United States: Using Irish Treaty Funds To Avoid US Taxes In Direct Lending

Last Updated: October 10 2019
Article by Jason D. Schwartz and Gregg S. Jubin

Private debt funds raised more than $100 billion for the fourth consecutive year in 2018,1 and reached their highest level of fundraising on record during the first half of 2019.2

However, U.S. tax law potentially hinders U.S. managers from sponsoring direct lending funds that have foreign investors: The IRS has asserted that foreign funds managed from within the U.S. and make loans directly to borrowers may be engaged in a U.S. trade or business and subject to U.S. tax.

One way a U.S. manager can engage in primary loan origination on behalf of a foreign fund and still avoid subjecting the fund to U.S. taxes is to organize the fund in Ireland and ensure the fund (1) qualifies for benefits under the U.S.-Ireland income tax treaty, and (2) does not have a U.S. permanent establishment.3 Structuring this Irish treaty fund is not without challenges. However, for some managers and investors, the rewards justify the effort.

General Structure

Irish treaty funds typically are organized either as Section 110 companies or as Irish collective asset management vehicles, or ICAVs.

A Section 110 company is an Irish entity that can issue profit-participating notes that provide for interest equal to substantially all of the company's net profits before interest. The interest on the profit-participating notes is deductible for Irish tax purposes, and can be paid in a manner that eliminates Irish withholding tax. Accordingly, by issuing profit-participating notes, a Section 110 company can reduce its net income to a nominal amount and eliminate virtually all Irish corporate tax liability.

An ICAV is a collective investment vehicle that is statutorily exempt from Irish tax on profits. ICAVs are subject to significantly more regulation — and therefore tend to be more expensive to set up and maintain — than Section 110 companies.

Qualifying for Benefits Under the Irish Treaty

To qualify for benefits under the treaty, an Irish resident, such as a Section 110 company or an ICAV, must satisfy the treaty's limitation on benefits article.

The limitation on benefits article is intended to prevent those that are not intended beneficiaries of the treaty from using the treaty to reduce their aggregate tax liability. The limitation on benefits article lists several categories of intended beneficiaries. The category most commonly used by Irish treaty funds (because it allows for the most diverse investor base) requires the fund to satisfy two tests: an ownership test and a base erosion test.

Ownership Test

Under the ownership test, at least 50% of the aggregate vote and value of the Irish treaty fund's shares generally must be directly or indirectly owned by U.S. residents and certain other "good persons."4

For this purpose, a Section 110 company's profit participating notes likely are treated as its shares.

Because the ownership test is a "direct or indirect" test, an Irish treaty fund generally should satisfy the test if more than 50% of its shares are ultimately owned by U.S. residents, even if those U.S. residents own the shares through feeder funds or other entities that are not, themselves, "good persons."

Base Erosion Test

Under the base erosion test, amounts the Irish treaty fund pays or accrues to those other than U.S. residents and other "good persons" and that are deductible for Irish tax purposes generally may not exceed 50% of the fund's gross income.

As mentioned above, ICAVs are not subject to entity-level tax on profits in Ireland. Accordingly, ICAVs do not make any payments that are treated as deductible for Irish tax purposes, and do not have to worry about satisfying the base erosion test.

By contrast, Section 110 companies must make deductible payments to minimize their Irish corporate tax liability. The most significant deductible payments that an Irish treaty fund will make if it is organized as a Section 110 company will be (1) interest payments on its profit participating notes, (2) interest payments on any other leverage it incurs, and (3) fees it pays to its investment manager.

The base erosion test does not count arm's-length payments in the ordinary course of business on a financial obligation to a bank, as long as the bank is a U.S. or Irish resident or the payments are made to a bank's U.S. or Irish permanent establishment. Accordingly, Irish treaty funds that are organized as Section 110 companies often sign credit facilities only with U.S. or Irish banks or their branches, and negotiate for provisions that limit or restrict the bank's ability to assign or participate the loan to bad persons.5

The base erosion test also does not count arm's-length service payments. Management fees should fall within this exclusion.

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Footnote

1 See Hannah George & Kelsey Butler, Who Needs a Bank? Why Direct Lending Is Surging, Bloomberg (Mar. 6, 2019), available at https://www.bloomberg.com/news/articles/2019-03-06/who-needs-a-bank-why-direct-lending-is-surging-quicktake-q-a. As of June 2018, private debt assets under management reached $769 billion. See Preqin, Press Release, Private Debt Industry Keeps Up Its Momentum (Feb. 21, 2019), available at https://docs.preqin.com/press/GPDR-Launch-2019.pdf.

2 See Kelsey Butler, Direct Lending Funds Raise Record-Breaking Cash, and Concerns, Bloomberg (July 1, 2019), available at https://www.bloomberg.com/news/articles/2019-07-01/direct-lending-funds-raise-record-breaking-cash-and-concerns.

3 The United States has income tax treaties with many jurisdictions. However, Ireland is a popular jurisdiction for U.S.-managed direct lending funds because (1) there are a number of sophisticated English-speaking legal services providers in Ireland, and (2) as discussed below, Irish treaty funds can be organized so as not to be subject to tax in Ireland.

4 "Good persons" include certain persons that are not U.S. residents. However, most U.S.-managed direct lending funds that are organized as Irish treaty funds rely on U.S. residents to satisfy both the ownership and base erosion tests.

5 If the bank preserves its right to assign or participate the loan to a bad person, then the fund typically would insist on having a right to prepay the loan in the event that the assignment or participation would cause the fund to fail the base erosion test.

Originally published by Law360.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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