On September 22, 2009, the Internal Revenue Service released guidance (Chief Counsel generic legal advice PRENO-119800-09) directing IRS field agents to treat a foreign corporation that originates loans in the United States through an agent as deriving taxable business income as a result of the loan origination activity.
By way of background, a foreign corporation that is engaged in a U.S. “trade or business” is subject to U.S. tax on so much of its income that is deemed to be “effectively connected” to that business. Such a taxable trade or business can include “banking, financing or similar” activity if the asset giving rise to the relevant income (typically, interest) is “attributable” to a U.S. office where the banking, financing or similar business takes place. An asset (typically a loan or security) is attributable to a U.S. office for this purpose if the U.S. office acquires the asset in the process of making loans to the public and actively participates in the solicitation, negotiation or performance of activities to acquire the loan or security. The nature of the U.S. office’s role is important – if (i) the office serves as an agent for the foreign corporation, (ii) exercises authority to negotiate contracts on behalf of the foreign corporation and (iii) is not an independent agent acting in the ordinary course of its business, then a U.S. trade or business can be attributed to the foreign corporation.
The recent IRS guidance postulates a foreign corporation (“Foreign Corp”) making loans to U.S. persons within the United States; it does not have any U.S. office of its own. To make these loans the foreign corporation engages a U.S. corporation (“U.S. Originator”) that solicits borrowers from the United States, negotiates loan terms, analyzes the U.S. borrowers’ credit and performs loan origination activities for Foreign Corp on a regular and continuous basis. Foreign Corp pays U.S. Originator a fee for its services, but U.S. Originator is not authorized to conclude any contracts on behalf of Foreign Corp (Foreign Corp’s employees are in charge of securing approval for the loans and for having the loan documents executed). On these facts, the guidance states that Foreign Corp is engaged in a lending business in the United States, because the lending activities of U.S. Originator are “considerable, regular, and continuous.” Therefore, the interest income earned by Foreign Corp from loans made through the U.S. office of U.S. Originator is deemed to be effectively connected with a U.S. trade or business. Foreign Corp thus must pay regular U.S. income tax at a 35 percent rate on the interest income and must also file a U.S. tax return.
In effect, under the guidance, the U.S. Originator is treated as the U.S. office of Foreign Corp, and it is through that U.S. office that Foreign Corp is viewed as engaging in a banking or financing business. This is true even though Foreign Corp concluded the loan transactions outside the United States, since the guidance focuses on the fact that U.S. Originator actively and materially participates in the origination of Foreign Corp’s loans to U.S. borrowers. Further, there is no suggestion in the guidance that the U.S. office is controlled by Foreign Corp, or that the relationship between Foreign Corp and U.S. Originator is anything other than at arm’s length.
Tax practitioners are trying to determine what can be inferred from this guidance. The Bureau of National Affairs reported that on September 25, 2009, IRS and Treasury officials told attendees at a meeting of the American Bar Association's Section of Taxation that the memorandum is based on a particular set of factors and should be considered broad guidance. BNA quotes IRS Associate Chief Counsel Steven Musher as saying, "I know people are looking for more guidance on when lending rises to the level of a trade or business. This ruling involved none of those issues and answered none of those questions." BNA reports that Theodore Setzer, IRS deputy associate chief counsel (strategic international programs), told a session, “if you're trying to read quantum guidance into this memorandum, you do so at your peril.” Similarly, John Harrell of International Tax Counsel's office at Treasury was quoted as saying that practitioners should read the memorandum “on its facts” and “not try to interpret too much on where IRS may go.”
Although only time will tell how broad an impact the recent guidance will have, the IRS is clearly serving notice that it believes the type of origination activity described in the guidance lends itself to abuse and that it will be seeking suitable cases to develop for litigation within the financial institution and investment pool spaces. While this increased level of scrutiny, and potential intransigence, in the examination process counsels caution for offshore banks and funds that engage in these practices, it is also possible to conclude that the guidance takes liberties with the analysis and precedents it contains, and that taxpayers may have cogent arguments available to them to rebut the position espoused by the IRS. It seems inevitable, however, that a harsher audit environment will come about as a result of the guidance, and offshore lenders would be well advised to discuss with their advisors whether their existing practices leave them vulnerable and what steps might be taken pro-actively to minimize adverse IRS action.