IRS CCA : Navigating New & Heightened Scrutiny of Foreign Investment Fund Lending Income

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1 Presenting a live 90-minute webinar with interactive Q&A IRS CCA : Navigating New & Heightened Scrutiny of Foreign Investment Fund Lending Income TUESDAY, MARCH 17, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Peter A. Glicklich, Partner, Davies Ward Phillips & Vineberg, New York Susan F. Klein, Partner, Akerman, Chicago Leonard Schneidman, Managing Director, Andersen Tax, Boston The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 10. NOTE: If you are seeking CPE credit, you must listen via your computer phone listening is no longer permitted.

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5 Key Tax Issues in Foreign Investment Funds Lending: Loan Origination and the Trading Safe Harbors Attracting Heightened IRS Scrutiny March 17, 2015 Seminar Panelists: Susan F. Klein, Akerman LLP Peter Glicklich, Davies Ward Phillips & Vineberg LLP Leonard Schneidman, Andersen Tax

6 AGENDA 1 OF 2 U.S. Taxation of Nonresidents Foreign Corporations Holding U.S. Notes Investor vs Trader Lender vs Trader Dealer vs Trader Trading Safe Harbors CCA The Facts CCA The Issues CCA s Conclusions 6

7 AGENDA 2 OF 2 Detailed Analysis: Trade or Business Standard Attribution of Activities of an Agent Effectively Connected Income CCA Rejects Access to Both Safe Harbors Other Tax Issues Raised by the CCA Summary Biographies of Your Panelists 7

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9 U.S. Taxation of Nonresidents Foreign corporations operating in the United States are subject to two alternative U.S. taxation regimes. Under the first regime, a foreign corporation engaged in a trade or business within the United States during the taxable year is taxable on its income which is effectively connected with the conduct of such trade or business within the United States ( ECI ). Such foreign corporation would also be subject to the branch profits tax at 30% (or lower treaty rate) on dividend equivalent amounts. Under the second regime, a flat tax of 30% (or reduced treaty rate) is imposed on a foreign corporation s gross income from fixed or determinable annular periodical gains, profits and income ( FDAP ) including interest, to the extent that the amount is received from sources within the United States and is not ECI. Portfolio interest from sources within the United States is not subject to U.S. tax. Portfolio interest does not include interest that is ECI, contingent interest, related party interest, or interest received by a foreign bank extending credit in the ordinary course of its trade or business. Two safe harbors may apply to exempt trading income from the disposition of stocks, securities or commodities. The stakes here are high: in the absence of a U.S. trade or business, income and gain of a foreign corporation from loans made to U.S. borrowers could avoid U.S. taxation entirely. But if a foreign corporation is treated as engaged in a U.S. trade or business its ECI could be subject to U.S. tax at a rate of 54.5% (including branch profit tax). Failure to file a timely tax return will also result in loss of all deductions and other penalties. 9

10 Foreign Corporations Holding U.S. Notes A foreign investor s transactions in debt securities could be characterized as one of the following: Passively holding the securities Trading the securities Carrying on a lending business by originating loans Dealing in the securities (as an underwriter or for previously issued securities) The U.S. federal income tax impacts again are different: Passive investors are generally not considered to be engaged in a U.S. trade or business and may be eligible for the portfolio interest exemption as noted above Trading in securities may otherwise be considered a trade or business but may still qualify for one of the trading safe harbors Engaging in a lending business giving rise to ECI and U.S. tax at graduated rates and branch profits tax; and Dealing in securities is also considered a trade or business and may be subject to U.S. tax. Note: If a partnership is engaged in a U.S. trade or business, then so are its partners, under Code Section 875(1). 10

11 Investor vs Trader Investors seek long-term appreciation due to an objective increase in value of the investment. Traders seek profit in the short-term fluctuations of value as reflected in the marketplace. The nature of the investment and the volume of transactions, as well as the degree to which the taxpayer commits his time to the activity, are relevant in distinguishing between investing and trading. 11

12 Lender vs Trader The critical distinction is between being a passive lender as contrasted with actively conducting a lending business. Current law fails to provide clear predictable standards to determine whether U.S. lending activities of a foreign person constitute a trade or business. Compare: Pasquel (12 TCM 1431 (a single transaction is not enough); InverWorld (71TCM3231) (regular engagement in numerous financing functions). Consider domestic lending trade or business cases under Section 166 (bad debt). The nature and extent of activity is critical, and the standard is whether the activity is considerable, continuous, and regular. A lender that is engaged in the active conduct of a banking, financing or similar business will be engaged in a U.S. trade or business and its profits will be ECI if they are attributable to a U.S. office. 12

13 Dealer vs Trader A dealer is a merchant of securities and earns its income through market making activities. Unlike a trader, however, a dealer s profit comes from the mark-up it charges for bringing together a buyer and seller rather than from a rise in value of the securities during the time held by the dealer. The Regulations provide that a dealer has to have an established place of business from which it regularly engages in purchasing securities and selling them to customers for profit. (Reg (c)(2)(iv)(a)). 13

14 Trading Safe Harbors First Safe Harbor: Trading in stocks, securities or commodities through a resident broker, commission agent, or other independent agent. IRC 864(b)(2)(A)(i), (b)(2)(b)(i). But trading through the taxpayer s U.S. office or other fixed place of business is not exempt. IRC 864(c)(2)(C). Second Safe Harbor: Trading in stocks, securities or commodities for the taxpayer s own account, directly, through employees or through a resident broker, commission agent, custodian or other agent, and whether or not any such employee or agent has discretionary trading authority. IRC 864(b)(2)(A)(ii), 864(b)(2)(B)(ii); but dealers do not qualify for the safe harbor. Note: The volume of trading is irrelevant to both safe harbors. Reg. 2(c)(2) (c)(1), 14

15 CCA The Facts A foreign limited partnership, treated as a partnership for U.S. tax purposes (the Fund ) participated in the origination and underwriting of convertible debt and equity instruments. Foreign Feeder, a foreign entity treated as a corporation for U. S. tax purposes, was a limited partner in Fund. Foreign Feeder did not qualify for treaty benefits. Management of Fund was vested exclusively in an unrelated Fund Manager. Fund appointed Fund Manager as Fund s agent and irrevocable attorney-in-fact with full power to buy, sell and otherwise deal in securities and related contracts on behalf of Fund. Pursuant to its grant of authority, Fund Manager conducted extensive lending, involving numerous loans and dozens of stock distribution agreements, in the United States and earned placement fees. The Fund Manager solicited potential borrowers, engaged in extensive due diligence, negotiated the terms of the loans and equity distribution agreements. Under its equity distribution agreements, the Fund was obligated to buy U.S. stock and pre-sell those shares. Fund Manager provided similar services to other investment entities through its U.S. office, but no employee of Fund Manager worked exclusively for Fund. The Fund itself had no employees or office in the U.S., and probably no office abroad. 15

16 CCA The Issues The CCA considered three issues: A. Did the Fund engage in a lending trade or business in the United States? B. If so, could its activities still be considered trading in stocks or securities for purposes of both safe harbors? C. If the Fund s activities qualified as trading in stocks or securities for purposes of the safe harbors, did either one apply? 16

17 CCA s Conclusions A. The Fund, through Fund Managers activities, was engaged in a U.S. trade or business. B. Activities of the Fund did not qualify as trading. C. Even if the Fund s activities qualified as trading, since the Fund provided discretionary authority to Fund Manager, it did not qualify for the first safe harbor and since the Fund was considered by the IRS to be a dealer, the second safe harbor did not apply either. 17

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19 Detailed Analysis: Trade or Business Standard The Code does not provide a comprehensive definition of the term, trade or business within the United States. Rather, the Code provides only that the term includes the performance of personal services within the United States at any time within the taxable year (subject to a de minimis exception) and does not include trading in stocks, securities or commodities. IRC 864(b)(2). The courts and the Internal Revenue Service ( IRS ) have generally applied the facts and circumstances test to determine whether the activities of a foreign person constitute the engagement in a trade or business within the United States. In order to be treated as so engaged, a foreign corporation s profit-oriented activities in the United States must be considerable, continuous and regular. Mere managerial attention to investments is insufficient to cause a foreign person to be treated as engaged in a trade or business in the United States. And sporadic activity (e.g., a single loan) would not normally give rise to a U.S. trade or business. The term trade or business is used elsewhere in the Code (such as the bad debt area under Code Section 166); some courts refer to those other cases in interpreting Code Section 864(b). 19

20 Attribution of Activities of an Agent In determining whether a foreign person is engaged in a trade or business within the United States and whether income is ECI, the IRS and courts have generally taken into account the activities of such person s agents irrespective of whether such agent is independent and frequently without regard to whether the agent has discretionary authority. The facts in CCA , where the Fund Manager had discretionary authority to negotiate and conclude contracts on behalf of the Fund, are thus distinguishable from those in AM , where a U.S. corporation ( Origination Co. ), that originated loans on behalf of a foreign corporation ( Foreign Corporation ) pursuant to a services agreement, did not have authority to conclude contracts on behalf of Foreign Corporation. Rather, the activities were restricted to the solicitation of customers, negotiation of contractual terms and performance of credit analyses. As was the case in the CCA, Origination Co. in AM provided similar services for other investment entities, and probably was not related to Foreign Corporation. Nonetheless, the AM concluded that the activities of Origination Co. could be attributed to Foreign Corporation, with the attendant result that Foreign Corporation was found to be engaged in business in a trade or business within the United States. NOTE: No consideration was given in the AM to the trading safe harbors. In any event, the result was more surprising in the AM than in the CCA. 20

21 Attribution of Activities of an Agent (Continued) Query in CCA as to whether, despite Fund Manager s discretionary authority, Fund Manager should be treated as an independent, rather than dependent agent? While resolution of the issue may not be determinative of the trade or business characterization of the activities of a foreign corporation under the Code, such status is relevant to other tax issues, including application of the trading safe harbors, and when the taxpayer has access to protection under a tax treaty. Treasury Regulation (d) provides some guidance as to the meaning of the term, independent agent. Essentially, an agent is viewed as being independent where, in fulfilling his duties, he is acting in the ordinary course of his business in that capacity. Generally, the determination of whether an agent is independent is made without regard to whether the principal owns or controls, directly or indirectly, that agent or whether the principal and agent are under common control. The Regulations do take into account the exclusivity of the relationship between the agent and principal for purposes of determining whether the agent is independent. Reg (d)(3)(iii); see also InverWorld Inc., et al., v. Commissioner, TC Memo

22 Attribution of Activities of an Agent (Continued) In Taisei Fire & Marine Ins. Co., Ltd., et al., v. Commissioner, 104 TC 535 (1995), the Court held that the profits of the taxpayers four unrelated Japanese insurance companies were not attributable to a permanent establishment under the income tax treaty between the United States and Japan where taxpayers reinsurance underwriting manager, Fortress Re, Inc. ( Fortress ) handled contracts with the insurance companies, underwrote the reinsurance entered into on behalf of such companies and managed claims with respect to reinsurance treaties. Since it was conceded that Fortress had the authority, which it exercised, to conclude contracts on behalf of the taxpayers, unless it were found that Fortress was a broker, general commission agent, or any other agent of an independent status the taxpayers would be deemed to have a U.S. permanent establishment. Citing the Commentary to the OECD Model Tax Convention on Income and on Capital, the Court adopted, as its criteria for determining whether Fortress should be characterized as an independent agent, whether Fortress possessed legal and economic independence. 22

23 Attribution of Activities of an Agent (Continued) o Legal Independence. Fortress was determined to be an independent agent, where it was found that it had complete discretion over the details of its work and was subject to no external control. o Economic Independence. The Commissioner argued that Fortress bore no entrepreneurial risk because its operating expenses were covered by a management fee and because it was guaranteed business due to the creditworthiness of the reinsurers on whose behalf it acted. The Court found that such argument ignored the fact that Fortress was required to acquire sufficient business in order to produce the gross premiums upon which its fee was based. While not expressly stated, the fact that Fortress did not rely solely on any one reinsurer, but rather, on multiple reinsurance companies was a key factor in such determination. This analysis is similar to the exclusivity criteria of Treasury Regulation (d) noted above. 23

24 Attribution of Activities of an Agent (Continued) While the distinction between a dependent and independent agent is addressed in the Taisei court in the context of a treaty permanent establishment definition, it is suggested that the criteria might also be used for purposes of the various Code provisions where that distinction is relevant, for example, the application of the first trading safe harbor as well as under the sourcing rules of Code Section 865(e)(2) and the ECI rules of Code Section 864(c)(4), (5) discussed below. The decision in InverWorld and the reasoning of the CCA suggest that both the activities and the office of an agent will be attributed to the principal under these Code provisions. Query as to the correctness of this proposition? 24

25 Effectively Connected Income Outside the trading safe harbors, in determining whether FDAP or gain of a foreign corporation is ECI, the Code and Regulations nearly always require a U.S. office or fixed place of business to which the income is attributable. Specifically, for U.S. source FDAP income and gain from the sale or exchange of capital assets to be ECI, the following factors are generally to be taken into account under Code Section 864(c)(2): Whether the income, gain or losses derived from assets used in or held for use in the conduct of such trade or business (the assets use test), or Whether the activities of such trade or business are a material factor in the realization of the income, gain or loss ( business activities test). The source of gains or losses are generally determined by reference to the residence of the taxpayer. If a foreign corporation maintains an office or other fixed place of business in the United States, however, under Code Section 865(e)(2), income from the sale of personal property attributable to such office or other fixed place of business is sourced in the United States. For this purpose, the rules of Code Section 864(c)(5) apply in determining whether a foreign corporation has an office or other fixed place of business in the United States and whether a sale is attributable to such office or other fixed place of business. Under Code Section 864(c)(5), in determining whether a foreign corporation has an office or other fixed place of business, an office or other fixed place of business of an agent is disregarded unless the agent (i) has the authority to negotiate and conclude contracts in the name of the foreign corporation, and (ii) is not a general commission agent, broker or other agent of independent status acting in the ordinary course of his business. 25

26 - In making the determination under the assets use and business activities tests, regard is given to whether such asset or the income, gain or loss is accounted for through such trade or business. IRC Section 864(c)(2). Under Regulation (c)(5)(ii) and (vi)(a), U.S. source FDAP or capital gain derived in the active conduct of a banking, financing or similar business in the U.S. (which requires dealing with the public ) can be treated as ECI only from a U.S. office or to the conduct of another business. Foreign source FDAP can also be ECI if it is attributable to a U.S. office of (i) a U.S. banking, financing or similar business or (ii) a foreign corporation which is principally engaged in trading for its own account. IRC 864(c)(4)(B)(ii). - For this purpose an agent s office can be attributed to its principal under the same standards for sourcing a foreign resident's gains in the United States under Code Section 865(e)(2) discussed above. 26

27 CCA Rejects Access to Both Safe Harbors Specifically, the CCA concluded that the first trading safe harbor cannot apply if discretionary authority was granted to Fund Manager. While logical and seemingly consistent with the legislative history, the concept that an independent agent cannot have discretionary authority is directly contradicted by Code Section 864(c)(5)(A), Reg (d)(1)(i) (requiring even a dependent agent to have the authority to conclude contracts - or fill orders from inventory - in order to attribute its office to the principal), and U.S. tax treaties (permanent establishment article). The CCA did not directly determine that the first safe harbor could not apply because Fund Manager s office would be considered Fund s office for this purpose but the CCA did attribute Fund Manager s office to the Fund in connection with finding the Fund a dealer. 27

28 Rejection of Safe Harbors (continued) The CCA thus concluded that the second trading safe harbor did not apply to the Fund, because its activities do not constitute trading. Specifically, the CCA suggested that the Fund might be considered to be conducting an active banking, financing or similar business, which the CCA asserts would not constitute trading. A similar conclusion was reached by the Tax Court in InverWorld. The CCA also concluded that the Fund should be considered a dealer, and thus not entitled to the second trading safe harbor. Reg (c)(2)(iv)(a) defines a dealer as a merchant with an established place of business, regularly engaged in the purchase and resale to customers. o o o There are exceptions for certain placements with foreign clients, but they were not applicable here. The CCA attributed the Fund Manager s U.S. place of business to the Fund. The CCA (controversially) found the Fund s buyers to be customers simply by virtue of the fact that they were providing market access to the issuers. 28

29 Other Tax Issues Raised by the CCA: - ECI: The CCA does not consider whether the Fund s income was ECI, but as noted above ECI can arise for FDAP and capital gain only if the foreign corporations had an office or other U.S. place of business. - InverWorld involved a U.S. subsidiary that engaged almost exclusively in activity for its foreign shareholder. The U.S. office of the subsidiary was attributed to its foreign shareholder, where the subsidiary had discretionary authority to conduct the business of its shareholder and where it was held to be a dependent agent. - The facts in the CCA suggest that the agent was independent, not dependent, so the IRS should have a more difficult time than InverWorld attributing the Fund Manager s office to the Fund for purposes of concluding the Fund s income is ECI. - The CCA notes that Fund earned certain placement fees. To the extent those were fees for services, with services rendered in the U.S., that income could be ECI without being attributed to a U.S. office. 29

30 Other Tax Issues: - Treatment as a Dealer: The CCA attributes Fund Manager s office to Fund in finding Fund is a dealer. - The CCA effectively reads out the requirement that a dealer have customers, at least in underwritings. - The CCA involved a Fund investing in PIPEs, which is not a typical investment fund activity. 30

31 Summary The CCA leaves other issues unresolved. We understand that the taxpayer involved in the CCA plans to initiate litigation if its assessment is not removed at Appeals. The CCA (2015) and prior AM (2009) reflect that the IRS will be taking a firm stand that loan origination and securities underwriting give rise to a U.S. trade or business for investment funds. Other approaches used by such funds, like season and sell techniques, are not considered by these authorities. Implications of agent-activity attribution to the service industry is very disturbing, but is a topic for another day. 31

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33 Biographies of Your Panelists 33

34 Susan F. Klein Susan F. Klein focuses her practice on tax matters relating to private international transactions, including mergers, acquisitions and dispositions of businesses, entity formations, venture capital, financial services taxation, tax controversies, and counseling with respect to complex real estate transactions. She has extensive experience advising individuals and companies with respect to their investments and business operations in Canada, Western Europe, Israel and Latin America. Susan also has experience representing foreign nationals and corporations in connection with U.S. investments, licensing operations, acquisitions, joint venture participations, and estate planning, and representing individuals and businesses in connection with foreign investments and operations. She has represented multinational groups (including foreign financial institutions) in connection with compliance with their obligations under the Foreign Account Tax Compliance Act (FATCA), counsels domestic and international businesses on transfer pricing issues, and participates in structuring of and tax planning with respect to the operations of offshore investment funds. Susan received her B.S. from Cornell University and her J.D., cum laude, from Harvard Law School. 34

35 Peter A. Glicklich Peter Glicklich is the Managing Partner of the firm s New York office and a partner in its Taxation practice. For over 25 years, he has counseled North American and foreign-based multinationals and other institutions on their international and corporate tax concerns. Peter concentrates his practice in the taxation of inbound corporate and international transactions. He advises public and closely held corporations and REITs in connection with their mergers and acquisitions, cross-border financings, restructurings, reorganizations, spinoffs and intercompany pricing. Peter has advised entities in diverse fields, including real estate, infrastructure, finance, retail, manufacturing, mining, biotechnology, service software, transportation, telecommunications, beverages and pharmaceuticals. He has worked with institutional investors, private equity, hedge and venture capital funds, foreign governments, pension plans, Fortune 500 companies, investment banks, commodities and securities dealers, insurance companies, and others. Peter also arbitrates tax-related contract disputes arising in connection with M&A and other transactions and handles tax controversies. Peter graduated with a B.A. honors degree from the University of Wisconsin-Madison and a J.D. cum laude from Harvard Law School. 35

36 Leonard Schneidman Office: Fax: Education: Hobart College, BA (Economics) Harvard Law School, LLB New York University School of Law, LLM (Taxation) Affiliations: New York State Bar Association Boston Bar Association American Bar Association International Bar Association International Fiscal Association American College of Tax Counsel Leonard Schneidman Managing Director Boston Len Schneidman has over 40 years of experience in international taxation. His work includes counseling clients on structuring and operation of private investment funds, advising high net worth foreign investors on U.S. investments and activities, and helping U.S. and non-u.s. corporate clients with tax-efficient structuring of their business operations. Len has had significant involvement with issues of U.S. international tax policy and tax reform, including chairmanship of the ABA s U.S. Activities of Foreigners and Tax Treaties Committee and co-chairmanship of the ABA s Task Force on International Tax Reform. Len is a frequent speaker, presenting annually at the NYU Federal Tax Institute and at private equity and hedge fund tax programs. A prolific writer on tax matters, Len is author of the treatise, U.S. Taxation of Foreign Portfolio Investors: A Practical Guide to Taxation in the U.S. Capital Markets and has edited a Practicing Law Institute treatise on Sovereign Wealth Funds - A Legal, Tax and Economic Perspective. Before joining Andersen Tax, Len practiced with several large law firms, including a position as tax department Chair. 36