Interest paid to a foreign subsidiary of a foreign leasing company involved in commercial lending qualifies as portfolio interest.

The IRS has ruled, in Letter Rulings (TAMs) 9822007 and 9822008, that interest paid to a foreign subsidiary of a foreign leasing company qualified as portfolio interest under Sec. 881 (c) and, therefore, was not subject to withholding tax. The Service argued in each case that the true lender was the leasing company, not the subsidiary, and that the leasing company, which made commercial loans in the ordinary course of its business, was a bank. Thus, the interest paid would not qualify for the portfolio interest exception under Sec. 881(c)(3)(A), because it was received by a bank on an extension of credit made pursuant to a loan entered into in the ordinary course of its trade or business. However, the TAMs concluded that the leasing companies were not "banks" as defined in Sec. 581; therefore, the interest qualified as portfolio interest and was not subject to withholding tax.

The facts in the two rulings are nearly identical. The first transaction, discussed in both ruling requests, involved a loan from a Country Y corporation, which was a subsidiary of a Country X corporation engaged in the leasing business. The Country X leasing corporation was regularly engaged in various financing activities, including commercial lending, equipment and real property leasing, installment financing, and other forms of financing and credit support; neither the Country X leasing corporation nor its Country Y subsidiary received deposits from customers.

The second transaction (discussed only in Letter Ruling (TAM) 9822008) involved a loan from a Country Y corporation, which was the subsidiary of a Country X corporation engaged in leasing. However, the Country X corporation was 70% owned by Corporation E, a commercial bank.

In both rulings, the loans by the taxpayer from the wholly owned Country Y subsidiaries of the leasing companies were registered obligations as defined by Regs. Sec. 5f.103-1. To avoid Country X restrictions on lending to nonresidents, the Country Y subsidiaries were designated as "special purpose vehicles."

Generally, Sec. 881(a) imposes a 30% tax on certain types of income received by a foreign corporation from U.S. sources. However, portfolio interest, as defined in Sec. 881(c), which includes interest on registered obligations as defined in Regs. Sec. 5f.103-4, is exempt from withholding if the payor receives a statement satisfying the requirements of Sec. 871(h)(5) (i.e., submitting a Form W-8, Certificate of Foreign Status). However, the portfolio interest exception does not apply to interest received by a foreign bank on a loan made in the ordinary course of the bank's trade or business. Determination of the banking exception to the portfolio interest rule was to be made with respect to regulations; however, no such regulations have been issued. In the absence of regulations, the letter rulings concluded that the term "bank" should be narrowly construed, under the definition provided in Sec. 581, and distinguished from all other entities that make commercial loans. To be a bank under Sec. 581, an entity has to be engaged in accepting deposits and making loans. Since neither the Country X leasing companies nor the Country Y special purpose corporations were engaged in accepting deposits, the loans were not deemed from a "bank," and the interest paid qualified as portfolio interest and was not subject to withholding tax.

The taxpayers also requested rulings on whether they had a duty to withhold on the interest payments under the "reason to know" standard of Secs. 1441(a)(9) and 1442 if the interest paid did not qualify as portfolio interest. Because the rulings concluded that the payments qualified as portfolio interest, the withholding issue was not addressed.

The taxable years at issue in the TAMs were 1990-1994, which precede the final conduit financing regulations issued pursuant to Sec. 7701(1) that apply to payments made after Sept. 11,1995; see also Regs. Sec. 1.881-3.

FROM MICHAEL LAYDEN, CPA, AND DIANE L. RENFROE, J.D., WASHINGTON, D.C.