Withholding exemptions to cross border interest payments
The US taxes foreign non-resident individuals and foreign entities on two type of income. First, effectively connect income (ECI) is active business income that is subject to US income tax. Second, fixed, determinable, annual or periodic income (FDAP) or what we would generally consider portfolio income is subject to a withholding tax regime. This article is going deal with interest paid by a blocker corporation which is subject to the withholding tax regime.
Investment Structure for US inbound real estate investment
In the typical inbound U.S. real estate investment structure, a US corporation (known as a blocker because the corporation as a taxable entity, blocks the income from being taxed offshore) is owned by one or more foreign corporations. In a significant number of cases, the foreign parent corporation will be incorporated in a non-tax jurisdiction such as the Cayman Islands. The foreign parent(s) fund the blocker with a combination of debt and equity, and the debt will provide deductible interest expense which will help shelter the income from the US real estate. With proper tax planning the foreign parent’s interest income will not be subject to US withholding tax.
The general rule is that the interest payments to the foreign parent are FDAP and subject to a 30% withholding tax. The 30% withholding is required to be paid directly to the IRS before the interest is paid offshore. Thus, the parent corporation would only receive 70% of any interest paid. There are two exceptions to the general rule, the portfolio debt exception and certain preferential tax treatment based on a treaty between the US and the jurisdiction of the parent corporation.
Portfolio Debt Exception
Portfolio interest is entirely exempt from the 30% US withholding tax. To qualify as portfolio interest, the loan must be from a foreign lender and the following requirements must be met:
- The interest is paid on debt that is in registered form.
- The loan cannot be from a bank lending in the ordinary course of business.
- The foreign lender does not own 10% or more of the voting stock of the blocker corporation directly or indirectly.
- The interest payments cannot be contingent.
The portfolio debt exception does not rely on any treaty. Therefore, it applies to lenders from any foreign country.
Ten Percent Voting Stock Ownership Rule.
Most of the structuring to qualify for the portfolio exemption revolves around making sure that the foreign lender does not own 10% or more of the voting stock of the blocker corporation either directly or indirectly. The 10% testing is done at the shareholder level of the foreign parent and the shareholders are considered to proportionately own stock held by that corporation. In testing for ownership, there are attribution rules that apply and can make the calculations quite complex. For example, a son is deemed to own the stock held by his father, any person holding options to purchase stock are treated as owning the stock, partners in a partnership are deemed to hold a ratable share of the stock held by the partnership, etc.
For planning it is essential that the blocker receive a schedule prepared by the owner of the voting shares at the inception of the transaction and annual updates to assure the foreign lender does not own 10% of the voting shares directly or indirectly. If it later turns out that the foreign lender owns 10% of the voting shares of the blocker, then the blocker will have secondary liability for taxes not withheld.
If all or a portion of the interest payments consist of contingent interest, the interest does not qualify for the portfolio debt exception, but may still qualify for a reduced withholding rate under an income tax treaty.
Contingent interest is defined as any interest if the amount of such interest is determined by reference to:
- Any receipts, sales, or other cash flow of the blocker
- Any income or profits of the blocker
- Any change in value of any property owned directly or indirectly by the blocker
- Any partnership or LLC distributions received by the blocker
The interest may still be exempt or subject to a reduced tax rate under an income tax treaty even if the portfolio debt exception does not apply. If a treaty provision is used, the foreign corporate lender can own 10 percent or more of the voting stock of the blocker. Contingent interest does not qualify under the portfolio interest exception. However, some treaties allow contingent interest to be tax free.
FDAP and FATCA IRS Foreign Status Forms
The blocker needs to receive a completed and signed Form W-8-BEN-E from the foreign lenders notifying it of the lenders foreign status to comply with the FDAP withholding rules and the FATCA requirements. Under the FATCA rules, the 30% withholding tax is required unless the W-8BEN-E form has been properly filled out and provided to the withholding agent prior to the interest being paid. Some of the information that must be provided on the form are the foreign lenders FDAP and FATCA status codes, and their global identification number. The withholding agent does not file this form with the IRS, but they will keep it in their files in case audited by the IRS. The W-8BEN-E also needs to be updated every three years. If the blocker cannot produce the W-8BEN-E on audit, the IRS will assess the 30% withholding tax.
Annual Tax Forms for Foreign Person’s US Source Income Subject to Withholding
The blocker will prepare and file IRS Forms 1042 and 1042S annually, informing the IRS of the amount of interest it paid the foreign lenders. Any exemption or reduced rate of withholding will be noted on the form when filed. The forms also provide the IRS the FATCA information that it requires.
Foreign corporate parent lenders to inbound US real estate blockers can avoid withholding tax under the portfolio debt exception or a tax treaty with proper tax structuring, documentation and compliance. It is important to make sure everything is in order and properly documented prior to any interest payment being made.
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