The IRS Office of Associate Chief Counsel (International) recently issued CCA 201501013 (the “CCA”), in which they concluded that the activities of an offshore fund manager with a US office (the “Fund Manager”) should be attributed to a private fund (the “Fund”). As a result, the IRS found that the Fund was engaged in a US trade or business. The IRS further concluded that the Fund’s underwriting and lending activities were not eligible for the stock and security trading safe harbors of Code Section 864(b)(2)(A) (“Trading Safe Harbors”), as the IRS found it was engaged in an active lending business. The effect of the IRS’s conclusions was that any foreign investor of the Fund would be subject to US federal income tax, and where the foreign investor was a foreign corporation, possibly also a 30% branch profits tax.
The CCA addresses what appears to be a typical offshore private fund structure. The Fund at issue in year one was organized as a US limited partnership and then, in year two, converted to a foreign partnership. The CCA mentions that one of the limited partners of the Fund was a foreign feeder fund, organized as a foreign corporation (the “Foreign Feeder”). It is this Foreign Feeder that presumably would be subject to tax on the Fund’s effectively connected income. Presumably, the Foreign Feeder would serve as a blocker corporation through which the foreign investors would invest. The Foreign Feeder was the only limited partner of the Fund that was mentioned in the CCA.
The Fund had no employees and conducted all of its activities through the Fund Manager. The Fund Manager conducted the activities primarily through an office in the United States. The Fund Manager did not work exclusively for the Fund, as it also provided similar services to other investment entities. The Fund Manager employed numerous employees in the US, and no employee worked exclusively for the Fund.
The Fund engaged the Fund Manager as an investment manager pursuant to a management agreement and appointed the Fund Manager as its “agent and irrevocable attorney in fact with full power to buy, sell, and otherwise deal in securities and related contracts for Fund’s account… and [t]he full power and authority to do and perform every act necessary and proper to be done as fully as Fund might or could do personally.” Pursuant to this grant of authority, the Fund, through the Fund Manager, engaged in lending transactions and stock distribution (i.e. underwriting) activities.
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With regard to the lending activities, the Fund, through the Fund Manager, negotiated with unrelated borrowers concerning all key terms of the loans, conducted extensive due diligence on potential borrowers, lent them money, and obtained discount conversion prices or warrants with its loans. The loans were mostly convertible debts and promissory notes. Typically, the conversion prices for converting the loans to equity were discounted from the trading price for the stock. This spread was possible as a result of the loan negotiations. The Fund would immediately sell the shares after exercising a conversion right, earning a spread by quickly disposing of the stock. In addition, the Fund received various fees from the borrowers. The CCA did not elaborate on the number of loans made by the Fund in the years at issue. It also did not provide any details as to loan amounts.
With regard to the underwriting activities, the Fund, through the Fund Manager, underwrote the shares of US companies for sale to both US and foreign customers. The Fund Manager negotiated the terms of these agreements directly with the issuers. The issuers had to register with the SEC so that the Fund could sell the shares into the US market and pay the advances requested by the issuers. The Fund would make money on the spread of the shares sold (because the Fund purchased the shares at a discounted price below the stock’s market value). The Fund also earned fees for commitment, structuring, and due diligence.
IRS’s Three Conclusions
Based on the foregoing facts, the IRS reached three conclusions.
1 - The Fund was Engaged in a US Trade or Business
The IRS found that the Fund was engaged in a US trade or business. Because the Fund Manager was the Fund’s legal agent under the management agreement, the IRS found that the US activities of the Fund Manager were attributable to the Fund. Relying on the general case law and authority that the activities of an agent are attributable to the principal, and given the Fund Manager’s “full power and authority to do and perform every act necessary and proper to be done as fully as Fund might or could do personally,” the IRS found that the activities of the Fund Manager should be attributed to the Fund. Second, the IRS, citing to De Amodio v. Commissioner, 34 TC 894 (1960), found that the activities of the Fund were “considerable, continuous and regular” where the Fund made loans to unrelated borrowers, entered into various Distribution Agreements, actively solicited potential borrowers and issuers, negotiated with counterparties, and performed extensive due diligence.
2 - The Fund’s Activities Were Not the “Trading in Stocks or Securities” Within the Meaning of the Trading Safe Harbors
The IRS found that the Fund’s lending and stock underwriting activities were not the “trading in stocks or securities” within the meaning of the “Trading Safe Harbors.” First, the IRS found that because the Fund was actively soliciting unrelated borrowers in the US and made a number of loans, the Fund was engaged in the active conduct of a banking, financing, or similar business. The IRS, without elaborating, concluded that the loans to the unrelated parties were loans to the public, and was likewise silent on the number of loans that created this lending business.
Second, the IRS found that the Fund’s underwriting activities did not fit within the limited underwriting exception of Treasury Regulation Section 1.864-2(c)(2)(iv)(b)(1), which provides that a foreign underwriter will not be treated as
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engaged in a US trade or business where they act as an underwriter for the purpose of making a distribution of stocks or securities of a US issuer only to foreign purchasers. The IRS found that, because the Fund also sold the shares to US purchasers, it did not meet this limited exception.
Third, the IRS took the position that the Fund’s resale of the securities obtained at a discount (whether through its lending activities or its underwriting activities) would not qualify as securities trading because it profited from its activities by earning fees, interests, and a spread, and not pure market appreciation as is typically how traders earn money. Rather, the Fund was acting as a dealer in the securities.
3 - Even if the Fund’s Activities Were “Trading in Stocks or Securities,” Neither of the Two Trading Safe-Harbor Exceptions Would Apply
The IRS concluded that even if the Fund’s lending and stock underwriting activities were “trading in stocks or securities” for the purposes of the Trading Safe Harbors, neither of the two exceptions would apply. Had one of the two Trading Safe Harbors applied, the Fund’s trading could have been exempted as a US trade or business.
The first exception exempts trading as a US trade or business when trading through a US broker, commission agent, custodian, or other independent agent. A grant of discretionary authority to the US broker will cause the foreign taxpayer to fall outside of this exception. The IRS found that the Fund was not eligible for this exception because the Fund had no employees of its own and instead conducted its business entirely through the Fund Manager, which had discretionary authority.
The second exception exempts trading in securities for the taxpayer’s own account as a US trade or business, regardless, whether the trader uses a US broker or its employees and regardless of whether its agent has discretionary authority, provided that the taxpayer is not a dealer. Thus, while this exception does permit the grant of discretionary authority, it is not available for dealers. The Treasury Regulations under section 864 define a dealer as a “merchant of stocks or securities, with an established place of business, regularly engaged as a merchant in purchasing stocks or securities and selling them to customers with a view to the gains and profits that may be derived therefrom.” The IRS concluded that the Fund was a dealer because it was purchasing the shares as a merchant as indicated in the above definition and as underwriters typically do, and selling the shares into the US market. The regulations provide two narrow exceptions to the definition of “dealer”, and the Fund did not fit into either. The first exception would apply if the Fund were not selling to US customers, even if another member in the group were selling to US customers. Because the Fund was selling to US customers, this exception did not apply. The second exception likewise did not apply, as the Fund was not trading for customers that were not themselves dealers, investment partnerships, or foreign corporations.
Thus, based on the above, the IRS concluded that the Fund was engaged in a US trade or business and was engaged in a lending and underwriting business. The Foreign Feeder, as a limited partner in the Fund, was deemed to be engaged in a US trade or business.
The CCA is not law and merely represents the IRS’s position. However, it is a reminder that the trading exception generally does not extend to the activities of lenders and securities dealers.