The portfolio interest exemption.

"Portfolio interest" helps U.S. borrowers obtain lower cost financing abroad. Before 1984, many U.S. corporations established finance subsidiaries in the Netherlands Antilles to issue bonds in the Eurobond market and to loan the proceeds back to the U.S. parent. The income tax treaty between the United States and the Netherlands Antilles exempted the interest paid by the U.S. parent to the Netherlands Antilles subsidiary from U.S. withholding tax; the payments from the finance subsidiary (a foreign corporation) were also not subject to U.S. withholding tax. Because of the additional costs required by these arrangements and an IRS challenge as to whether such "back-to-back" loans or "conduit" financing transactions should qualify for treaty benefits, Congress repealed the withholding provision on this interest.

U.S.-source interest paid to a nonresident alien or a foreign corporation is generally subject to a 30% U.S. withholding tax, unless the interest is effectively connected with a U.S. business of the nonresident alien or foreign corporation. In the case of an original issue discount (OID) obligation, withholding is required when the OID is paid or the obligation is sold. Only the portion of OID that accrued during the foreign person's holding period is subject to withholding.

Interest is generally U.S. source if it is paid by the Federal government, a U.S. resident or a domestic corporation. However, interest paid by an individual or corporation that derives at least 80% of its gross income from an active foreign business during the prior three tax years is foreign source. Interest paid by a foreign branch of a U.S. bank also is foreign source.

If a foreign corporation is engaged in business in the United States, interest paid by the U.S. business is generally treated as U.S. source. Under Regs. Sec. 1.884-4, interest shown on U.S. branch books, interest on liability secured by a U.S. business property or U.S. real estate, and interest on certain other liabilities are treated as paid by a U.S. business.

If a nonresident alien individual or foreign corporation that receives interest is engaged in business in the United States, interest effectively connected with that business is generally subject to U.S. tax at normal graduated rates and is not subject to withholding. In general, interest on receivables of a U.S. business and interest on investments held to meet the operating needs of a U.S. business are considered effectively connected with that business. In addition, if (1) the funds are generated by a U.S. business, (2) the investment is managed by U.S. personnel actively involved in the business and (3) the income from the investment is reinvested in the business, income from the funds is presumed to be effectively connected with a U.S. business.

U.S. tax is generally imposed on a nonresident alien or a foreign corporation that receives U.S.-source interest. However, the payor of the interest is required to withhold the tax and is liable for the tax if it is not withheld. The payor is generally required to provide Form 1042S, Foreign Person's U.S. Source Income Subject to Withholding, to the recipient and to the IRS; Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, which summarizes withholding tax that has been paid over to the Service, must be submitted to the IRS Center in Philadelphia by March 15 of the year following the year in which the interest is paid.

Withholding tax is not imposed on portfolio interest received by foreign corporations or nonresident alien individuals. Separate requirements apply, depending on whether the interest is paid on debt obligations that are in bearer form or registered form. In addition, interest paid to banks and certain related parties does not qualify as portfolio interest.

In order for interest on bearer obligations to qualify as portfolio interest, three conditions must be met.

1. Arrangements must be made that are designed to reasonably ensure that the obligation will be sold only to foreign persons. In general: a. the issuer and distributors may not offer or sell the obligation within the United States or its possessions, or to U.S. persons; b. the issuer and distributors may not deliver the obligation in the United States or its possessions; and c. the issuer must receive a statement (before issuance or before the first interest payment, if earlier) that the obligation is owned by a person who is not a U.S. person (or is owned by a financial institution for purpose of resale to non-U.S. persons).

The requirements relating to foreign offers, sale and delivery apply to a 40-day period beginning on the closing date (or on the receipt of loan proceeds if there is no closing date). The statement requirement does not apply to certain obligations that are sold in a single foreign country, payable only in that country, and denominated in that country's currency.

2. In general, interest must be payable by presenting a coupon, or making any other demand for payment, only outside the United States.

3. The following legend generally must appear on the face of the obligation and interest coupons (or, if the obligation is evidenced by a book entry, in the book in which the entry is made): "Any United States person who holds this obligation will be subject to limitations under the United States income tax laws, including the limitations provided in sections 165(j) and 1287(a) of the Internal Revenue Code." Sec. 165(j) may deny a deduction for a loss with respect to the obligation, and Sec. 1287(a) may deny capital gain treatment for any gain on the obligation.

The purpose of these requirements is to ensure that bearer obligations of U.S. issuers are not owned by U.S. persons. Because interest on bearer obligations cannot be identified with the recipient, Congress was concerned that U.S. persons might use such obligations to avoid U.S. tax. Under Sec. 163(f), the issuer of an obligation that does not meet the three requirements may be denied a deduction for the interest payments - in addition to subjecting a foreign recipient to U.S. tax.

Interest on an obligation in registered form qualifies as portfolio interest if the issuer receives a statement from the lender, signed under the penalties of perjury, stating that the lender is not a U.S. person and including the lender's name and address. The statement may be made on a Form W-8, Certificate of Foreign Status. If the obligation is targeted to foreign markets and the holder of the obligation is a financial institution, the financial institution may provide a statement that the obligation's beneficial owner is not a U.S. person. In general, an obligation is targeted to foreign markets if it meets the three requirements that bearer obligations must meet in order to give rise to portfolio interest.

The special rules that apply to registered obligations targeted to foreign markets permit the beneficial owner of these obligations to maintain anonymity with respect to the issuer and the IRS.

An obligation is in registered form if one of three conditions is met: 1. The obligation is registered with the issuer as to both principal and stated interest, and the obligation may be transferred only by surrender and reissuance (or issuance of a new obligation); 2. The right to principal and stated interest may be transferred only through a book entry system maintained by the issuer; or 3. The obligation is registered with the issuer as to both principal and stated interest and may be transferred only through one or both of the methods in (1) and (2) (i.e., by surrender or by book entry).

An obligation is transferable through a book entry system if its ownership is required to be reflected in a book entry. Issuance of the physical securities is not required.

Interest received by banks, "10% shareholders" and related controlled foreign corporations cannot qualify as portfolio interest.

Interest received by a bank pursuant to a loan entered into in the ordinary course of its business is not portfolio interest. However, interest paid to banks on obligations issued by the United States qualifies.

Interest on deposits (including certificates of deposit) with banks, savings and loan institutions, and insurance companies is exempt from withholding tax, as is an obligation with OID that is payable not more than 183 days after the date of issue.

In addition, U.S. income tax treaties may exempt interest from withholding or reduce the rate of tax. Treaties with a number of the major U.S. trading partners (such as France, Germany and the Netherlands) exempt interest payments from withholding tax. Other treaties, such as with Canada and Japan, reduce the withholding tax rate to between 5 % and 15 %. Under some treaties, the recipient of the interest must meet anti-treaty shopping rules in order to qualify for the exemption or reduced rate. If interest is received by a treaty-country resident and passed through to a nonresident in a "conduit" financing or "back-to-back" loan arrangement, treaty benefits may be denied.