often make withholdable payments (e.g., general counsel’s office, treasury groups, human resources, etc.).

Further, in multinational structures it isn’t uncommon for global payment or fulfillment centers to be based offshore, outside of the U.S., making payments on global/master contracts. Where the amounts paid by the global centers are in relation to, e.g., services rendered in the U.S., U.S. risks insured, etc., such payment may be in scope for FATCA purposes and the center may be a withholding agent for FATCA.

An acquirer should therefore carefully review the target’s efforts toward identification of its FATCA-relevant payment centers and the processes adopted in relation to each such payment center. If FATCA-relevant payment centers are missed and outside of the target’s FATCA compliance program, a significant risk can result.

Payment Classification

Not all payments are subject to FATCA reporting and/or withholding. In general, payments can be classified into one of three baskets for FATCA purposes:

• they may be outside of the scope of FATCA (i.e., neither reportable nor subject to withholding);
• they may be subject to FATCA reporting (Form 1042-S) only; or
• they may be subject to both withholding and reporting.

A payor generally must determine which of these baskets each payment falls within, and then perform the required documentation collection, reporting and withholding (if any) accordingly. This analysis can be difficult and, at the current time, many companies don’t have the systems capabilities to classify multiple payments to a single vendor differently. Further, in certain instances a single payment may need to be allocated across these baskets.

For example, each payment to a technology vendor under a single contract may include interest, service fees and royalty payments. Each component part of the payment is subject to specific sourcing rules and specific FATCA classification rules.

It is therefore necessary to review a target’s processes for reviewing and classifying the nature of its payments to confirm the appropriate basket(s) into which the payments fall. A target’s past incorrect analysis and classification of payments can result in withholding exposure and/or reporting penalties that will carry over to the acquirer.

Payee Documentation

Where a target’s payment centers make in-scope FATCA payments, and payee documentation is required/collected (e.g., a Form W-8BEN-E), the target group must have procedures in place to confirm the veracity of the documentation collected. The regulations provide specific standards of knowledge indicating when documentation must be deemed unreliable or incorrect and therefore may not be relied upon without further remediation or verification. ¹¹Reg. §1.1471-3(e).

Very generally, depending on the context, a payor must confirm that documentation is internally consistent (e.g., the content of a collected form doesn’t itself contain conflicting data) and that the documentation is consistent with certain other information that the payor may have in relation to the payee.

Many taxpayers are struggling to implement systems that will automate these standards to ensure the documentation satisfies the required standards. If documentation contains certain deficiencies that the payor is obligated to identify, but the payor fails to identify and address the deficiencies, then the payor can be liable for taxes, penalties and interest.

Acquirers should therefore review the target’s relevant procedures and systems in relation to documentation collection, review and remediation to ensure the veracity of the documentation.

Classification of Target Group’s Foreign Entities

If the target group includes non-U.S. operations, FATCA classification of its non-U.S. entities (and potentially branches) within the target group may be necessary. As a threshold matter, non-U.S. entities are generally initially classified as either financial or nonfinancial for FATCA purposes.

Certain limited categories of financial institutions are largely exempt from the more onerous FATCA provisions, ¹²Such entities generally include certain types of pension funds, government organizations and international organizations. Section 1471(f) and Reg. §1.1471-6. but as a general matter financial institution status will result in increased FATCA compliance obligations and increased exposure to the FATCA penalties. As a result, taxpayers generally prefer to classify entities as nonfinancial rather than financial where possible for FATCA purposes.

To that end, taxpayers may seek to apply special FATCA provisions that permit the classification of entities with apparent financial institution status as nonfinancial, provided specific requirements are met. Specifically, the target group must satisfy both an expanded affiliated group ¹³The EAG is essentially the consolidated group concept from §1504 with a 50% test instead of 80%, with the inclusion of foreign companies and insurance companies. Reg. §1.1471-5(i)(2). Establishing an EAG can itself be challenging where, for example, group structures include partnerships that can sever EAGs into pieces or where complex ownership arrangements are involved. (EAG) level test (i.e., the tested entity’s group must be a nonfinancial group ¹⁴Determining nonfinancial group status requires insight as to the income and assets of the entire EAG. To be classified as a nonfinancial group, the EAG must have no more than 25% passive income and no more than 25% passive assets. Reg. §1.1471-5(e)(5)(i)(B)(1). A number of issues remain with respect to these tests. For instance, it is unclear whether the passive income must be measured under generally accepted accounting principles, international financial reporting standards or some other method. Further, the 25% passive asset test is based on “fair value.” Very few companies keep books on a fair value basis, so confirming the satisfaction of this test can be difficult. Finally, no more than 5% of the EAG’s income can be attributable to group financial institutions. Thus, to rely upon these special rules a thorough analysis of the entirety of the target group’s EAG will often be required. ) and an entity level test (i.e., the entity’s activities must be limited to specific types of activities ¹⁵The specific entity level tests are found in Reg. §1.1471-5(e)(5)(i)(C), Reg. §1.1471-5(e)(5)(i)(D), or Reg. §1.1471-5(e)(5)(i)(E). These rules generally require that the tested entity be primarily engaged in either limited holding company activity, treasury center functions limited to the EAG members or captive finance activities for the EAG members and their customers. ).

Analysis of Entities in Target Group’s EAG for FATCA Classification Purposes

Confirmation of the availability and application of these rules can require a complex analysis with respect to the target group’s EAG and specific entities within the EAG. Further, while certain acquisitions may not change the EAG of a tested entity, many transactions will change the target’s EAG. In these latter cases, entities that had claimed a particular FATCA status based on the attributes of their pre-acquisition EAG will need to be re-analyzed.

Further, where the target groups include foreign financial institutions, acquirers generally should be prepared to conduct more thorough diligence in relation to financial institution-specific FATCA requirements. Such requirements will include, for example, compliance with the Foreign Financial Institution Agreement, ¹⁶Reg. §1.1471-4 and Rev. Proc. 2014-13, 2014-3 I.R.B. 419. including registration requirements, the reporting of specifically required financial information, the reporting of specific account holder information and the exercise of appropriate diligence in relation to account holder documentation and review.

Where a target group includes nonfinancial entities, confirmation of those entities’ FATCA classification should also generally be confirmed. Specifically, nonfinancial entities must generally be classified as either passive or excepted (with a number of further FATCA subcategories for excepted NFFEs). If passive, the NFFE must disclose the identity of its U.S. substantial shareholders as well as potentially complete additional reporting. ¹⁷Reg. §1.1471-3(d)(12). Alternatively, if the entity is classified as excepted, no additional reporting is generally needed at the entity level, but appropriate documentation must still be provided. Depending on the complexity of the target group’s ownership structure pre- and post-acquisition, their preferences regarding passive or excepted status may change. ¹⁸Reg. §1.1472-1(c)(1)(iv). Establishing active status at the entity level can be challenging. In this respect the rules require that less than 50% of the entity’s gross income be passive income, and less than 50% of the entity’s assets produce or be held for the production of passive income. In applying this test, related party look-through rules are applicable to the extent certain passive payments are received from related parties if the payments are allocable to active income of the related party payor.

Frequently, target groups will contain both financial and nonfinancial entities, necessitating the application of broad diligence considerations. Once again, depending upon the timing of the acquisition and the state of the then current law, the general preparedness of the target group and/or the historic status claimed by each target entity will be relevant. The impact of the acquirer’s own group makeup and FATCA-relevant attributes on the target group, post-acquisition, should again be confirmed. ¹⁹For instance, a target group’s non-U.S. holding companies may qualify for nonfinancial status pre-acquisition. If the acquirer’s EAG includes, e.g., a captive insurance company, however, those holding companies may be classified as financial institutions for FATCA purposes post-acquisition. Reg. §1.1471-5(e)(1)(iv).

Application of Presumption Rules

The FATCA rules require withholding agents to apply presumption rules regarding the status of a payee as, e.g., a U.S. or foreign person, as well as whether the recipient is a foreign financial institution (FFI) where valid documentation is otherwise lacking at the time of payment. ²⁰Reg. §1.1471-3(f).

Where there is actual knowledge or a reason to know that certain presumptions are incorrect, however, taxpayers generally may not rely upon the presumption. If a payor nevertheless incorrectly relies upon a presumption the payor is responsible for the under-withheld tax, penalties and interest.

It should therefore be confirmed whether the target group relied upon the presumption rules and, if so, that it has applied those rules correctly.

Application of Grandfathered Status

The FATCA rules provide that certain arrangements may be granted grandfathered status, such that only reporting (but not withholding otherwise required under FATCA) will be necessary. Should the grandfathered item undergo a substantial modification, however, grandfathered status is lost and withholding (to the extent otherwise applicable) should arise. ²¹Reg. §1.1471-2(b)(2).

Where a target has relied upon grandfathered status to avoid FATCA withholding the acquirer must confirm that the item in fact qualified for such status and that no subsequent substantial modification arose with respect to the item causing the grandfathered status to be lost.

Reporting Capabilities

Ultimately, FATCA requires specific information to be reported with respect to specific payments. A failure to capture and report the required information can result in reporting penalties.

For instance, withholding agents that don’t file and make available to relevant foreign payees the Form 1042-S required information in relation to the preceding calendar year in a timely manner are subject to filing penalties ranging from $30 to $100 per form. ²²Section 6721 provides for the following penalties: $30 per Form 1042-S for forms correctly filed within 30 days of the failure (up to a maximum of $250,000 per year); $60 per form for forms correctly filed by Aug. 1, 2013 (up to a maximum of $500,000 per year); $100 per form for forms filed after Aug. 1 (up to a maximum of $1.5 million per year). Intentional disregard for these reporting rules can increase the penalty per form up to the greater of $250 or 10% of the total amount of items required to be reported, with no maximum penalty. ²³§6721(e).

Failure to furnish a correct and complete form to each recipient without reasonable cause will trigger its own set of penalties. ²⁴Section 6722 provides for penalties of up to $100 for each failure to furnish, with a maximum penalty of $1.5 million for all failures to furnish, correct recipient statements during a calendar year. Reduced penalties may apply if the error is rectified by Aug. 1. Any intentional failure to report correct information will increase the penalty up to the greater of $250 or 10% of the total amount of items required to be reported, with no maximum penalty. ²⁵§6722(e).

A target’s capabilities and historic compliance, and the ability to integrate the target’s system into the acquirer’s process and systems, should therefore be on diligence review lists.

Considerations Beyond Due Diligence

FATCA will result in M&A-related issues beyond due diligence considerations. For instance, the FATCA regulations provide that in the event of certain mergers a withholding agent that acquires an account from a transferor is permitted to rely upon documentation collected by the transferor, and may also rely upon the transferor’s determination of the FATCA status for a transition period equal to the lesser of six months from the date of the merger or until the acquirer knows that the claim of status is inaccurate (or a change in circumstances occurs). ²⁶Reg. §1.1471-3(c)(9)(v). At the end of the transition period, the acquirer is permitted to rely upon the transferor’s determination only if the documentation that the acquirer has for the account holder supports the FATCA status claimed.

If it is determined that the FATCA status assigned by the transferor is incorrect and withholding is required on future payments, the acquirer must withhold on payments to the extent tax should have been withheld during the transition period. Thus, when applicable, the acquirer must have a plan in place to review the status of the acquired relationships and, presumably, to remediate when differences exist.

Further, when an FFI is a target in an acquisition, the rules provide that the FFI Agreement (if any) can terminate. ²⁷Notice 2013-69, 2013-46 I.R.B. 503. Anticipating this termination may be crucial to ensuring that the FFI doesn’t inadvertently lose its participating FFI status, as nonparticipating financial institution status will generally result in significant adverse consequences.

FATCA can be a consideration in relation to certain branch/asset acquisitions and restructurings as well. For instance, branches can have quasi-entity status for certain FATCA purposes (e.g., each branch can potentially have its own FATCA tax identification number (“GIIN”) and related FATCA responsibilities ²⁸Reg. §1.1471-3(c)(3)(iii)(H).). These considerations are especially complex where IGAs are applicable, as the corporate entity may be subject to one set of FATCA rules (e.g., the U.S. regulations or an IGA) with each branch subject to a second set of FATCA rules (e.g., an alternative IGA in effect for the country in which the branch is located).

Currently, the status of IGA discussions between the U.S. and foreign countries, as well as the terms of implementing legislation, is far from clear in relation to many jurisdictions. As indicated above, this can mean that a taxpayer must proceed under the regulations for some time, with a contingency plan to switch to the application of the applicable IGA at a later date.

Finally, corporate structuring should be completed with a view toward the FATCA rules. As described, the FATCA rules are nuanced such that unexpected implications can flow from, e.g., hybrid, branch and joint venture structures. The FATCA regulations also include an anti-abuse rule that disregards a change in ownership, voting rights or the form of an entity if the principal purpose is to avoid FATCA withholding or reporting obligations. These concepts will therefore need to be considered in the context of many restructurings.

What to Do?

On the buy side, expanded diligence and integration plans addressing FATCA are likely the best protection against inadvertently assuming a substantial FATCA issue. In many instances, the testing of a target’s processes and systems to confirm FATCA compliance can leverage Chapter 3 diligence efforts.

In most instances specific contractual language will be utilized, with alternative “buyer favored” and “seller favored” provisions to be negotiated. Already, FATCA language is working its way into certain deal documents, becoming commonplace in loan facility documentation and investment documentation. ²⁹See, e.g., Loan Marketing Association FATCA Riders (http://www.lma.eu.com/landing_documents.aspx); International Swaps and Derivatives Association 2012 FATCA Protocol (http://www2.isda.org/functional-areas/accounting-and-tax/fatca). Buyers (and sellers) will need to spend time understanding the scope and utility of such language.

Additionally, as of 2017, FATCA will apply to gross proceeds paid in relation to assets that give rise to U.S.-source dividends and interest so buyers of such assets—including many mergers and acquisitions structured as stock deals—will need to adopt FATCA compliance processes.

On the sell side, taxpayers should establish audit trails in relation to their FATCA compliance activities. For example, a record of the actions taken around U.S. withholding agent issues, non-U.S. entity classification, work papers in relation to important calculations (e.g., nonfinancial group determination, active entity status determination), copies of documents collected and of course information and tax returns filed should be maintained.

Further, target groups should test their processes and procedures in advance of acquisition transactions to ensure FATCA compliance is in fact achieved, as buyers will most certainly test relevant processes. A review by the target group of its compliance status as measured under the IRS audit procedures for withholding tax audits may be considered, and the adoption of a FATCA procedures manual can save time and provide increased confidence to a buyer.

Ultimately, FATCA considerations will become a standard consideration in the context of merger and acquisition transactions. Until such time, merger and acquisition professionals will need to develop procedures in light of the evolving contours and phased effective dates of FATCA.