July 16, 2020
Tax Benefits for International Investors: The Portfolio Interest Exemption
Many investors may be surprised to learn that the U.S. Internal Revenue Service (“IRS”) allows certain international investors to pay absolutely no U.S. tax on interest they receive from some common forms of debt to U.S. borrowers. Most U.S. taxpayers are taxed at the highest applicable rates on the interest from these debt instruments while foreign persons receive the interest from the exact same debt instruments tax free.
This unique vehicle is called “Portfolio Interest” and is described in Internal Revenue Code (“IRC”) Sections 871(h) and 881(c) for non-resident aliens and corporations, respectively. The favorable treatment of this special kind of interest under the Internal Revenue Code also extends to the estate tax as the underlying loan instruments are exempt from the estate tax.
In addition to its tax-free nature, Portfolio Interest requires no Form 1042 (Annual Withholding Tax Return for U.S. Source Income of Foreign Persons), or Form 1042-S (Foreign Person’s U.S. Source Income Subject to Withholding) and absent other sources of income no U.S. tax return filing.
The requirements for interest to qualify as tax-exempt Portfolio Interest can be summarized as follows:
- The borrower must be a U.S. person. See IRC § 871(h)(2)(B)(ii)(I).
Loans to U.S. corporations, limited liability companies, partnerships, etc. all qualify so long as the borrower is a U.S. person.
- The investor must be a foreign person that provided proof of its foreign status. See IRC §§ 871(h)(2)(B)(ii)(I) & (II), 881(c)(2)(B)(ii)(I), (II), 871(h)(5).
This requirement is satisfied for individuals that are not U.S. citizens or residents by submitting Form W-8BEN to the lender or its agent (i.e. not to the IRS). The applicable form for foreign entities is Form W-8BEN-E.
- The investor cannot be a bank extending credit in the course of its ordinary trade or business. See IRC § 881(c)(3)(A).
- The investor cannot be related to the borrower if the foreign person is a Controlled Foreign Corporation (CFC). See IRC § 881(c)(3)(C).
This requirement does not apply to individuals and will be satisfied for foreign entities so long as they are not controlled by U.S. shareholders.
- The investor cannot be a “10-percent shareholder” in the borrower at the time the interest is received. See IRC §§ 871(h)(3), 881(c)(3)(B).
This requirement would not be met if the investor beneficially owns 10% or more of the borrower’s equity.
- The underlying loan must be in “registered form.” See IRC §§ 871(h)(2)(B)(i), 881(c)(2)(B)(i), as defined by IRC §§ 163(f), 871(h)(7), 881(c)(7).
The loan documentation will contain disclaimers that the loan may not be transferred to U.S. persons and the borrower or agent must keep a register of all investors and restrict transfers to U.S. persons (which are possible but would trigger a U.S. tax liability for such U.S. transferee).
- The interest must not be contingent interest (with some exceptions). See IRC §§ 871(h)(4), 881(c)(4).
The loan must have a fixed interest rate that does not depend on the borrower’s cash flows, e.g. it cannot replicate a dividend. Floating-rate loans, e.g. paying interest at a spread over a reference rate, do qualify as portfolio interest, because the floating rate does not depend on the borrower.
- The foreign country of the creditor cannot have inadequate information exchange with the U.S. See IRC §§ 871(h)(6), 881(c)(6).
This requirement is generally met for all countries that report information on U.S. persons to the IRS.
- The interest must be passive as it cannot be income “effectively connected” to a U.S. trade or business (ECI). See IRC §§ 871(a), 881(a), 871(h), 881(c).
The investor cannot make so many loans to U.S. borrowers such that it would be considered a loan origination business. The U.S. Tax Court concluded that one loan from a foreign person to a U.S. taxpayer did not rise to the level of a trade or business. The IRS has mentioned the magic number “five” in a private letter ruling.
The main goals of these provisions are to ensure that (1) U.S. persons do not benefit from the tax free interest, and (2) the underlying debt is not like equity in the hands of the holder.
In addition to direct loans, the Portfolio Interest exemption applies also to loan participations that pass through interest received from the borrower by the lender to, ultimately, the investor.
Note however, that the exemption from U.S. taxation has no bearing on the taxation of the investor’s home country.
Chicago Atlantic Group, LLC and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
 The terms “borrower” and “investor” are referred to in the IRC as “issuer” and “holder” of the debt obligation in question.