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 that are traders of stock and securities from being subject to taxation. However, a similar exemption does not apply, generally, 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, the interest income would most likely not be subject to withholding under the “portfolio interest exemption,” providing a 0% tax rate to 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 be a capital gain sourced to the domicile of the non-U.S. investor.
Technically, one could buy and sell debt on the secondary market on a regular and continuous basis and not generate 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 in situations where 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 interest income is then taxed at the rates applicable under the terms of that 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, the types of funds that are transparent in the home jurisdictions would most often default to being treated as transparent in the United States. This may mean that a non-U.S. investor needs to file a tax return in the United States. To avoid this requirement, these structures often involve the investor investing through a separate entity, which is transparent in their home jurisdiction, but that checks the box to be treated as a corporation in the United States.
Bottom Line for the Bring Your Own Treaty Structure
In summary, the benefit of being able to qualify to have a manager be 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. There are several states that honor all federal tax treaties. Consequently, the fund would be considered transparent and as a result there would be no state tax liability. However, there are several states that do not honor the federal tax treaties, such as 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 us.
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