In Chief Counsel Advice 201501013 (CCA), issued on January 5, 2015, the Internal Revenue Service (IRS) considered whether a fund manager (US Manager) that made loans and acted as a stock underwriter through its US office and as an independent agent on behalf of a foreign fund (Fund) caused the Fund and its foreign feeder (Foreign Feeder) to have a US trade or business under the Internal Revenue Code of 1986, as amended (Code). While some of the facts of the CCA are not typical in the hedge fund industry, it presents the most complete analysis to date by the IRS of funds engaged in lending activities. Most importantly, the CCA encourages IRS field office agents to obtain guidance from the National Office regarding funds involved in lending activities, signaling the IRS's intent to pursue this issue aggressively.
While the CCA is not binding precedent, it presents the IRS' views and conclusions on the following issues:
- Did the Fund have a US trade or business? Yes, the US Manager held the Fund out to the public as a lender and stock underwriter that caused the Fund to have a US trade or business.
- Do the Fund's activities (through the US Manager) qualify as "trading in stocks or securities" under Code Section 864(b)(2)(A)(i)? No, the Fund is a dealer and not a trader because it profited from its lending and underwriting activities by earning fees and a spread on convertible debt and stock and not merely through market appreciation. In addition, the Fund's activities do not qualify as "trading in stocks or securities" because (1) the Fund's lending activities constitute the active conduct of a banking, financing, or similar business; and (2) the Fund's stock underwriting business does not fit within the narrow circumstance under which a foreign underwriter can qualify for the trading safe harbor exceptions.
- If we assume that the Fund's activities do qualify as "trading in stocks or securities," does the Fund satisfy the requirements for either of the two safe harbor exceptions to having a US trade or business under Code Section 864(b)(2)(A)? No, the Fund does not qualify for (1) the first safe harbor because the US Manager had discretionary authority to conduct the lending and stock underwriting activities on behalf of the Fund such that the US Manager is not an independent agent under the first safe harbor; or (2) the second safe harbor, because its stock underwriting activities make it a dealer.
The Fund was formed in a foreign jurisdiction and was treated as a partnership for US tax purposes. The Foreign Feeder, a limited partner in the Fund, was formed in a foreign jurisdiction that does not have an income tax treaty with the United States. The Foreign Feeder was treated as a corporation for US tax purposes. Under a management agreement with the Fund, the US Manager agreed to act as agent with authority to buy, sell, and otherwise transact in securities for the Fund's account. The US Manager provided similar services for other investment entities. The US Manager conducted an extensive lending and stock underwriting business through its US office on behalf of the Fund. In the lending business, the Fund made loans in exchange for promissory notes, convertible debt instruments with discounted conversion prices determined at the time of conversion, or warrants to purchase additional shares of the borrower's stock. The Fund received various fees from the borrowers. In the stock underwriting business, the Fund signed distribution agreements with unrelated issuers allowing the issuer to issue and sell its stock periodically to the Fund for a specified purchase price, a portion of which the issuer can request as an advance after filing a registration statement to register its stock for resale by the Fund. The Fund purchased the issuer's stock at a discount, sold it to the public at its market price, and earned a spread on each share sold plus fees from the issuer.
If the Fund's activities rise to the level of a US trade or business, the Foreign Feeder, as a partner of the Fund, would also be treated as having a US trade or business and would be allocated its share of income from the Fund that is considered effectively connected income (ECI) to such US trade or business. The Foreign Feeder's ECI would be subject to US tax at a 35 percent rate (subject to withholding by the Fund), plus potentially a branch profits tax of 30 percent on the after-tax amount, resulting in a maximum blended rate of 54.5 percent. The Foreign Feeder would be required to file US federal income tax returns with respect to its ECI, even if the Fund withholds US taxes with respect to the amounts due.
Generally, a lending business arises from originating loans (as opposed to purchasing loan notes that another person has originated). For purposes of determining whether a lending activity is a US trade or business under Code Section 864, the IRS refers, by analogy, to cases decided under the bad debt deduction rules of Code Section 166. Those cases take into account a number of factors, such as the number of loans, the amount of time and effort expended, whether the loans are made to unrelated borrowers and whether the taxpayer actively sought out the lending business and solicited borrowers.
The IRS finds that the Fund met these standards through the activity of the US Manager. The IRS also cites Treas. Reg. Section 1.864-4(c)(5) which states that ECI exists from the active conduct of a banking, finance or similar business in the United States (US Lending Business). Although this regulation provides rules for determining whether ECI arises from a US Lending Business, the IRS interprets it as demonstrating, by negative inference, that a US Lending Business cannot qualify as "trading in stocks or securities." The IRS cites Inverworld, Inc. v. Comm'r, T.C. Memo. 1996-301, as supporting authority.
The IRS took the same position in a 2009 general legal advice memorandum (GLAM), in which it concluded that loan originations by a foreign corporation that were performed by a US corporation under a service agreement was a US Lending Business and not trading or investing. Accordingly, because the Fund actively solicited borrowers in the United States (through the US Manager) and made multiple loans to those borrowers, the IRS concluded that the Fund's lending activities constitute a US Lending Business such that the Fund is treated as engaged in a US trade or business and does not qualify as a trader (meaning the trading safe harbors are inapplicable).
Trading safe harbors
Even though the IRS concluded, for the reasons described above, that the Fund's lending and stock underwriting activities constitute a US trade or business, for the sake of completeness, the IRS considered whether both the Fund's lending activities and stock underwriting activities, taken together, could qualify for the trading safe harbors if both activities did constitute trading in stocks or securities. Code Section 864(b)(2)(A) has two safe harbors for foreign persons trading in stocks or securities. If either applies, the foreign person would not be treated as having a US trade or business.
First safe harbor—trading through an independent agent—available for dealers and non-dealers
Under the first safe harbor, a US trade or business does not include trading stocks or securities through a resident broker or other independent agent provided the taxpayer does not have a US office through which the transactions in stock and securities are effected. At first glance, one might think that the Fund qualifies for this safe harbor because the US Manager is an independent agent such that its activities should not be attributed to the Fund; as a result, the Fund should not be viewed as having a US office through which the stock transactions are effected.
However, citing the statutory language of Code Section 864(b), its legislative history and its regulations, the IRS concluded that a taxpayer cannot qualify for the first safe harbor if it delegates discretionary authority to a US resident agent, regardless of whether the agent is independent (i.e., manages multiple funds) or not. Part of the IRS' rationale for interpreting the first safe harbor in this way is its analysis of the second safe harbor. More specifically, Congress expanded the first safe harbor to add "or other independent agent" and at the same time enacted the second safe harbor to permit foreign non-dealers to trade in stocks or securities through US resident agents with discretionary authority which implies that an "independent agent" in the first safe harbor means an agent lacking discretionary authority. The IRS also reasoned that permitting foreign dealers to trade in the United States through US resident agents with discretionary authority would undermine Congress' decision to exclude dealers from the second safe harbor (see below). Thus, because the US Manager had discretionary authority to act on behalf of the Fund for its lending and stock underwriting activities, the Fund does not qualify under the first trading safe harbor.
Second safe harbor—trading for one's own account—available for non-dealers only
Under the second safe harbor, a US trade or business does not include a taxpayer trading stocks or securities for its own account, including through its employees, a resident broker, or other agent, and irrespective of whether it has discretionary authority to make decisions on behalf of the taxpayer; provided, however, that the taxpayer is not a dealer in stocks or securities. By preventing foreign dealers from qualifying for the second safe harbor when trading through a US office, Congress sought to prevent foreign dealers from having a competitive advantage over their US counterparts by not being subject to US tax. (The only narrow exception that permits a foreign dealer to qualify for the second safe harbor and avoid US tax is where the foreign dealer effects transactions of a customer through an agent with discretionary authority.)
In order to preserve this equal footing between US and foreign dealers, it must also be the case that foreign dealers that give US agents discretionary authority to act on their behalf could not otherwise be exempt from US tax under the first safe harbor. In addition, in a footnote, the IRS warns taxpayers not to rely necessarily on Treasury regulations under Code Section 475 (i.e., rules regarding mark-to-market accounting methods for dealers) to assert that originating loans alone without sales of the securities is the acquisition of a security that fits within a trading safe harbor. Instead, the IRS cautions that loan originations without more may be sufficient to cause a person to be treated as a dealer. The IRS concludes that, because the Fund is a dealer in stocks or securities (and not a trader) that effects transactions for its own account by earning service income, it is does not qualify for the second trading safe harbor.
What does this mean for foreign investment funds?
The CCA presents the most comprehensive analysis by the IRS of fund lending activities and a US trade or business. While the GLAM on loan origination did take similar positions on certain issues, such as loan originations constituting a US Lending Business, the CCA goes further, such as citing legislative history to analyze why an independent agent with discretionary authority can cause a foreign person to fail the trading safe harbors, analyzing the meaning of a dealer, and broadly interpreting the meaning of customers under the dealer definition. By issuing this CCA, the IRS is putting the investment fund community on notice that it is aware of lending strategies, that it intends to pursue such arrangements as failing the trading safe harbors, and that it stands ready and able to assist the field on this front. Thus, we expect the CCA to have an enormous impact on foreign funds that engage in lending or underwriting activities, especially in regards to the following:
Expanded tax audits of investment funds
Significantly, the IRS stated in the CCA that it will support audit adjustments on the basis that offshore investment funds engaged in lending or underwriting activities do not qualify for the trading safe harbors and are engaged in a US trade or business. In addition, the CCA encourages IRS field agents to actively challenge strategies used by foreign investment funds in the lending and underwriting business, even if their facts differ from those in the CCA. Thus, the CCA presents a concerted effort by the IRS to stop foreign investors from avoiding US tax based on what the IRS sees as the funds' flawed reasoning for not having a US trade or business.
Because foreign investment funds engaged in such activities would otherwise not have filed US tax returns (absent protective filings) on the basis that they were not engaged in a US trade or business, all of their tax years would remain open and subject to audit. In addition, as a result of not having filed US tax returns, the foreign feeder fund would lose its ability to offset its US taxable income with otherwise allowable deductions under Code Section 162 because its Form 1120-F (US Income Tax Return of a Foreign Corporation) would not have been filed within 18 months of the due date of the return. The penalty for missing the 18-month deadline can therefore be costly.
A foreign fund that has ECI must file a US partnership return with Schedules K-1 for all partners, including foreign partners, showing their allocable share of ECI and all items of partnership income, gain, loss, deductions and credits. A fund's foreign feeder that is not considered engaged in a US trade or business generally is not subject to US withholding tax on capital gain or interest income that constitutes exempt portfolio interest. However, a foreign feeder that has ECI from a US trade or business is subject to US tax. In this context, the US tax is collected through withholding by the foreign fund regardless of cash flow (generally at a 35 percent rate). Additionally, a foreign feeder that is a corporation for US tax purposes generally will be subject to another level of tax on any ECI not reinvested in a US trade or business (i.e., the branch profits tax), which could give rise to an effective tax rate on ECI of up to 54.5 percent.
Certain activities of fund in CCA not typical of hedge funds
The business of the Fund, as described in the CCA, involved certain unique features. For example, in addition to simple loan originations, the Fund acquired (1) shares of the borrower through convertible notes that were convertible at a discount and (2) shares of unrelated issuers at a discount pursuant to its underwriter-type distribution activities. Thus, in each case, the Fund profited through spreads on the convertible notes and the issuer's stock and not from a change in value of the securities.
This combination of loan originations and stock underwriting at a discount by a foreign fund is atypical. Moreover, while the CCA states that the "number of transactions that occurred over the course of several years shows that the Fund regularly engaged in this underwriting activity," the IRS does not give any indication of what that number is nor whether having a significant equity participation in the lending transaction matters. For example, many mezzanine funds and private equity funds rely on the fact that a substantial part of their return is appreciation in the borrower's equity. The IRS also gives no indication whether so-called "season and sell" lending arrangements present a sufficiently different set of facts to make the foreign fund in a parallel fund structure a trader that earns income from market fluctuations and not services. Despite these uncertainties, it is possible to extract three basic principles for foreign investment funds that intend to qualify for the trading safe harbors:
- The foreign fund cannot be in the business of originating loans under Treas. Reg. Section 1.864-4(c)(5).
- The foreign fund cannot otherwise be a dealer in stocks or securities within the meaning of Treas. Reg. Section 1.864-2(c).
- Unless qualifying as an investor, the foreign fund must qualify as a trader in a manner typical of those authorities issued under Code Section 1221(a)(1).
Broad interpretation of a dealer and its customers
The IRS analyzed the meaning of a dealer in detail and, significantly, suggests that loan originations automatically result in dealer status without any subsequent sale being required. The IRS also stated that a dealer need not have "customers" in the typical fashion. Rather, persons selling to, and buying from, a dealer are its customers, including where those persons are other brokers or dealers. The key to defining a dealer is whether it is "earn[ing] a mark-up through the transaction."
Finally, it appears that the Fund argued that, even if it were a dealer, it qualified for the first trading safe harbor (i.e., trading through an independent agent—available for dealers and non-dealers) because the US Manager was an independent agent that performed similar management services for other funds. Significantly, the IRS clarifies that an independent agent with discretionary authority to act on behalf of a fund cannot qualify for the first trading safe harbor.