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| Seth Entin |
Background
Foreign investors may earn interest income on debt issued by U.S. companies free of U.S. tax, if certain conditions are met. Foreign investors may also earn income from the sale or retirement of debt issued by U.S. companies free of U.S. tax, if certain conditions are met.
These rules make distressed debt of U.S. companies an attractive investment for foreign investors. However, despite these favorable rules, there are certain pitfalls that may cause foreign investors to nonetheless be subject to U.S. tax on these investments.
This article first summarizes the U.S. tax regimes that apply to foreign investors. It then discusses certain specific beneficial rules that allow foreign investors to earn income from debt instruments free of U.S. tax. Then, it discusses some of the issues that may cause foreign investors to be subject to U.S. tax on their income from distressed debt, and some (but not all) of the approaches that may be taken to address these concerns.
Taxation of Foreign Persons
In general, a foreign person is subject to U.S. taxation in the following ways.
Effectively Connected Income
A foreign person that is engaged in a trade or business in the U.S. is subject to U.S. federal income tax on income that is effectively connected with that trade or business. Effectively connected income is taxed on a net basis (i.e., deductions allocable to such income are allowed), at the graduated rates applicable to U.S. persons.
In addition, in the case of a foreign corporation, a 30% branch profits tax is imposed (unless reduced by treaty) on earnings and profits attributable to the corporation's effectively connected earnings and profits that are not reinvested in a U.S. trade or business. Under the Foreign Investment in Real Property Tax Act of 1980, or FIRPTA, income earned by a foreign person from the sale of a U.S. real property interest, or USRPI, is taxed as effectively connected income.
30% Withholding Tax
A foreign person is also subject to U.S. federal income tax at a flat 30% rate (unless reduced by treaty) on certain categories of U.S. source income that are not effectively connected income, such as U.S. source interest and dividends.
This tax is imposed on a gross basis (i.e., deductions are not allowed). In general, this tax is collected by means of withholding and is often referred to as the 30% withholding tax.
There is, however, an important exception to this 30% withholding tax, known as the portfolio interest exemption, discussed below. The portfolio interest exemption allows a foreign person to earn U.S. source interest income free of the 30% withholding tax.
Furthermore, a foreign person is not subject to tax on gain from the sale of property, unless the gain is effectively connected income (including, under FIRPTA, gain from the sale of a USRPI). Therefore, a foreign person may potentially sell a debt instrument free of U.S. tax.
Portfolio Interest Exemption
The 30% withholding tax is not imposed on U.S. source portfolio interest received by foreign persons.
Portfolio interest is interest that meets certain specific requirements. Generally, interest on an obligation constitutes portfolio interest if the obligation is in registered form and the withholding agent receives a Form W-8 from the IRS stating that the beneficial owner of the obligation is not a U.S. person.
Registered form generally means that the lender's interest in the debt obligation is transferable only through a book entry system maintained by the issuer — or its agent — or by surrender of the old instrument and issuance of a new instrument. If foreign investors acquire a pool of loans that are not in registered form, the tax law allows for portfolio interest treatment if the loans are held by a trust or other type of entity that issues a pass-through certificate that is in registered form.
There are, however, certain limitations on the availability of the portfolio interest exemption. For example, the portfolio interest exemption does not apply to:
- Interest income that is effectively connected income;
- Interest received by a 10% shareholder of the borrower;[3]
- Contingent interest;[4] or
- 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.
Market Discount
Under general U.S. tax principles, the purchase of debt in the secondary market at a discount gives rise to what is known as market discount. This market discount accrues over the remaining term of the debt pursuant to a formula, and then is required to be recognized by the holder of the debt as ordinary income upon redemption or disposition of the debt.
For example, say that investors purchase a note with a $100 million face amount in the secondary market for $70 million. The investors hold the note to maturity and collect the full $100 million. Under general U.S. tax principles, the $30 million of market discount will be taxed to them as ordinary income. Moreover, partial principal payments that are made prior to maturity can often accelerate the recognition of this ordinary income for the investors.
Fortunately, however, foreign persons are not subject to U.S. tax on market discount if the market discount is not effectively connected income. This allows a significant opportunity for foreign investors to realize gain from distressed debt free of U.S. tax.
Effectively Connected Income and Other Issues
As can be seen from the discussion above, in order to obtain favorable tax treatment, a foreign investor's income and gain from distressed debt must not be treated as effectively connected income. Several challenges in this regard, as well as several others, are discussed below.
Origination and Modification of Loans
In general, if foreign investors buy and sell debt on the secondary market, this, in and of itself, should not cause the foreign investors' income and gain from the distressed debt to be treated as effectively connected income.
The tax law provides a safe harbor under which foreign persons are not treated as engaged in a trade or business in the U.S. as a result of trading in stocks and securities (which includes debt instruments) for their own account.
However, if foreign persons originate loans in the U.S., the safe harbor described above will not apply. Therefore, in many cases, foreign persons will be deemed engaged in a trade or business in the U.S. by virtue of their U.S. loan origination activities, and their income from the loans therefore will be taxed as effectively connected income.
According to the IRS, this is the case even if the loans are originated by an independent agent of the foreign person.[5]
What if foreign persons purchase debt instruments and then renegotiate the debt instruments with the borrowers? Under U.S. tax principles, a significant modification of a debt instrument is treated as the exchange of one debt instrument, the unmodified debt instrument, for a new debt instrument, the modified debt instrument, and the extinguishment of the old debt instrument.
There is a meaningful concern that this may be treated as the origination of a loan in the U.S., which may cause the foreign persons to be deemed engaged in a trade or business in the U.S. and the income from the loans to be taxed as effectively connected income.
The issue of whether the modification of debt in the U.S. gives rise to a trade or business in the U.S. is not settled, and the analysis is highly fact specific. Foreign investors who anticipate engaging in such activity should consult with U.S. tax counsel beforehand.
Furthermore, it should be noted that even if a modification of the debt does not give rise to a trade or business in the U.S., if the modified debt has contingent interest (e.g., interest contingent on the cash flow of the debtor), this may not qualify for the portfolio interest exemption under the rules set forth above. Furthermore, if the foreign investors are given options or warrants in the debtor company, this may in certain cases cause the portfolio interest exemption to be inapplicable under the 10% shareholder limitation noted above.
Foreclosures
If the distressed debt instrument is backed by a mortgage on U.S. real estate, and the foreign investors foreclose on the mortgage, the foreign investors will wind up owning a USRPI. Under FIRPTA, the foreign investors will be subject to U.S. tax on gains from the sale of the USRPI.
Furthermore, if the foreign investors earn rental income from the property, the rental income may be classified as effectively connected income, taxed at graduated rates on a net basis, or, perhaps worse, subject to 30% withholding tax on the gross rental income. Similar concerns apply to the foreclosure on a mortgage backed by property used in a trade or business in the U.S.
Use of U.S. Blocker Corporations
If foreign investors are concerned that they may be engaged in activity that will cause their income to be effectively connected income (e.g., the origination or modification of debt, or the foreclosure on U.S. real estate), it may be prudent for the investors to form a U.S. corporation (sometimes referred to as a blocker corporation) to hold the debt.
This can prevent the foreign investors from having to file U.S. tax returns and may also help insulate the foreign investors' other activities from U.S. taxation. It may also be prudent for this U.S. corporation to, in turn, be owned by one or more foreign corporations, in order to protect the foreign investors from the U.S. estate tax.
As a further enhancement of the structure, it may be possible for the foreign investors to make portfolio interest loans to the U.S. corporation (assuming that the requirements set forth above are met), which may allow them to earn interest income free of U.S. federal income tax.
Other Considerations
Tax Treaties
The analysis above may change in some respects if the investors are resident in countries that are parties to income tax treaties with the U.S. For example, under the terms of a particular treaty, interest income may not be subject to the 30% withholding tax even if it does not meet the requirements for the portfolio interest exemption.
Furthermore, in certain cases, even if the U.S. activities cause the income from the distressed debt to constitute effectively connected income under regular U.S. tax principles, a treaty may prevent the income from being subject to U.S. tax. This analysis would have to be done on a case-by-case basis.
Alternative Structures
The above discussion does not cover all of the possible alternatives and permutations for foreign investment in distressed debt. For example, there are certain significant advantages that can be achieved by using a real estate mortgage investment conduit. A real estate mortgage investment conduit is a special purpose vehicle that is formed to hold a nontraded pool of mortgage loans and is generally exempt from entity-level U.S. tax. Similarly, a real estate investment trust may provide foreign investors with significant benefits.
Conclusion
With proper planning, there are many U.S. tax efficiencies that may be achieved by foreign investors in distressed debt issued by U.S. companies. However, it is critical that the foreign investors' income from the loans not be classified as income that is effectively connected with a trade or business in the U.S. This requires careful advance tax planning by foreign investors and/or the funds in which they invest.
Seth J. Entin is a partner at Holland & Knight LLP.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] See, e.g., "Cash Pours Into Distressed Real-Estate Funds as Investors Aim to 'Play Offense'," The Wall Street Journal, April 21, 2020.
[2] This alert only addresses certain U.S. federal income tax matters. It does not address other tax matters, such as U.S. federal non-income tax matters, state or local tax matters, or foreign tax matters.
[3] In the case of an obligation issued by a corporation, a 10% shareholder is any person that owns (directly, indirectly, or pursuant to certain constructive ownership rules) 10% or more of the total combined voting power of all classes of stock entitled to vote of the corporation. In the case of an obligation issued by a partnership, a 10% shareholder is any person that owns (directly, indirectly, or pursuant to certain constructive ownership rules) 10% or more of the capital or profits interest in the partnership.
[4] For this purpose, contingent interest includes, for example, interest that is determined by reference to: 1) receipts, sales, other cash flow, income or profits of the debtor or a related person; 2) a change in the value of property owned by the debtor or a related person; or 3) dividends, partnership distributions or similar payments made by the debtor or a related person.
[5] GLAM 2009-010 (Sept. 22, 2009).
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