Private equity funds and the new portfolio interest Regs.

• Author: Keller, Brian E.

On April 12, 2007, the IRS issued final regulations that address withholding on interest earned by a partnership and allocable to the partnership's foreign investors (TD 9323). Regs. Sec. 1.871-14(a) provides that, as a general rule, no tax shall be imposed under Secs. 871(a)(1)(A), 871(a)(1)(C), 881(a) (1), or 881(a)(3) on any portfolio interest (as defined in Secs. 871(h) (2) and 881(c)(2)) received by a foreign person.

A private equity leveraged buyout fund is typically organized as a large limited partnership with a diverse, widely held limited partner investor base and one general partner (usually itself organized as a limited partnership). The limited partner base in a typical fund often includes a significant number of foreign investors. Prior to the issuance of these final regulations, it was unclear if U.S. withholding taxes were due in certain instances. At issue was the definition of "portfolio interest" when the interest is paid to a partnership with foreign partners (i.e., the typical fund).

Portfolio interest is not subject to U.S. withholding taxes. Interest that is not portfolio interest is subject to U.S. withholding by the fund on behalf of certain foreign investors. In addition to numerous other requirements (e.g., the debt must be in "registered form," interest must not be contingent, etc.) for interest to be classified as portfolio interest, the recipient cannot own more than 10% of the obligor (Sec. 871(h)(3)). Prior to the issuance of these final regulations, it was unclear whether this ownership test was applied at the partnership level (i.e., the fund) or at the individual partner level. In many instances, a fund will clearly own an interest in the obligor in excess of 10%. However, because the fund is widely held by a diverse limited-partner investor base, it might also clearly be the case that no one investor (including any one foreign investor) owns 10% or more of the fund itself. These final regulations make it clear that the 10%-ownership test is to be applied at the individual partner level.

Specifically, final Regs. Sec. 1.871-14(g) provides that, for purposes of Sec. 871(h), the term "portfolio interest" does not include any interest received by a 10% shareholder. The term "10% shareholder" means, in the case of an obligation issued by a...