Business and tax planning with the portfolio interest exemption.

• Author: Jordan, Brian K.

Generally, the United States imposes a flat tax rate of 30 percent on interest received from sources within the United States by a foreign payee, which is the obligation of the payor to withhold.[1] However, if the portfolio interest exemption applies, the flat tax rate of 30 percent generally will not apply.[2] Therefore, structuring a loan transaction to fit within the portfolio interest exemption has tax benefits for the American payor and the foreign payee. This article discusses the application of the portfolio interest exemption and the potential effects of any treaty between the U.S. and the pertinent foreign country when the portfolio interest exemption does not apply with respect to the interest received. It is important to note that the portfolio interest exemption does not extend to interest which is "effectively connected" with a U.S. trade or business.[3] The interest from loans made by foreign banks in the ordinary course of a U.S. banking business will be "effectively connected" to that business, and, therefore, not portfolio interest.

For purposes of this article, the term Code or I.R.C. refers to the Internal Revenue Code of 1986, as amended. The term limited liability company may be abbreviated and referred to as "LLC." U.S. Department of Treasury Income Tax Regulations may be referred to as "Regulations." The following example facts[4] illustrate the terminology and circumstances addressed in this article. A Florida limited liability company (the company) wishes to borrow money (the loan) from a foreign Country X corporation (the mirror lender), which loan essentially is a back-to-back loan because another foreign Country X corporation is the originating lender (the originating lender). The company has always filed its federal and state tax returns as a partnership, and, for purposes of U.S. and state tax law, is treated as a partnership. The loan will not be guaranteed. The interest on the loan will be set at a fixed rate and will not constitute "contingent interest." Neither the originating lender nor the mirror lender is a member of the company directly or indirectly. The mirror lender and the originating lender are not related entities. Neither the mirror lender nor the originating lender is a foreign bank.

Portfolio Interest Exemption

The Code provides an exemption from the flat tax rate (which generally is imposed on U.S.-source interest at a 30 percent rate but may be reduced by a treaty) for "portfolio interest" received from U.S. sources by foreign taxpayers.[5]

Portfolio interest is any interest[6] which is:

1) Paid on any promissory note or other obligation which is either

1. Issued in registered form to a foreign taxpayer, or

2. Part of an issue which is not in registered form and which is sold only to foreign persons with interest payable only outside the U.S. and possessions, and bearing on its face a statement that any U.S. person holding the obligation is subject to certain limitations, and

2) Not received by a 10 percent member of the payor.[7]

Even though there are two types of qualifying obligations ((a) and (b) above), in most instances this author believes it is preferable to utilize the broader class of debt, i.e., registered form, and, therefore, the analysis herein is restricted to registered obligations.[8]

An obligation is in registered form[9] only if:

1) The obligation is registered as to both principal and any stated interest and any transfer of the obligation may be accomplished only through the surrender of the old instrument and the reissuance by the issuer of the old instrument to the new holder or the issuance of a new instrument to the new holder by the issuer; or

2)The right to the principal of, and stated interest on, the obligation may be transferred only through a book-entry system; or

3) The obligation is registered as to both principal and any stated interest with the issuer (or its agent) and may be transferred through both of the methods described in paragraphs 1 and 2.[10]

Foreign Ownership. Foreign beneficial ownership of an obligation[11] (i.e., the loan) is the primary requirement for exempt portfolio interest. Exempt portfolio interest can be paid on the loan only if the loan is beneficially owned by foreign persons.[12]

Interest paid on a registered obligation qualifies as portfolio interest only if the U.S. withholding agent (e.g., the company) receives a statement,[13] made under penalties of perjury by the beneficial owner, certifying that the beneficial owner is not a U.S. person and documenting the owner's name and address.[14] The statement may be made on Form W8 or on a substantially similar substitute form.[15] There are time frames within which the Form W-8 or...