14 March 2012

International Tax Alert

IRS issues guidance on repeal of rules allowing bearer bonds to be issued abroad
Executive summary
On 7 March 2012, Treasury issued Notice 2012-20, providing guidance relating to the repeal of most of the rules that allowed bearer debt to be issued in foreign-targeted offerings without sanctions. This repeal becomes effective after 18 March 2012. The Notice provides the following: Notwithstanding requests made by commentators, the government declined to extend the 18 March 2012, deadline after which bearer debt may no longer be issued in offerings targeted to foreign persons while qualifying for the portfolio debt exemption from 30% US withholding tax and avoiding the various US sanctions for issuers of bearer bonds. The government temporarily resurrected the foreign-targeted registered debt rules, eliminated in 2006, which allowed borrowers to issue non-bearer debt into foreign markets based on documentation of a Z]f][aYd gof]jk fgf%MK klYlmk hjgna\]\ lg oal``gd\af_ Y_]flk ^jge fYf[aYd afklalmlagfk gj [d]Yjaf_ gj_YfarYlagfk oal`gml l`] []jla[Yl] gj \g[me]flYlagf fgjeYddq j]imaj]\ ^jge Z]f][aYd gof]jk lg \g[me]fl their non-US status. L`] \]falagf g^ o`]f []jlYaf gZda_Ylagfk `]d\ l`jgm_` k][mjala]k \]hgkalgja]k Yj] af j]_akl]j]\ ^gje `Yk Z]]f [dYja]\ af oYqk [gfkakl]fl with market practice. Procedures will remain in effect unchanged: (1) on when interest on shortterm obligations in large denominations issued in foreign-targeted offerings without documentation of investor status will be exempt from backup

withholding and (2) that allow bearer obligations to be issued in foreign-targeted offerings without imposition of the Section 4701 excise tax. There had been concern because these procedures crossreferenced other rules that were repealed as of 18 March 2012.

Background
Portfolio debt The portfolio debt rules of Sections 871(h)/881(c) provide an exemption from US withholding tax for most debt obligations held by unrelated foreign persons. Under prior law, there were two ways for issuing such obligations. First, they could be issued in registered form, in which case the Z]f][aYd gof]j `Y\ lg \g[me]fl his non-US status on IRS forms, such as Form W-8BEN, or, in the case of obligations held through certain imYda]\ afl]je]\aYja]k$ mkaf_ approved know-your-customer/antimoney laundering documentation. Interest paid on such bonds was generally reported to the IRS on Form 1042-S. Obligations held through the book-entry facilities of the Depository Trust Company or Fedwire, which is usual for US obligations intended to be widely traded or pass from hand to hand, are in registered form for this purpose. Other obligations can be drafted so as to be in registered form. Second, they could be issued in bearer form, but only in an offering specially targeted to non-US investors. Typically, this was done
2

under the TEFRA D rules of Treas. Reg. Section 1.163-5(c)(2)(i)(D). In this case, it was not necessary for the investor to document his nonUS status, and no Form 1042-S reporting was required. For these purposes, an obligation that can be converted into bearer form is deemed to be in bearer form, even if it has not been so converted. In some countries, bonds must be issued in bearer form for various local reasons. Generally, such bearer bonds would not actually be issued af \]falan] ^gje lg afn]klgjk$ Zml could only be held through a central securities depository, such as Clearstream or Euroclear. Investors would have to hold their interest in such bonds through the book-entry systems of such a depository and participating banks and brokers. There was some confusion about o`]l`]j km[` aeegZadar]\ Zgf\k (as well as bonds for which there never was a physical instrument, a&]&$ \]eYl]jaYdar]\ Zgf\k! o]j] in bearer form or in registered form for US tax purposes. Notice 200699 generally provided that bonds of this type issued after 2006 would be treated as in registered form, but some uncertainties still remained. A third alternative, the foreigntargeted registered debt rules, allowed registered obligations to be issued in offerings targeted to foreign persons without the f]]\ ^gj ]al`]j Z]f][aYd gof]j documentation of non-US status, when payments were made to a fYf[aYd afklalmlagf gj lg Y e]eZ]j g^ Y [d]Yjaf_ gj_YfarYlagf gj >gje
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1042-S reporting. Instead, such bonds had to be held through foreign Y[[gmflk Yl fYf[aYd afklalmlagfk& The institution would certify that such bonds were only held on behalf of non-US investors, but the rules did not specify what due diligence, if any, the institution had to perform Z]^gj] _anaf_ l`ak []jla[Ylagf& Al oYk thought that these rules might be helpful to Federal instrumentalities, such as Fannie Mae and Freddie Mac (although these rules are available to all issuers), since such Federal instrumentalities are not permitted under non-tax law to issue bearer debt. Treas. Reg. Section 1.1461-1(c)(2)(ii)(H) provided that interest on such obligations was not subject to reporting on Form 1042-S. But the foreign-targeted registered debt rules were so little used that they were eliminated by Notice 2006-99. Other sanctions on issuing bearer debt Prior law had six sanctions on US issuers of, and investors in, registration-required debt, i.e., debt that (1) was of a type that was issued to the public and (2) had a term of more than one year, unless the debt was in fact in registered ^gje& L`] jkl l`j]] Yhhda]\ lg issuers, and there were exceptions if the obligation was issued in an offering targeted to foreign investors, e.g., under the TEFRA D rules. The last three applied to holders. There was no exception to the holder sanctions even if the obligation had been issued in a foreign-targeted offering. These holder sanctions

have not been changed by the HIRE Act, as discussed below, and are not affected by the Notice. The six sanctions are as follows: Section 163(f) provided that issuers could not deduct interest on registration-required debt that was not issued in registered form. Section 312(m) provided that interest on registration-required debt that was not issued in registered form could not be deducted for purposes of [gehmlaf_ ]Yjfaf_k Yf\ hjglk (certain non-foreign-targeted exceptions also applied). Section 4701 imposed an excise tax on issuers of registrationrequired debt that was not issued in registered form. The extent to which Section 4701 might apply to debt with a US connection issued by a non-US issuer is not entirely clear. Section 165(j) provided that holders could not deduct losses on registration-required debt that was not issued in registered form, unless either the holder of the debt met certain conditions or the Section 4701 excise tax was paid when the debt was issued. Section 1287 provided that gains on sale of a registration-required obligation that was not issued in registered form would be ordinary, not capital, unless either the holder of the debt met certain conditions or the Section 4701 excise tax was paid when the debt was issued.

Section 149(a) provided that interest on a registrationrequired bond issued by a state or local government other than in registered form could never qualify for the Section 103 exemption from tax Short-term obligations Interest on obligations with an original term to maturity of 183 days or less is exempt from withholding tax when paid to a foreign person and there is no need to obtain documentation. (This exemption has nothing to do with the portfolio debt rules, and so was not affected by the HIRE Act amendments.) However, such interest could be subject to 28% backup withholding under Section 3406 unless the investor provided its MK lYphYq]j a\]fla[Ylagf fmeZ]j on Form W-9, documented its nonUS status (as described above), or otherwise was exempt (e.g., because it was a corporation or a bank). GZlYafaf_ []jla[Ylagfk af l`] k`gjl% term commercial paper market would have been a nuisance. Thus, a special rule (Treas. Reg. Sections 1.6049-5(b)(10)(11)) allowed certain obligations with an original term to maturity of 183 days or less to be issued in denominations of $500,000 or greater in an offering targeted to non-US persons without backup withholding. These rules largely cross-referenced the TEFRA D rules. The HIRE Act The HIRE Act, Pub. L. No. 111147 (please see International Tax Alert, HIRE Act signed by President

Obama; major changes to US tax rules governing payments to non-US persons/entities, dated 26 March 2010) repealed the rules that allowed bearer debt to qualify for portfolio debt treatment and avoid the issuer sanctions when issued in offerings targeted to foreign persons, effective for obligations issued after 18 March 2012. The exception from the Section 4701 excise tax for obligations issued in foreign-targeted offerings remained, as did the rule allowing short-term debt to be issued in bearer form in foreign-targeted offerings. There were a number of unanswered questions under these rules, with a particular concern in certain countries where investors were reluctant to complete IRS forms certifying their non-US status and imYda]\ afl]je]\aYja]k o]j] fgl widely available.

The Notice
No extension of time for issuing bearer bonds The IRS refused to extend the deadline for issuing debt in bearer form in offerings targeted to foreign persons past the statutory deadline of 18 March 2012. Resurrection of the foreigntargeted registered debt rules The foreign-targeted registered debt rules are reinstated, for obligations issued after 18 March 2012 and before 1 January 2014. The Notice kh][a]k l`Yl Y fYf[aYd afklalmlagf o`a[` f]]\ fgl Z] Y imYda]\ intermediary must use either IRS forms (such as Form W-8BEN) or

International Tax Alert

certain approved documentary evidence to determine that investors are non-US before making the f][]kkYjq []jla[Ylagf l`Yl l`] obligations were held for the account of non-US persons. (As noted above, there was no such guidance under hjagj dYo&! L`] Fgla[] Ydkg [dYja]k that the exemption from Form 1042-S reporting for interest paid on foreign-targeted registered debt remains in effect (there had been some question about the position for obligations issued before Notice 2006-99). Section 871(h)(5), as amended by the HIRE Act, would allow these rules to continue in existence, but one can only speculate if they will extended past 2013. Clarification of when an instrument is in registered form L`] Fgla[] [dYja]k Fgla[] *((.%11 by providing that an obligation that ak ]al`]j \]eYl]jaYdar]\ gj fgeafYddq in bearer form will be treated as in registered form if it is can only be held through a securities depository. Also, an obligation can allow conversion aflg Z]Yj]j ^gje af l`j]] kh][a]\ circumstances and will not be treated as being in bearer form unless and until it is actually converted into bearer ^gje& L`] l`j]] kh][a]\ kalmYlagfk are: The depository (referred to in the Fgla[] Yk Y [d]Yjaf_ gj_YfarYlagf! goes out of business and no successor can be found;

The issuer defaults on the obligation; or The issuer requests that the obligation be converted into bearer form because tax law changed in a way that was adverse to the issuer unless this was done. Clarification of rules for foreigntargeted short-term bearer obligations As noted above, there was some confusion about whether the special rules allowing obligations with an original term to maturity of 183 days or less to be issued in denominations of $500,000 or greater in foreign-targeted offerings would continue in effect, because they cross-referenced rules that were Z]af_ j]h]Yd]\& L`] Fgla[] [dYja]k that these special rules will remain in effect unchanged. Section 4701 excise tax There was some question as to whether one could continue to use the same procedures as were used before to issue bearer debt in foreign-targeted offerings without imposition of the Section 4701 ]p[ak] lYp& L`] Fgla[] [gfjek l`Yl these special rules will remain in effect unchanged.

Implications
There was concern that the termination of the rule allowing portfolio debt to be issued in bearer ^gje ogmd\ \akjmhl []jlYaf fYf[aYd markets, especially the market for certain US-issued bonds in Japan. It would seem that the government views the resurrected foreign-targeted registered debt rules as a satisfactory substitute. Whether there now will be much interest in this procedure remains to be seen; there was very little under prior law. Furthermore, if an institution that is not currently Y imYda]\ afl]je]\aYjq emkl hml in place systems and procedures to `Yf\d] l`] f][]kkYjq []jla[Ylagf under these rules, such an institution might as well consider becoming a imYda]\ afl]je]\aYjq a^ al ak af Yf approved jurisdiction). 9dl`gm_` l`] [dYja[Ylagfk lg l`] \]falagf g^ o`]f Yf gZda_Ylagf ak af registered form are consistent with how certain commentators interpreted ]paklaf_ dYo$ l`] [dYja[Ylagfk af l`] Notice are welcome. Furthermore, Ydl`gm_` l`] [dYja[Ylagfk j]_Yj\af_ short-term bearer debt and the Section 4701 excise tax merely resolve the problems created by rules that cross-reference other rules that no longer exist, they are helpful.

International Tax Alert

For additional information with respect to this Alert, please contact the following: Ernst & Young LLP, International Tax Services, Washington, DC Lilo Hester +1 202 327 5764 lilo.hester@ey.com Julia Tonkovich +1 202 327 8801 julia.tonkovich@ey.com Ernst & Young LLP, ITS, Capital Markets, Washington, DC David Golden +1 202 327 6526 david.golden@ey.com Ernst & Young LLP, Capital Markets Tax Services Boston Matthew Blum +1 617 585 0340 matt.blum@ey.com Ernst & Young LLP, Withholding Tax Services, Boston Ann Fisher +1 617 585 0396 ann.fisher@ey.com

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