On September 22, 2009, the IRS Office of the Chief Counsel issued a memorandum (the "Memorandum") which has broad application to offshore hedge funds that undertake lending activities, CDO and CLO issuers, and the investment managers of these entities. The Memorandum provides that, under certain circumstances, an offshore vehicle—such as a hedge fund or a CDO or CLO issuer—that hires a US service provider to originate loans in the United States on its behalf may be treated as directly engaging in a lending trade or business in the United States. Consequently, any interest earned on those loans may be effectively connected with that trade or business and subject to US federal income taxation. The Memorandum serves as an important reminder to investment managers that, in order to avoid becoming subject to net income taxation in the United States, neither they nor their investment vehicles should engage in any loan origination or servicing activities in the United States, either directly or through a US-based service provider.
Background–Summary of the Memorandum
Generally, a foreign corporation that is engaged in a trade or business within the United States is subject to US federal income tax on its taxable income that is effectively connected with that trade or business. The active conduct of a banking, financing or similar business within the United States is one such "trade or business." The IRS concluded in the Memorandum that interest income earned on loans made from within the United States by a foreign corporation engaged in the active conduct of a banking and financing business was "effectively connected" with that trade or business, even where the foreign corporation outsourced its US banking and financing activities to a US corporation.
Specific Facts of the Memorandum
A lending hedge fund ("Foreign Co.") was organized in a jurisdiction without a tax treaty with the United States and had no offices or employees within the United States. Foreign Co. was in the business of making loans to US borrowers by outsourcing loan origination activities to a US corporation (the "Origination Co.") that performed the loan origination activities from an office located in the United States. Specifically, Origination Co. was hired to (i) solicit US borrowers; (ii) negotiate terms of the loans; (iii) perform credit analysis regarding the US borrowers; and (iv) perform all other loan origination activities other than final approval and signing of the loan documents. Origination Co. was compensated an arm's-length fee for its services. Origination Co. was not authorized to conclude contracts on behalf of Foreign Co., and Foreign Co.'s employees, who worked in an office located outside of the United States, gave final approval for the loans and physically signed the loan documents on behalf of Foreign Co.
IRS Conclusions in the Memorandum
- Origination Co.'s Business and Lending Activities were Attributed to Foreign Co.
First, the IRS ruled that Origination Co. acted as an agent of Foreign Co. and thus Origination Co.'s loan origination activities (the solicitation of customers, the negotiation of contractual terms, the performance of credit analysis and other activities) were attributable to Foreign Co. The IRS stated that this was the case even though Origination Co. was not authorized to conclude contracts on behalf of Foreign Co. or give final approval for the loans. It was apparently not relevant to the IRS's analysis whether (i) Origination Co. was related to or owned by Foreign Co., or (ii) Origination Co. provided loan origination services to other lenders or investors.
- Foreign Co. was Engaged in a US Trade or Business
Second, because Origination Co.'s loan origination activities were attributed to Foreign Co., the IRS determined that Foreign Co. was engaged in a US trade or business. Specifically, Foreign Co. was engaged in the active conduct of a banking and financing business. Critically, the loan origination activities, the IRS found, were conducted on a continuous and regular basis (rather than on a one-off basis which may not have risen to the level of a trade or business).
- Interest Received by Foreign Co. was Effectively Connected Income
Finally, the IRS stated that the interest income that Foreign Co. received with respect to the loans originated in the United States was effectively connected with its US banking and financing business because the loans giving rise to the interest income were attributable to the US office through which such business was carried on (the office of Origination Co.). The IRS rejected the argument that business must be carried out through a US office of Foreign Co. Instead, the fact that business was conducted through the US office of Foreign Co.'s agent, Origination Co., satisfied this requirement. As a result, interest income from the loans originated by Origination Co. through its US office was effectively connected to Foreign Co.'s banking and financing business and subject to US tax.
Takeaways from the Memorandum
The Memorandum seems to encourage IRS agents to audit foreign corporations that engage in lending activities and arrangements similar to the one described in the Memorandum (indeed, the Office of Chief Counsel explicitly encourages field offices to develop these cases). Accordingly, the Memorandum serves as a reminder to offshore hedge funds and CDO and CLO issuers that, in order to avoid effectively connected income, they should not engage in loan origination or servicing activities in the United States, either directly or through a US-based service provider. Offshore hedge funds and CDO and CLO issuers who wish to acquire loans from US borrowers should continue to structure such activities as secondary market purchases. Furthermore, strict investment guidelines should be followed to ensure that US managers or service providers are not considered agents of the offshore investor.