Investor appetite for direct lending has remained consistently strong in recent years, with North American private debt funds reaching their highest level of fundraising on record in the first half of 2019, and 2018 marking the fourth consecutive year in which private debt funds raised more than $100 billion.1
However, foreign funds that are managed from within the United States and make loans directly to borrowers may be engaged in a U.S. trade or business and subject to U.S. tax. Accordingly, many foreign funds limit themselves to purchasing loans on the secondary market.
One way that a U.S. manager might be able to engage in primary loan origination on behalf of a foreign fund and still avoid causing the fund to be subject to U.S. tax is to organize the fund in Ireland and ensure that it qualifies for benefits under the 1997 Ireland-U.S. income tax treaty.2 Structuring this kind of Irish treaty fund is not without challenges — but for some managers and investors, the rewards justify the effort.
This article discusses the tax considerations applicable to Irish treaty funds.
I. Background
A. Tax Guidelines
The IRS has asserted that making loans to the public in the United States, whether directly or through a U.S. agent, constitutes a U.S. trade or business.3 Foreigners that engage in a U.S. trade or business are subject to U.S. federal income tax on any income that is effectively connected with that U.S. trade or business.4
By contrast, purchasing loans on the secondary market constitutes a protected activity under section 864(b)(2), which generally provides that a non-U.S. taxpayer is not treated as engaged in a U.S. trade or business solely because it trades in stocks or securities for its own account (whether directly or through an agent), as long as the taxpayer is not a dealer in stocks or securities.
Accordingly, most foreign funds that have U.S. managers and invest in loans comply with tax guidelines provided by their U.S. tax counsel to ensure they are not making loans to the public.
There is little authority that distinguishes between making loans (which the IRS has asserted constitutes a U.S. trade or business) and trading loans (which does not constitute a U.S. trade or business), and tax guidelines merely reflect tax practitioners' best judgment in this regard. That said, tax guidelines typically contain three overarching principles: The fund may not negotiate the terms of a loan, may not be an original lender, and may not be the first person to bear economic risk with respect to a loan. These principles are predicated on the traditional view of a lender as the party that negotiates the loan, funds the loan, bears first risk with respect to the loan, and holds itself out as the lender.5
B. Non-Treaty Fund Structures
1. Master-feeder structure.
U.S. managers commonly organize masterfeeder structures to accommodate both U.S. and foreign investors. In a typical master-feeder structure, a master fund is organized in the Cayman Islands or another low-tax jurisdiction. The master fund is the main investing entity and is treated as a partnership for U.S. tax purposes. Its partners are a domestic feeder and a foreign feeder.6 U.S. taxable investors typically invest in the domestic feeder, which is treated as a domestic partnership for U.S. tax purposes, while foreign and tax-exempt investors typically invest in the foreign feeder, which is organized in the same low-tax jurisdiction as the master fund and is treated as a foreign corporation for U.S. tax purposes.7
If the master fund in a master-feeder structure were engaged in a U.S. trade or business, the foreign feeder would be subject to U.S. corporate tax, and potentially the branch profits tax, on its allocable share of the master fund's effectively connected income. The master fund would be liable for failing to withhold on the foreign feeder, and investors in the domestic fund would indirectly bear their share of that liability. Accordingly, master-feeder structures are not appropriate as direct lending funds if they have U.S. managers.
2. Season and sell structure.
Some U.S. managers that want to originate loans but also want to accommodate both U.S. and foreign investors rely on "season and sell" structures, under which a standalone domestic fund generally originates loans. The domestic fund is treated as a domestic partnership for U.S. tax purposes, and its investor base is limited to U.S. persons (who are indifferent to being engaged in a U.S. trade or business). After the domestic fund holds an originated loan for a specified seasoning period (typically 30 to 90 days), it offers a portion of the loan for sale to a standalone foreign fund. The foreign fund is organized in the Cayman Islands or other low-tax jurisdiction, treated as a foreign corporation for U.S. tax purposes, and allowed to have foreign investors. The foreign fund's purchase of its portion of the loan generally may be at arm'slength pricing and requires the prior approval of an investment professional that has the skills to evaluate the loan as an investment on behalf of the foreign fund and is unaffiliated with the manager (other than as a passive investor). The foreign fund takes the position that because it makes its decisions independently of the domestic fund, the domestic fund is not making loans as its agent and all the foreign fund's loan purchases are secondary market acquisitions.
Because the foreign fund in a season and sell structure cannot be required to purchase loans from the domestic fund, the domestic fund is subject to the risk that the foreign fund may choose not to acquire its portion of a loan. As a result, the domestic fund must have sufficient financial capacity to hold each loan it makes, and the economic return to investors in each of the domestic and foreign funds could be materially different.
Footnotes
1 See Kelsey Butler, "Direct Lending Funds Raise Record-Breaking Cash, and Concerns," Bloomberg, July 1, 2019; and Hannah George and Butler, "Who Needs a Bank? Why Direct Lending Is Surging," Bloomberg, Mar. 6, 2019. As of June 2018, private debt assets under management reached $769 billion. Preqin, "Private Debt Industry Keeps Up Its Momentum" (Feb. 21, 2019).
2 The United States has income tax treaties with many jurisdictions. See IRS, "United States Income Tax Treaties — A to Z." However, Ireland is a popular jurisdiction for U.S.-managed direct lending funds because there are sophisticated English-speaking legal service providers in Ireland, and Irish treaty funds can be organized so as not to be subject to tax in Ireland.
3 See AM 2009-010; and reg. section 1.864-4(c)(5)(i)(b) (a banking, financing, or similar business includes "making personal, mortgage, industrial, or other loans to the public").
4 See section 882 (corporate income tax on effectively connected income); section 884 (branch profits tax on some deemed dividends attributable to ECI); section 875 (attributing activities of a partnership that is engaged in a U.S. trade or business to its partners); and section 1446 (enforcing partner-level income tax on ECI through partnershiplevel withholding obligations).
5 Cf. AM 2009-010 (a non-U.S. corporation whose U.S. agent's activities included "the solicitation of U.S. Borrowers, the negotiation of the terms of the loans, the performance of the credit analyses with respect to U.S. Borrowers, and all other activities relating to loan origination other than the final approval and signing of the loan documents" was engaged in a U.S. trade or business); and ILM 201501013 (fund was engaged in a U.S. trade or business when its U.S. manager actively solicited potential borrowers and issuers, negotiated directly with borrowers on all key loan terms, and conducted extensive due diligence on potential borrowers and issuers). Compare Land O'Lakes Inc. v. United States, 514 F.2d 134, 139 (8th Cir. 1975) (middleman with risk of loss and opportunity for gain was not an agent), cert. denied, 423 U.S. 926 (1975), with Rupe Investment Corp. v. Commissioner, 266 F.2d 624 (5th Cir. 1959) (middleman protected against risk of loss was an agent).
6 The manager or a related entity might hold a carried interest in the master fund, in which case it also would treat itself as a partner in the master fund.
7 See generally David S. Miller and Jean Bertrand, "Federal Income Tax Treatment of Hedge Funds, Their Investors, and Their Managers," 65 Tax Lawyer 309 (2012).
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