By Anthony Diosdi
The United States is the world’s top destination for foreign direct investment. Foreign investors generally have the same goals of minimizing their income tax liabilities from their U.S. real estate and business investments as do their U.S. counterparts, although their objective is complicated by a special income tax regime that is applicable to foreign persons. Specifically, if the non-U.S. person receives passive U.S. source income, the income is taxed at a flat 30 percent rate, unless a tax treaty reduces this rate. On the other hand, if the U.S. activities of the foreign investor rises to the level of a “trade or business,” then the foreign person will be taxed at the same graduated tax rates applicable to U.S. persons.
Portfolio Debt Planning
Foreign investors often utilize portfolio debt to acquire U.S. real estate and businesses. Under Internal Revenue Code Sections 871 and 881, nonresident alien individuals and foreign corporations are typically subject to a 30 percent tax on U.S. sourced income that is not connected with a U.S. trade or business. However, portfolio interest is exempt from this 30 percent tax. Therefore, foreign investors can utilize portfolio debt which can not only avoid the 30 percent withholding tax, but it can also potentially generate a valuable interest deduction for U.S. income tax purposes. Portfolio debt can also be a very useful tax planning tool for foreign investors that do not qualify for tax treaty benefits. Portfolio debt eliminates U.S. withholding tax with the need to utilize any particular provision of a tax treaty. For a cross-border loan to qualify as portfolio debt, the following requirements must be met:
The Lender Must be a Foreign Person
The first requirement of the portfolio debt rules is that the lender must either be a foreign person, foreign corporation, or foreign trust. The foreign lender must provide the U.S. borrower a statement that is 1) signed by the beneficial owner of the foreign lender under penalties of perjury; 2) that certifies that such owner is not a U.S. person, and 3) provides the name and address of the beneficial owner.
If the borrower is a corporation, a 10 percent ownership rule requires that the recipient of the loan must not own 10 percent or more of the combined voting power of all classes of stock of such corporation. Because the 10 percent shareholder requirement applied to a corporate borrower is limited to voting rights, in many cross-border financing situations, many foreign investors establish a structure in which the lender owns 99 percent of the equity in the borrower but less than 10 percent of the voting rights in the borrower. A U.S. domestic non-grantor trust can also be established as a borrower in order to avoid the 10 percent shareholder rules discussed above.
The Borrower Must be a U.S. Person
The second requirement of the portfolio debt rules is that the lender must be a U.S. person. The term “U.S. person” means: 1) a citizen or resident of the United States; 2) a domestic partnership; 3) a domestic corporation; 4) any estate other than a foreign person; or 5) a U.S. trust.
The Lender Cannot be a Related Party Controlled Foreign Corporation or (“CFC”)
Third, the portfolio debt rules require that the payment of interest to a CFC that is considered a related person with respect to the borrower. 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. The applicable related party rules under this rule is Internal Revenue Code Section 267(b). Under these so-called downward attribution rules, 50 percent or more in the value of the stock in a corporation is owned, directly, or indirectly, by or for any person, such corporation shall be considered as owning the stock owned, directly or indirectly, by or for such person.
The Loan Cannot be from a Bank Lending in the Ordinary Course of Business
The portfolio interest exemption does not apply to the payment of interest to a bank that is in the ordinary course of lending.
The Debt Must be in “Registered Form”
In order to satisfy the portfolio debt rules, the loan must be evidenced by a loan agreement. At a minimum, the loan agreement must state the names of the lender and borrower. The loan agreement should state the terms of the loan, including the amount borrowed, terms of repayment, and interest rate. The loan agreement should also be recorded with the county recorder’s office where the investment real property is located.
The loan instrument or bond must also be in registration form as provided 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, Treasury Regulation Section 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 Section 5f. 103-1.
Generally, under Section 5f. 103-1, 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.
In order satisfy the above discussed rules, the debt instrument should include a provision that provides something to the effect of:
“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 affected 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 Internal Revenue Code Section 871(h)(2)(B) or Section 881(c)(2)(B), and shall be interpreted accordingly.”
This language is in the spirit of the registration requirement as it limits the transfer of the debt by one lender to the next lender through a surrender of an old obligation and the reissuance to a new holder. This proposed language also clearly states that the borrower will keep a register of the principal and interest with respect to the obligation stated in the note (This will obviously require the borrower to develop a system for tracking the payment of principal and interest to the Lender).
Obtaining the Tax Deduction
In order to obtain a deduction for portfolio interest for U.S. tax purposes, Internal Revenue Code Section 163(j) limits the deductibility of interest payments on portfolio debt to 30 percent of “adjusted taxable income.” Adjusted taxable income is determined without regard to certain deductions, including those for net interest expense, and net operating loss carryforwards. The Section 163(j) limitations are subject to small business and real property trade or business exceptions. A deduction is also not permitted for portfolio interest under Section 267A in connection with hybrid transactions. A hybrid transaction means any transaction, series of transactions, agreement, or instrument, if one or more payments are treated as interest 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 resident for tax purposes.
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.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in foreign tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or 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.