Tax Exemption Tucked Into US Law Carries Cross-Border Benefits

Foreign lenders and US borrowers may learn that they qualify for a significant tax exemption if they take the time to examine whether they meet its complex and technical qualifications.

The US tax code imposes a 30% withholding tax on the interest payments paid by US borrowers to foreign lenders. This means that the borrower must hold back 30% of the interest payment and pay it to the Treasury Department instead of to the lender. This provision, even when a tax treaty reduces the withholding rate, makes it unattractive for foreign lenders to lend to US borrowers.

However, Sections 871(h) and 881(c) waive the withholding requirement for foreign individual and entity lenders in what’s known as the portfolio interest exemption. The entire interest payment goes to the foreign lender, making it tax-free to the lender and still deductible by the borrower.

Moreover, a foreign lender holding a portfolio debt investment is exempt from US estate and gift taxes when transferring the loan during their lifetime or upon death. Portfolio interest loans may also be used to protect assets from potential creditor claims.

Understanding the intricacies of the exemption takes some time and effort.

How to Qualify

To qualify for the exemption, a foreign lender can’t be classified as a controlled foreign corporation, which is a non-US corporation that is primarily owned and controlled by US shareholders, nor can it be classified as a foreign bank.

The foreign lender also can’t be engaging in a US trade or business, meaning that it’s in the business of making personal, mortgage, or other loans to the public. A lender making an occasional loan into the US is covered by the exemption, and a lender that consistently lends to US borrowers isn’t protected by the exemption.

A foreign lender that meets these requirements and owns less than a 10% stake in a US borrower qualifies. The tax code calculates the 10% threshold by pretending the lender owns shares or profits of others—such as family members, corporate parents, partnerships, and trusts—if the 10% threshold is met, restructuring the ownership structure of the US borrower or the foreign lender could solve the issue.

Foreign lenders who want to make more loans to US borrowers may want to set up a separate foreign legal entity to act as a lender for each loan. The additional cost of that will be far outweighed by the tax savings.

Structuring and Drafting

The loan transaction must be in registered form, much like a corporation keeps track of its shareholders in a registry. This means that the borrower must maintain a book of registry that lists the lender’s name, address, principal, and interest rate.

Foreign lenders must certify that they’re foreign individuals or foreign entities. And because they need to meet rigid standards to qualify, the drafter should include limits on how the loan can be transferred.

Loans that tie the interest amount to sales, cash flow, income, profits, or property value changes don’t qualify for the exemption. However, contingent interest loans can be modified to include simple interest features within the same loan documents to qualify for the exemption.

Make sure the loan terms stick to what banks usually do, such as keeping the loan-to-value ratio at around 80% and setting interest rates based on the current market. Using an escrow company to handle the loan funds and record the mortgage, along with a lender’s policy of title insurance, lowers IRS scrutiny for disguised gifts or equity investments.

When drafting deals secured by equity interests or accounts receivable, stick to the Uniform Commercial Code rules by drafting a solid security agreement, correctly attaching the security interest, and filing a UCC financing statement.

The parties need to treat this like a proper loan by sticking to the terms and pay late fees for overdue interest. Otherwise, IRS auditors may claim that the loan is a disguised equity investment or a gift.

Array of Benefits

Foreign lenders benefit from the portfolio interest exemption by boosting their investment returns without taking a tax haircut on the interest earned from US debt investments.

US borrowers benefit by deducting qualifying interest to reduce their tax bite and by protecting valuable assets from creditor claims with a completely transparent first-priority lien held by a favorable lender.

Cross-border families benefit by increasing their overall wealth. Instead of going to US banks for loans, US business owners with family ties abroad boost their family’s wealth by funding their business ventures, purchases, or investments from relatives overseas or their affiliated foreign companies.

The foreign family earns tax-free interest from the US, and the US family reduces their tax bite with interest deductions, thereby growing the multinational family’s overall wealth. Finally, a foreign individual lender can forgive the loan tax free during life or leave it as a tax-free legacy to US or foreign family members at death.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Leticia Balcazar is a tax attorney with more than two decades of expertise guiding international investors, particularly in the greater China and Southeast Asian markets.

Write for Us: Author Guidelines