By Anthony Diosdi
As a general matter, the Internal Revenue Code imposes a 30 percent withholding tax on U.S. sourced payments of interest to foreign persons if such interest income is not effectively connected with a U.S. trade or business of the payee. See IRC Sections 871(a)(1), 881(a)(1). U.S. payors of interest subject to this 30 percent withholding tax are required to withhold the 30 percent tax from the interest otherwise payable to the non-U.S. person and pay it to the Internal Revenue Service (“IRS”). Interest paid to foreign persons with respect to certain “portfolio debt instruments” is not subject to withholding tax. Portfolio interest received by a foreign corporation or nonresident alien individual is exempt from U.S. withholding tax. See IRC Sections 1441(c)(9) and 1442(a). Congress enacted the portfolio interest exemption in 1984, party in recognition of the widespread avoidance of U.S. taxes on portfolio interest.
To collect on a registered obligation, such as the Portfolio Debt Loan free of U.S. withholding tax, a foreign payee must provide the 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) provides the name and address of the beneficial owner (the “Payee Statement”). The Payee Statement would generally be valid for up to three years from the date provided unless the payee knows or has reason to know of a change that would affect the information provided on such form.
There are three important exceptions to the exemption from the 30 percent withholding tax, the exemption will not apply to any interest 1) received by a bank; 2) received by a 10-percent shareholder, or 3) received by a controlled foreign corporation (“CFC”) from a related person. With the exception of category one (interest received by a bank), we will discuss these exceptions below in more detail.
Is the Interest Received by a 10 Percent Shareholder
One of the requirements for valid portfolio debt is that the interest must not be paid to a so-called “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 stock 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 owns 99 percent of the equity in the borrower but less than 10 percent of the voting rights in the borrower, it is also possible to use a U.S. domestic “non-grantor” trust as a borrower as there is no concept of a 10 percent shareholder of a trust.
Is the Lender a Related Party CFC
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, like 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 the vote or value of the subsidiary corporation. See IRC Sections 864(d)(4), 267(b)(3), 267(f)(1), 1563(a)(1).
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. individual, 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. See IRC Section 957(a), 951(b).
For these purposes, certain attribution rules can apply to attribute stock ownership of a foreign corporation to U.S. persons, especially subsequent to the repeal of Internal Revenue Code Section 958(b)(4) of the Tax Cut and Jobs Act of 2017. For example, suppose a foreign corporation (“Forign Parent Company”) owns 51 percent of a U.S. company (“U.S. Finance Subsidiary Company”). Foreign Subsidiary company owns 51 percent of a U.S. company (“U.S. Finance Subsidiary”), but only holds non-voting shares- with the voting shares being held by a completely unrelated and independent third party. Foreign Subsidiary Company makes loans to U.S. Finance Subsidiary that are intended to qualify for the portfolio interest exemption.
If Foreign Parent Company were to directly or indirectly own a U.S. corporation (or partnership) that was not a subsidiary of Foreign Subsidiary Company, it is possible that Foreign Subsidiary Company could be considered a CFC since Foreign Subsidiary Company’s stock would be attributed from Foreign Parent Company down to the U.S. corporation directly or indirectly owned by Foreign Parent. The example above has far greater reach than one would expect. Under the Tax Cut and Jobs Act, it is possible for a foreign corporation to be a CFC (and be subject to U.S. tax) if either: 1) the ultimate beneficial owners (or any spouse, ascendant or descendant of the ultimate beneficial owners) owns interests in a U.S. corporation or partnership, or 2) any entity in the ownership chain between the foreign corporation and the ultimate beneficial owners owns interests in a U.S. corporation or partnership.
Careful consideration must be given in establishing any structure utilized in the cross-border loan transactions. Failure to do so may trigger unintended U.S. tax consequences.
Obtaining an Interest Deduction Under the New Section 163(j) Limitations
Internal Revenue Code Section 163(j), as amended by the Tax Cut and Jobs Act of 2017, can potentially apply to limit deductions for interest, including deductions for interest payments on portfolio debt loans.
Internal Revenue Code Section 163(j) disallows any interest expense incurred by a taxpayer if the interest expense exceeds the sum of 1) business interest income; 2) 30 percent of the taxpayer’s adjusted taxable income; and 3) the floor plan financing interest of the taxpayer. In this context, adjusted taxable income (“ATI”) is similar to a taxpayer’s earnings before interest, taxes, depreciation, and amortization (“EBITDA”).
The general rule of the new Section 163(j) limits the deductibility of interest expense paid or accrued on debt properly allocable 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 ATI; however, for tax years beginning in 2022, depreciation, amortization, and depletion are deducted from ATI before determining the limitation. 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).
Congress exempted from the application of Section 163(j) taxpayers that have gross receipts that do not exceed $25 million. See IRC Section 163(j)(3). 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 gross receipts for the three tax year period ending with the prior year exceeds $25 million. However, for purposes of applying these rules, certain aggregation rules will apply such that entities that are “under common control” will be aggregated for purposes of determining whether the $25 million threshold is met. The relevant tests to determine common control between entities generally looks for 50 percent minimum ownership thresholds and/or whether five or fewer persons own more than 50 percent of two or more entities. See IRC Sections 58(a), (b).
Even if the foreign investor’s gross receipts do not exceed $25 million, Section 163(j) may apply if the investor is considered a “tax shelter.” For purposes of Internal Revenue Code Section 163(j), a tax shelter includes any partnership, among other entities, where 35 percent or more of the losses of the partnership are allocable to limited partners.
Internal Revenue Code Section 448 uses Internal Revenue Code Section 461(i)(3)’s definition of “tax shelter,” which includes any “syndicate” under Section 1256. The Code’s definition of the term “syndicate” means any partnership or other entity (other than a corporation which is not an S corporation) if more than 35 percent of the losses of such entity during the taxable year are allocable to limited partners or limited entrepreneurs (within the meaning of IRC Section 461(k)(4). The reference to Section 461(k)(4) is to the definition of limited entrepreneur, which defines a limited entrepreneur as a person who has an interest in an entity other than as a limited partner and does not actively participate in the management of the enterprise.
Internal Revenue Code Section 163(j) will significantly impact investment structures and will increase due diligence. Foreign investors should examine the investment structure to determine if it will be subject to one or more exemptions from Section 163(j). As noted above, seemingly unrelated businesses could be considered related for the purpose of disallowing interest deduction if the two businesses share common ownership. Thus, if the investment sponsor proposes or the investor believes that the investment will qualify for the “small business exemption,” the investor should conduct reasonable due diligence to ensure that the investment does not need to be aggregated together with any other investment or investment structures such that, for purposes of Section 163(j), the investment’s gross receipts will exceed $25 million. Such due diligence must include a review of the investor’s own portfolio, a review of the sponsor’s own portfolio, a review of the sponsor’s ownership position in this and any other entity, and the ownership position of any other investor in this or any other entities. Further, even if the investment’s gross receipts should not exceed $25 million, the foreign investor should determine if the investment could be considered a tax shelter.
Finally, Congress has provided a major exception to Section 163(j) for real estate trades or businesses within the meaning of Internal Revenue Code Section 469(c)(7)(C). These type of businesses can elect out of Section 163(j) treatment if the real estate trade or business elects to use the alternative depreciation system. See IRC Section 163(j)(10)(A). Generally, the Internal Revenue Code provides for two basic depreciation schemes: 1) an accelerated depreciation system; and 2) a straight-line depreciation system. Instead of allowing 100 percent expensing for capital assets used in a business in the year of acquisition, the amount used to acquire such property by a business is recovered through depreciation deductions. These deductions are designed to match the recognition of the expense to the periods in which the assets are consumed or used by the business.
The accelerated depreciation system contained in Section 168 provides higher depreciation deductions in the periods immediately after the depreciable asset is acquired, declining in later periods until the entire cost to acquire the asset is depreciated. The accelerated depreciation system includes certain types of “bonus” or special depreciation deductions whereby a taxpayer can expense the full cost to acquire certain types of property in the year acquired rather than expensing the property over a longer period of time.
Land is never depreciable. However, buildings upon the land are depreciable. However, the accelerated depreciation system cannot be used for depreciation and buildings on land is not eligible for bonus depreciation under Section 168(k). In particular, residential real estate has a recovery period of 27.5 years under the accelerated depreciation system while non-residential real estate has a recovery period of 39 years. The alternative depreciation system extends residential real property’s recovery period to 30 years and non-residential real property to 40 years. See IRC Section 168(g)(2).
For most real estate businesses, the vast majority of depreciation deductions recognized by a real estate business will be for real property, that is, buildings upon land depreciated over a shorter period of time and on an accelerated schedule. Thus, a qualifying real estate trade or business that elects out of application of Section 163(j) by electing to have the alternative depreciation does not give up much: the type of property it acquires (land and buildings) would not be entitled to accelerated, including bonus, depreciation. The Tax Cut and Jobs Act changes to Internal Revenue Code Section 168 includes allowances for “qualified improvement property,” which usually includes certain improvements to the interior of a building or certain equipment affixed to the exterior of a building. Such property, in some cases, would be eligible for bonus depreciation deductions. But such improvements also qualify for a separate depreciation scheme provided for in Internal Revenue Code Section 179.
Therefore, a taxpayer operating a real estate trade or business, which might be subject to the interest limitations of Section 163(j) should consider electing out of the application of Section 163(j). With that said, there is a “cost” to the election in that any electing real property trade or business must use the alternative depreciation system. This cost must be carefully weighed before an election is made.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. 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.