IRS to Expand Tax Exemption for Interest Income Earned by Foreign ...

IRS to Expand Tax Exemption for Interest Income
Earned by Foreign Investors
By Seth J. Entin*
THE PROPOSED REGULATIONS ARE VERY
FAVORABLE TO PARTNERSHIPS—SUCH AS
FUNDS—WITH FOREIGN INVESTORS.
On June 12, 2006, the IRS issued
Proposed Regulations (“Proposed
Regulations”) 1 under the “portfolio
interest” exemption of Sections 871(h)
and 881(c). This exemption allows
foreign persons to earn U.S.-source
interest income free of U.S. federal
income tax. The Proposed Regulations
are very favorable to partnerships--such
as funds--having foreign investors,
because they expand the availability of
the portfolio interest exemption when
the partnership holds both debt and
equity in a U.S. company.
BACKGROUND
The United States imposes a flat 30% tax
on U.S.-source “fixed or determinable,
annual or periodical” (FDAP) income
(such as interest, dividends, rents,
royalties, and similar types of income)
earned by a nonresident alien or foreign
corporation. 2 This tax is imposed on
gross income, with no deductions
allowed. Generally collected by means of
withholding, 3 the tax is known as the
“30% withholding tax.” The 30%
withholding tax does not apply to
“portfolio interest” earned by a
nonresident alien or foreign corporation,
4 usually referred to as the
“portfolio interest exemption.”
“Portfolio interest” is interest (including
original issue discount) that meets
certain specific requirements, which
The Proposed Regulations
adopt the taxpayer-friendly
“aggregate” approach,
providing that the 10%
ownership limitation is
tested at the partner level.
vary depending on whether the debt
obligation is issued in “registered” or
“bearer” form. 5 Interest on an
obligation in registered form generally
constitutes portfolio interest if the
withholding agent receives a form
stating that the beneficial owner of the
FOOTNOTES:
1
REG-118775-06 (June 12, 2006).; 2 Sections 871(a) and 881.When the income is "effectively connected" with a U.S. trade or business of the nonresident alien or
foreign corporation, a different regime applies. Sections 871(b) and 882(a).; 3 Sections 1441 and 1442.; 4 Sections 871(h) and 881(c).; 5 Sections 871(h)(2) and
881(c)(2).; 6 Sections 871(h)(2)(B) and 881(c)(2)(B).
7 Derivatives 19 (August 2006). Reprinted with permission of Thomson/RIA. All rights reserved.

obligation is not a U.S. person. 6 Interest
earned on an obligation not in
registered form (i.e., in bearer form)
can be portfolio interest if the issuer of
the obligation complies with certain
procedures generally designed to
ensure that the holder of the obligation
is not a U.S. person. 7
There are, however, certain limitations
on the availability of the portfolio
interest exemption. For example, it
does not apply to:
1. Interest received by a “10%
shareholder” of the borrower
(referred to herein as the “10%
ownership limitation”). 8
2. Interest received by a controlled
foreign corporation from a related
person. 9
3. Interest received by a bank on an
extension of credit made pursuant
to a loan agreement entered into in
the ordinary course of its trade or
business. 10
4. Certain contingent interest. 11
10% OWNERSHIP LIMITATION
The portfolio interest exemption does
not apply to interest received by a
“10% shareholder” of the borrower. For
an obligation issued by a corporation, a
“10% shareholder” is any person who
owns 10% or more of the total
combined voting power of all classes of
stock entitled to vote. 12 For an
obligation issued by a partnership, a
“10% shareholder” is any person that
owns 10% or more of the capital or
profits interest in the partnership. 13
The Section 318 attribution rules apply
in determining ownership for purposes
of the 10% ownership limitation, with
several important modifications. 1 4 One
example, discussed below, is that a
person owns an option to acquire
stock and is treated as owning the
stock under the Section 318 attribution
rules. 1 5 The portfolio interest statute,
however, modifies that general rule.
This modification provides that ownership
of an option to acquire stock is not
treated as stock ownership in applying
the attribution rules to determine
whether stock ownership is attributed
from a partnership to its partner, from
a trust to its beneficiaries, or from a
corporation to its shareholders (or vice
versa). 16
WHERE THE 10% OWNERSHIP
LIMITATION IS TESTED
Practitioners and commentators have
debated how the 10% ownership
limitation should be tested if the holder
of the debt is a partnership that has
foreign members. The issue is whether
the 10% ownership limitation is tested
at the partnership level (“entity”
approach) or at the partner level
(“aggregate” approach).
Under the entity approach, the
determinative factor is whether the
partnership itself owns a 10% or
greater interest in the U.S. borrower. If
it does, the interest paid by the U.S.
borrower will not qualify for the
portfolio interest exemption, regardless
of the magnitude of the foreign
partner’s interest in the partnership.
On the other hand, if the 10%
ownership limitation is tested at the
partner level, the proportionate
interest of each foreign partner in the
borrower is looked at to determine
whether the foreign partner qualifies
for the portfolio interest exemption on
the partner’s proportionate share of
the interest income. 17
Example. A partnership (U.S. or
foreign) holds a debt instrument issued
by a U.S. corporate borrower. The
partnership also owns 20% of the
borrower’s voting stock. Each of 100
unrelated nonresident alien partners
owns 1% of the partnership. If the 10%
ownership limitation is tested at the
partnership level, the interest paid by
the U.S. borrower will not qualify for
the portfolio interest exemption,
because the partnership owns 20% of
the corporation’s voting stock. On the
other hand, if the 10% ownership
limitation is tested at the partner level,
the interest will qualify for the portfolio
interest exemption, because none of
the partners indirectly owns a 10% or
greater interest in the U.S. borrower.
Previously, the only indication of the
IRS’ position was a 1994 field service
advice (“1994 FSA”) that took the
stance that the 10% ownership
limitation is tested at the partner level,
not at the partnership level. 18
A field service advice, however, is not
binding authority. Therefore, practitioners
have requested more formal
guidance from Treasury. 19
FOOTNOTES:
7
Sections 871(h)(2)(A) and 881(c)(2)(A).; 8
Sections 871(h)(3) and 881(c)(3)(B).; 9
Section 881(c)(3)(C).;
10
Section 881(c)(3)(A).;
11
Sections 871(h)(4) and
881(c)(4); 1 2 Section 871(h)(3)(B)(i).; 1 3 Section 871(h)(3)(B)(ii).; 1 4 Section 871(h)(3)(C).; 1 5 Section 318(a)(4).; 1 6 Section 871(h)(3)(C)(iii).; 1 7 See, e.g., Garlock, Federal
Income Taxation of Debt instruments (4th ed., 2000) sec. 17.04(C); Entin, "Partnerships and the Portfolio Interest Exemption," 100 Tax Notes 1171 (Sept. 1, 2003);
Needham, "A Guide to Tax Planning for Private Equity Funds and Portfolio Investments (Part 1)," 99 Tax Notes 1215, 1239-40 (May 20, 2002); Staffaroni,
"Partnerships: Aggregate v. Entity in U.S. International Taxation," 49 Tax Law 55, 123 (1995); 1 8 1994 Westlaw 1866354; 1994 FSA LEXIS 430 (Feb. 2, 1994); 19
ABA Section of Taxation, "The Need for Guidance on the Portfolio Interest Exemption," 101 Tax Notes 701 (May 10, 2004).

Proposed Regulations. The Proposed
Regulations adopt the taxpayer-friendly
“aggregate” approach and provide that
the 10% ownership limitation is tested
at the partner level. Therefore, in the
above example, the interest would
qualify for the portfolio interest
exemption. 20
If Treasury believes that the
aggregate approach reflects the
proper interpretation of the
statute, that interpretation
should control regardless of
when the note is issued.
Under the Proposed Regulations,
accordingly, foreign partners in a
partnership can earn their distributive
share of the partnership’s interest
income free of the 30% withholding tax
even if the partnership holds 10% or
more of the equity in the U.S.
borrower, so long as the partners do
not each own a 10% or greater direct
or constructive equity interest in the
U.S. borrower.
The Preamble to the Proposed
Regulations states that Treasury’s
adoption of the aggregate approach
reflects its view that a partnership may
be treated either as an aggregate of its
partners or as an entity separate from
its partners, depending on which
characterization is more appropriate to
carry out the purpose of the specific
Code provision at issue. According to
the Preamble, the aggregate approach
here is supported by the policy and
structure of the portfolio interest
statute. 21
WHEN 10% OWNERSHIP
LIMITATION IS TESTED
The statute does not explicitly provide
at what point in time the 10%
ownership limitation is tested. Under the
Proposed Regulations, it is tested with
respect to a nonresident alien individual
or foreign corporation that is a partner
in the partnership when a withholding
agent, absent any exceptions, would
otherwise be required to withhold
under Sections 1441 and 1442 with
respect to the interest. 2 2 It is hoped that
Treasury will eventually expand this
guidance to all cases involving the 10%
ownership limitation, not just partnership
situations.
EFFECTIVE DATE
The Proposed Regulations apply to
interest paid on obligations issued on
or after the date that the Regulations
are issued as final. One would have
hoped that the Regulations would be
effective for obligations issued prior to
this date--if Treasury believes that the
aggregate approach reflects the proper
interpretation of the statute, that
interpretation should control regardless
of when the obligation is issued.
PLANNING OPPORTUNITIES
The Proposed Regulations present at
least two important opportunities for
foreign persons investing in the United
States. First, they establish the general
proposition that the 10% ownership
limitation is tested at the partner level.
Therefore, if a partnership invests in the
debt of a U.S. borrower, a foreign
partner’s distributive share of the
interest income can qualify for the
portfolio interest exemption even if the
partnership owns a 10% or greater
interest in the U.S. borrower, so long as
the foreign partner’s interest in the U.S.
borrower is less than 10%. This significantly
expands the opportunities for
foreign investment in partnerships that
own U.S. debt instruments, such as
investment funds.
Further, it would appear that the
Proposed Regulations provide an
opportunity for foreign investors,
through a properly structured
partnership investment vehicle, to
obtain ownership potential in a U.S.
corporate or partnership borrower
through convertible debt without
forfeiting the portfolio interest
exemption. This is because, under the
Proposed Regulations, the 10%
ownership limitation is tested at the
partner level. Yet simultaneously, as
discussed above, an option (which
generally includes a conversion right) is
not attributed from a partnership to its
partners under the statutory portfolio
interest attribution rules.Therefore, due
to the statutory restriction on
attribution, when testing the 10%
ownership limitation at the partner
level, a conversion right or option held
by the partnership should not be
FOOTNOTES:
20
Reg. 1.871-14(g)(3)(i).The Proposed Regulations provide a similar rule for interest paid to a simple trust or a grantor trust: when interest is paid to a simple trust
or grantor trust and the interest is distributed to or included in the gross income of a nonresident alien individual or foreign corporation that is a beneficiary or owner
of the trust, the 10% ownership limitation is tested at the beneficiary or owner level. Prop. Reg. 1.871-14(g)(4); 2 1 This approach is also reflected in the "Brown Group"
Regulations, which apply the Subpart F rules to some situations involving partnerships. See REG-112502-00, 65 Fed. Reg. 56836 (Sept. 20, 2000); REG-104537-
97, 63 Fed. Reg. 14613 (Mar. 26, 1998), withdrawn by REG-113909-98, 64 Fed. Reg. 37727 (July 13, 1999).; 2 2 Prop. Reg. 1.871-14(g)(3)(ii).

attributed to the partners.
Example. Two unrelated foreign
persons, X and Y, want to loan money
to a U.S. corporation and obtain upside
equity and control potential in the U.S.
borrower through convertible debt
instruments. If X and Y were each to
directly acquire a debt instrument
convertible into a 10% or greater
equity interest in the borrower, neither
of them would be entitled to the
portfolio interest exemption, and thus
both would be subject to the 30%
withholding tax on the interest (subject
to reduction by treaty).
On the other hand, suppose that X and
Y formed a partnership that acquired a
debt instrument convertible into a 10%
or greater voting equity interest in the
U.S. borrower. Under the Proposed
Regulations, X and Y could obtain
equity potential and control potential in
the U.S. borrower without forfeiting the
portfolio interest exemption. Although
the partnership would be deemed to
own a 10% or greater voting equity
interest in the borrower by virtue of
the conversion feature, that deemed
ownership would not be attributed to
X and Y due to the attribution
limitation of Section 871(h)(3)(C)(iii).
While this conclusion may be
surprising, it is indeed the result
reached by the IRS in the 1994 FSA. 23
As a result, X and Y could earn interest
on the convertible debt instrument
free of U.S. federal income tax.
Moreover, if the value of the U.S.
borrower increases, and X and Y want
to exercise their conversion rights 2 4 and
sell their stock in the borrower, X and Y
could do so free of U.S. federal income
tax. 25
CONCLUSION
These Proposed Regulations should be
of great interest to foreign investors
who invest in the United States and to
funds that seek to provide tax-efficient
investment vehicles for foreign
investors. Further, if Treasury believes
that the aggregate approach reflects
the proper interpretation of the
statute, that interpretation should
control regardless of when the note is
issued.
FOOTNOTES:
24
See Rev. Rul. 72-265, 1972-1 CB 222 (no gain is realized on the exchange of a convertible debenture for stock of the obligor corporation).; 2 5 Foreign persons are
not subject to U.S. federal income tax on gain from the sale of stock that is not deemed to be effectively connected with a U.S. trade or business. See Sections
881(a)(2), (4); 871(a)(1)(B), (D); 1441(c)(1); Regs. 1.881-2(a)(1), 1.1441-2(b)(2)(i), 1.1441-5(b)(2)(i)(B). If the stock constitutes a "U.S. real property interest," the
gain from the sale of the stock will be deemed effectively connected with a U.S. trade or business. Section 897.
SETH J. ENTIN (entins@gtlaw.com) is an attorney with the law firm of Greenberg Traurig, P.A., in Miami. The views expressed herein are solely
those of the authors.This article is intended solely as an educational introduction to the topics addressed. It is not designed to provide, and
does not constitute or include, legal, tax or professional advice on any matter, and should not be relied upon for that purpose. 2456