There are two things that offshore fund managers and their advisors should remember about income that is effectively connected with a United States trade or business (ECI):
- It is easy to have ECI; and,
- It is bad to have ECI.
By way of background – U.S. non-residents that are not engaged in a United States trade or business are subject to a tax on U.S.-source fixed, determinable, annual, or periodic income (FDAP). FDAP includes dividends, interest, rents, royalties – and pretty much everything else, except for gain from the disposition of property. By contrast, U.S. non-residents that are engaged in a United States trade or business are subject to United States federal income tax on net ECI, and are subject to the same self-assessment and reporting requirements as U.S. residents.
Because of the tax burden associated with ECI, as well as the associated reporting and disclosure requirements, offshore funds generally do not want to be treated as engaged in a United States trade or business.
Most offshore funds that trade U.S. instruments manage to avoid the ECI issue by restricting themselves to U.S. activity that fits within the “stocks, securities and commodities” safe harbor. Under this rule, trading by a U.S. non-resident for its own account in stocks, securities, and commodities (and in derivatives that reference stocks, securities, and commodities) does not constitute a trade or business in the United States even if the trading is done by an agent or employee of the non-resident located in the United States. Absent a trade or business in the U.S., there is no way income can be effectively connected thereto.
The stocks, securities, and commodities safe harbor comes with a few caveats. First, it does not extend to dealers. For these purposes, a dealer is generally a party that makes money by providing liquidity to customers, rather than by profiting from current payments, or changes in changes in value of its positions. Second, the safe harbor only extends to instruments that constitute “stocks,” “securities”, or “commodities” (or derivatives thereon) for relevant purposes. Finally, it does not extend to activities that do not constitute “trading.”
Fund managers investing in the U.S. run the risk of falling out of the stocks, securities, and commodities safe harbor if they do any of the following:
- Investing in MLPs: For purposes of the safe harbor, a “stock” is a share of stock issued by a corporation, and a “security” is a debt instrument. Interests in partnerships, including master limited partnerships (MLPs), whose interests are listed and traded on public exchanges, are not stocks for this purpose. Furthermore, any person who owns an interest in a partnership that is engaged in a United States trade or business is themselves treated as engaged in the partnership’s trade or business. Since most MLPs are engaged in tangible businesses such as natural resource extraction, storage, and transmission, U.S. non-residents who own interests therein are deemed engaged in these businesses.1 Therefore, funds which hold interests in MLPs that are engaged in a United States trade or business run the risk of being deemed engaged in that trade or business.
Certain positions in MLP interests may not give rise to ECI. For example, a purchase of an MLP interest to cover a short position may be OK, as may be the purchase of an MLP interest that is coincident with an obligation to sell the interest instantaneously (e.g, pursuant to an ETF creation or redemption transaction). Fund managers contemplating these transactions should contact their tax advisors.
- Buying Bonds at Original Issue: As discussed above, a debt obligation is a “security” for purposes of the safe harbor. Buying and selling bonds, participations and whole loans constitutes trading in securities for these purposes – so long as it is done on the secondary market. By contrast, a U.S. non-resident that regularly purchases bonds, participations, or whole loans at original issue runs the risk of being deemed engaged in a United States lending business. The relevant distinction is between a lender, who provides funds to borrowers, and a trader, who speculates on price moves.
Funds wishing to gain exposure to newly-issued bonds may mitigate this risk through a “season and sell” policy. Under a policy of this type, there may be no contractual privity between the fund and the issuer; the fund may not negotiate directly with the issuer beyond certain routine due diligence; funds must be available to finance the deal independent of any investment by the fund; and there must be a suitable interval between funding and purchase. Most advisors take the position that, if debt is originally issued to an unrelated party, it is OK for a fund to purchase it after 24 to 48 hours after issuance, while a 30 to 90 day interval is required if debt is originally issued to a party related to the fund. In either event, the original purchaser must be fully exposed to fluctuations in price of the debt instrument during the time that they hold it.
This is an area in which there is more lore than law. Again, funds are urged to consult their tax advisers prior to trading newly-issued debt.
- Distressed Debt: Distressed debt creates two different types of risk. First, if a holder of a distressed debt instrument becomes a creditor in possession, there is a risk that its activities in managing the debtor could be treated as a United States trade or business. Second, a fund that regularly purchases deeply distressed debt instruments for the purpose of entering a bankruptcy or workout proceeding runs the risk of being treated as being engaged in a United States lending business. This is because, when a debt instrument is significantly modified, for United States federal income tax purposes, the issuer is treated as redeeming the unmodified instrument and issuing the modified instrument. As such, the holder of the debt instrument is treated as lending under the new, modified debt instrument. Therefore, an offshore fund that regularly engages in debt workouts could be treated as engaged in a United States lending business.
Funds that engage in significant distressed debt trading tend to put this activity into a “blocker” corporation. While this does not remove the risk of ECI, it limits it to the income of the blocker corporation.
- Registration as a Market Maker: Some trading desks at banks and buy-side funds have registered as market makers in certain securities. This may be done for Volcker Act purposes, in the case of banks, or, in the case of buy-side funds engaged in high frequency trading and ETF arbitrage, in order to mitigate the impacts of the pre-locate requirement and to allow more time to correct fails. Although registration as a market maker would seem to doom a taxpayer to “dealer” status for purposes of the stocks, securities, and commodities safe harbor, in certain cases it may be possible to take the position that a taxpayer is not a dealer for tax purposes, even though it is a registered market maker for regulatory purposes. The analysis in cases like this tends to not be straightforward, and a reasoned opinion is generally necessary.