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Business and tax planning with the portfolio interest exemption.

Generally, the United States imposes a flat tax rate of 30 percent on interest received from sources within the United States by a foreign payee, which is the obligation of the payor to withhold.[1] However, if the portfolio interest exemption applies, the flat tax rate of 30 percent generally will not apply.[2] Therefore, structuring a loan transaction to fit within the portfolio interest exemption has tax benefits for the American payor and the foreign payee. This article discusses the application of the portfolio interest exemption and the potential effects of any treaty between the U.S. and the pertinent foreign country when the portfolio interest exemption does not apply with respect to the interest received. It is important to note that the portfolio interest exemption does not extend to interest which is "effectively connected" with a U.S. trade or business.[3] The interest from loans made by foreign banks in the ordinary course of a U.S. banking business will be "effectively connected" to that business, and, therefore, not portfolio interest.

For purposes of this article, the term Code or I.R.C. refers to the Internal Revenue Code of 1986, as amended. The term limited liability company may be abbreviated and referred to as "LLC." U.S. Department of Treasury Income Tax Regulations may be referred to as "Regulations." The following example facts[4] illustrate the terminology and circumstances addressed in this article. A Florida limited liability company (the company) wishes to borrow money (the loan) from a foreign Country X corporation (the mirror lender), which loan essentially is a back-to-back loan because another foreign Country X corporation is the originating lender (the originating lender). The company has always filed its federal and state tax returns as a partnership, and, for purposes of U.S. and state tax law, is treated as a partnership. The loan will not be guaranteed. The interest on the loan will be set at a fixed rate and will not constitute "contingent interest." Neither the originating lender nor the mirror lender is a member of the company directly or indirectly. The mirror lender and the originating lender are not related entities. Neither the mirror lender nor the originating lender is a foreign bank.

Portfolio Interest Exemption

The Code provides an exemption from the flat tax rate (which generally is imposed on U.S.-source interest at a 30 percent rate but may be reduced by a treaty) for "portfolio interest" received from U.S. sources by foreign taxpayers.[5]

Portfolio interest is any interest[6] which is:

1) Paid on any promissory note or other obligation which is either

a) Issued in registered form to a foreign taxpayer, or

b) Part of an issue which is not in registered form and which is sold only to foreign persons with interest payable only outside the U.S. and possessions, and bearing on its face a statement that any U.S. person holding the obligation is subject to certain limitations, and

2) Not received by a 10 percent member of the payor.[7]

Even though there are two types of qualifying obligations ((a) and (b) above), in most instances this author believes it is preferable to utilize the broader class of debt, i.e., registered form, and, therefore, the analysis herein is restricted to registered obligations.[8]

An obligation is in registered form[9] only if:

1) The obligation is registered as to both principal and any stated interest and any transfer of the obligation may be accomplished only through the surrender of the old instrument and the reissuance by the issuer of the old instrument to the new holder or the issuance of a new instrument to the new holder by the issuer; or

2)The right to the principal of, and stated interest on, the obligation may be transferred only through a book-entry system; or

3) The obligation is registered as to both principal and any stated interest with the issuer (or its agent) and may be transferred through both of the methods described in paragraphs 1 and 2.[10]

Foreign Ownership. Foreign beneficial ownership of an obligation[11] (i.e., the loan) is the primary requirement for exempt portfolio interest. Exempt portfolio interest can be paid on the loan only if the loan is beneficially owned by foreign persons.[12]

Interest paid on a registered obligation qualifies as portfolio interest only if the U.S. withholding agent (e.g., the company) receives a statement,[13] made under penalties of perjury by the beneficial owner, certifying that the beneficial owner is not a U.S. person and documenting the owner's name and address.[14] The statement may be made on Form W8 or on a substantially similar substitute form.[15] There are time frames within which the Form W-8 or substitute form must be received.[16]

Exceptions to Portfolio Interest Exemption

There are several exceptions to the portfolio interest exemption. If one of these exceptions applies, then the portfolio interest exemption does not apply and interest received by the foreign lender (e.g., mirror lender) will be subject to U.S. tax under either the Code or a treaty. The exceptions are: 1) interest received by a 10 percent shareholder, partner, or member[17]; 2) interest received by foreign banks[18]; 3) pre-1984 obligations[19]; 4) interest received by a controlled foreign corporation from a related person[20]; 5) interest paid within certain countries with an inadequate exchange of information with the U.S.[21]; and 6) contingent interest.[22]

10 Percent Members. Exempt portfolio interest does not include interest received by a 10 percent shareholder of the company.[23] The 10 percent rule applies to shareholders and to holders of partnership and LLC member interests.[24] As noted above, the attribution rules of I.R.C. [sections] 318 apply such that indirect ownership can cause the portfolio interest exemption not to apply.[25] Thus, any indirect ties to other parties to the transaction may result in the imposition of U.S. tax on the interest in question.

Foreign Banks. Exempt portfolio interest also does not include interest received by any foreign bank on an extension of credit made pursuant to a loan agreement entered into in the ordinary course of its trade or business.[26] Further, as discussed above,[27] if loans to U.S. persons are made by foreign banks in the ordinary course of a U.S. banking business, the interest from those loans will be "effectively connected" to that business, and, therefore, will fall outside the definition of portfolio interest and will be subject to U.S. tax at full graduated rates. "Back-to-back loans," such as in our example, may be viewed as "conduit" financing. Prior to 1993, it may have been possible for a foreign bank to qualify its loans into the U.S. for the portfolio interest exemption by structuring its loans into the U.S. as back-to-back loans. The bank's loan would first pass through a foreign person (such as a finance company) which qualified to receive exempt portfolio interest, and the finance company would then make the loan into the U.S. (thus, the finance company was a conduit or mirror lender).[28] However, I.R.C. [sections] 7701(1) and the resulting anticonduit Regulations specifically provide for the imposition of a withholding obligation[29] on the ultimate U.S. borrower involved in a "financing arrangement"[30] that is a conduit financing arrangement[31] when the ultimate U.S. borrower knows or has reason to know that it is a conduit financing arrangement.[32] A finance intermediary created to hold just one such loan could be attacked by the IRS as a conduit through which the foreign bank made the loan. More numerous loans by an intermediary, particularly with different lenders and different borrowers, may increase the chances of defeating an IRS challenge. However, an intermediary with a loan portfolio may itself be considered a foreign bank, and as such precluded from using the portfolio interest exemption. Further, the mirror loan should not be entered into such that one obligation secures its mirror obligation; otherwise, if a foreign bank is a party, there is clearly a prohibited back-to-back debt and a conduit financing transaction, and the U.S. borrower would be liable for its failure to withhold U.S. tax on the interest payments to its lender.

Pre-1984 Obligations The portfolio interest exemption applies to interest received after July 18,1984, on obligations issued after July 18, 1984.[33]

Controlled Foreign Corporation. There are additional rules that apply when portfolio interest is received by controlled foreign corporations (e.g., foreign corporations owned or controlled by U.S. persons), and, therefore, the adviser must be sure, with regard to the originating lender and the mirror lender or any other party to the transaction, that this is not the case. The discussion of these controlled foreign corporation portfolio interest exemption rules are beyond the scope of this article.[34]

Countries with Inadequate Exchange of Information. U.S.-source interest paid to a resident of a foreign country may not be exempt from U.S. tax if the exchange of information between that country and the U.S. is deemed inadequate.[35] Country X, in our example, is not one of these countries. However, pursuant to concepts similar to the "fiscally transparent" entity concept discussed below,[36] it is important for the tax advisor to know as much as possible about 1) the type of entity of each of originating lender and mirror lender; and 2) the owners of each such entity in order to determine if the portfolio interest exemption will apply.

Contingent Interest. Contingent interest is excluded from the portfolio interest exemption.[37] Contingent interest is interest the amount of which is determined by reference to: 1) sales, receipts, or other cash flow of the debtor or any related party; 2) any income or profits of the debtor or any related party; 3) any change in the value of the property of the debtor or any related party; and 4) any dividend, partnership distribution, or similar payment made by the debtor or a related person.[38]

Other Considerations

Earnings Stripping. As a further concern, under I.R.C. [sections] 163(j), an interest deduction may not be available to the company if the corresponding interest income is received by a related person or an unrelated person if the indebtedness is guaranteed by a related person and is not subject to the full 30 percent U.S. withholding tax. The earnings stripping rules of I.R.C. [sections] 163(j) were enacted to limit the interest deduction of the payor when certain recipients would not be subject to U.S. tax on the corresponding interest income (e.g., interest is exempt under treaty). Thus, I.R.C. [sections] 163(j) disallows an interest deduction to a U.S. corporation, or to a foreign corporation with U.S. effectively connected income, for interest paid to a related person (or for interest paid to an unrelated person if the indebtedness is guaranteed by a related person or corporation) if the recipient is exempt from U.S. tax or pays a reduced rate of U.S. tax under a treaty on such income. Accordingly, the advisor should obtain adequate representations that no party is related and that no prohibited guaranty will be executed.

Effects of a Treaty

If the portfolio interest exemption does not apply, the U.S. tax and required withholding on interest paid by a U.S. obligor (e.g., the company) to a foreign Country X resident payee (e.g., the mirror lender) may be reduced by the terms of an applicable treaty from 30 percent. These benefits do not generally apply to interest attributable to a permanent establishment that the payee has in the U.S.[39]

Many types of treaties with the U.S. exist and the provisions of each treaty are unique to that treaty. For that reason and for purposes of brevity, this article does not discuss specific treaty provisions. Similarly, this article does not discuss the procedures necessary to obtain reduction in tax rate under a treaty, except to advise that if the portfolio interest exemption does not apply but reduced rate withholding under a treaty is available, the foreign recipient of interest (mirror lender) must file Form 1001, Ownership Exemption or Reduced Rate Certificate, with the withholding agent (e.g., the company).[40] Further, under Temporary Regulations [sections] 1.894-1T(d), treaty benefits (such as a reduced tax rate) apply to interest received by U.S. or treaty country entities only if the interest received is treated as derived by a treaty resident who is the beneficial owner of the receipt. Two basic principles apply.[41] First, residence is determined under the treaty country's law.[42] Second, beneficial ownership is determined under the source country's law.[43] "Fiscally transparent" entities under treaty country law (a partnership or LLC treated as a partnership in the U.S. would be fiscally transparent because of its pass-through nature) are not resident of a treaty country because they are not subject to tax in that country.[44] The withholding agent must "look through" to the actual recipient. "Nonfiscally transparent" entities (for example, corporations in the U.S.) are resident in a treaty country if they are subject to tax in that country.[45] The "fiscally transparent" concepts of the Temporary Regulations can be very similar to the provisions of a treaty.[46] Thus, for the tax advisor's purposes, it is important to ascertain exactly what type of entities the originating lender and mirror lender are; if either the originating lender or the mirror lender is fiscally transparent, it is important to ascertain the type of person or entity and the country of residence of the owners thereof.

Conclusion

The portfolio interest exemption and its exceptions create a complex set of rules for U.S. borrowers and foreign lenders. When the complexities of the portfolio interest exemption and its exceptions are coupled with the earnings stripping rules and, if applicable, treaty provisions, an even more intricate puzzle presents itself. This article, by example, walks the adviser through the maze created by the portfolio interest exemption, its exceptions, and related concepts. The company should be able to borrow money from the mirror lender without withholding on the interest payments made to the mirror lender, and the company should be able to deduct the interest payments to the mirror lender because of the specific facts presented; however, it should be clear that if certain of the facts were to change, then the analysis in this article could change drastically. The facts that the loan will not be guaranteed; that the interest on the loan will be set at a fixed rate and will not constitute contingent interest; that neither the originating lender nor the mirror lender is a member of the company directly or indirectly; that the mirror lender and the originating lender are not related entities; and that neither the mirror lender nor the originating lender is a foreign bank are each critical facts.

[1] I.R.C. [sections] 871(a)(1) (nonresident alien individual) (CCH) (1986) as amended (the Code) and I.R.C. [sections] 881(a)(1) (foreign corporation); see also I.R.C. [subsections] 1441(a) and 1441(b) which similarly impose a withholding requirement on the payor and its agent(s).

[2] I.R.C. [subsections] 871(h) (nonresident alien individuals) and 881(c) (foreign corporations).

[3] I.R.C. [subsections] 871(a) and 881(a).

[4] The analysis herein may change if any one of these facts were to change.

[5] I.R.C. [subsections] 871(h) (nonresident alien individuals) and 881(c) (foreign corporations); J. KUNTZ AND R. PERONI, U.S. INTERNATIONAL TAXATION (1996) (hereinafter KURTZ) [paragraph] 18.4, at 18:5.

[6] Interest for this purpose includes original issue discount. I.R.C. [subsections] 871(h)(2) and 881(c)(2).

[7] I.R.C. [sections] 871(h)(2);see a/so I.R.C. [sections] 881(c)(2).

[8] The reader should, however, keep in mind that an unregistered or bearer-type obligation may also be tax-advantaged with respect to the portfolio interest exemption.

[9] I.R.C. [subsections] 871(h)(7) and 881(c)(7) both refer to I.R.C. [sections] 163(f) in order to provide a meaning to "registered form." I.R.C. [sections] 163(f) provides no definition to the terminology, but [sections] 163(f) provides the starting point of an analysis which leads to the definition in the text. See Temp. Treas. Reg. [sections] 5f. 163-1(c)(1)(as amended in 1984); see also Temp. Treas. Reg. [sections] 5f. 163-1(b) (as amended in 1984).

[10] Id.; see also Anderson and Krebs, U.S. Income Tax Withholding-Foreign Persons, TAX MGMT. (BNA) 915, at A-18 (hereinafter, 915 T.M.).

[11) "Obligation" is not defined by the Code.

[12] Kuntz, supra note 5, [paragraph] 18.8, at 18:13.

[13] I.R.C. [subsections] 871(h)(2) and 881(c)(2);see also 915 T.M., supra note 10, at A-17 and A-18. The statement may be made by the beneficial owner of the obligations or by certain entities. I.R.C. [sections] 871(h)(5). In the case of an individual beneficial owner, the statement must certify that the beneficial owner is not a citizen or resident of the United States. Temp. Treas. Reg. [sections] 35a.9999-5(b), Q&A 9 (as amended in 1993). Caution is advised because Temp. Treas. Reg. [sections] 35a.9999-5(b) was removed by T.D. 8734, 62 Fed. Reg. 53387, 1997-44 I.R.B. 5, 1997-2 Adv. Sh. Ed. C.B. 123 (T.D. 8734), effective January 1, 1999; however, Notice 9816, 1998-1 Adv. Sh. Ed. C.B. 322 (Notice 98-16), "provides new transition rules for satisfying the withholding certificate or statement under the withholding regulations." Id. Notice 98-16 generally extends the applicability of the final regulations to payments made after December 31, 1999, and provides that "a withholding agent holding a valid existing certificate or statement on December 31,1998, may treat that statement as valid through December 31, 1999." Id. at 322-23.

[14] Id.

[15] Temp. Treas. Reg. [sections] 35a.9999-5(b), Q&A 9 (as amended in 1993); see supra note 13.

[16] See Treas. Reg. [sections] l.6049-5(b)(2)(iv) (as amended in 1996); Treas. Reg. [sections] 1.6049-5(b) was further amended by T.D. 8734; however, Notice 98-16 generally extends the applicability of the final regulations to payments made after December 31, 1999.

[17] I.R.C. [sections] 871(h)(3). The attribution rules of I.R.C. [sections] 318(a) apply as adjusted by I.R.C. [sections] 871(h)(3). I.R.C. [sections] 871(h)(3)(C). A partnership which issues an obligation is similarly treated under I.R.C. [sections] 871(h)(3)(B)(ii). See also I.R.C. [sections] 881(c)(3).

[18] I.R.C. [sections] 881(c)(3)(A). An exception to the exception exists with respect to interest paid on obligations of the U.S. government. Id.

[19] See Amendments to I.R.C. [subsections] 871(h) and 881(c), specifically, Pub. L. No. 98-369, [sections] 127(a)(1), and Pub. L. No. 98-369, [sections] 127(b)(1), respectively.

[20] I.R.C. [sections] 881(c)(3)(C).

[21] I.R.C. [subsections] 871(h)(6) and 881(c)(6).

[22] I.R.C. [subsections] 871(h)(4) and 881(c)(4); see also Notice 94-39, 1994-1 C.B. 350.

[23] See supra note 17 and accompanying text.

[24] Id.

[25] Id.

[26] See supra note 18 and accompanying text.

[27] See supra note 3 and accompanying text.

[28] See, generally, discussion in 915 T.M., supra note 10, at A-23 to A-24; see also Kuntz, supra note 5, [paragraph] 18.15, at 18:27.

[29] See Treas. Reg. [sections] 1.1441-3(j) and [sections] 1.1441-7(d)(2)(i) (each as amended in 1995). Caution is advised because Treas. Reg. [sections] 1.1441-3 and [sections] 1.1441-7 were amended by T.D. 8734, however, Notice 98-16, supra note 13, generally extends the date of applicability of the final regulations to payments made after December 31, 1999.

[30] See Treas. Reg. [sections] 1.881-3(a)(2)(i) (1995) for definition.

[31] See Treas. Reg. [sections] 1.1441-3(j) (as amended in 1995) (supra note 29) and Treas. Reg. [sections] 1.881-3(a)(2)(iv) (as amended in 1995).

[32] See Treas. Reg. [subsections] 1.1441-3(j) and 1.1441-7(d)(2)(i) (as amended in 1995) (supra note 29).

[33] See Amendments to I.R.C. [subsections] 871(h) and 881(c), specifically, Pub. L. No. 98-369, [sections] 127(a)(1), and Pub. L. No. 98-369, [sections] 127(b)(1), respectively.

[34] See, generally, I.R.C. [sections] 881(c)(3)(C); see also 915 T.M., supra note 10, at A-20 and A-21

[35] I.R.C. [subsections] 871(h)(6) and 881(c)(6).

[36] See infra 46 below and accompanying text.

[37] I.R.C. [subsections] 871(h)(4) and 881(c)(4).

[38] Id.

[39] See, e.g., U.S.-Egypt Income Treaty, I Tax Treaties (Warren, Gorham & Lamont) (hereinafter, Tax Treaties) [paragraph] 34,000 et seq.

[40] Treas. Reg. [sections] 1.1441-6(b) and (c) (as amended in 1992); caution is advised because Treas. Reg. [sections] 1.1441-6 was amended by T.D. 8734; however, Notice 98-16, supra note 13, generally extends the applicability of the final regulations to payments made after December 31, 1999.

[41] Treas. Reg. [sections] 1.894-IT(d) (as amended in 1997).

[42] Id.

[43] Id.

[44] Id.

[45] Id.

[46] Id. See, e.g., Tax Treaties [paragraph] 34,103, at 34,103 (Fiscal Residence, Article 3 of the U.S.-Egypt Income Tax Treaty).

Brian K. Jordan practices business and tax law at Lowndes Drosdick Doster Kantor & Reed, P.A., in Orlando. He is a member of The Florida Bar's Business Law and Tax sections and of the International and Tax Law sections of the ABA. He is licensed to practice law in Florida, Alabama, Tennessee, and the United States Tax Court. He holds a Master of Laws in taxation and is a certified public accountant.

This column is submitted on behalf of the Business Law Section, Stephen D. Busey, chair, and T.A. Borowski, Jr., editor
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Date:Jan 1, 1999
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