On September 22, 2009, the Office of Chief Counsel of the IRS released a generic legal advice memorandum, AM 2009-010 (“Memorandum”), concluding that interest income earned by a foreign corporation with respect to loans originated by an agent in the U.S., whether dependent or independent, is subject to net income tax in the U.S. as income “effectively connected” with the conduct of a U.S. trade or business. The Memorandum is significant in that a literal reading indicates that it appears the IRS is prepared to argue against strategies developed by offshore funds and lenders that use intermediaries to originate loans in the U.S. without subjecting income derived from those activities to U.S. tax. An expansive view of the Memorandum indicates that the IRS might also challenge situations in which an intermediary acquires or services loans pursuant to a management agreement.
The Memorandum addresses the following fact pattern: Foreign Corporation (“FCo”) is a corporation organized outside the U.S. in a country that does not have a bilateral income tax treaty with the U.S. and is wholly owned by shareholders who are not U.S. persons. FCo makes loans to U.S. borrowers within the U.S., but FCo has no office or employees in the U.S. To originate loans to U.S. borrowers, FCo outsources the origination activities to a U.S. corporation (“Origination Co”). Under a service agreement between FCo and Origination Co, the activities performed by Origination Co include the solicitation of U.S. borrowers, the negotiation of the terms of the loans, the performance of the credit analyses with respect to U.S. borrowers, and all other activities relating to loan origination other than the final approval and signing of the loan documents. Origination Co conducts these activities on a considerable, continuous, and regular basis. Under the service agreement, FCo pays Origination Co an arm’slength fee for its services. Origination Co performs the origination activities from an office in the U.S., and Origination Co is subject to U.S. federal net income taxation. Although Origination Co performs all of the origination activities on behalf of FCo, Origination Co is not authorized to conclude contracts on behalf of FCo. FCo’s employees, who work in an office outside of the U.S., give final approval for the loans and physically sign the loan documents on behalf of FCo.
The U.S. federal income taxation of a foreign corporation depends on whether the foreign corporation is engaged in a trade or business and, if so, whether that trade or business is carried on in the U.S. The existence of a trade or business in any given tax year and the determination whether the trade or business is in the U.S. is based on all the facts and circumstances, including the presence or absence of a profit motive; the continuity, regularity, and substantiality of the activities; and the nature of the activities. If a foreign corporation is engaged in a U.S. trade or business, it will generally be subject to U.S. federal income tax on its net income that is “effectively connected” with its U.S. trade or business.
The IRS concludes in the Memorandum that FCo is engaged in a trade or business in the U.S. In arriving at this conclusion, the IRS found that Origination Co is an agent, the activities of which are attributable to FCo, the principal:
Although Origination Co. acts on behalf of [FCo] pursuant to a service contract and does not have authority to conclude contracts, Origination Co. performs activities that are a component of [FCo]’s lending activities, such as the solicitation of customers, the negotiation of contractual terms and the performance of credit analyses. In similar circumstances, courts have found an agency relationship to exist in fact and have attributed the activities of the U.S. agent to the foreign principal in determining whether the foreign principal conducted considerable, continuous, and regular activity within the U.S. […] Because the lending activities of [FCo], which were carried on by Origination Co., were considerable, continuous, and regular, [FCo] is engaged in a U.S. trade or business.
In coming to its conclusions, the Memorandum does not indicate whether Origination Co is related to FCo, nor does it state whether Origination Co acts only on behalf of FCo or acts in the ordinary course on behalf of other unrelated parties. It also does not indicate that it would regard the status of an agent as dependent or independent as affecting whether the acts of the agent should be attributed to an offshore taxpayer. Further, it does not indicate whether FCo had any tax avoidance motives. In light of these omissions, an expansive view of the Memorandum would conclude that the IRS is prepared to take the stance that these distinctions do not matter. In particular, the IRS may be prepared to take the stance that the acts of an independent agent that has no power to conclude contracts in the U.S. on the principal’s behalf can put the principal in a U.S. trade or business.
The Memorandum is generic legal advice issued by the Office of the Associate Chief Counsel (International), is not binding on the IRS, and is not taxpayer specific. Rather, it is intended to provide assistance to IRS field agents administering industry-wide programs or programs that give rise to issues that apply across classes of taxpayers. The Memorandum is nonetheless significant because it indicates clearly that the IRS stands ready to challenge foreign persons that in the IRS’ view have originated loans in the U.S. through the strategy described in the Memorandum as well as “other strategies,” leaving open the scope of any future guidance in this area. Since the publication of the Memorandum the IRS has indicated, in the course of making comments to practitioners at industry events, that the Memorandum should not be read broadly as providing guidance on when and under what circumstances lending gives rise to a U.S. trade or business. These statements, coupled with the Memorandum, have created substantial confusion about whether or when a foreign person acting through a U.S. intermediary to originate loans in the U.S. is engaged in a U.S. trade or business.