Fund Investors Need To Know These Limits Of Portfolio Interest Exemption

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New Section 163(j) Interest Limits

The Budget Fiscal Year 2018 made drastic changes to Internal Revenue Code (“Section”) 163(j)
If the gross income of a taxpayer is less than $25 million, these new rules do not apply.

What Is Section 163(j) All About?

It is also known as earning stripping limitations. According Castro and CO  The legislative purpose with it is to prevent erosion of a form’s taxable income through over-leveraging with excessive debt capitalization.  Section 163(j) was added to avoid the following by analyzing the company’s debt-to-equity ratio.

Load a subsidiary company with massive debt.
When the subsidiary makes $100 in profit, it is zeroed-out with a $100 deductible interest payment to its foreign parent company
The parent company is in a treaty jurisdiction for which the treaty lowers the withholding rate.
The result is that the US subsidiary has zero taxable income

It was straightforward to avoid the old Section 163(j).

  • Many income tax treaties allowed taxpayers to circumvent the limits.
  • With proper planning working with related parties that were not technically related in respect to the meaning of Section 276(b), it was easy to reduce ownership in the US subsidiary.

New Section 163(j)

To simplify, it limits your ability to deduct business interest to 30-percent of your “adjusted taxable income.”

  1. It is essential to understand the legal meaning of ‘business interest.’
  2. Business interest income is added back not to fall under the 30% cap.
  3. Floor plan finance is disregarded.
  4. The manner adjustable taxable income is determined to apply the 30-percent limitation, affords many planning opportunities.

Business Interest (BI)

BI includes all interest payments made except for ‘investment interest,’ which is exempt.  Take note: since Portfolio Interest has always been recognized as investment interest, a significant planning opportunity arises here.



The Calculation Of Adjusted Taxable Income

One way to approach this is by fragmenting the company. If you leave all the income in one entity and isolate all the expenses into another entity, to inflate the income of the entity incurring the interest expenses.  This is what Section 163(j)(8)(A)(i) specifically refers to as any “deduction or loss, which is not properly allocable” to the business. With careful restructuring using flow-through entities and consolidated compliance elections, lawful avoidance of Section 163(j) is possible.


Many businesses are exempt.  A real property trade or business can make an election under Section 163(j)(7)(B) to be exempt from the new Section 163(j) limitations.

What Does it Mean?

It means a real estate business could use earnings-stripping strategies to reduce its entire US tax base and pay zero federal income taxes.

More exempt enterprises:

  • Farms
  • Energy Providers
  • Water & Sewage Services


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The Portfolio Interest Exemption


Some countries do not tax their citizens on the interest income from foreign sources. This makes it very enticing to lend money to foreign nationals. As long as they can invest in countries with a robust and comprehensive civil legal system that upholds the rule of law, this is a perfect opportunity.  This makes lending money to US citizens a fit.  One such country is Hong Kong.

Things are complicated since the US subjects interest payments from the US to foreign nationals, to a 30-percent withholding tax rate.  Tax treaties can lower this withholding rate.  Since Hong Kong is a Special Autonomous Region (SAR) the US Chain Income Tax Treaty does not apply in this instance.  As a result, Hong Kong investors created special purpose intermediaries in Luxembourg and Cyprus that have income tax treaties with the US that lowers the withholding tax rate on interest income leaving the US to 0%.

In the meantime, Luxembourg and Cyprus passed domestic legislation to facilitate transactions like these – in principle, these are state-sponsored tax avoidance.

The Hong Kong Investors can now make a loan to the intermediary in Luxembourg or Cyprus, which facilitates credit to the person in the US.

When the US person makes interest payments on the loan, there is no withholding tax because of the treaty benefits – since the destination is a company established in a treaty country that satisfies the Limitation on Benefits provision of the income tax treaty.  In turn, the Luxembourg entity forwards almost the entirety of the interest to Hong Kong tax-free, too.

Congress, aware of the economic benefit of the scheme to facilitate foreign investment, decided to simplify the process by creating the so-called Portfolio Interest Exemption, limited by several restrictions and requirements, including the requirement that the debt obligation must be in registered form.


A debt obligation qualifies as a registered obligation if :

  • It is registered with the issuer’s agent with a clearly stated principal amount and interest rate transferable only by surrender of the original debt instrument and re-issuance to the new holder, which is like a debtor-register program.
  • It is registered in a book-entry system and beneficial ownership to the debt obligation’s principal and interest can only be transferred through a book-entry system maintained by the issuer’s agent, which serves to identify and track beneficial ownership of the obligation

In other words, Congress created a network of tracking of the beneficial ownership of debt obligations to qualify for the Portfolio Interest Exemption.

A beneficial owner is a person who is the owner of the income for tax purposes (required to include it in gross income under section 61)and who beneficially owns the income (so not a nominee or agent or custodian).

Restrictions Limits & Opportunities

The code prohibits a 10% or greater shareholder from claiming the Portfolio Interest Exemption.  With proper tax planning, it can become possible, however.

The legal definition of a related-person in terms of Section 267(b) in respect of family members does not include in-laws.  Similar exceptions exist concerning the relationships between entities. Bearer bonds are not eligible, and neither does interest paid to a bank for a loan in the ordinary course of its business.

More limits apply to the use of contingent interest.  Contingent interest is basically dividend payments disguised as interest for the sake of obtaining the favorable tax treatment of interest.  There are ways to structure interest to qualify. If, for example, you can identify other unrelated companies in your industry whose financials are public, you can tie the interest to those companies, just as long as it is not the borrower’s financials.

Loans with indexed rates and mandatory convertible notes repayable with the issuer’s stock or proceeds of the sale of the stock, have been recognized as debt instruments by the IRS and would provide stronger corporate rights.

Loans with an equity kicker will be disallowed to the extent attributable to profits.  It is all about planning.

To Combat The Use Of finance Subsidiaries In Luxembourg

Treasury promulgated the Multiparty Conduit Financing Transactions to this end.  The regulations state that when a financing party uses an intermediary financing entity to finance the target entity pursuant to a tax avoid-ant plan, then the IRS can re-characterize the interest payment to the intermediary financing entity in the tax-favored jurisdiction as a payment to the real financing party.

If the intermediary entity is unrelated and the terms of the loan are arm’s length, then it is unlikely that you will be challenged; the IRS cannot detect you across arms-length transactions, because all of the records and evidence of receipt and re-lending of funds are in a foreign jurisdiction.

Click Here For Tax Planning For U.S. Hedge and Private Equity Funds


A US borrower that wants to make interest payments to foreign persons, especially if the debt owner is from a treaty country and claiming a reduction in withholding tax, he must obtain a statement on Form W-8BEN from the foreign lender that the beneficial owner is not a US person.

When a US subsidiary borrows from a foreign corporation, then the interest payments are subject to gross-basis withholding tax, even if the foreign corporation sells or lends the note to a third-party who makes identical payments and if the foreign corporation has the discretionary right to repurchase the note after a specific time.  This is known as a sale-repurchase transaction, and the IRS will re-characterize the substitute payments as interest payments from the payer to the valid beneficial owner of the note. Click to mail us and create the best tax plan for you hedge and private equity funds

Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intends for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services.  This article cannot serve as a substitute for such professional services or advice.  Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation.  This article is subject to change at any time and for any reason.


Thanks to FAS & CPA Consultants and Fulton Abraham Sanchez, CPA, I was able to resolve a debt of $479,677.71 that I had with the IRS.

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Fulton Abraham Sanchez, CPA

Fulton Abraham Sánchez, CPA I am Certified Public Accountant, specialized in Tax Planning & Offshore Strategies for Real Estate, Hedge/Equity Funds, Fintech, Crypto, Expats, IRS Debt Resolution. You can email me fa@fascpaconsultants.com and follow us on Facebook : FAS CPA & Consultants.

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