On September 22, 2009, the Internal Revenue Service (the Service), in a non-binding generic legal advice memorandum, (the Memorandum) issued guidance that could adversely impact investment funds that engage in indirect lending to US borrowers. The Memorandum dealt with the US federal income tax treatment of certain lending activities of foreign corporations and non-resident aliens conducted within the US through unaffiliated agents. The conclusions in the Memorandum are very significant because the Memorandum indicates that the Service may assert that certain offshore investment funds may be subject to US federal income tax on interest received from US borrowers.
In the Memorandum, the Service concludes that a foreign corporation that originated loans in the US through an agent had effectively connected income, although the foreign corporation approved and signed the loan documents outside of the US. The activities of the US agent, which included soliciting and negotiating terms of loans, were attributed to the foreign corporation without regard to whether the agent may have been an agent of independent status.
The Memorandum did not address:
- The extent of the foreign company’s lending activities in the US (such as the number of loans originated)
- When and if similar lending activities performed by an agent on behalf of a non-US person who is resident in a country that has entered into a tax treaty with the US would cause such person to have a permanent establishment in the US
- Whether loans acquired by a non-US person from affiliated or unaffiliated persons who were the initial lenders (“season and selling”) would be treated as effectively connected income
The Service put the investment fund community on notice that it is aware that other lending strategies have been employed by foreign corporations and non-resident aliens and that it intends to address those strategies in the future.
Summary of Memorandum
A foreign corporation, organized in a country that does not have an income tax treaty with the US, having no US office or employees located in the US, pursuant to a service agreement, outsources the origination of loans to US borrowers to an unrelated US corporation. The US corporation performs, from its office located in the US, all activities relating to the loan origination, other than the final approval and signing of the loan documents by employees of the foreign corporation who are regularly located at the office of the foreign corporation outside the US, including solicitation of US borrowers, negotiation of the terms of the loans and performance of credit analyses with respect to US borrowers. The US corporation’s activities relating to loan origination are conducted on a considerable, continuous and regular basis. Under the service agreement, the foreign corporation remunerates the US corporation on an arms-length basis for its services.
The Service concludes that, although the US corporation does not have authority to conclude contracts on behalf of the foreign corporation, the US corporation performs activities that are a component of the foreign corporation's lending activities, such as the solicitation of customers, the negotiation of contractual terms and the performance of credit analyses, which, in similar circumstances, courts have found an agency relationship to exist in fact and have attributed the activities of the US agent, to the foreign principal in determining whether the foreign principal conducted considerable, continuous and regular activity within the US. The Service, citing case law in which courts have held that the activities of a US corporation, although nominally an independent contractor and not an agent, were attributed to a foreign corporation where the activities of the US corporation were in fact those of an agent, concludes that the activities performed by the US corporation are attributable to the foreign corporation for purposes of determining whether the foreign corporation engages in a trade or business within the US. The Service also concludes that, because the lending activities of the foreign corporation, which were carried on by the US corporation, were considerable, continuous and regular, the foreign corporation is engaged in a US trade or business.
The Service concludes that the interest income that the foreign corporation receives with respect to the loans originated in the US is effectively connected with the conduct of a trade or business within the US because the foreign corporation is engaged in a banking business and such interest income is “attributable to an office in the US.” For this purpose, the US office may be that of the taxpayer or that of a person other than the taxpayer. Thus, the US corporation’s office satisfies the office requirement because the day-to-day activities required of the foreign corporation's lending business take place there.
The Service further states that the foreign corporation’s interest income is effectively connected income because a US office materially participated in the origination of the loans.
Finally, the Memorandum states that the IRS understands that non-US persons may be using other strategies to engage in lending activities that give rise to effectively connected income and encourages the IRS field operations to develop fact patterns addressing these strategies for future analysis.