On September 22, 2009, in its first written guidance on the topic, the IRS Chief Counsel’s Office issued a memorandum to the IRS’s Manhattan Financial Services Office in which the Associate Chief Counsel (International) concluded that interest income from loans made by a foreign lender to a U.S. borrower was effectively connected with a U.S. trade or business where the lender operated through an independent contractor with agent-like powers. In concluding that the interest income at issue was “effectively connected income,” the IRS applied the special rules for a banking or financing business under Treas. Reg. § 1.864-4(c)(5). It is clear from the Chief Counsel memorandum that the IRS intends to pursue this and similar issues further, as it specifically encouraged the Manhattan Financial Services Office to develop other effectively connected income cases and assured that office that the Associate Chief Counsel (International) “stands ready” to assist in the related legal analysis.
The facts described in the memorandum are straightforward. A foreign corporation lender contracted with an apparently unrelated U.S. corporation to provide regular and continual loan origination services to the foreign lender under an arm’s-length fee arrangement. The U.S. corporation solicited potential borrowers, negotiated loan terms, performed credit analyses, and conducted all other loan origination activities, but was not authorized to conclude or execute contracts on behalf of the foreign lender. The final approval and execution of the loan documents was performed by employees of the foreign lender outside the United States. Notwithstanding that the U.S. corporation was not empowered to bind the foreign lender (the typical hallmark of a true agent), the IRS took the position that the U.S. corporation was the lender’s agent for U.S. income tax purposes.
Based on its conclusion about the nature of the U.S. corporation as the agent of the foreign lender and on the frequency of the loans made by the foreign lender, the IRS concluded that the foreign corporation was engaged in a U.S. lending trade or business. It further concluded that the foreign lender was not a trader or investor and that the statutory exceptions for such persons from the effectively connected income rules therefore did not apply to the foreign lender.
As noted above, the IRS based its analysis in part on Treas. Reg. § 1.864-4(c)(5), which provides special rules applicable to U.S. banking, financing or similar business activities to determine whether U.S. source dividends or interest, or capital gain or loss from the disposition of stocks and securities, are effectively connected with the active conduct of that U.S. banking, financing or similar business. Under Treas. Reg. § 1.864-4(c)(5)(ii), notwithstanding the asset-use and business-activities tests of section 864(c)(2) and Treas. Reg. §§ 1.864-4(c)(2) and (3), interest or dividends paid on stocks or securities derived by a foreign corporation engaged in the banking, financing or similar business in the United States are treated as effectively connected with the conduct of a U.S. trade or business only if the securities giving rise to such income are “attributable to the U.S. office through which such business is carried on.”
The memorandum took the position that the reference to “the U.S. office” in Treas. Reg. § 1.864-4(c)(5) does not require that the office be that of the taxpayer, i.e., the foreign lender, but rather can be the office of any person, including the U.S. dependent or independent agent of the taxpayer. In reaching this conclusion, the memorandum stated that the regulation would have used different words if the regulation had intended for the office to be that of the taxpayer, observing at one point that the term “the U.S. office” uses the article “the,” as opposed to the pronoun “its.” The IRS’s position on the definition of “the U.S. office” is notable because it is contrary to the conclusion reached by the IRS in FSA LEXIS 270 (Sept. 18, 1998), in which the IRS adopted the rationale of the Tax Court decision in the InverWorld case, which applied the definition of the term “U.S. office” in Treas. Reg. § 1.864-7 (applicable to foreign source effectively connected income) for purposes of Treas. Reg. § 1.864-4(c)(5) (applicable to U.S. source effectively connected income). The memorandum distinguished InverWorld on the basis that the case merely dealt with whether a taxpayer had a U.S. office (either directly or by attribution), rather than whether a U.S. office (of someone) existed at all.
Based upon the language of the memorandum, it appears that the IRS believes that many taxpayers have taken the position that loans to U.S. borrowers do not result in a U.S. trade or business where loan origination services are provided by U.S. independent agents that receive arm’s-length fees for their services. The memorandum clearly indicates that it disagrees with any such position.
The memorandum does not address the use of the so-called “48-hour” rule, whereby a U.S. person originates the loan and then sells a participation to a foreign person after a relatively short aging period, although representatives of the IRS have previously indicated that they do not believe that there is any specific period that would prevent the IRS from taking the position that the origination of purchased loans should be attributed to a foreign purchaser of those loans. The memorandum also references “other strategies” that may have been used by foreign lenders to avoid effectively connected income treatment and strongly implies that it disagrees with such strategies, so further guidance may be on its way.
We believe that the IRS guidance contained in the memorandum is far from the final word on the issue. There are a number of strong legal arguments that would support a position counter to that taken in the memorandum. Moreover, somewhat different facts may also make a difference in the legal conclusion. Furthermore, the attribution of the U.S. activities of an independent agent to a foreign person in the non-treaty context may have implications for taxpayers in businesses other than lending. The memorandum position reflects what could be viewed as an erosion of the general understanding of what constitutes the conduct of a U.S. trade or business through an agent.