On March 18, 2010, President Obama signed into law the "Hiring Incentives to Restore Employment Act" (the "HIRE Act"), which included a provision that generally repeals the foreign targeted obligation exception for bearer bonds issued after March 18, 2012. This repeal will likely dissuade many U.S. issuers from issuing bearer bonds, as they will no longer be entitled to the tax benefit of deductions for interest paid on such bonds.

Background

Under current law, adverse tax consequences are imposed on issuers of bearer bonds (i.e., bonds not in registered form). In particular, an issuer may not deduct interest paid with respect to such obligation and is subject to an excise tax equal to 1% of the principal amount of the obligation multiplied by the number of calendar years (or portions thereof) between the issue date and the maturity date of such obligation. However, issuers are exempt from the above mentioned sanctions if the bearer bonds are "foreign targeted obligations." Foreign targeted obligations are those where:

  • there are arrangements reasonably designed to ensure that such obligations will be sold (or resold in connection with the original issue) only to a person who is not a U.S. person,
  • interest on such obligations is payable only outside the U.S. and its possessions, and
  • on the face of such obligation there is a statement that any U.S. person who holds such obligation will be subject to limitations under the U.S. income tax laws.

Holders of bearer bonds are also subject to sanctions that include the disallowance of a deduction for losses incurred on these bonds and a requirement that any gain on the sale or other disposition of the bond be treated as ordinary income rather than capital gain. In addition, interest payments on bearer bonds are generally not eligible for the portfolio interest exemption from U.S. withholding tax, unless such bonds are foreign targeted obligations.

HIRE Act Changes

The HIRE Act made two significant changes to the treatment of bearer bonds, effective on March 19, 2012:

  • repealed generally the foreign targeted obligation exception with respect to the deductibility of interest claimed by issuers and
  • repealed generally the foreign targeted obligation exception with respect to the portfolio interest exemption for U.S. withholding tax claimed by non-U.S. holders.

The general repeal of the foreign targeted obligation exception denies issuers an interest deduction for interest paid on bearer bonds, even if foreign-targeted, and the portfolio interest exemption for U.S. withholding tax will no longer be available for such bonds.1 Accordingly, any interest paid on a bearer bond by a U.S. issuer to a non-U.S. holder will be subject to a 30% withholding tax, unless such holder qualifies for an exemption other than portfolio interest or for a reduced rate of withholding under an applicable income tax treaty.2

The HIRE Act retains the foreign targeted obligation exception with respect to the issuer excise tax and thus, issuers will still avoid the excise penalty tax for foreign targeted bearer bonds. U.S. holders and non-U.S. issuers will likely not be impacted by the repeal of the foreign targeted obligation exception. The foreign targeted obligation exception did not provide a means of avoiding the U.S. holder sanctions referenced above. In addition, non-U.S. issuers can continue to issue bearer bonds as they may not need to claim interest deductions for U.S. tax purposes, the interest paid is not U.S. source and any bearer bonds issued will most likely be foreign-targeted.

Further, the HIRE Act added a provision that treats obligations held through a dematerialized book entry or other book entry systems specified by the Treasury Secretary as being in registered form. The HIRE Act failed to provide a definition of a "dematerialized book entry system." However, this addition effectively codifies Notice 2006-99, 2006-2 C.B. 907 where the Internal Revenue Service held that certain dematerialized bonds held and transferred only through book entry systems are in registered form "when a holder may only obtain a physical certificate in bearer form if the clearing organization that maintains the book entry system goes out of business without a successor."

Footnotes

1. Note that the following obligations will not be affected by this repeal: (a) bearer bonds that are issued before March 19, 2012 and (b) obligations that are issued by a natural person, of a type not issued to the public or mature within one year.

2. The portfolio interest exemption would only apply if these obligations are in registered form and either (1) the beneficial owner has provided the applicable withholding agent with a statement, typically on IRS Form W-8, certifying that such owner is not a U.S. person or (2) the Treasury Secretary determines that such statement is not required in order to carry out the purpose of the exemption. The Treasury Secretary may waive the IRS Form W-8 requirement where there is low risk of evading tax and adequate documentation standards in the country where the beneficial owner resides.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.