Offshore Investment Funds
OFFSHORE INVESTMENT FUNDS are up in arms over an internal memo the Internal Revenue Service released in January.
The memo said that an offshore fund using an independent agent with an office in the United States to make regular loans to US borrowers and underwrite equity issuances by placing the equity with both US and foreign persons is engaged in a US trade or business. That means the fund would be subject to US corporate income taxes at a 35% rate plus possibly a branch profits tax for another 30% of the remaining earnings, for a total tax on its US earnings of as much as 54.5%.
The IRS memo is Chief Counsel Advice 201501013.
It discusses a fund that was formed in a country outside the US. The country did not have a tax treaty with the United States. If it did, then the fund might limit any US tax on its earnings to a possible withholding tax on interest and dividends at the US border, as long as the fund does not have a “permanent establishment” in the United States.
The fund is a partnership for US tax purposes. A “feeder” fund immediately above it is a corporation for US tax purposes. Both are organized in the same country, probably the Cayman Islands.
The fund has no employees. It relies on an independent agent that originates all its deals, negotiates them and does diligence. The agent has an office in the US. It does similar work for other funds.
The fund regularly makes loans to US borrowers and also engages in underwriting of equity interests. It enters into “distribution agreements” committing to buy up to a fixed dollar amount of shares for resale. There is a notice period: the fund buys the shares within an agreed number of days after notice from the client, and it arranges during the notice period to place all the shares. The stock is bought at a discount from current market and then resold at market. The fund also earns fees on both the loans and the underwriting.
Under the US tax code, any foreign corporation that engages in a US trade or business must pay full US corporate income taxes on its income from that business. Partners in partnerships are treated as if they engaged directly in any business in which the partnership engages.
There is no clear line for what is considered a trade or business. Activities undertaken for profit are a trade or business if they are “considerable, continuous, and regular.”
The IRS said in the memo that business that a foreign person does through an agent is treated as if done by the foreign person directly, regardless of the degree of control the foreign person exercises over the agent.
The fund in this case engaged in a steady stream of US transactions.
The fund argued that it was shielded from being viewed as engaged in a US trade or business by two trading “safe harbors.”
One shields foreigners who are merely “trading in stock or securities through a resident broker, commission agent, custodian, or other independent agent.” The foreign person cannot effect the trades through an office in the US.
The IRS said this safe harbor does not apply because the fund is engaged in a banking business rather than “trading.” Trading is purchasing and selling in secondary markets in order to profit from changes in value of the traded securities, the IRS said. A trader does not earn fees or a price markup in exchange for services.
The IRS said it also thinks the fund is acting through a US office. An independent agent’s office is not usually treated as belonging to someone who hires the agent, but the IRS said this agent is not “independent” because it has been delegated too much discretionary authority to run the deals.
The other “safe harbor” shields foreigners who are merely trading stocks and securities for their own accounts. It does not matter whether such a taxpayer trades directly or through an agent. It does not matter how much discretionary authority the agent has to make decisions, and it does not matter whether the foreign person trades through an office in the US. However, a “dealer” in stocks or securities cannot use this safe harbor, as he is considered to be engaging in a business rather than merely investing for his own account. Under IRS rules, a foreign person is not a “dealer” if he underwrites securities by placing them solely with foreign purchasers or if the agent is merely investing funds belonging to a particular customer, such as where a foreign bank engages as US agent to invest funds of a particular customer in the US.
The IRS said this fund is a “dealer” and is not merely investing for its own account. Moreover, it resells the underwritten securities to both US and foreign buyers.
Most offshore funds try to avoid a US trade or business for their lending by acquiring loans in the secondary market and by engaging in “season-and-sell” strategies where securities are held for a period of time before reselling.
Keith Martin in Washington