By Anthony Diosdi
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. See IRC Section 871(h), 881(), 1441(a)(9). Thus, portfolio debt can be used as a U.S. tax planning tool where a foreign investor does not qualify for the benefits of a tax treaty that eliminates U.S. withholding tax and where foreign source interest is not subject to income tax in an individual’s or a company’s home jurisdiction because interest paid on portfolio debt is completely exempt from 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.
Portfolio interest will not include will not include certain interest payments that are contingent. Such interest payments will be subject to the withholding rules. 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).
While an investor usually knows if a debt is contingent on an event or if a bank is involved, making a determination from a ten-percent shareholder or CFC for the portfolio interest rules are less clear. Thus, we will discuss these rules in more detail below.
Determining Whether Interest is Received by a 10 Percent CFC Shareholder
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 withholding tax, the foreign investor may also want to claim a deduction for interest payments. There are three provisions every foreign investor should know that may limit their ability to claim a deduction on interest payments. These provisions 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. The small business exception is met where the person meets the $25 million gross receipts test of Internal Revenue Code Section 448(c), which essentially looks at whether average annual; gross receipts for the three-tax-year period ending with the prior tax year exceeds $25. However, for purposes of applying these rules, certain aggregation rules will apply such that entities or persons that are “under common control” will be aggregated for the purposes of determining whether the $25 million threshold is met. The relevant tests to determine common control between entities generally look for 50 percent minimum ownership thresholds and/or whether five or fewer persons own more than 50 percent of two or more entities.
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 or royalty 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. Under the Section 385 equity classification rules, debt of a corporate borrower may be reclassified as equity in the event of specified distributions or acquisitions involving related parties and instruments for affiliate stock, issuance of these debt instruments to a shareholder, exchange of the instruments for affiliate stock, issuance of these debt instruments in an internal asset reorganization, or issuance of these instruments with a principal purpose of funding any of the above transactions.
Base Erosion Anti-Abuse Tax
Finally, 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).
If a U.S. corporation makes significant payments to foreign related parties (for example, the U.S. corporation owns 25 percent or more of the foreign entity) and is subject to the BEAT, then such U.S. corporation may have to pay a tax in addition to the regular U.S. tax liability. A foreign person will be considered a foreign related party for BEAT purposes if it is 1) a 24 percent owner of a U.S. corporation; 2) related to a U.S. corporation or any 25 percent owner of a U.S. corporation, or 3) related to a U.S. corporation under Section 482. The constructive ownership rules of Internal Revenue Code Section 318 apply in determining whether any non-interest holders are 25% owners of a U.S. corporation or a person related to a 25% owner. Section 318 treats a taxpayer as “owning” stock that is actually owned by various related parties. The attribution rules in Section 318 fall into the following four categories.
1. Family Attribution. An individual is considered as owning stock owned by his spouse, children, grandchildren, and parents.
2. Entity to Beneficiary Attribution. Stok owned by or for a partnership or estate is considered as owned by the partners or beneficiaries in proportion to their beneficial interest.
3. Beneficiary to Entity Attribution. Stock owned by partners or beneficiaries of an estate is considered as owned by the partnership or estate.
4. Option Attribution. A person holding an option to acquire stock is considered as owning that stock.
These general rules are supplemented by a set of “operating rules” in Section 318(a)(5), which authorize chain attribution (i.e., parent to child to child’s trust).
Any portfolio debt planning involving a corporation that has average annual gross receipts of at least $500 million should take into consideration the BEAT.
Bond Registration Rules
In 1984, Congress repealed the 30 percent withholding tax imposed by Internal Revenue Codes 871 and 881 with respect to certain interest paid on (non-effectively connected to US trade or business)) portfolio debt, referred to as “portfolio interest”. 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 § 5f. 103-1.
Generally under § 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.
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.
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 Ching & 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.
provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. 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.