Many private equity (PE) and venture capital (VC) funds have had to consider the structuring of investments in loans, specifically loan originations, as it relates to their non-U.S. investors. The U.S. tax code provides an exemption for non-U.S. investors who are traders of stock and securities from being subject to taxation. However, a similar exemption does not generally apply to loan origination or financing activity that can give rise to a trade or business. For arrangements that are considered to be in the trade or business of lending, it may be a worthwhile effort to consider employing a treaty structure that maximizes the use of treaties in the U.S.’s network of tax treaties with other jurisdictions.
Understanding the Portfolio Interest Exemption
For a non-U.S. investor in a fund, interest income is generally not subject to withholding under the “portfolio interest exemption,” resulting in a 0% tax rate for non-U.S. investors who realize U.S.-source interest income and are not engaged in a U.S. trade or business. The ultimate sale of this debt instrument would constitute a capital gain sourced to the non-U.S. investor’s domicile.
Technically, one could buy and sell debt in the secondary market on a regular, continuous basis without generating income effectively connected with a U.S. trade or business. This is due to the Internal Revenue Code Section (IRC) 864(b)(2) safe harbor provision that excludes from the definition of the term “trade or business within the United States” trading for one’s own account through a U.S. broker or manager, so long as the activity does not rise to that of a dealer in stocks and securities.
When Do Investments in Loans with Non-U.S. Investors Give Rise to a Trade or Business of Lending?
Once a PE/VC fund has significant loan origination activity, it will be considered to be engaged in the trade or business of lending. As a result, the income will no longer be eligible for the portfolio interest exemption. If a non-U.S. investor is treated as engaged in a trade or business, then the non-U.S. investor can be required to file U.S. federal income tax returns on an annual basis and pay income taxes as if the investor were a U.S. resident. A non-U.S. corporate investor may also be subject to an additional 30% branch profits tax on the corporation’s effectively connected earnings and profits that are not reinvested in a U.S. trade or business.
How the Treaty Structure Helps
The non-U.S. investor benefits from employing a treaty structure when the portfolio interest exemption does not apply. The non-U.S. investor may rely on provisions in the U.S. network of tax treaties with other jurisdictions that also provide relief from taxation. In this area, various treaty structures rely on specific rules stating to the effect that a non-U.S. investor eligible for benefits under a treaty will not be subject to tax in the U.S. when treated as engaged in a U.S. trade or business, as a result of activities carried out on behalf of that non-U.S. investor through a so-called “independent agent.” If the non-U.S. investor realizes interest income as a result of activities of an independent agent, that income is taxed at the rates applicable under the applicable U.S. tax treaty, which in many tax treaties can be a 0% rate.
At a more granular level, having a treaty structure often involves a “bring your own treaty” structure.
The “Bring Your Own Treaty” Structure
The “bring your own treaty” structure seeks to secure capital commitments from investors who are eligible for the benefits of a tax treaty between their home jurisdiction and the United States. Those investors will typically be investing in a Cayman Islands or a Delaware Limited Partnership, and they will have general partners that are unaffiliated with the investment manager.
This fund structure relies on the need for the fund to be considered transparent in the investors’ jurisdiction. This is crucial in order for the fund itself to look through to the investors’ treaty to determine whether the benefits of that treaty are available to the income of the fund.
However, funds that are transparent in their home jurisdictions are most often treated as transparent in the United States. This may mean a non-U.S. investor must file a U.S. tax return. To avoid this filing requirement, a reverse foreign hybrid structure may be used. This involves a foreign entity that is treated as a corporation for U.S. tax purposes but considered transparent in the foreign owner’s home country. While this structure is effective for managing U.S. tax liabilities, it can raise issues with the branch profits tax under IRC Section 884. If the business profits are not attributable to a U.S. permanent establishment of either the entity or, in proportion, a treaty-qualified owner, then those profits may be exempt from U.S. tax under the Business Profits article, in line with the treaty-qualified owner’s interest.
Bottom Line for the Bring Your Own Treaty Structure
In summary, the benefit of being able to qualify to have a manager treated as an independent agent of a non-U.S. investor is that the investor is not treated as having a permanent establishment in the U.S. solely as a result of that agent’s activities. As a result, depending on the tax treaty, this will lower the tax rate but may not completely eliminate the liability.
Another consideration is the state in which your PE/VC fund operates. Several states honor all federal tax treaties. Consequently, the fund would be considered transparent, and as a result, there would be no state tax liability. However, several states do not honor federal tax treaties, including California and New York. States like this still consider this fund to be a check-the-box corporation and, therefore, subject to corporate tax on its income.
Working with an experienced tax team that understands both the international tax treaties and structures available, as well as potential state and local consequences of your fund’s activities, helps ensure your fund and its investors meet all requirements in both domestic and international jurisdictions.
For More Information
To learn more about the benefits of the “bring your own treaty structure” and its implications for your fund, please contact a member of our Private Equity & Venture Capital team.
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