Highlights
- The US Treasury Department has issued proposed regulations (the Proposed Regulations) that would limit the ability of foreign persons to minimize US taxes through “conduit” funding arrangements.
- This Holland & Knight Warning provides a brief overview of the 30 percent withholding tax and the current “anti-conduit” rules, and then describes the key changes the proposed regulations would make.
The US Treasury released a proposed regulation (the Proposed Regulation) on April 8, 2020 that would restrict the ability of foreign persons to minimize US taxes through “conduit” funding arrangements.1 The proposed regulations may have an impact a set of regulations from types of structures used by foreign persons to fund the United States, and therefore these structures should be re-evaluated.
The discussion below provides a brief overview of the 30 percent withholding tax and “anti-conduit” rules, and then describes the main changes the proposed regulations would make.
The withholding tax of 30 percent
The US federal income tax law imposes a 30 percent tax on a foreign person’s US source of “fixed or determinable annual or periodic income” (such as interest, dividends, rents, royalties, and similar types of income). This tax is levied on gross income with no deductions allowed. Generally, this tax is collected through withholding tax and is therefore commonly referred to as 30 percent “withholding tax”. The 30 percent withholding tax can be reduced or eliminated through treaties in which the United States is a party.
Anti-conduit rules
Congress became aware of numerous “conduit” structures that foreigners have used to minimize or eliminate the 30 percent withholding tax. As an example, assume that a foreign individual lives in a country that does not have an income tax treaty with the United States. If that foreign person were to borrow funds directly to a U.S. borrower, the foreign person’s interest income would be subject to 30 percent withholding tax. On the other hand, the alien could lend money to a corporation that: 1) has a resident tax that has an income tax treaty with the United States that reduces or eliminates 30 percent withholding tax, and 2) that qualifies benefits from that Contract.2 This land contractor could then pass the funds on to the US borrower (maintaining a reasonable market spread). Structures like this have been addressed by courts over the years and in some cases upheld.
In 1993, Congress passed Section 7701 (l) of the Internal Revenue Code (the Code), which empowers the Treasury Department to make regulations that re-characterize a multi-party financing transaction as a transaction directly between two or more parties when such re-characterization is appropriate is to prevent the avoidance of taxes 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 19953 and have been amended several times over the years. (These terms are referred to herein as the “Current Anti-Conduit Terms”.)
Current anti-conduit regulations
Under current anti-conduit regulations, the IRS may re-characterize a number of legally segregated financing transactions as direct financing between the ultimate provider and the ultimate recipient of the funding. The IRS has this authority if: 1) two or more “financing transactions” are linked by an “intermediate company”, 2) the intermediate company’s interest reduces US withholding tax by 30 percent, and 3) the intermediate company’s interest is subject to a tax avoidance scheme
Under current anti-conduit regulations, a financing transaction includes a debt instrument, lease, or license.5 On the other hand, an instrument classified as equity for US tax purposes cannot constitute a financing transaction (with certain exceptions) .6 The use of Equity is therefore sometimes referred to as the “wall of equity” as this precludes the application of the anti-conduit rules.
For example, a foreign individual could advance funds as an equity stake in a company that is resident in a country that has an income tax treaty with the United States and that is eligible for benefits under the contract. This creates the equity wall discussed above. That company could then make a loan to a US borrower. With a few limited exceptions, this agreement is not currently the subject of an attack under current anti-conduit regulations.
Proposed Anti-Conduit Regulations
The proposed regulations do not completely eliminate the capital wall rule. However, they expand the definition of participations that are treated as financing transactions by taking into account the tax treatment of the agreement under the tax law of the respective foreign country. The Treasury Department appears to be of the opinion that US tax benefits should not be allowed if the arrangement enjoys favorable tax treatment overseas, since the arrangement “promotes the relaying of income by the intermediary issuer in a functional manner, as if an intermediary company did a Debt instrument issued that is treated as a financing transaction under applicable regulations. “
Accordingly, the proposed regulations contain the following rules:
- In the proposed regulations, shares or similar interest will be treated as a financing transaction if the issuer receives a deduction or other tax benefit (e.g. an exemption, exclusion, credit or notional deduction in relation to the shares or similar interest) on amounts granted is paid, accrued, or distributed (as or otherwise) in relation to the stock or similar interest under either the laws of the issuer’s country of residence or any country in which the issuer is taxable, such as B. a permanent establishment in which a The payment for a financing transaction is attributable. 7
Example: Foreign company A owns 100 percent of foreign company B. Foreign company B is established in country L. Foreign company A makes a loan to an affiliated US company in exchange for a promissory note. Foreign corporation A then pays the promissory note to foreign corporation B in exchange for 49-year convertible bonds that are treated as debt under country L tax laws but as equity for US federal income tax purposes. Without the proposed regulations, there would be an “equity wall” preventing the application of the current anti-conduit regulations. However, since the transaction will result in deductions under country L tax laws, the Foreign Corporation B stock will be treated as a financing transaction and anti-conduit rules will apply
- The proposed regulations treat stocks or similar interest as a financing transaction when any person related to the issuer (generally a shareholder or other company owner) is entitled to a refund (including a credit) or similar tax advantage for taxes paid by the issuer in his country of residence, regardless of the person’s tax liability in relation to payment, accrual or distribution under the issuer’s laws. 9
Example: Foreign company A owns 100 percent of foreign company B. Foreign company B is incorporated in country M. Foreign company B lends its US subsidiary $ 1 million. Country M has a tax system whereby the foreign company A, as the sole shareholder in foreign company B, receives a refund on the distribution of income from foreign company B equal to 90 percent of the country M’s taxes paid by the foreign company B in relation to these revenues.10 Without the proposed regulations, there would be an “equity wall” preventing the application of the current anti-conduit regulations. However, since Foreign Corporation A is eligible for a refund, it is a funding transaction and anti-conduit rules apply.
Effective Date
It is proposed that these rules apply to payments made on or after the date the final provisions are published in the Federal Register.
Conclusion
The proposed ordinances, if and when finalized, will result in certain multi-party structures used for lending, leasing, or licensing in the United States being subject to 30 percent US withholding tax. In addition, under Section 267A of the Code, enacted under the Tax Reduction and Employment Act in late 2017, U.S. borrowers may in some cases be prohibited from deductions in such structures. (These withdrawal disallowance rules are beyond the scope of this Holland & Knight Warning.) Inbound funding structures should be carefully reviewed in light of these developments.
Remarks
1 REG-106013-19; 85 FR 19858-19873.
2 In practice, the ability to obtain contract performance has become increasingly difficult over the years due to “performance restrictions” and other limitations on contract performance.
3 TD 8611, 60 FR 40997 (August 11, 1995).
4 treasure. Reg. § 1.881-3 (a) (4) (i).
5 treasure. Reg. § 1.881-3 (a) (2) (ii) (A).
6 According to the applicable anti-conduit regulations, shares in a company (or a similar interest in a partnership, trust or other person) are only considered a financing transaction if one of the following conditions is met: 1) The issuer is obliged to do so Redemption of the share or similar interest at a certain point in time or the holder has the right to demand from the issuer the redemption of the share or similar interest or any other payment in relation to the share or similar interest; 2) The issuer has the right to redeem the share or similar interest, but only if, based on all facts and circumstances on the day of issue, a redemption under this right is more likely than not. or 3) the owner of the stock or similar interest has the right to require any person associated with the issuer (or any other person acting under any plan or arrangement with the issuer) to acquire the stock or similar interest acquire or a payment in relation to the stock or similar interest. Sweetheart. Reg. § 1.881-3 (a) (2) (ii) (B) (1).
7 Prop. Treasure. Reg. § 1.881-3 (a) (2) (ii) (B) (1) (iv).
8 See Prop. Treas. Reg. §1.881-3 (e), example 4.
9 Prop. Third. Reg. § 1.881-3 (a) (2) (ii) (B) (1) (v).
10 See Prop. Treas. Reg. §1.881-3 (e), example 5.