                     

              
   .  ,  . ,         

 

Hard Work Produces 2002 ISDA Master Agreement:

New Tax Provisions Reflected

By Micah Bloomfield and Mark Eichler

Payee tax representations for dealing with the new U.S. reporting and
withholding regulations have been added to the 2002 ISDA Master Agreement

On January 6, 2003, after two years of hard work by
hundreds of people from firms throughout the world
and from all market segments, the International
Swaps and Derivatives Association (ISDA)
announced the publication of its 2002 ISDA Master
Agreement. Last revised in 1992, the ISDA Master
Agreement has been used to document the vast
majority of derivatives transactions. In the tax year
ended December 31, 2001, the last full year for
which statistics are available, it is estimated that
transactions with a notional amount of $69 trillion
were executed using the ISDA Master Agreement or
the equivalent.
Although the majority of the modifications made
to the ISDA Master Agreement relate to the rela-
tionship between the parties, some of them — in
particular, the payee tax representations in Part 2(b)
of the Schedule to the Master Agreement — reflect
changes in U.S. tax law that have been enacted over
the last decade. A clear understanding of the 2002
ISDA Master Agreement is not possible without at
least a rudimentary understanding of these new tax
provisions. This article discusses the implications of
these changes to a U.S. payer and foreign payee and
suggests some additional modifications parties using
the 2002 Agreement may wish to consider.
   
Part 2(b) of the Schedule to the 2002 ISDA Master
Agreement has been expanded to include four new
payee tax representations, added in response to
changes made in January 2001 to the U.S. federal
income tax information-reporting and withholding
rules for “notional principal contracts.”1 Depending
on the status of the payee, one or more of the repre-
sentations should be included in Part 2(b) of the
Schedule. The four representations from which the
payee may choose are:
                      
1. It is a “U.S. person” for U.S. federal income tax
purposes.
2. It is a “non-U.S. branch of a foreign person” for
U.S. federal income tax purposes.
3.With respect to payments made to an address
outside the U.S. or made by a transfer of funds
to an account outside the U.S., it is a “non-U.S.
branch of a foreign person” for U.S. federal
income tax purposes.
4. It is a “foreign person” for U.S. federal income
tax purposes.
The second representation differs from the third in
that it applies only to a foreign counterparty that
does not have a branch located in the U.S. The third
applies to a foreign counterparty with multiple
branches, including at least one in the U.S.
   
   
In general, a “notional principal contract” is a finan-
cial instrument that provides for payments by one
party to another at specified intervals, with the
amounts calculated by reference to a specified index
and a notional amount, in exchange for specified
consideration or amounts calculated in a similar man-
ner. Common transactions that qualify as notional
principal contracts include equity swaps, credit
default swaps, interest rate swaps, and foreign curren-
cy swaps.
Under the new information-reporting and with-
holding rules, if a U.S. person makes a notional prin-
cipal contract payment that it is required to treat as
effectively connected with a U.S. trade or business of
its counterparty, the U.S. person must report that
payment to the IRS by filing Form 1042-S (Foreign
Person’s U.S. Source Income Subject to
Withholding). Alternatively, if the payment is not
treated as effectively connected with a U.S. trade or
business, the U.S. person may be required to with-
hold and remit a portion of such payment to the
IRS.

A U.S. person usually must treat payments as effec-
tively connected with a U.S. trade or business of its
counterparty if either of the following applies:
1.The payments are made to, or to the account of,
an office of a foreign counterparty that is locat-
ed in the U.S.
2.The payments are made to, or to the account of,
an office of the foreign counterparty that is
located outside the U.S., and the U.S. person
knows (or has reason to know) that the payments
nonetheless are effectively connected with the
conduct of a trade or business within the U.S.
     -

The new information-reporting and withholding
rules contain certain exceptions. The Agreement’s
new payee tax representations play the important role
of documenting the exceptions to the new rules.
Reporting Rules
Under an exception to the reporting rules, no
reporting is required if the payee represents in an
agreement that governs the transaction, such as an
ISDA Agreement, that it is a “U.S. person” or a “non-
U.S. branch of a foreign person.” The first three new
payee tax representations in the ISDA Agreement
Schedule provide the mechanism for documenting
whether this exception applies.
Withholding Rules
The last representation relates to a U.S. person’s with-
holding obligation. Under the new rules, a U.S. per-
son is generally required to withhold a portion of
each payment made pursuant to a notional principal
contract and remit that amount to the IRS unless the
payee is a corporation, or other exempt recipient, or
the payment is treated as effectively connected with
the conduct of a trade or business in the U.S.2
However, if the payee is a “foreign person” and
includes that representation in the ISDA Agreement
Schedule (the agreement governing the notional
principal contract), a U.S. counterparty is not
                      
required to withhold any amount (unless such pay-
ment, or portion of, is characterized as interest).3
Thus, even if a foreign counterparty cannot represent
that it is a “non-U.S. branch of a foreign person”
because, for example, it is acting through a U.S.
office, it at least will be able to eliminate its U.S.
counterparty’s obligation to withhold by making this
representation.
  
As welcome as these new provisions are, parties using
the 2002 ISDA Master Agreement and accompanying
Schedule may want to consider some additional
modifications. Some of these suggested modifications
have been accepted by practitioners as reasonable
changes to the 1992 ISDA Master Agreement and
were forwarded to ISDA in connection with the
drafting of the 2002 ISDA Master Agreement.4
Expand “Gross-Up” Exception for Inaccurate Tax
Representation to Include New Agency Representation
The 2002 ISDA Master Agreement has been expand-
ed to include an optional “No Agency” representa-
tion. In new section 3(g), each party to the
Agreement represents that it is entering into the
Agreement as “principal” and not as “agent.” This is
important for tax purposes because the particular tax
form that a U.S. payer should request from a foreign
counterparty to avoid withholding (in respect of a
payment, or portion thereof, characterized as interest)
depends, in part, on whether the counterparty is act-
ing as principal or agent. A foreign counterparty
acting as principal typically would provide a Form
W-8BEN (Certificate of Foreign Status of Beneficial
Owner for United States Tax Withholding), whereas
a counterparty acting as agent would provide Form
W-8IMY (Certificate of Foreign Intermediary,
Foreign Partnership, or Certain U.S. Branches for
United States Tax Withholding).
Section 2(d)(i) of the 2002 ISDA Master
Agreement requires all payments made under the
Agreement to be made without deduction for with-

holding. If withholding is required, the payer is obli-
gated to “gross-up” the payment (i.e., pay additional
amounts to compensate for the withholding imposed
on the original payment). However, under subpart
4(B) of section 2(d)(i), if the withholding is imposed
as a result of the inaccuracy or falsity of a payee tax
representation made pursuant to section 3(f), no
gross-up obligation is imposed.
Perhaps because the section 3(g) “No Agency”
representation is an optional provision, subpart 4(B)
of section 2(d)(i) was not amended to include it and
continues to reference only section 3(f). Thus, as cur-
rently drafted, a party breaching the section 3(g) “No
Agency” representation would still be entitled to a
gross-up.
As stated above, for a U.S. payer to determine
which form to request from a foreign counterparty, it
must first ascertain whether the counterparty is act-
ing as agency or principal. An incorrect determina-
tion likely will result in the payer requesting the
wrong form, thereby causing the payments made
under the Agreement (to the extent characterized as
interest) to be subject to withholding and the payer
to be subject to a gross-up obligation. If the payer
asked for the wrong form because the payee’s “No
Agency” representation was false, fairness dictates that
the payee, and not the payer, should bear the burden
of any withholding. Nonetheless, because the mis-
representation would not be deemed to have been
made under section 3(f) (and the payee technically
would have complied with the payer’s form request),
a literal reading of the provision very well might
require a “duped” payer to gross-up a misrepresenting
payee. To avoid this result, parties using the 2002
ISDA Master Agreement should amend section
2(d)(i)(4)(B) to include a reference to section 3(g).
Eliminate “Material Prejudice” Exception to “Obligation
to Deliver Tax Forms”
Section 4(a)(iii) of the 2002 ISDA Master Agreement
(as well as the 1992 Agreement) generally requires a
party, on reasonable demand by the other party, to
                      
provide any form or document that allows the
requesting party to make payments under the
Agreement without any deduction or withholding.
A payee that fails to provide a requested tax form is
denied the right to a tax gross-up if its failure to
deliver the form resulted in a withholding obligation.
This delivery requirement, however, applies only
“so long as the completion, execution, or submission of
such form or document would not materially prejudice
the legal or commercial position of the party in receipt
of such demand….”
The italicized language essentially allows the payee
to refuse to provide the requested tax form—if doing
so will materially prejudice its legal or commercial
position—but nonetheless to maintain its right to the
gross-up. This leaves the payer in the inequitable
position of having to pay a withholding tax that
would not have been due “but for” the payee’s failure
to provide the requested form, and then gross up the
payee. Many market participants have amended sec-
tion 4(a)(iii) of the 1992 Agreement to delete the
italicized language because it shifts to the payer a risk
that they believe should be borne by the payee who
fails to deliver the necessary form. Although some
have taken a contrary position, discussed below, many
would argue that the same change should be made
with respect to the 2002 ISDA Master Agreement.
The alternative position is that deleting the italicized
language unfairly affects the payee by removing any
protection that it has against unexpected requests for
forms or documents that could prove harmful if
provided. For example, assume that during negotiations
a payer does not reveal that it will require tax forms or
documents from the payee. Subsequently, after the
transaction closes, the payer asks the payee to provide
a certain form or document that, if provided, would
materially prejudice the payee’s commercial or legal
position. In that instance, if the italicized language had
been deleted from section 4(a)(iii), the payee would be
placed in the unenviable position of either providing
the form or document (and materially prejudicing its
position) or losing its right to a gross-up.

In this scenario, where the payer could have pro-
tected itself had it requested the form or document
prior to closing, the more equitable solution might
be to allow the payee to avail itself of the italicized
language and to impose the gross-up obligation on
the payer. A potential middle ground might be to
delete the italicized language but have the payer con-
tractually agree that the payee’s refusal to provide a
“harmful” form will not obviate the payee’s gross-up
right if the payer could have requested the form
prior to closing.
Modify Definition of “Tax Event”
Under section 6(b)(iv) and 5(b)(iii) of the 2002 ISDA
Master Agreement (as well as the 1992 Agreement),
the payer and payee, respectively, may terminate a
transaction if, as a result of any change in the tax law,
either of the following apply:
1.The payer will be required, or there is a “sub-
stantial likelihood” that it will be required, to
gross-up its payment to the other party.
2.The payee will be required, or there is a “sub-
stantial likelihood” that it will be required, to
receive a payment without a gross-up (a “Tax
Event”).
While the likelihood that a payment will or will
not be subject to a gross-up is a legal determination,
this provision would seem to afford broad discretion
to the effected party to determine whether there is a
“substantial likelihood” that it will be adversely
affected by a change in tax law, without requiring
that it provide any support for its determination.
Accordingly, parties using the 2002 ISDA Master
Agreement may want to amend the definition of Tax
Event in section 5(b)(iii) to state that a party attempt-
ing to terminate a transaction on “substantial likeli-
hood” grounds must provide the other party with a
written legal opinion from independent counsel sub-
stantiating that determination.
On the other hand, allowing a party to terminate a
transaction based on an opinion of counsel, rather
than on a “legal determination,” arguably might lower
                      

the legal threshold. The existing definition of Tax these or other adverse consequences. In effect, the
Event permits a party to terminate a transaction only Tax Event Upon Merger provision allows the merg-
if it reaches the legal conclusion that it will, or there ing party to shift the consequences of what is usually
is a “substantial likelihood” that it will, be adversely its own volitional, unilateral act to the non-merging
impacted by the change in tax law. party. Accordingly, parties using either Master
Because legal determinations are reviewable by a Agreement form may choose to remove this provision.
court, the terminating party must be confident that a
court will agree with its determination—a test not
 “  ” 
easily satisfied. In contrast, a court might be reluctant
As discussed above, payments to a foreign counter-
to rule against a terminating party that obtained a
party that represents that it is a “foreign person” are
legal opinion and relied on it in good faith, even
not subject to withholding. This rule, however,
though the requirement for a legal opinion was
applies only if the payments are characterized as
intended as an additional condition to termination
notional principal contract payments. It does not
and not as a substitute for the relevant party’s legal
apply to any payment (or portion thereof) that, under
determination that the triggering event had
U.S. federal income tax law, is characterized as inter-
occurred.
est. A payment (or portion thereof) may be charac-
terized as interest if, for example, the payer had previ-
 “     ” 
ously received a large upfront payment in connection
In both the 1992 and 2002 ISDA Master
with the transaction or was holding collateral secur-
Agreements, sections 6(b)(iv) and 5(b)(iv) allow the
ing the counterparty’s obligation under the transac-
payer and payee, respectively, to terminate a transac-
tion. In these instances, the payment (or portion
tion if, as a result of a merger or similar event, either
thereof) characterized as interest will be subject to
of the following apply:
withholding unless either of the following apply:
1.The payer is required to gross-up a payment to
1.The payee is entitled to the protection of a tax
the payee.
treaty that eliminates such withholding.
2.The payee is required to receive a payment
2.The interest qualifies for the portfolio interest
without a gross-up (a “Tax Event Upon
exemption to withholding.
Merger”).
For a payment to qualify for the portfolio interest
The potentially adverse consequences to the non-
exemption, the instrument giving rise to that payment
merging party of a premature termination include
must be in “registered form.” 5 In general, an instru-
the following:
ment is in registered form if the issuer is required to
1. It will not be able to enter into a replacement record a transfer of that instrument on its books and
transaction. records. Thus, to ensure that a 2002 ISDA Master
2. It will have to currently recognize taxable gain. Agreement (or a 1992 Master Agreement) is in regis-
3.The termination will have an undesirable effect tered form, a U.S. counterparty should amend the
on earnings. Transfer provision in section 7 of the Agreement to
provide that no transfer will be recognized unless the
Also, it is not certain that the termination payment
transferor provides the counterparty with the name
to which the non-merging party is entitled under the
and address of the transferee so that the counterparty
relevant Master Agreement will compensate it for
can record the transfer on its books and records.


                      


The 2002 ISDA Master Agreement has some helpful
representations to deal with the new U.S. withholding
regulations. In particular, if the representations are
made, U.S. withholding should not be required for
swap payments, except potentially for swap payments
that are interest or deemed to consist of interest.
Careful attention should be paid to changing the tax
representations and obtaining the right tax forms in
order to minimize or eliminate withholding obliga-
tions with respect to interest. Other modifications for
consideration are discussed above. Also, ISDA is in the
process of completing its User Guide, which may sug-
gest further modifications for users to consider.
Micah Bloomfield is a Partner and Mark Eichler is an
Associate at Stroock & Stroock & Lavan LLP, New York
__________________________________________
1. TD 8881 (May 15, 2000).
2. The current withholding rate is 30%. It is scheduled to be
reduced to 29% for payments made during the 2004 and 2005
calendar years and to 28% for payments made in 2006 through
2010. Beginning January 1, 2011, the withholding rate is
scheduled to increase to 31%.
3. This exception to withholding applies only to a notional
principal contract payment. However, a payment (or portion
thereof) that is characterized as interest generally will be sub-
ject to withholding unless, as described below in the context
of the Transfer Provision, the payment qualifies for the portfo-
lio interest exemption to withholding or the payee is entitled
to treaty protection.
4. Sutherland Asbill & Brennan LLP raised several of the
issues discussed below in a letter to ISDA dated November 22,
2002.
5. Several other requirements also must be met for a payment
to qualify for the portfolio interest exemption. In particular,
the payee must provide the payer with a properly completed
and executed Form W-8BEN (Certificate of Foreign Status of
Beneficial Owner for United States Tax Withholding), and the
payment cannot consist of interest paid to a bank making a
loan in the ordinary course of its business. Further, interest
payments made to a controlled foreign corporation or to an
entity that owns 10% or more of the payer and several types of
contingent interest will not qualify for the portfolio interest
exemption.

Reprinted with permission. ©  Derivatives Report, a publication of Warren, Gorham & Lamont/RIA. For more information,
visit www.riahome.com.
This publication offers general information and should not be taken or used as legal advice for specific situations which depend
on the evaluation of precise factual circumstances.
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