an in-depth look at the “loan origination” issue

An In-Depth Look at the “Loan Origination” Issue

International Tax InstituteDecember 13, 2016

Pamela Lawrence Endreny

Skadden, Arps, Slate, Meagher & Flom LLP

Erika W. Nijenhuis

Cleary Gottlieb Steen & Hamilton LLP

Stephen E. Shay

Harvard Law School

Mark Stone

Holland & Knight LLP

Background– U.S. Trade or Business

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• Foreign persons are subject to net basis U.S. federal income tax if they engage in a trade or business in the U.S. (“USTB”)

– Must file U.S. federal income tax returns and pay tax at regular rates on income effectively connected with the USTB ("ECI").

• USTB depends on particular facts and circumstances.

• Requires considerable, continuous and regular activity in the U.S. for profit

– See, e.g., Pinchot v. Comm'r, 113 F2d 718 (2d Cir. 1940)(“regular and continuous activity of the kind which is commonly concerned with the employment of labor; the purchase of materials; the making of contracts; and the many other things which come within the definition of business").

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• Management of investments in the U.S. is not a USTB even though it may involve substantial time and activity. Higgins v. Comm'r, 312 U.S. 212 (1941); Treas. Reg. §1.864-3(a), Ex. 2.

• Little direct authority addresses loan origination activity.

• Making a single loan is not a USTB. Pasquel v. Comm'r, 12 TCM 1431 (1953).

• Authorities arise more often in other areas, such as Section 166.

• The analysis turns on factors such as

– the number and frequency of loans

– time and effort devoted to lending activities

– whether the loans are made to customers

– whether the taxpayer advertises, solicits business, has a reputation as a lender

– whether the taxpayer provides services.

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• Section 864(b)(2) provides two trading safe harbors:

• Section 864(b)(2)(A)(i)–

– USTB does not include trading in stocks or securities through a resident broker, commission agent, custodian or other independent agent, provided the foreign person does not have an office or other fixed place of business in the U.S. This safe harbor is available to dealers.

• Section 864(b)(2)(A)(ii)–

– USTB does not include trading in stocks or securities for a foreign person's own account, whether by the person or employee or through a resident broker, commission agent, custodian or other agent and whether or not the employee or agent has discretionary authority to make decisions or the foreign person has a U.S. office. This safe harbor does not apply to dealers.

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• It is unclear whether the trading safe harbor applies to loan origination.

• Under Treasury Regulation §1.864-2(c)(2), the trading safe harbor covers "effecting of transactions in the U.S. in stocks or securities for the taxpayer's own account," which includes:

– buying, selling… or trading in stocks, securities, or contracts or options to buy or sell stocks or securities, on margin or otherwise, for the account and risk of the taxpayer and any other activity closely related thereto...

• A “security” includes a "note, bond, debenture, or other evidence of indebtedness.“ Treas. Reg. §1.864-2(c)(2)(i)(c).

• Neither the Code nor the regulations under section 864(b)(2) state that the debt cannot be acquired at original issuance.

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• Treas. Reg. §1.864-4(c)(5)(i)(b) may support excluding certain loan origination activities from the trading safe harbor.

• That regulation provides that a foreign person is engaged in the active conduct of a banking, financing or similar business in the U.S.:

– "if at some time during the year, the taxpayer is engaged a trade or business and the activities of such trade or business consist of one or more of the following activities carried on, in whole or part, in the U.S… making personal, mortgage, industrial, or other loans to the public…“

• The Tax Court has concluded that Treas. Reg. §1.864-4(c)(5)(i) provides a useful framework for determining whether a foreign person is engaged in a USTB. See Inverworld Inc. v. Comm’r, 71 T.C.M. 3231 (1996).

• The regulation presupposes a USTB, however, and so is not dispositive.

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• In making the USTB determination, authorities attribute activities of agents to the foreign person, but the scope of the agency relationship is ambiguous in this context

• Comm’r v. Bollinger, 485 U.S. 340 (1988), sets out relevant factors generally in a parent/subsidiary context, such as operating in name of the principal and ability to bind the principal.

• Agency attribution is more likely where the principal has control over the agent, although some authorities minimize the importance of control.

– See Adda v. Comm'r, 10 T.C. 273 (1948), aff'd, 171 F.2d 457 (4th Cir. 1948), Lewenhaupt v. Comm'r, 20 T.C. 151 (1953), aff'd, 221 F.2d 227 (9th Cir. 1955).

• Some authorities have attributed activities of an independent agent.

– See De Amodio v. Comm'r, 34 T.C. 894 (1960), aff'd, 299 F.2d 623 (3rd

Cir. 1962).

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• In the face of uncertainty in the law, practitioners have developed operating guidelines for foreign private equity and hedge funds, CLOs, etc., to ensure that “loan origination” does not result in the foreign funds being treated as engaging in a USTB.

• Among other things, the guidelines may include the following factors:

• Restrictions to ensure loans are acquired on the secondary market.

– Minimum waiting period (e.g., 24-48 hours) following original lender’s funding/ commitment before foreign person purchases, or commits to purchase (e.g., pursuant to a forward commitment), the loan.

– No negotiation or other communication with borrower.

– No fees

– No relationship with original lender.

• Additional restrictions apply if loans are originated by affiliates (“season and sell”) in order to preclude agency attribution.

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• Limited number of loans

– Based on section 166 and other authorities that require “extensive and continuous” lending activity and give significant weight to the frequency and number of loans.

– Also based on section 864 case law that requires “considerable, continuous and regular” activity in order for a foreign person to be engaged in a USTB.

• Exceptions for loans incident to equity investments or to protect the value of a pre-existing investment

– Examples:

• Mezzanine or “PIPE” investments in debt coupled with equity or equity-related investments, such as convertible debt or debt plus warrants

• Loan to protect distressed equity or debt investment

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• Two recent IRS pronouncements:

– General Legal Advice Memorandum 2009-010 (Sept. 22, 2009) (the “GLAM”)

– Chief Counsel Advice 201501013 (Sept. 5, 2014) (the “CCA”)

• In the GLAM, the IRS determined that a foreign corporation was engaged in a USTB and recognized ECI under Treas. Reg. § 1.864-7 as a result of lending activities (solicitation, due diligence, and negotiation with borrowers) attributed to the foreign corporation through an independent agent in the U.S.

• In the CCA, the IRS concluded that a foreign fund engaged in “lending” and “underwriting” activities that constituted a USTB not covered by the trading safe harbors.

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• The CCA involved a foreign hedge fund investing in “PIPE” transactions including promissory notes, convertible debt, warrants and common stock.

• The fund purchased convertible debt and notes with warrants, which were convertible into common stock in the future at a discount to the then trading price.

• The CCA describes the fund manager (whose activities were imputed to the fund) as devoting extensive time and resources to negotiating numerous “distribution agreements” with issuers entitling them to issue stock to the fund at specified times and prices in the future after filing SEC registration statements for the stock; the fund sought to pre-sell an amount of stock to cover the advances.

• The CCA says that the issuers also paid commitment, structuring and due diligence fees to the fund.

• The fund manager spent extensive time engaging in negotiation, due diligence, soliciting, sourcing and originating these transactions.

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• The IRS concluded that the fund’s "lending" and "underwriting" activities were a USTB that did not constitute “trading in stocks and securities” for purposes of the section 864(b)(2)(A) safe harbors.

– The IRS looked to Treas. Reg. §1.864-4(c)(5)(i)(b) and section 166 factors to determine whether loan origination was a USTB.

– The IRS indicated the fund primarily looked to profit from earning fees, a spread and interest payments.

• The IRS alternatively concluded that even if the fund’s activities did constitute “trading in stocks and securities,” the fund did not qualify for the first safe harbor because its manager was not an independent agent and did not qualify for the second safe harbor because the fund's "underwriting" activities made it a dealer.

• The taxpayer has filed a petition challenging IRS notices of deficiency, and the case is currently pending in the U.S. Tax Court.

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• Recent “trade or business” cases in other areas:

• In Dagres v. Comm’r, 136 T.C. 263 (2011), the Tax Court allowed an individual member of the general partner of venture capital funds to claim a business bad debt deduction for loans made to a person who sourced investments for the fund. The court attributed to the individual member the GP’s trade or business of providing investment management services to the fund.

• Tax Court pointed to the general partner’s profits interest– “compensation for its work”– as being in excess of an investor’s return.

• The IRS had stipulated that the venture capital firm itself was an investor.

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• In Sun Capital Partners III, LP, et al. v. New England Teamsters & Trucking Industry Pension Fund, No. 12-2312, 2013 WL 3814984 (1st Cir. 2013), the First Circuit found a private equity fund (Fund IV) was in a trade or business rather than a mere investor under the ERISA rules and thus potentially liable for pension withdrawal liabilities of a portfolio company.

• The First Circuit determined that:

– GP and affiliates performed significant management services for the fund’s portfolio companies

– the fund received an economic benefit from the fees for services through the management fee offset.

• Thus the court attributed the GP’s performance of services to the fund.

• Court distinguished Whipple v. Comm’r, 373 U.S. 193 (1963), where the shareholder’s only return was that of an investor (e.g., dividends and appreciation).

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• On remand, the Massachusetts District Court found, among other things, that Fund III was in a trade or business for ERISA purposes. Sun Capital Partners III LP v. New England Teamsters & Trucking Industry Pension Fund, No. 10-10921, D.C. Mass. (2016).

• The court concluded the management services performed by the GP and affiliates could be attributed to the funds due to the management fee offset carryforwards, which provided an economic benefit to the fund.

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Do Existing Factors Make Sense in Today’s World?

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• Factor: time period before foreign person purchases (or enters into a commitment to purchase) a syndicated loan.

– Significant focus on which party is taking the risk of providing capital to the borrower.

– Yet a foreign person generally may purchase notes or bonds at original issuance in a registered or private placement securities offering without giving rise to “loan origination” concerns.

– The syndicated loan market today behaves much like the bond market.

– Most loans are priced and quoted daily on sources such as MarkIt, Bloomberg and Thompson Reuters Loan Pricing Corporation.

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• Factor: Negotiation or other communication with borrower.

• Focus on lender’s relationship with borrower.

• Lending business authorities emphasize the importance of having “customers.”

• Treas. Reg. § 1.864-4(c)(5)(i)(b) requires loans to be made to “the public.”

• Lending authorities also focus on taxpayer’s promotional, solicitation and negotiation activities.

• This factor puts attention on the scope of agency attribution.

• Is the “customer” relationship still relevant in the modern economy?

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• Factor: Whether foreign person earns any fees / provides services.

• This factor derives from concept that lending business involves provision of a service for which lenders earn compensation from interest and fees.

– Authorities support the concept of a lender as providing a “service.” See, e.g., Burbank Liquidating Corp. v. Comm’r, 39 T.C. 999 (1963) (loans received in exchange for “services” were not capital assets for purposes of Section 1221(a)(4)).

• Note that certain “fees” may also be present in transactions involving only purchases of equity.

– For example, lead investors may agree to “backstop” an equity capital raise in exchange for a backstop fee.

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• Factor: Number and frequency of loans.

• USTB requires “regular and continuous” activity.

• The frequency and number of loans is a key factor in Section 166 and other lending authorities.

• Yet making and managing investments is not a USTB no matter how active it is. See Higgins; Treas. Reg. § 1.864-2(b).

• A limited number of loans makes it less likely that the foreign person has “customers” or is making loans to the “public” or providing a “service.”

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• Factor: Loan incident to equity investment or to protect value of existing equity or debt investment.

• Investing in newly issued equity does not give rise to a USTB. SeeWhipple v. Comm’r, 373 U.S. 193 (1963) (loan made by shareholder to protect or enhance equity investment not a USTB).

• This factor turns on purpose of the loan.

• Theory that lender is engaged in lending business primarily to earn interest and compensation for services and not returns on equity.

• What justifies the distinction between debt and equity?

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Back to First Principles

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• If the existing rules are not well-suited to the modern economy, what should first principles be?

• One alternative approach—

– The “loan origination” inquiry would start with the question of whether a foreign person is providing services in the transaction.

• If no, then the foreign person would not be subject to net-basis taxation in the U.S. in connection with the transaction.

• If yes, then the foreign person’s income derived from the services would be subject to U.S. federal income tax in the same manner as in the hands of a U.S. person.

• The foreign person’s return on its capital, however, would not be subject to U.S. federal income tax provided that the foreign person earned arms’-length compensation for the services.

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• Tax law generally treats income from services and return on capital

differently

– Character – ordinary vs. capital and related limitations on deductions

– Timing – accrual/constructive receipt vs. realization

– Business activity – ECI, UBTI, section 892

– Source – where services performed vs. residence

– Withholding tax (follows source)

– Treaties

– Subpart F/PFIC rules

– Partnership rules

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• In other contexts we allow a single taxpayer to earn both kinds of income without one “tainting” the other

– Employee/shareholder earns both salary + return on capital

– Partnership profits interest vs. capital interest

– Partnership profits interest vs .loan to partnership

– Global dealing regulations require separate allocations to “people” functions and to capital

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• Advantages include:

– Shift away from elusive fact-specific “trade or business” inquiry.

– Consistent with current investment structures, where separate taxpayers typically provide management services while others provide (most of) the capital.

– Consistent with typical current tax planning for offshore funds, so not as radical as it sounds.

– U.S. investors remain subject to current taxation on income attributable to their investments, through partnership, PFIC or CFC rules.

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• This approach could give rise to complexities in identifying and quantifying the income attributable to services in some situations.

– Where both a foreign person (and/or its affiliate or agent) provide both services and capital, the approach would require reliance on transfer pricing principles to ensure sufficient income is subject to tax.

– Transfer pricing may give better results where the service provider and investors are not related parties, but is likely to be more problematic where parties are related.

– Even with unrelated parties, distinguishing between fees for services vs return on capital can be elusive:

• Banks in recent years have increased the number and type of fees they earn in order to keep headline interest rates low.

• Carried interest has been the subject of extended debate.

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• Another concern is that there are transactions that have components of both services and capital. Current law does not do a good job of classifying them.

– Is a guarantee a service or a commitment of capital? See Container Corp. v. Comm’r, 134 T.C. 5 (2010); legislatively reversed by section 861(a)(9).

– Is a consent solicitation fee a fee for services or a return on the bond? See Priv. Ltr. Rul. 201105016 (Oct. 19, 2010).

– Lease of hardware + license of software

– Sale vs. license of software

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• One could consider a rule where no additional services income would be imputed if a third-party lender acting in the ordinary course of its business received sufficient compensation for its services originating or arranging the loan, guarantee or commitment.

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• This alternative approach would be consistent with the policy considerations underpinning the existing statute.

• The concept of a U.S. trade or business as the foundation for net-basis taxation of foreigners dates back to 1936.

• The legislative history of Section 864(b)’s evolution and its amendments over the years, including the Section 864(b)(2)(A) safe harbors, shows a policy of:

– encouraging foreign capital investment into the U.S.

– maintaining fairness and protecting against foreign competition with U.S. dealers.

• The alternative approach ensures that foreign persons engaging in business in the U.S. would not be treated more favorably than U.S. persons while encouraging capital investment and facilitating liquidity in the U.S. capital markets.

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Looking Ahead

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Looking Ahead

• House Republicans proposed destination-based cash-flow tax system.

– Border adjustments designed to tax imports and exempt exports

• Taxation of cash flows:

– Revenues from products sold in the U.S., services, royalties

– Deductions for U.S. expenses, including U.S. wages

– No deduction for net interest

• Concept of “effectively connected with a U.S. trade or business” may remain.

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Looking Ahead

• Method of taxing “financial institutions?”

• VAT generally exempts investment income and income of financial institutions.

– Destination-based cash-flow tax = hybrid between income tax and VAT.

• Several possibilities:

– Cash-flow tax could apply to the net investment income of financial institutions.

– Or the tax could apply to the services element of financial institutions’ business by characterizing a portion of investment income as services income.

– The tax could also be limited to income from transactions with customers.

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an in-depth look at the “loan origination” issue

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