- The U.S. Department of the Treasury has issued proposed regulations (the Proposed Regulations) that would restrict foreign persons' ability to minimize U.S. tax through "conduit" financing arrangements.
- This Holland & Knight alert presents a brief overview of the 30 percent withholding tax and the current "anti-conduit" rules, then describes the key changes that the Proposed Regulations would make.
The U.S. Department of the Treasury (Treasury) issued proposed regulations (the Proposed Regulations) on April 8, 2020, that would restrict foreign persons' ability to minimize U.S. tax through "conduit" financing arrangements.1 The Proposed Regulations potentially impact a number of types of structures used by foreign persons for financing into the United States, and therefore these structures should be reevaluated.
The discussion below first presents a brief overview of the 30 percent withholding tax as well as the "anti-conduit" rules, then describes the key changes that the Proposed Regulations would make.
The 30 Percent Withholding Tax
The U.S. federal income tax law imposes a 30 percent tax on a foreign person's U.S. source "fixed or determinable, annual or periodical income" (such as interest, dividends, rents, royalties and similar types of income). This tax is imposed on gross income, with no deductions allowed. In general, this tax is collected by means of withholding, and it is therefore commonly referred to as the 30 percent "withholding tax." The 30 percent withholding tax may be reduced or eliminated by treaties to which the United States is a party.
Congress became aware of numerous "conduit" structures that foreign persons were utilizing to minimize or eliminate the 30 percent withholding tax. As but one example, suppose that a foreign person resides in a country that does not have an income tax treaty with the United States. Therefore, if that foreign person were to lend funds directly to a U.S. borrower, the foreign person's interest income would be subject to the 30 percent withholding tax. On the other hand, the foreign person could loan funds to a company that is: 1) a tax resident in a country that has an income tax treaty with the United States that reduces or eliminates the 30 percent withholding tax and 2) that qualifies for benefits under that treaty.2 This treaty country company could then on-lend the funds to the U.S. borrower (retaining a reasonable arm's-length spread). Structures such as this have been addressed by courts over the years, and in some cases have been upheld.
In 1993, Congress enacted Section 7701(l) of the Internal Revenue Code (the Code), which authorizes Treasury to issue regulations recharacterizing a multiple-party financing transaction as a transaction directly among any two or more of the parties where such recharacterization is appropriate to prevent the avoidance of any tax imposed by the Code. (These rules are referred to herein as the "Anti-Conduit Rules.")
The Regulations under Section 7701(l) of the Code were first issued in 1995,3 and have been amended several times over the years. (These Regulations are referred to herein as the "Current Anti-Conduit Regulations.")
Current Anti-Conduit Regulations
Under the Current Anti-Conduit Regulations, the IRS may recharacterize a series of legally separate financing transactions as a direct financing between the ultimate provider and the ultimate recipient of the financing. The IRS has this authority where: 1) there are two or more "financing transactions" linked by an "intermediate entity," 2) the participation of the intermediate entity has the effect of reducing the 30 percent U.S. withholding tax and 3) the participation of the intermediate entity is pursuant to a tax avoidance plan.4
Under the Current Anti-Conduit Regulations, a financing transaction includes a debt instrument, lease or license.5 On the other hand, an instrument that is classified as equity for U.S. tax purposes cannot (with certain exceptions) constitute a financing transaction.6 The use of equity is therefore sometimes referred to as an "equity wall," because it precludes the application of the Anti-Conduit Rules.
Therefore, for example, a foreign person could advance funds as an equity investment in an entity that is resident in a country that has an income tax treaty with the United States and that qualifies for benefits under the treaty. This creates the equity wall discussed above. This entity could then make a loan to a U.S. borrower. With some limited exceptions, this arrangement is not currently subject to attack under the Current Anti-Conduit Regulations.
Proposed Anti-Conduit Regulations
The Proposed Regulations do not completely eliminate the equity wall rule. They do, however, expand the definition of equity interests treated as financing transactions by taking into account the tax treatment of the arrangement under the tax law of the applicable foreign country. Treasury apparently believes that if the arrangement enjoys favorable tax treatment in that foreign country, then U.S. tax benefits should be disallowed because the arrangement "encourages the routing of income through the intermediary issuer in functionally the same manner as when an intermediate entity issues a debt instrument that is treated as a financing transaction under the current regulations."
Accordingly, the Proposed Regulations provide the following rules:
- The Proposed Regulations treat stock or a similar interest as a financing transaction if the issuer is allowed a deduction or another tax benefit (such as an exemption, exclusion, credit, or a notional deduction determined with respect to the stock or similar interest) for amounts paid, accrued or distributed (deemed or otherwise) with respect to the stock or similar interest, either under the laws of the issuer's country of residence or a country in which the issuer has a taxable presence, such as a permanent establishment, to which a payment on a financing transaction is attributable.7
Example: Foreign Corporation A owns 100 percent of Foreign Corporation B. Foreign Corporation B is established in Country L. Foreign Corporation A makes a loan to a related U.S. corporation in exchange for a promissory note. Foreign Corporation A then contributes the promissory note to Foreign Corporation B in exchange for convertible debt with a 49-year term that is treated as debt under the tax laws of Country L but as equity for U.S. federal income tax purposes. Without the Proposed Regulations, there would be an "equity wall" that would prevent the Current Anti-Conduit Regulations from applying. However, because the transaction gives rise to deductions under the tax laws of Country L, the Foreign Corporation B stock is treated as a financing transaction and the Anti-Conduit Rules apply.8
- The Proposed Regulations treat stock or a similar interest as a financing transaction if a person related to the issuer (generally a shareholder or other interest holder in an entity) is entitled to a refund (including a credit) or similar tax benefit for taxes paid by the issuer to its country of residence, without regard to the person's tax liability with respect to the payment, accrual or distribution under the laws of the issuer.9
Example: Foreign Corporation A owns 100 percent of Foreign Corporation B. Foreign Corporation B is established in Country M. Foreign Corporation B lends $1 million to its U.S. subsidiary corporation. Country M has a tax regime under which Foreign Corporation A, as the sole shareholder of Foreign Corporation B, is allowed a refund with respect to distributions of earnings by Foreign Corporation B that is equal to 90 percent of the Country M taxes paid by Foreign Corporation B with respect to those earnings.10 Without the Proposed Regulations, there would be an "equity wall" that would prevent the Current Anti-Conduit Regulations from applying. However, because Foreign Corporation A is entitled to a refund, there is a financing transaction and the Anti-Conduit Rules apply.
These rules are proposed to apply to payments made on or after the date that final regulations are published in the Federal Register.
The Proposed Regulations, if and when enacted in final form, will cause certain multiparty structures utilized for lending, leasing or licensing into the United States to be subject to the 30 percent U.S. withholding tax. Additionally, under Section 267A of the Code, which was enacted as part of the Tax Cuts and Jobs Act at the end of 2017, deductions may in some cases be disallowed to U.S. borrowers in structures of this nature. (These deduction disallowance rules are beyond the scope of this Holland & Knight alert.) Inbound financing structures should be reviewed carefully in light of these developments.
1 REG-106013-19; 85 F.R. 19858-19873.
2 In practice, the ability to obtain treaty benefits has become increasingly difficult over the years given "limitation on benefits" and other restrictions on treaty benefits.
3 TD 8611, 60 FR 40997 (Aug. 11, 1995).
4 Treas. Reg. § 1.881-3(a)(4)(i).
5 Treas. Reg. § 1.881-3(a)(2)(ii)(A).
6 Under the Current Anti-Conduit Regulations, stock in a corporation (or a similar interest in a partnership, trust, or other person) will constitute a financing transaction only if one of the following conditions is satisfied: 1) the issuer is required to redeem the stock or similar interest at a specified time or the holder has the right to require the issuer to redeem the stock or similar interest or to make any other payment with respect to the stock or similar interest; 2) issuer has the right to redeem the stock or similar interest, but only if, based on all of the facts and circumstances as of the issue date, redemption pursuant to that right is more likely than not to occur; or 3) the owner of the stock or similar interest has the right to require a person related to the issuer (or any other person who is acting pursuant to a plan or arrangement with the issuer) to acquire the stock or similar interest or make a payment with respect to the stock or similar interest. Treas. Reg. § 1.881-3(a)(2)(ii)(B)(1).
7 Prop. Treas. Reg. §1.881-3(a)(2)(ii)(B)(1)(iv).
8 See Prop. Treas. Reg. §1.881-3(e), Example 4.
9 Prop. Treas. Reg. § 1.881-3(a)(2)(ii)(B)(1)(v).
10 See Prop. Treas. Reg. §1.881-3(e), Example 5.
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.