Most forms of U.S.-source income received by foreign persons that are not effectively connected with a U.S. trade or business will be subject to a flat tax of 30 percent on the gross amount received. Sections 871(a) (for nonresident aliens) and 881(a) (for foreign corporations) impose the 30-percent flat tax on interest income. This interest income is part of the regime often referred to as “FDAP income.” The collection of the 30-percent tax is affected primarily through the imposition of an obligation on the person or entity making the payment to the foreign person to withhold the tax and pay it over to the Internal Revenue Service (“IRS”). The tax collected is, therefore, often referred to as a “withholding tax.” Tax treaties generally provide for the reduction or elimination of the 30 percent flat tax. Even though tax treaties may reduce or eliminate the withholding tax, there are a significant number of foreign investors who are not residents of countries the U.S. has bilateral tax treaties in place.In these situations, foreign investors may consider utilizing a “portfolio debt instrument” and portfolio debt to reduce or eliminate the 30 percent withholding tax. “Portfolio debt instruments” is not subject to U.S. withholding tax.
By way of background, in 1984, Congress effectively eliminated the 30-percent tax on interest from “portfolio debt investments.” See IRC Section 871(h) and 881(c). As a result of the exclusion, most interest payments to foreign persons on publicly traded debt securities that are either registered obligations or are bearer obligations that are subject to certain arrangements specified in Section 163(f)(2)(B) (designed to assure that interest is payable only outside of the United States to foreign persons) will not be subject to the withholding tax. Not all interest payments will be excluded even if they meet the qualification requirements for debt obligations in bearer or registered form. In particular, interest paid by a U.S. corporation to an individual or entity that owns at least ten percent of the voting power of the corporation is not eligible for the exemption. Interest received by a controlled foreign corporation (“CFC”) from a related person is not eligible. Further, interest on non governmental obligations paid to banks on an extension of credit made pursuant to a loan agreement is not exempt. In addition, portfolio interest will not include certain interest payments that are contingent. Interest is treated as contingent if the amount of the interest is determined by reference to receipts, sales or cash flow, income or profits or changes in property value of the debtor or a person related thereto. (Interest will also be deemed to be contingent if it is dependent upon dividend or partnership distributions by the debtor or related person).
In order for portfolio interest to avoid U.S. withholding tax, interest must accrue from a “portfolio debt interest.” Portfolio debt instruments include only obligations issued in registered form. To collect interest on a registered obligation, such as portfolio debt loan free of U.S. withholding tax, a foreign payee must provide the U.S. paying agent with a statement that (1) is signed by the beneficial owner under penalties of perjury; (2) certifies that such owner is not a U.S. person; and (3) provide the name and address of the beneficial owner (the “payee statement”). While a U.S. taxpayer identification number (“TIN”) for the beneficial owner generally must be included on an IRS Form W-8, a TIN is not required to claim an exemption from withholding tax under the portfolio interest rules. See Treas. Reg. Section 1.1441-1(e)(4)(vii).
In the next subsections of this article, we will take a closer look at the rules governing the portfolio debt rules.
One of the requirements for valid portfolio debt is that the interest paid must not be paid to a “10 percent shareholder.” If the borrower is a corporation, the 10 percent shareholder rule requires that the recipient of the interest not own 10 percent or more of the combined voting power of all classes of such corporation. If the borrower is a partnership, the 10 percent shareholder requirement is measured by capital or profits interest. Because the 10 percent shareholder requirement applied to a corporate borrower is limited to voting rights, many investors set up a structure whereby the lender under a portfolio debt loan owns 99 percent of the equity in the borrower but less than 10 percent of the voting rights in the borrower.
The CFC Related Party Rules
The portfolio interest exemption does not apply to payment of interest to CFCs that are considered related persons with respect to the borrower. The applicable related party rules in this case are under Internal Revenue Code Section 267(b), and unlike the 10 percent shareholder rules which only consider voting stock, these rules would consider two corporations to be related where a parent corporation owns more than 50 percent of vote or value of the subsidiary corporation. A CFC is defined as a foreign corporation in which more than 50 percent of its total voting power or value is owned by U.S. persons (U.S. individuals, U.S. trusts, U.S. corporations, or U.S. partnerships) who each own at least 10 percent of the combined voting power of all classes of stock, or at least 10 percent of the total value of shares of all classes of stock. For these purposes, certain attribution rules can apply to attribute stock ownership of a foreign corporation to U.S. persons.
Potential Limitations on the Interest Deduction
A foreign investor may not only want to avoid the 30 percent U.S. withholding tax on interest income, the foreign investor may also want to claim a deduction for interest payments against U.S. source income (e.g. rental income). Any foreign investor seeking to claim an interest deduction associated with portfolio debt should understand there are a number of limitations in connection with utilizing portfolio debt to claim income tax deductions. These limitations are discussed in detail below.
Internal Revenue Code Section 163(j)
Internal Revenue Code Section 163(j) can potentially apply to limit deductions for interest, including deductions for interest payments on portfolio debt loans. The general rule for Section 163(j) limits the deductibility of interest expense paid or accrued on debt properly allocated to a trade or business to the sum of business interest income, and 30 percent of “adjusted taxable income.” For these purposes, a rough estimate of what will be adjusted taxable income will be earnings before interest, taxes, depreciation, and amortization (“EBITDA”). Any deduction in excess of the limitation is carried forward and may be used in a subsequent year, subject to the limitations of Internal Revenue Code Section 163(j) is subject to two major exceptions: 1) the small business exception, and 2) the real property trade or business exception. It should be noted that for tax years 2022 through 2025, adjusted taxable income does not back out depreciation and amortization, so for these years it would only be earnings before interest and taxes (“EBIT”). The “One Big Beautiful Bill Act (“OBBA”) restored the more favorable EBITDA (Earnings before interest, taxes, depreciation, and amortization) calculated for determining the 30% limitation on deductible interest, a more generous standard than the restrictive EBIT.
Internal Revenue Code Section 267A- The Anti-Hybrid Rules
A portfolio interest deduction may also be limited by Section 267A of the Internal Revenue Code. Under Section 267A, a deduction is disallowed for a disqualified related party amount paid or accrued pursuant to a hybrid transaction. A deduction is also disallowed for a disqualified party amount paid or accrued pursuant to a hybrid transaction. A deduction is also disallowed for a disqualified related party amount paid or accrued by, or to, a hybrid entity. Any interest paid or accrued to a related party is a “disqualified related party amount” to the extent that under the tax law of the country where the related party is a resident for tax purposes or is subject to tax: 1) the amount is not included in the income of the related party, or 2) the related party is allowed a deduction for the amount.
“Related party” means a related person as defined under Section 954(d)(3) of the Internal Revenue Code, except that the person is related to the payor rather than a CF.
A “hybrid transaction” means any transaction, series of transactions, agreement, or instrument, if one or more payments are treated as interest or royalties for federal income tax purposes, but are not treated as such for purposes of the tax law of the foreign country where the recipient of the payment is a resident for tax purposes or is subject to tax.
A “hybrid entity” means any entity that is either: 1) treated as fiscally transparent for federal income tax purposes, but not under the tax law of the foreign country where the entity is resident for tax purposes or is subject to tax, or 2) treated as fiscally transparent under the tax law of the foreign country where the entity is a resident for tax purposes or is subject to tax, but not for federal income tax purposes.
Internal Revenue Code Section 385
Portfolio debt planning involves the use of “portfolio debt instruments.” Anytime a debt instrument is used in corporate portfolio debt planning, Internal Revenue Code Section 385 must be considered. Section 385 of the Internal Revenue Code was enacted to determine for all tax purposes whether an interest in a corporation is to be treated as stock or debt. Section 385 authorizes the IRS to issue regulations that determine whether corporate interest is stock or debt. The goal of the Section 385 regulations is to prevent corporations from eroding the U.S. tax base by placing debt with foreign affiliates and to prevent interest deductions on debt that should be classified as equity. Treasury Regulation Section 1.385-3 is the core of the regulations promulgated by the IRS under Section 385. Treasury Regulation Section 1.385-3 requires “factors” to be taken into account in determining in a particular fact situation whether a debtor-creditor relationship exists and goes on to specify the following factors in connection with “targeted transactions.”
- Targeted Transactions: these include distributions with an expanded group, asset acquisition within the group, and stock acquisitions within the group.
- Expanded Group: The recast rules primarily apply to debt between members of an “expanded group” of corporations.
- Recharacterization: If a debt instrument is issued to fund a targeted transaction without resulting in new investment in the issuer’s operation, it can be treated as stock for federal tax purposes rather than debt.
Base Erosion Anti-Abuse Tax
In certain limited cases, the base erosion tax and anti-abuse tax provisions of the Internal Revenue Code may be triggered by the use of portfolio debt planning. The 2017 Tax Cuts and Jobs Act introduced the base erosion and anti-abuse tax (“BEAT”) under Section 59A of the Internal Revenue Code. Section 59A was enacted to prevent base erosion of the U.S. tax base through cross-border transactions. Section 59A imposes a type of alternative minimum tax which adds back to taxable income certain deductible payments, such as interest to related foreign corporations. The BEAT applies to corporations with gross receipts of at least $500 over a three-year testing period and a “base erosion percentage” for a taxable year of at least 3 percent. (A 2 percent threshold applies to banks and registered securities dealers). The BEAT rate of tax varies by year: For the 2025 tax year, the rate is 10%. After the 2025 tax year, the BEAT rate is 12.5%.
Any portfolio debt planning involving a corporation that has average annual gross receipts of at least $500 million should consider the implications of BEAT.
Bond Registration Rules
Portfolio interest refers to interest payments made to a foreign corporation (owning less than 10% of the payor entity) pursuant to debt obligations that are in registered form with the appropriate certification. See IRC Section 881; IRC Section 163(f)(1). If the debt is not in registered form the interest does not qualify for the portfolio debt exemption. See IRC Section 871(h)(2); IRC Section 881(c)(2); Treas. Reg. Section 1.871-14; IRS Notice 2012-20. To qualify for the Portfolio Debt Exemption, the withholding agent must also receive a statement (usually on Form W-8) indicating that the beneficial owner of the obligation is not a U.S. person. See IRC Section 871(h)(5); IRC Section 881(c)(5).
For purposes of determining whether a bond is in registered form under Internal Revenue Code Section 163(f) and the portfolio interest exception, the principles of Internal Revenue Code Section 149(a)(3) apply. Internal Revenue Code Section 163(f)(3) and Internal Revenue Code Section 149(a)(3) provide that a book entry bond is treated as in registered form if the right to the principal of, and stated interest on, the bond may be transferred only through a book entry consistent with regulations prescribed by the Secretary. In addition, Treas Reg. 1.871-14(c) provides that for purposes of the portfolio interest exception, the conditions for an obligation to be considered in registered form are identical to the conditions described in 26 CFR Section 5f. 103-1.
Generally under 26 CFR Section 5f. 103-1, an obligation is in registered form if:
(1) An obligation not of a type offered to the public. The determination as to whether an obligation is not of a type offered to the public shall be based on whether similar obligations are in fact publicly offered or traded.
(2) An obligation that has a maturity at the date of issue of not more than 1 year.
(3) An obligation described in Section 5F.163-1(c) (relating to certain obligations issued to foreign persons.
(c Registration Form. An obligation pursuant to a binding contract must be in registered form in order to qualify for the portfolio debt exception. An obligation is in registered form 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 affected 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. An obligation is considered transferable through a book entry system if the ownership of an interest in the obligation is required to be reflected in a book entry, whether or not physical securities are issued. A “book entry” is a record of ownership that identifies the owner of an interest in the obligation. An obligation that would otherwise be considered to be in registered form is not considered to be in registered form as of a particular time if it can be converted at any time in the future into an obligation that is not in registered form.
A book entry system is essentially an electronic system of tracking ownership of debt (bonds), securities, etc. No paper certificates are issued.
Example of Book Entry System:
The Commercial Book-Entry System (“CBES”) is a multitiered automated system for purchasing, holding, and transferring marketable securities. CBES exists as a delivery versus payment system that provides for the simultaneous transfer of securities against the settlement of funds.
At the top tier of CBES is the National Book-Entry System (“NBES”), which is operated by the Federal Reserve Banks. For Treasury securities, the Federal Reserve operates NBES in their capacity as the fiscal agent of the U.S. Treasury. The Federal Reserve Banks maintain book-entry accounts for depository institutions, the U.S. Treasury, foreign central banks, and most government sponsored enterprises (GSEs). At the next tier in CBES, depository institutions hold book-entry accounts for their customers, which include brokers, dealers, institutional investors, and trusts. At the next tier, each broker, dealer, and financial institution maintains book-entry accounts for individual customers, corporations, and other entities. When an investor purchases securities through a broker, dealer, or financial institution, the securities are held on the book-entry system of that firm. Holding Treasury securities in this manner is known as indirect holding since there is one or more entities between the investor and the issuer (U.S. Treasury).
The CBES has succeeded in replacing paper securities with electronic records, eliminating the potential for theft, loss, or counterfeiting. Securities owners receive interest and redemption payments wired directly to their linked accounts, no more clipping interest coupons or presenting certificates for redemption.
The registration form and book entry system requirement ensures tracking of the ownership of debt. However, these rules are incredibly complicated. In order to simplify these registration rules for purposes of a promissory note, the short paragraph below may be inserted into a promissory note to satisfy the registration requirement:
Borrower shall keep a register of this Note as to both principal and any interest. Lender may transfer this Note, but such transfer may only be effected by surrender of this Note to the Borrower by the transferor Lender, and by issuance by the Borrower of a new Note with identical terms (other than Lender, which shall be the transferred rather than the transferor). This registration requirement is intended to qualify the Note for portfolio-interest exemption of the Internal Revenue Code Section 871(h)(2)9B) or 881(c)(2)(B), and shall be interpreted accordingly.
The above register language is in spirit of the “registration form” requirements as it limits the transfer of the debt by the lender directly to another lender. As typically the case in cross-border transactions, there is no “one-size fits all” language. Each case should be reviewed to determine the proper language to be used in the promissory note for purposes of the register language.
Finally, it should be noted that an obligation that is not in registered form is considered to be in bearer form. A bearer form obligation is a debt security payable to the person who physically possesses it, or the “bearer.” A bearer form of obligation is not eligible for an exemption under the portfolio interest rules.
Below, please find the following examples contained in the regulations discussing the registration form requirements rules:
EXAMPLE (1).
Municipality X publicly offers its general debt obligations to United States persons. The obligations have a maturity at issue exceeding 1 year. The obligations are registration-required obligations under Section 5f.103-1(b). When individual A buys an obligation, X issues an obligation in A’s name evidencing A’s ownership of the principal and interest under the obligation. A can transfer the obligation only by surrendering the obligation to X and by X issuing a new instrument to the new holder. The obligation is issued in registered form.
EXAMPLE (2).
Municipality Y issues a single obligation on January 4, 1983 to Bank M provided that (i) Bank M will not at any time transfer any interest in the obligation to any person unless the transfer is recorded on Municipality Y’s records (except by means of a transfer permitted in (ii) of this example) and (ii) interests in the obligation that are sold by Bank M (and any persons who acquire interests from M) will be reflected in book entries. C, an individual, buys an interest in Y’s obligation from Bank M. Bank M receives the interest or principal payments with respect to C’s interest in the obligation as agent for C. Bank M records interests in the Municipality Y obligation as agent of Municipality Y. Any transfer of C’s interest must be reflected in a book entry in accordance with Bank M’s agreement with Municipality Y. Since C’s interest can only be transferred through a book entry system maintained by the issuer (or its agent), the obligation is considered issued in registered form. Interest received by C is excludable from gross income under Section 103(a) of the Internal Revenue Code.
EXAMPLE (3).
Municipality Z wishes to sell its debt obligations having a maturity in excess of 1 year. The obligations are sold to Banks N, O, and P, all of which are located in Municipality Z. By their terms the obligations are freely transferable, although each of the banks has stated that it acquired the obligations for purposes of investment and not for resale. Obligations similar to the obligations sold by Municipality Z are traded in the market for municipal securities. The obligations issued by Municipality Z are of a type offered to the public and are therefore registration-required under Section 5f.103-1 (b).
EXAMPLE (4).
Corporation A issues an obligation that is registered with the corporation as to both principal and any stated interest. Transfer may be effected by the surrender of the old instrument and either the reissuance by the issuer of the old instrument to the new holder or the issuance by the issuer of a new instrument to the new holder. The obligation can be converted into a form in which the right to the principal of, or stated interest on, the obligation may be effected by physical transfer of the obligation. Under Section 5f.103-1 (c) and (e), the obligation is not considered to be in registered form and is considered to be in bearer form.
EXAMPLE (5).
Corporation B issues its obligations in a public offering in bearer definitive form. Beginning at X months after the issuance of the obligations, a purchaser (either the original purchaser or a purchaser in the secondary market) may deliver the definitive bond in bearer form to the issuer in exchange for a registration receipt evidencing a book entry record of the ownership of the obligation. The issuer maintains the book entry system. The purchaser identified in the book entry as the owner of record has the right to receive a definitive bearer obligation at any time. Under Section 5f.103-1 (c) and (e), the obligation is not considered to be issued in registered form and is considered to be issued in bearer form. All purchasers of the obligation are considered to hold an obligation in bearer form.
EXAMPLE (6).
Corporation C issues obligations in bearer form. A foreign person purchases a definitive bearer obligation and then sells it to a United States person. At the time of the sale, the United States person delivers the bearer obligation to Corporation C and receives an obligation that is identical except that the obligation is registered as to both principal and any stated interest with the issuer or its agent and may be transferred at all times until its maturity only through a means described in Section 5f.103-1(c). Under § 5f.103-1(e), the obligation is considered to be in registered form from the time it is delivered to Corporation C until its maturity.
Conclusion
Portfolio debt can be a very useful U.S. tax planning tool where an investor does not qualify for the benefits of a tax treaty that eliminates withholding tax and where foreign source interest is not subject to income tax in an individual’s home country because interest paid on portfolio debt is completely exempt from U.S. federal tax. However, careful tax planning is necessary to not only avoid the U.S. withholding rules, but also to ensure interest payments on portfolio debt are deductible for U.S. tax purposes.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. As a domestic and international tax attorney, Anthony Diosdi advises both U.S. and international individuals in relation to a broad range of personal taxation and estate planning matters. He has extensive experience of advising on complex cross-border estate planning matters. Anthony Diosdi is a frequent speaker at international tax seminars. Anthony Diosdi is admitted to the California and Florida bars.
Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.
Written By Anthony Diosdi
Anthony Diosdi focuses his practice on international inbound and outbound tax planning for high net worth individuals, multinational companies, and a number of Fortune 500 companies.
