The private capital of foreign lenders who invest in the United States is exposed to a hidden tax burden of which many are unaware until their first interest payment is taxed. By default, the U.S. taxes interest paid to foreign persons as U.S. source income: and at a rate that, if not carefully planned, will take 30 cents of each dollar before it is received by the lender. The provisions that pertain to this field of law are very specific, very strict and completely insensitive to good intentions. But within these rules is a significant exemption that will remove the withholding tax burden for the right lenders – if and only if all the requirements are properly set up in advance. Knowing the lay of the land – the tax by default, the exemption from tax, and the ownership restrictions that rule out the arrangements that most people think of as eligible – is the key to developing a sensible U.S. lending strategy for a foreign lender.
The United States Method of taxing foreign lenders by default
The basic principle is simple though not necessarily its implications. Interest payments made by a U.S. borrower to a foreign person or entity are deemed to be U.S. source income, and are subject by default to a 30% withholding tax. This is the responsibility of the borrower, not the lender, that is, the U.S. party to the transaction is under common law duty to withhold the relevant tax on each payment and remit it to the IRS on schedule and file the relevant reporting forms, irrespective of any private agreement made between the parties.
It is this that would make U.S. tax on interest paid to foreign lenders to all types of private lending transactions, such as basic bilateral lending between related parties, to sophisticated multi-tranche financing structures between institutional investors. The 30% rate is not a negotiating tool – it is the starting point. It can be lowered, at times drastically, by treaties between the United States and some countries, but the treaty relief must be actively documented, formally certified by the necessary IRS forms, and must be available which not all foreign lenders will have. This is the only domestic law route that can result in full withholding tax elimination, when it comes to lenders in non-treaty countries, or those who want full exemption instead of a reduced rate.
The Exemption Pathway – and Who It was really intended to benefit
The requirements of the portfolio interest exemption were drafted with a particular type of lending structure in mind: arm-length transactions between unrelated parties, the type that defines the public bond markets and institutional debt investment. The typical qualifying lender is a foreign investor buying registered bonds of a U.S. corporation in a public offering without a stake in the company issuing the bonds. The exemption was created to ensure that U.S. debt markets are attractive to foreign capital by eliminating the friction of withholding tax that would otherwise render them less appealing than other markets of similar nature elsewhere.
To be considered as a qualified lending arrangement, all the conditions must be met at the same time and in full. The debt instrument should be registered form, that is, it should be formally registered with ownership being registered using an official system and not transferred by physical delivery only. A foreign lender should submit valid IRS certification of foreign status by submitting Form W-8BEN or W-8BEN-E, which should be submitted to the U.S. borrower prior to the first payment of interest. The lender should not be a bank which receives interest in the usual course of business under some structural arrangements. And the lender cannot have a disqualifying ownership interest in the U.S. borrowing entity – 10% or more of aggregate combined voting stock in corporate borrowers, 10% or more of capital or profits interest in partnership borrowers.
All these conditions are equal. A structure meeting four of five of the requirements, but not the fifth, is eligible to nothing– the entire 30 percent withholding rate is imposed as though no exemption attempt whatsoever had been made.
The Related Party Problem — Where the majority of Structures Fail noiselessly
Among all the conditions which control the exemption eligibility, the ownership condition qualifies more real-world lending programs than any other, and is the most overestimated at the beginning of the transaction planning. The name that is given to exactly this type of disqualified arrangement is related party portfolio interest: the lending cases in which the foreign lender has a substantial ownership interest in the U.S. entity that it is financing, where the failure to comply with all the formalities of the debt instrument completely disqualifies the exemption.
The parent company located in a foreign country loaning its subsidiary in the U.S. that is completely owned will fail the test of ownership instantly and wholly. A foreign investor that has a majority share in a partnership in the U.S. and at the same time lends to the same entity is subject to the same disqualification. Even when the loan documents are fashioned in a way that the family office that owns 15 percent of a U.S. real estate venture is allowed to receive and pay interest on the loan, the family office cannot claim exemption on the interest it receives.
The significance of this is that these are not edge cases or special constructions – these are used to characterize a very high percentage of the cross-border privately lent money which in fact occurs between foreign investors and U.S. businesses. Most of these structures were put together with limited understanding of the ownership limitation and in most cases by parties whose legal advice was of general commercial experience and not specifically of international tax expertise to recognize the disqualifying relationship prior to its entrapment in a multi-year lending relationship.
It is both technically tricky and costly to put the correction path in place, after a disqualifying structure has been created and money has started flowing without due withholding. Restructuring possibilities can be available – separation of ownership and lending relationships, addition of intermediary structures, or renegotiation of the terms of underlying investment, and lending structure – but none of these is easy, and none is cheap. Cost of prevention on the other hand is a small percentage of the cost of remediation.
As a Partner at Aliant Law, Leticia Balcazar, J.D., LL.M., specializes in international tax law and is one of the most specialized in the United States in the specific areas of foreign lending, the United States withholding tax law, and the structuring of cross-border loans. Having over 20 years of experience working on behalf of foreign investors, private lenders, family offices and international businesses throughout Asia, Europe and other regions of the world, she advises on the entire spectrum of portfolio interest planning; including initial ownership and eligibility analysis, full loan documentation and long term compliance plan. Having studied at Loyola Law School and Golden Gate University School of Law where she pursued her LL.M. in Taxation, and experience in the field as Deloitte Tax in Los Angeles, Leticia has a blend of technical expertise and transactional accuracy, which advanced cross-border lending requires. Her experience has been honed in Bloomberg Tax and her work with clients covers all aspects of inbound U.S. lending strategy. Assuming that your cross-border lending deal will include foreign capital, U.S. borrowers and interests that will have to be properly organized at the very start, you will be right in hiring Leticia Balcazar as the counsel your deal will be worth.