The Portfolio Interest Exemption

Introduction

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.

Requirement For Registered Obligation

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.