When a foreign person or organization loans funds to a U.S. borrower, the interest payments being returned back across the border, do not escape the IRS notice. Actually, the U.S. levies withholding tax on such payment. To the managers of international lending arrangements, the portfolio interest of related party portfolio interest is not something to learn about, but a must. Luckily, there are certain clauses in the U.S. tax code that can greatly ease this burden or even remove it altogether, serving as a strategic tool for those who know the proper circumstances of financial harmonization.
The fundamentals of the U.S. Withholding tax on interest.
Under the default setting, a U.S. individual or company that remits interest to a foreign lender will be subject to a 30 percent withholding tax under U.S. federal law. This may be lowered with the help of tax treaties between the United States and the country of residence of the foreign lender – usually to 15, 10 or no tax at all in some instances. But, treaty benefits are not automatic. The foreign lender is required to take up the initiative to claim them by submitting the relevant documentation, which is usually the IRS Form W-8BEN or W-8BEN-E to the U.S. borrower prior to payments.
What most foreign lenders and their advisors fail to understand is that in addition to the benefits of the treaties, there are structural exemptions that are directly provided in the U.S. tax law that can either do away with withholding tax altogether without the need to use a treaty at all. The portfolio interest exemption is one of the most strong and one of the most misconceived of them.
Learning about the Portfolio Interest Exemption.
Portfolio interest exemption enables a part of interest payments to foreign lenders to be fully exempted of the U.S. withholding tax. In order to be eligible, the debt instrument must be in registered form – i.e. the ownership of the debt must be registered and can only be transferred by way of a formal registration system – and the foreign lender must not be a 10% shareholder of the U.S. borrower. This is the threshold of ownership which many cross-border lending arrangements are taken aback by.
This is where the notion of related party portfolio interest comes into play of paramount importance. This exception was intended to be applied in arm-length lending situations, including bonds sold to foreign investors, who were not related parties, in open markets. It was not aimed at enriching foreign lenders who have large ownership shares in the U.S. company that they are lending to. The portfolio interest exemption is not available at all when the proportion of voting stock of the U.S. corporate borrower, or of capital or profits interest, is 10% or greater of the total: (a) in a U.S. partnership; or (b) with a foreign lender owning 10% or more of the total stock in the U.S. corporate borrower. The interests are once again subject to full taxation in accordance with normal withholding provisions.
This difference makes a great difference in practice. Most of the cross-border business structures include parent companies, affiliated funds or family-related entities lending to the subsidiaries or partners of the U.S. Under such circumstances, ownership relationship has to be scrutinized and then it has to be assumed that it is treated tax-free.
The Implication of this on the Structure of Cross Border Loans.
The implications of the regulations regarding taxation of interest paid to foreign lenders by U.S. have a practical implication on how international business dealings ought to be set up at the very onset. A foreign parent company making a loan to its U.S. subsidiary can not assert the portfolio interest exemption, irrespective of the way the debt instrument is recorded. The 30 percent withholding tax or a lower rate specified in the treaty, would be paid on all interest payments.
The exemption can be a valuable planning tool to lenders and other investors who do not have a significant ownership in the U.S. borrower. Well-designed debt instruments sold to foreign investors that are not related can earn fully exempt interest which allows U.S. investments to be much more attractive on an after tax basis.
The planning lessons learned are simple. The initial point is that, when structuring any kind of cross-border loan, it is always necessary to analyze the relationship between the foreign lender and the U.S. borrower in terms of ownership. Second, have debt instruments duly registered in writing to maintain exemption (in certain instances). Third, consider treaty rates as they may also be of real use when the portfolio interest exemption does not apply, even when the interest rates are not covered by treaties. Fourth, do not presume that no interest payment is made without a thorough examination to the cost of such a mistake can be quite high and may include back taxes, interest and penalties.
Before you lend, Seek Expert Guidance.
The cross-border lending practice is on the border of the international tax law, treaty interpretation, and the prudent structuring of transactions. The regulations are technical, the stakes are high and the details count a lot. A lapse in ownership analysis or documentation procedure can result in a costly compliance issue in the form of a tax-efficient loan.
Leticia Balcazar is an authoritative figure in international tax consultancy, having assisted foreign lenders, multinational corporations, and cross-border investors to understand the intricacies of the U.S. tax on interest paid to foreign lenders law clearly and confidently. Whether you are designing a new lending package, an existing package, or just attempting to comprehend what you must do, Leticia Balcazar offers the professional and personalized advice that you will require to make appropriate decisions and remain in full compliance.
