U.S. Tax Consequences of Loan-Related Activities of Offshore Funds

Client Advisory

January 29, 2007

Over the last few years, the private securities markets--in particular, hedge funds and issuers of CLOs--have captured much of the market share for loans that was formerly held by U.S. banks and other U.S. institutional lenders. These investment funds purchase loans and participations from banks and other originators; and make loans directly, particularly to distressed companies and start-ups. Investment funds have also been extremely active participants in credit derivatives, including credit default swaps and total return swaps. These activities raise potentially troubling income tax issues.

Many of the investment funds engaged in these activities are organized outside the United States, in order to minimize U.S. income taxes and appeal to non-U.S. investors and U.S. tax-exempts. These offshore funds must be extremely careful however to avoid becoming subject to U.S. income tax on their trading profits.    The Internal Revenue Service is expected to begin examining these “lending” activities more closely. In its Guidance Priority Plan issued in August of 2006, the IRS included lending activities by foreign persons on the list of issues it intends to address in the near future.

U.S. Taxation of Non-U.S. Corporations

A non-U.S. corporation that engages in a trade or business within the United States is subject to United States federal income tax, including the additional branch profits tax, on its taxable income that is treated as effectively connected with such trade or business.[1]  If there is an income tax treaty between the United States and the country in which the non-U.S. corporation is a tax resident, the non-U.S. corporation will be subject to U.S. income tax only if its trade or business is conducted through a “permanent establishment” in the United States.[2] Offshore funds, however, are generally organized in low-tax jurisdictions that do not have income tax treaties with the United States.

Activities That Give Rise to a U.S. Trade or Business

Neither the Internal Revenue Code of 1986, as amended (the “Code”), nor the applicable regulations thereunder provide a definition of what constitutes being engaged in a trade or business within the United States. The limited caselaw considering the issue does not provide definitive guidance and generally holds that a non-U.S. corporation will be considered to be engaged in a United States trade or business if it regularly and continuously carries out business activities in the United States, whether directly or through agents.[3] All facts and circumstances are relevant. Pursuant to Code section 864(b)(2), however, a non-U.S. entity will not be deemed to be engaged in a U.S. trade or business if it only “trades” in securities and commodities for its own account. The regulations under Code section 864 provide that “securities” include any note, bond, debenture, or other evidence of indebtedness, or any evidence of an interest in or right to subscribe to or purchase any of the foregoing. The “trading” safe harbor does not protect “banking” or “financing” activity. Understandably, then, there are a great many questions as to precisely which types of activities are protected and which are taxable.

It is reasonably clear, for example, that the acquisition of loans or debt securities in the secondary market (or of derivatives on such loans or securities) will not cause a foreign entity to be engaged in a U.S. trade or business, because of the safe harbor for trading in securities for one’s own account. On the other hand, it is likely that negotiating and originating loans in the U.S. on a regular and continuous basis will result in a U.S. trade or business.   Where the line falls in between these two extremes, for example with respect to unfunded revolvers or swaps entered into concurrently with originations, is a matter of great concern to the industry.

One case addressing cross-border lending activities is Pasquel v. Commissioner, 12 T.C.M. 1431 (1953). In Pasquel, the Tax Court considered whether a nonresident alien who made a loan to a U.S. company was engaged in a U.S. trade or business. The court ruled that the taxpayer was not engaged in a U.S. trade or business since the taxpayer had limited involvement in the loan transaction and the loan was a single and isolated transaction. Thus, relevant factors for determining when cross-border lending activities constitute a U.S. trade or business include the number of loans and the extent of U.S. activities. However, Pasquel is of limited precedential value for offshore funds that engage in more frequent cross-border lending activities involving U.S. borrowers.

There is some potentially useful guidance concerning domestic lending activities under Code section 166, which allows a deduction for a bad debt that was created or acquired in connection with a trade or business. Some of the factors which the courts and the IRS have looked at in determining whether or not a taxpayer was engaged in a lending business for purposes of section 166 include the following: the number and frequency of loans made by the taxpayer, whether the taxpayer held itself out to the public as engaged in the business of lending, and the amount of time and effort spent on money lending activities, including whether the taxpayer maintained an office for purposes of engaging in lending activities, hired employees or other dependent agents to conduct its lending activities, and maintained books and records detailing the taxpayer’s lending activities.[4] It is unclear, however, to what extent the authorities under section 166 apply to the analysis of whether a foreign entity is engaged in a U.S. trade or business for purposes of section 864, since the two sections have different underlying policies.

Avoiding U.S. Trade or Business Status

In order to avoid being engaged in a U.S. trade or business, offshore funds should clearly minimize negotiation and origination of loans within the U.S., whether directly or indirectly. As noted above, a non-U.S. entity may acquire loans or debt securities in the secondary market. We generally recommend a minimum seasoning period of at least several business days between the date the original lender funds the loan and the date an assignment or participation becomes effective, during which period the original lender is fully at risk. Similarly, with proper planning, an offshore fund generally should also be able to invest in revolvers and derivatives without becoming engaged in a U.S. trade or business.

We often assist offshore investment funds by analyzing potential investments and by drafting internal tax and regulatory operating guidelines. Such guidelines are designed to minimize the risk that the non-U.S. entity will become subject to U.S. regulation or will conduct its activities in a manner that will cause it to be subject to U.S. taxation. The scope of the guidelines will be affected by, among other things, the nature of the businesses conducted by the offshore company, whether it is located in a jurisdiction with which the U.S. has an income tax treaty, and management’s appetite for risk.

The above discussion was prepared by the Tax and Corporate Departments at Carter Ledyard & Milburn LLP. If you have any questions about the contents of this Advisory, please contact Howard J. Barnet (212-238-8606, of the Tax Department, or John J. Hanley (212-238-8722, of the Corporate Department.

[1]For purposes of this advisory, we assume that the offshore fund will be classified as a corporation for U.S. tax purposes, as is typically the case.
[2] A permanent establishment is generally defined in income tax treaties as a fixed place of business through which business is wholly or partly carried on, and includes a place of management, a branch and an office. Further, an agent acting on behalf of a non-U.S. entity in the U.S., other than an independent agent, is generally deemed to be a permanent establishment of the non-U.S. entity in the U.S. if such agent has and habitually exercises an authority to conclude contracts on behalf of the non-U.S. entity.
[3] The activities of an agent operating within the U.S. may cause a foreign taxpayer to be deemed engaged in a U.S. trade or business. The caselaw generally provides that activities of persons subject to a high degree of control by the foreign entity, such as employees and “dependent” agents acting exclusively or almost exclusively for the entity, are properly imputed to the corporation. Less clear is whether the activities of independent contractors, commission agents, brokers and other “independent” agents can be imputed. In many instances the courts have taken an expansive view, imputing the activities of seemingly independent agents to foreign persons for purposes of determining whether those foreign persons are engaged in a U.S. trade or business.
[4] See PLR 9701006 (Sept. 24, 1996) and FSA 199911003 (Nov. 18, 1998).

Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © 2020 Carter Ledyard & Milburn LLP.
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