March 8, 2012 Foreign-Targeted Bearer Bonds IRS Issues Transitional Guidance on the Upcoming “Bearer Bond” Repeal SUMMARY On March 7, 2012, the IRS issued Notice 2012-20 (the “Notice”), which provides transitional guidance regarding the upcoming sunset of the U.S. tax law provisions that permit the issuance of “foreign-targeted bearer” obligations. The rules set forth in the Notice will generally be effective for obligations issued after March 18, 2012. The Notice provides guidance on four subjects: First, the Notice clarifies the definition of a “registered” obligation by (i) providing that an obligation will be considered “registered” notwithstanding the fact that a holder may be entitled to definitive certificates in very limited circumstances and (ii) confirming—consistent with many practitioners’ expectations—that “immobilized bearer” obligations will be treated as “registered” for U.S. tax purposes. Second, the Notice provides that issuers of obligations that pay “U.S.-source” interest will be entitled to pay “portfolio interest” (i.e., interest free of U.S. tax withholding) on obligations issued after March 18, 2012 but before January 1, 2014 if those obligations are issued under the “foreign-targeted registered obligation” rules (which had previously been scheduled to be phased-out for obligations issued after the end of 2006 and in some circumstances, the end of 2008). This extension has two significant consequences. First, in contrast to the general “portfolio interest” rules, issuers of “foreign- targeted registered obligations” will be entitled to rely on certifications from nonqualified intermediaries to pay interest without collecting U.S. withholding tax. Second, issuers may not be required to report interest paid on “foreign-targeted registered obligations” on a Form 1042-S. Third, the Notice confirms that the current exemption from information reporting of interest with respect to debt obligations with an original term of 183 days or less (and satisfy certain requirements intended to prevent such obligations from being held by non-exempt U.S. persons) will remain available for obligations issued after March 18, 2012. Fourth, the Notice provides that the excise tax exemption for “foreign-targeted” bearer obligations (which will remain after the other provisions for “foreign-targeted” bearer obligations expire) will be governed by “foreign-targeting” criteria that are identical to the current rules governing “foreign- targeted” obligations (i.e., the current “TEFRA C” and “TEFRA D” rules). New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com Significantly, the Notice does not extend the March 18, 2012 deadline for issuing “foreign-targeted” bearer obligations. DISCUSSION A. BACKGROUND The repeal of the laws permitting “foreign-targeted” bearer obligations was enacted as part of the Hiring Incentives to Restore Employment Act of 2010 (the “Act”) and is effective for obligations issued after March 18, 2012. 1. Bearer vs. Registered Debt Debt obligations may be classified as either “bearer” or “registered” for U.S. federal income tax purposes.1 Whether a debt instrument is “bearer” or “registered” is significant because issuers and holders of “registration-required obligations” issued in “bearer” form are subject to adverse U.S. tax consequences. An obligation is generally “registration required” unless it (i) has a maturity of one year or less, (ii) is an obligation of a natural person, (iii) is not “of a type” offered to the public or (iv) is a “foreign-targeted” obligation (under rules that will sunset—save for a continuing exemption from the “excise tax” described below—for obligations issued after March 18, 2012). As noted above, issuers and holders of a “registration-required” obligation that is in “bearer” form are subject to unfavorable U.S. tax rules. In particular: An issuer (whether U.S. or foreign) is prohibited from deducting interest paid with respect to such an obligation and is subject to an excise tax equal to 1% of the principal amount of the obligation multiplied by the number of calendar years until the obligation matures; A U.S. holder of such an obligation is required to treat any gain as ordinary income and is not permitted to deduct any losses; and A non-U.S. holder of such an obligation that bears U.S.-source interest is ineligible for the customary (i.e., “portfolio interest”) exemption from U.S. withholding tax.2 Notwithstanding the limitations imposed on them, “bearer” notes were common in certain markets (including the Eurobond market) because, as long as the notes were issued in accordance with certain “foreign-targeting” rules, non-U.S. holders did not need to provide U.S. withholding certificates in order to 1 An obligation is typically “registered” if: (i) the obligation is registered as to both principal and any stated interest with the issuer (or its agent) and any transfer of the obligation may be effected only by surrender of the old obligation and reissuance to the new holder; (ii) the right to principal and stated interest with respect to the obligation may be transferred only through a “book-entry system” maintained by the issuer or its agent; or (iii) the obligation is registered as to both principal and stated interest with the issuer or its agent and can be transferred both by surrender and reissuance and through a “book-entry system”. However, an obligation is generally not “registered” if it can be converted at any time in the future into an obligation that is not in registered form. Any obligation that is not “registered” is considered to be in “bearer” form. 2 However, a non-U.S. holder may still qualify for treaty relief. -2- Foreign-Targeted Bearer Bonds March 8, 2012 receive interest free of U.S. withholding tax. By contrast, interest paid on a “registered” obligation is subject to U.S. withholding tax unless the issuer has received a statement (often, an IRS Form W-8) that the beneficial owner of the obligation is not a U.S. person. 2. Foreign-Targeted Registered Obligations As noted above, “registration required obligations” issued in bearer form generally do not qualify for the customary exemption from U.S. withholding tax unless the issuer has received a “statement” that the beneficial owner of the obligation is not a U.S. person. The “statement” required for this purpose ordinarily must consist of (i) documentation (most often, an IRS Form W-8) on which a U.S. person can rely to treat the payment as made to a foreign beneficial owner under the general withholding rules or (ii) a withholding certificate from a qualified intermediary, withholding foreign partnership or U.S. branch of a foreign bank or insurance company.3 Interest paid on registered obligations must also generally be reported to the IRS on Form 1042-S. Despite the general rules outlined in the paragraph above, there was a partial relaxation of these requirements for “foreign-targeted registered” obligations. In general, interest on a registered obligation that complied with the following rules would not be subject to U.S. withholding tax. First, the offering of the obligation was required to take place in accordance with “procedures similar to” the so-called “TEFRA D” rules that are intended to ensure that a bond offering was “foreign-targeted”. Second, a U.S. withholding agent was required to receive a certificate4 from a financial institution or member of a clearing organization (which member was the registered owner of the obligation) stating that the beneficial owner of the obligation on any interest payment date was not a U.S. person. This certificate did not require that non-U.S. beneficial owners be identified, but the U.S. withholding agent could not rely on such a certificate if it had actual knowledge or reason to know that a U.S. person was the beneficial owner of the obligation. Notice 2006-99 stated that the IRS and Treasury Department intended to issue regulations phasing out these “foreign-targeted registered obligation” rules for instruments issued after December 31, 2006 (and in some cases, December 31, 2008). Given this, few, if any, “foreign-targeted registered” obligations have been issued since 2008. 3 However, alternative procedures exist for payments made to financial institutions. 4 The content of this certificate and related requirements are described in Treas. Regs. § 1.871- 14(e)(3)(i). -3- Foreign-Targeted Bearer Bonds March 8, 2012 B. NOTICE 2012-20 As noted above, the Notice provides guidance on four topics, each of which is discussed below. 1. “Registered” Obligations a. Immobilized Bearer Instruments The Notice provides that “effectively immobilized” obligations will be treated as “registered” obligations for U.S. tax purposes. Such obligations are common in certain non-U.S. markets where issuers wish to issue “registered” debt for U.S. tax purposes, but local law or custom dictates that obligations be in “bearer” form under local law. Under the Notice, an obligation will be “effectively immobilized” if: the obligation is represented by one or more global securities in physical form that are issued to and held by a “clearing organization”5 (or by a custodian or depository acting as an agent of a clearing organization) for the benefit of purchasers of interests in the obligation under arrangements that prohibit the transfer of the global securities except to a successor clearing organization subject to the same terms; and beneficial interests in the underlying obligation are transferable only through a book-entry system maintained by the clearing organization (or one of its agents). The IRS had previously stated—in a private letter ruling—that such an “immobilized bearer” security would be treated as “registered” for U.S. tax purposes.6 However, private letter rulings are not precedential, and while many practitioners expected that such structures would continue to be treated as “registered” for U.S.