When is a Portfolio Interest Loan Useful?

This is just a little interlude about portfolio interest for nonresident real estate investors. I just got through working on a portfolio interest loan transaction, so this is fresh in my head.

Professions are a conspiracy against the laity, said George Bernard Shaw. And in the legal profession, I see . . . a tendency towards opacity when a lawyer explains a portfolio interest loan is proposed. (Opacity = perceived complexity = expensive, to put it bluntly.)

It’s not rocket science. We are not discovering new principles of physics. It’s just engineering. We know how to do it. We know how to build bridges–it’s hard, careful work, but the problem-space is known.

The same is true for portfolio interest loans. Here’s my attempt at de-mystifying the basics so you understand how they work and can decide if such a loan is useful for you.

Why is “portfolio interest” useful?

A nonresident who lends money to a U.S. borrower will be repaid all of the principal, with interest. The interest income is “U.S. source” income earned by a nonresident taxpayer. The default U.S. tax rate on interest earned by the nonresident lender is 30%.

A nonresident lender would rather pay 0% tax on interest income received from a U.S. borrower.

The “portfolio interest” rule is a way for the nonresident lender to pay 0% U.S. tax on interest earned on loans to U.S. borrowers.

Give me an example of a successful portfolio interest loan

Nonresident parent has a child living in the United States.

The child wants to buy a house to live in. The nonresident parent can lend money to the child to buy the house.

“Bank of Dad” becomes the mortgage lender. Interest paid by the borrower is not subjected to tax when paid to the nonresident lender.

Give me another example

Nonresident individual wants to buy investment property in the United States and can pay cash.

Rather than pay all cash, the individual sets up a valid structure to own the property, and a valid finance structure to make a loan to the entity that owns the property.

Now the nonresident lender can repatriate principal tax-free. And we have created the possibility for an interest expense deduction on the mortgage.

(My bias: “valid structure” to hold the real estate, in my preference, is a nongrantor trust. “Valid structure” for the lending entity is a simple foreign corporation.)

What does “portfolio interest” mean?

The phrase “portfolio interest” is yet more jargon from the Internal Revenue Code. But all it means is that the interest income received by a foreign lender is (1) interest on a loan; and (2) the loan is configured in a certain way.

It’s kind of like Eddie Izzard saying she’s not a transvestite, but an executive transvestite. (Funny lady by the way. I saw her show long ago.) The interest income received by the nonresident lender is not only interest–it is portfolio interest.

The adjective “portfolio” is earned if you jump through all of the hoops that the Internal Revenue Code requires.

What are the hoops to jump through so you have “portfolio” interest?

There are a parallel set of rules, one for nonresident humans (Internal Revenue Code Section 871(h)) and one for foreign corporations (Internal Revenue Code Section 881(c)).

I will refer to the rules for foreign corporations, but they work exactly the same way for nonresident human lenders.

In order for interest to be portfolio interest, there are four requirements:

• The payment must be interest, and not some other type of income.
• The interest cannot be income effectively connected with the conduct of a United States trade or business by the lender.
• The loan document must be in “registered form.”
• The lender has to provide written proof that it is a nonresident taxpayer.

Requirement 1: this is interest

The first requirement is that this is interest, not something else. There are special rules for things that look like interest, but are not. Contingent interest. Dividends that are interest-related. That kind of thing.

For this explanation, let’s just assume this is a normal loan transaction: I lend you money, there is an interest rate stated, and you promise to pay back the principal, with interest.

IRC §881(c)(2) says:

Requirement 2: this isn’t effectively connected income

The second requirement is that the interest on the loan is not earned as part of an active business in the United States. The loan is an investment, and the income earned on the loan is investment income.

IRC §881(c)(2)(A) says portfolio interest is . . . uhhh . . . interest that, among other things:

The cross-reference to IRC §881(a) takes us to the rules for taxation of a foreign corporation’s income that is not connected with the conduct of a trade or business in the United States–the FDAP rules, in other words.

If the foreign corporation were found to be engaged in business in the United States, then its interest income (if connected to the conduct of that business) would be subjected to tax under the rules found in IRC §882.

Practice tip: this is why I like to spin up special purpose lending companies. I create a little Bahamas corporation that does one thing and one thing only: it makes a mortgage loan to a U.S. borrower.

It is impossible to be “engaged in business” if you only take one action. The IRS takes the position that you need “considerable, continuous, and regular” activity to be engaged in a trade or business.

One transaction can never be continuous. It can never be regular. (It might be considerable, depending on your definition of “considerable”). Therefore, a foreign corporation that only makes one loan–and does nothing else–can never be accused of being engaged in business in the United States.

Now we have ensured that because our lender can never satisfy the definition of being “engaged in business” we must have the interest income taxed under the rules of IRC §881(a).

Requirement 3: The loan document is in “registered form”

Now we come to the picky part. The loan must be in “registered form.” This is required by IRC §881(c)(2)(B)(i).

What does “registered form” mean? Here’s the objective: we want the U.S. borrower, when paying interest to a foreign lender, to be absolutely sure who the lender is. The government does not want the portfolio interest rules used to secretly send interest income tax-free to a U.S. person.

So when I say “registered form” I just mean the loan document provisions and behavior of the parties will ensure that result.

“Holder” is legal jargon for the person who owns the debt obligation as an asset. The person is holding a receivable for a stated amount of principal and interest.

This is a system that works for ensuring that a loan is in “registered form:”

• You don’t have to put everything on paper, but FFS put everything on paper. (You will see stuff about “book entries” here and there in the Code and Regulations. Ignore it. You are doing one deal and you can create paper documents signed by real people with blue ink.)
• Principal and interest can only be paid to the holder of the debt obligation and no one else.
• The borrower must know at all times who the holder is.
• If the current holder wants to transfer the debt obligation to someone else, make the current holder send the original loan document back to the borrower.
• The borrower will cancel the old loan document and re-issue a new loan document in the name of the new holder.
• If the holder attempts to transfer the debt obligation to someone without following these rules, the transfer is void. The borrower will keep paying the old holder, not the person who is supposed to be the new holder.

You know how the opera ain’t over until the fat lady sings? To be in “registered form” a debt obligation cannot be transferred until the U.S. borrower jumps through the hoops of canceling the debt instrument payable to the old holder and issuing a new debt instrument to the new holder.

Practice tip: if you are reviewing a loan structure to see if it qualifies for the portfolio interest exception, the very first thing you should do is CTRL-F and look for the word “order”. Lots of promissory notes say “Pay to LENDER or order” which grants the lender the unilateral power to assign the right to receive principal or interest. That means the lender can control who gets the interest payment, and that means the IRS can’t be sure if the lender is the holder or a U.S. person is the secret holder. If you see the word “order”, amend the promissory note pronto.

Requirement 4: beneficial owner statement

The final requirement for portfolio interest treatment is proof that the lender is not a U.S. taxpayer. Remember that the whole point of the portfolio interest rules is to ensure that nonresidents not engaged in business in the United States can lend money to U.S. borrowers and receive interest payments tax-free.

Specifically, the borrower must receive a statement showing that the beneficial owner of the obligation is not a U.S. person. If the lender is a foreign corporation, who is the shareholder? Is the shareholder a nonresident or a U.S. person?

The requirement is in IRC §881(c)(2)(B)(ii)(I):

As a practical matter, what this means is that the borrower receives the correct version of the Form W-8 family from the lender.

Conclusion

This is only a taste of the portfolio interest rules. Because this is tax law, there are exceptions and exceptions to the exceptions. There are limitations and curlicues. But that gives you the basics of how it works. Hopefully, there is a little less mysticism and esotericism attached to the topic now. It’s not magic.