The economic troubles that many businesses are facing because of the coronavirus pandemic have given rise to significant interest by investors in acquiring (or investing in funds that acquire) distressed debt instruments.
If certain conditions are met, foreign investors may earn interest income on debt issued by U.S. borrowers, and gain from the sale or retirement of these debt instruments, free of U.S. federal income tax. These rules make distressed debt of U.S. companies an attractive investment for foreign investors from a tax standpoint. However, despite these favorable rules, there are certain pitfalls that may cause foreign investors to nonetheless be subject to U.S. tax on these investments. These matters are discussed below.
In general, foreign persons are subject to a 30% U.S. withholding tax on certain types of “passive” U.S. income that they earn, such as dividends or interest paid by U.S. corporations. Under this general rule, foreign investors may be subject to a 30% U.S. withholding tax on their income from an investment in distressed debt.
Fortunately, however, there are certain exceptions to this rule that can be extremely beneficial for foreign investors. For example:
- Foreign investors are not subject to the 30% withholding tax on U.S. source interest that qualifies as “portfolio interest.” (This exemption is referred to as the “portfolio interest exemption.”) In order to qualify for the portfolio interest exemption, certain specific requirements must be met. For example, the debt instruments must be in “registered form” (that is, there must be certain restrictions on transferability of the instruments), the lender must not own 10% or more of the borrowers, and the interest must not be “contingent” interest.
- Foreign investors are not subject to U.S. tax on capital gain income, which includes gain from the sale or retirement of debt instruments issued by U.S. companies. This is the case even if the foreign investors bought the debt instruments at a discount from their face amount.
These beneficial rules allow foreign investors to acquire, hold, and dispose of debt instruments issued by U.S. companies free of U.S. tax.
There is, however, a critical challenge to obtaining these benefits. Specifically, notwithstanding the beneficial rule set forth above, foreign investors are subject to U.S. tax (on a net basis) on what is known as “effectively connected income.” Effectively connected income is income that is “effectively connected” with a “trade or business” of the foreign investors in the U.S. (referred to as a “U.S. trade or business”).
Therefore, it is critical to evaluate whether a foreign investor’s income from distressed debt will be taxed as “effectively connected income.” While this area of the tax law is very detailed, the following are some key points for foreign investors to consider:
- If a foreign investor merely purchases a portfolio of performing debt on the secondary market and collects on the debt, the income should not be effectively connected income. This is the case even if the foreign investor has an office in the U.S. from which these activities are conducted.
- If a foreign investor conducts loan origination activities in the U.S., the income from the debt (e.g., interest income and gain from the sale of or retirement of the debt) will in many cases be effectively connected income.
- If a foreign investor conducts loan workout activities in the U.S., there is a risk that the income from the debt will be taxed as effectively connected income. While there is little direct authority in this area, many practitioners are concerned that (at least in certain cases) loan modification activities give rise to a U.S. trade or business.
- If the debt is secured by U.S. real estate or a U.S. trade or business, and the foreign investor forecloses on the debt, the foreign investor may be deemed engaged in a U.S. trade or business by reason of owning or realizing income from the foreclosed property.
- Even if the debt modification does not give rise to effectively connected income, if the interest on the renegotiated debt is “contingent” interest (e.g., contingent on the cash flow of the borrower), or the foreign investor receives warrants of the U.S. company, the interest may not qualify for the portfolio interest exemption from the 30% U.S. withholding tax.
- In certain circumstances, the effectively connected income issues described above may be minimized if the foreign investor is a resident of a country that has an income tax treaty with the U.S. Unfortunately, however, the U.S. does not have income tax treaties with all countries. For example, with two exceptions, the U.S. does not have income tax treaties with countries in Latin America.
Fortunately, with advance planning, some or all of these challenges can be overcome. For example, it may be beneficial for the foreign investors to segregate the debt instruments that will be modified and U.S. real estate acquired by means of foreclosure in a separate U.S. corporation. There are also certain significant advantages that in some cases can be achieved by using a “real estate mortgage investment conduit” (REMIC), or a “real estate investment trust” (REIT).
In conclusion, there are very meaningful opportunities for foreign investors to earn income from distressed debt free of U.S. tax. However, the U.S. tax rules are intricate, and careful planning is necessary in order to achieve the desired benefits.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Seth Entin is a partner in Holland & Knight’s Miami office and focuses his practice on international taxation.