International lending can be a very profitable venture, but an adventure in navigating the U.S. tax laws can be quite a perilous journey. The portfolio interest exemption is one of the strongest, but least understood exemptions. If set up properly, this exemption permits foreign individuals to make loans to U.S. borrowers without the withholding tax on interest payments. But strict compliance of portfolio interests and careful documentation of portfolio interest loan documentation cannot be compromised. One missing signature or misfiled form can break the exemption, resulting in hefty tax bills for the lender and borrower.
To make this complicated area easier to navigate, Leticia Balcazar offers expert advice on structuring cross-border loans that will pass the IRS muster. We have dissected the important components of portfolio interest compliance and the documents you don't want to miss.
A full understanding of the Portfolio Interest Exemption Rules
Portfolio interest exemption is granted to foreign persons on interest earned on certain foreign obligations as provided in Internal Revenue Code Sections 871(h) and 881(c). The rules are clear however, that the lender is not allowed to hold, or be able to hold, 10% or more of the borrower's voting stock, directly or indirectly. Moreover, the interest may not depend on the borrower's income, profits, or property's value increase.
The first step to portfolio interest compliance is determining the foreign lender's status. The loan must be issued in registered form (not bearer form), and the lender must provide a satisfactory statement that they are not a “10% shareholder” and are not a controlled foreign corporation related to the borrower.
Some of the main checks for compliance are:
- The confirmation by the lender that it is not a U.S. person and that it does not have any U.S. trade or business connected to the loan.
- Making it dependent on debtor receipts, sales or other measurements.
- The process of verifying the lending vehicle is not a conduit for disqualification of a disqualified person.
The requirements for documentaries for critical portfolio interests will be the same
Documentary requirements for critical portfolio interests will be the same.
The documentation is the main support of the exemption. The IRS has certain documents needed before, during and after the loan. You can't choose not to have portfolio interest loan documentation; that's the proof you need to beat withholding tax demands.
In the first place, the obligation itself should be declared as being in registered form in the contract for the loan. This means that the loan is registered on the borrower's books and transfers are subject to registration. Second, the borrower needs to obtain from the foreign lender IRS Form W-8BEN (or W-8BEN-E for entities) that contains a certification confirming that the lender is eligible for the portfolio interest exemption. This form is to be signed under penalties of perjury and shall be amended every three years.
Third, have a signed letter from the lender stating that he or she is not a 10% shareholder. This is included as an exhibit with many practitioners to the loan agreement.
Here are some key papers to have:
- Clearly recorded portfolio interest in registered form loan agreement.
- An IRS Form W-8BEN or W-8BEN-E with the portfolio interest exemption on Part II of the form.
- Ownership/disqualification certificate from the lender (also known as “10% shareholder statement”).
The most prevalent compliance pitfalls and what to do to prevent them.
Even the most advanced lenders have difficulty with portfolio interest compliance. An often-made error is using the old W-8. In case the form is lapsed, the borrower has to withhold 30% retroactively. One of the more common mistakes is not recording the “registered form” requirement which means that the agreement must be in writing or an informal promissory note is not acceptable.
Further, a 10% acquisition of the borrowing by the lender can cause the exemption to be lost. It is important that it is monitored continually. Certain cross-border restructurings, mergers or stock issuances may result in a person becoming disqualified by accident.
To stay safe:
- Schedule reminders to fill out W-8s (every 3 years).
- Ensure there are contractual covenants that would ensure that the lender immediately notifies the borrower of any change in ownership.
- Try to avoid loans where payments based on gross income or net profits (contingent interest).
Securing the cross-border loan is an excellent way to get a deal.Securing the cross-border loan is a great deal to get
Proactive structuring is much more than forms. When the lender and borrower both make a priority to ensure that their loan portfolios are in compliance, the result is a more tax-efficient loan, without needless withholding or IRS hassle. In private credit, in mezzanine financing and for real estate loans, foreign investment is often the norm – this is particularly important.
If borrowers in the U.S. do not pay the unpaid withholding tax (and interest and penalties), they may be liable for it. The loss of exemption would result in a 30% tax haircut on interest income for foreign lenders (and would be more complicated if there's a treaty involved).
Best practices include:
Getting legal and tax advice before entering into term sheets.
- Utilizing custodial/agent services to keep registered form documentation.
- Carrying out an annual compliance audit on a cross border loan by loan basis.
With a trusted specialist like Leticia Balcazar, loan documentation packages will be prepared to meet the IRS requirements, and also take care of commercial flexibility to make sure the portfolio interest exemption is utilized as planned.
Conclusion
Compliant with Portfolio interest compliance is no box-ticking activity, but rather a necessary step in any cross-border lending deal. The exemption is strong, but has to be carefully drawn and supported in substance and documentation. Every item needs to be duly executed and kept.Each item should be executed and maintained in a proper form.
Don't get caught out by potentially expensive surprises and ensure that the documentation of the interest that you receive on your portfolio is a key part of your lending strategy.
This is a set of questions that are asked often along with the answers
A1: The portfolio interest exemption could be applied by a foreign bank.
The portfolio interest exemption is not available to banks that make loans as a part of their trade or business. Lenders who are 10% shareholders, persons with a contingent interest or CFCs with U.S. connections are also disqualified.
Q2 If our W-8BEN form expires during our loan, what will be the consequences?
The borrower then has to start withholding 30% of the interest payments from the day the form expires until a new, valid form is given to them. If the borrower was already under obligation to withhold payment of the previous loan, he may also be responsible for the failure to do so on the previous loan. Penalties will be incurred if a renewal isn't made immediately.
Q3: If you have a convertible note or equity linked instruments, do you need to comply with portfolio interest?
Yes, but not that easy. If the instrument can be converted to stock, the lender could be considered to be a potential shareholder by the IRS. In order to qualify for the portfolio interest exemption, the lender must have no “right to acquire” 10% or more of the borrower's stock. Extraordinary structuring provisions on convertible debt like delayed conversion, third party equity holders, etc., are recommended to maintain the exemption.
