United States: Offshore Lenders Targeted By IRS Audit Campaign

Highlights

• Offshore lenders have become the latest target of an Internal Revenue Service (IRS) audit campaign because of concern that foreign lenders are not properly reporting or paying U.S. tax on certain types of "inbound" lending transactions.
• The IRS wants to audit more returns in this area because, absent an IRS review of the underlying facts and circumstances, the agency is unable to ascertain whether the return has been properly prepared and filed.
• This IRS campaign, announced on June 10, 2021, without much fanfare, is reflective of the agency's interest in activities of "inbound" taxpayers, particularly those engaging in offshore lending to U.S.-based borrowers.
• As a result, U.S. taxpayers and advisors in this area should take heed.

Since 2017, the Internal Revenue Service (IRS) Large Business and International Division (LB&I) has shifted its audit efforts to issue-based examinations, premised on strategically identified and prioritized areas of compliance risks to address taxpayer compliance. LB&I's goal has been to improve return selection, identify issues with significant compliance risks and make the best use of its limited resources.

On June 10, 2021, the IRS announced a new campaign that focuses on the U.S. activities of financial service entities.¹ The campaign addresses the issue of whether foreign investors participating in "inbound" lending transactions were engaged in a U.S. trade or business and generated income effectively connected with a U.S.-situs lending trade or business. The description of the IRS campaign notes that under the U.S. Internal Revenue Code, foreign investors who only trade stocks and securities for their own account are not treated as being engaged in a U.S. trade or business under a safe harbor.² However, that safe harbor is unavailable to dealers in stocks or securities, to entities engaged in a lending business or to foreign investors in partnerships engaged in such activities.

To ascertain whether there has been correct reporting, the IRS must audit the applicable taxpayer and review the underlying facts and circumstances, since a mere review of the face of the return does not provide information sufficient for the IRS to make a determination as to whether a taxpayer is or is not engaged in a U.S. trade or business.

A recent article³ reports that IRS LB&I initiated the campaign focused on foreign investors' lending income because the IRS has reason to believe that there may be noncompliance in this area by certain foreign investors. The article further reports that the campaign is in its early stage, that the IRS currently is in the process of reviewing returns to ascertain which returns the IRS will select to audit and that the first set of selected returns will be sent for audit this fall. More generally, the IRS wants to focus more on "inbound" taxpayers (i.e., non-U.S. persons making U.S. investments) as opposed to "outbound" taxpayers (i.e., U.S. persons making offshore investments).

Offshore Lending, In General

The U.S. tax consequences of offshore lending can be extremely beneficial. On one hand, if properly structured, a non-U.S. lender who is not otherwise engaged in a U.S. trade or business in connection with a U.S. loan and qualifies for the "portfolio interest" provisions and/or is entitled to a reduced or zero rate of withholding tax of interest under a bilateral income tax treaty, 1) can avoid the 30 percent U.S. withholding tax imposed on gross U.S. source interest payments made to a foreign lender and 2) may avoid U.S. tax on gain from the disposition of the loan instrument. On the other hand, if the offshore lender were found to be engaged in a U.S. trade or business, a series of potentially detrimental tax consequences could result.⁴ So, the stakes are quite high.

Whether foreign lenders making loans to U.S. persons are engaged in a U.S. trade or business is not a new issue for the IRS.⁵ Under the IRS LB&I campaign, the IRS likely will scrutinize offshore lending transactions involving: 1) origination of loans in the United States, either directly by a foreign investor or indirectly by an agent of the foreign investor; 2) "season and sell" transactions, whereby, for example, in a two parallel fund structure, one fund originates the loan and the second fund purchases the loan from the other fund after a stated period of time; 3) offshore lending through treaty-protected fund structures; and 4) other structures involving direct or indirect activities by a foreign lender (or through fund structures partnerships).

Takeaways

• In structuring new loan transactions with U.S. borrowers, offshore lenders need to be aware of the increased audit exposure resulting from the new campaign.
• With respect to past transactions, a review of past loan acquisition policies and structures may be advisable to ascertain whether any remedial actions can or should be taken.
• Further, with respect to past transactions, in cases where a foreign lender has not filed a U.S. tax return, the IRS can audit the taxpayer's return whenever it decides to do so – the otherwise applicable three-year statute of limitations does not begin to run until a tax return is filed; thus, the IRS has what is referred to as an "open statute."⁶
• Moreover, depending on the structure utilized, there may be multiple return filing requirements; e.g., such as the income tax return of a U.S. entity, a withholding tax return (IRC 1446) and the tax return of a non-U.S. entity. Each of these returns is discrete from the other returns; for example, the filing of a U.S. Return of Partnership Income (Form 1065) is separate from the filing of the Annual Return for Partnership Withholding Tax (Form 8804), and both of these are separate from the return of a non-U.S. person (1040-NR, individual, or Form 1120, corporate).⁷
• A non-U.S. taxpayer who would like to remediate noncompliance, depending on the circumstances, may not be able to claim deductions in computing its effectively connected income.⁸ Whether an IRS voluntary disclosure procedure can mitigate detrimental tax consequences is not clear.

Footnotes

1 See "Financial Services Entities Engaged in a U.S. Trade or Business Campaign," Internal Revenue Service, (last visited Aug. 23, 2021).

2 Internal Revenue Code (IRC) § 864(b)(2).

3 IRS Sees Noncompliance in Foreign 'Financial Service Entities,' Bloomberg Daily Tax Report, Michael Rapoport, Aug. 10, 2021.

4 These include one or more of the following: 1) income effectively connected with a U.S. trade or business is taxable; 2) in addition, if the offshore lender is a foreign corporation there is the potential imposition of a branch profits tax on the U.S. branch earnings and profits for the year that are not reinvested in branch assets absent bilateral income tax treaty protection to reduce or eliminate this exposure; 3) the requirement to file a U.S. federal income tax return – if a true and accurate tax return is not filed timely, generally within 18 months of the due date, allowable deductions and credits generally cannot be claimed, and, if no return is filed, the statute of limitations remains open. See, e.g., Inverworld, Ltd., Appellant, v. Commissioner of Internal Revenue, Appellee, 979 F.2d 868 (D.C. Cir. 1992); 4) withholding obligations on the effectively connected income of a foreign partnership if the lending entity is a partnership; and 5) state and local tax, depending on the state.

5 In a Chief Counsel Attorney Memorandum, the IRS found that a foreign corporation whose U.S. agent originated loans on behalf of the foreign corporation was engaged in a U.S. trade or business. AM 2009-010 (Sept. 22, 2009). In Chief Counsel Advice 201501013 (CCA) (Jan. 2, 2015), the IRS considered whether a U.S. fund manager that extended loans and acted as a stock underwriter through its U.S. office and, acted on behalf of a foreign fund as an independent agent caused the foreign fund and its foreign feeder to be engaged in a U.S. trade or business, and not to qualify for the Section 864(b) safe harbor.

6 IRC § 6501(c)(3).

7 See "Assessment and Collection of U.S. Taxes from Non-U.S. Taxpayers," 38 Tax Notes International 1171, Jeffrey L. Rubinger and Andrew H. Weinstein, (June 27, 2005). This article, written by a former and current colleague at Holland & Knight, explores the complicated area of multiple filing requirements and how the statute of limitations applies in these situations.

8 U.S. Department of the Treasury Regulation § 1.882-4.

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.