Foreign lenders and US borrowers have the opportunity to take advantage of a significant tax exemption under the US tax code, though it requires careful navigation of its complex rules.
In the US, a 30% withholding tax is normally applied to interest payments from US borrowers to foreign lenders. This means the borrower must withhold 30% of the interest and pay it to the US Treasury, not the lender. This can discourage foreign lenders from providing loans to US entities.
However, under Sections 871(h) and 881(c) of the US tax code, the portfolio interest exemption is available. This exemption removes the withholding requirement for foreign lenders, both individuals and entities, allowing the full interest payment to be received tax-free by the lender and still be deductible for the borrower.
Additionally, foreign lenders with portfolio debt investments are exempt from US estate and gift taxes on transferring the loan, either during life or at death. These loans can also serve as a means to protect assets from creditor claims.
Eligibility Criteria To be eligible for this exemption, a foreign lender must not be a controlled foreign corporation or a foreign bank. They must also not be engaged in a US trade or business. The exemption applies to lenders who make occasional loans to the US but not to those who consistently lend to US entities.
A foreign lender qualifies if they own less than a 10% stake in the US borrower. The 10% ownership is calculated by considering indirect ownerships, such as family members or partnerships. If this threshold is exceeded, restructuring might be necessary to become eligible.
Foreign lenders might consider setting up separate legal entities for each loan to the US to maximize tax benefits, outweighing the additional costs involved.
Loan Structuring For the loan to qualify, it must be in registered form, with the borrower maintaining a registry of the lender’s details. The foreign lender must certify their status, and the loan agreement should include restrictions on transferability.
The loan should avoid tying interest to sales, profits, or property value changes. However, contingent interest loans can be modified to include simple interest features to qualify.
Standard banking practices should be followed in loan terms, such as maintaining an 80% loan-to-value ratio and market-based interest rates. Utilizing an escrow service and adhering to the Uniform Commercial Code for equity-secured loans can help reduce IRS scrutiny.
Benefits The portfolio interest exemption benefits foreign lenders by enhancing their investment returns without tax deductions on US debt investments. US borrowers gain by deducting interest payments and protecting assets through transparent, first-priority liens.
Cross-border families can increase their wealth by using this exemption. US business owners with overseas family ties can fund ventures through foreign relatives or companies, leading to tax-free interest for the foreign family and tax deductions for the US family, thus increasing the family’s overall wealth. Additionally, foreign lenders can forgive these loans tax-free or leave them as a tax-free legacy.
