Portfolio Interest: Free Money

Portfolio Interest: Free Money

by Dmitriy Kustov*

Following the world's recent financial troubles, governments worldwide are seeking new sources of revenue, raising tax rates, promising (only, it seems) to close gaping tax loop holes, attempting to increase tax compliance generally, and actively fighting against bank secrecy jurisdictions and tax havens. In this financially troubled world, many U.S. taxpayers may well be surprised to learn that our government allows certain investors to pay absolutely no tax on interest they receive from some common forms of debt. In fact, most U.S.-based taxpayers are taxed at the highest applicable rates on the interest from these debt instruments while other persons receive the interest from the exact same debt instruments tax free. This tax free interest is the "Portfolio Interest" (PI) tax exemption.

PI, broadly defined, is the interest on specified debt obligations paid to certain foreign persons. Since 1984, PI has been tax exempt, although interest in general had already been tax exempt for many foreign investors under various U.S. tax treaties.

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Requirements of the Portfolio Interest Income Exemption

A 30 percent tax is generally imposed on U.S. source Fixed or Determinable Annual or Periodic (FDAP) income not effectively connected with a U.S. trade or business (e.g., interest, dividends, and royalties) paid to non-resident aliens and corporations. [IRC § 871(a), 881(a).] The tax is reduced under most tax treaties. Under the right circumstances, and only if certain complicated rules are observed, the rightnon-residents can be exempt from the U.S. tax on FDAP interest income from U.S. sources without regard to the respective tax treaty. [IRC § 871(h), 881(c)]

This unique vehicle is called "Portfolio Interest" (PI) and is described in IRC Sections 871(h) and 881(c) for the cases of non-resident aliens and corporations, respectively. The favorable treatment of this special kind of interest under the Internal Revenue Code also extends to the estate tax regime as the underlying loan instruments are exempt from the estate tax. [The gift tax will still apply though, according to IRC § 2511(b)] PI is also exempt from the reporting requirements of IRC Section 6049, and the corresponding Treasury Regulation Section 1.6049-5(b)(8). No Form 1042 (Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, or Form/1042(S) (Foreign Person's U.S. Source Income Subject to Withholding) is necessary for PI.

The rules for PI can, perhaps, be compressed into the following few statements,...

  1. The issuer must be a U.S. person. [IRC § 871(h)(2)(B)(ii)(I)]
  2. The holder must be a foreign person that:The underlying obligation must be in "registered form." [IRC §§ 871(h)(2)(B)(i), 881(c)(2)(B)(i), as defined by IRC §§ 163(f), 871(h)(7), 881(c)(7)]
    1. provided proof of its foreign status [IRC §§ 871(h)(2)(B)(ii)(I) & (II), 881(c)(2)(B)(ii)(I), (II), 871(h)(5)], and that is:
    2. not a bank extending credit in the course of its ordinary trade or business (except if buying U.S. obligations) [IRC § 881(c)(3)(A)]
    3. not related to the issuer, if the foreign person is a Controlled Foreign Corporation (CFC) [IRC § 881(c)(3)(C)]; and
    4. not a "10-percent shareholder" in the issuer at the time the interest is received. [IRC §§ 871(h)(3), 881(c)(3)(B)]
  3. The underlying obligation must be in "registered form." [IRC §§ 871(h)(2)(B)(i), 881(c)(2)(B)(i), as defined by IRC §§ 163(f), 871(h)(7), 881(c)(7)]
  4. The interest must not be contingent interest (with some exceptions). [IRC §§ 871(h)(4), 881(c)(4)]

  5. Before the obligation is issued, the Secretary must not have determined in writing (and published a statement) that the foreign country of the creditor has inadequate information exchange with the U.S. [IRC §§ 871(h)(6), 881(c)(6)]

  6. The interest must be FDAP, and cannot be income "effectively connected" to the U.S. trade or business (ECI). [IRC §§ 871(a), 881(a), 871(h), 881(c)]

The main goals of these provisions are to ensure that (1) U.S. persons do not benefit from the tax free interest, and (2) the underlying debt is not like equity in the hands of the holder.

The PI rule is to be distinguished from the general rule on deposits under IRC Section 871(i). The subsection exempts non-residents from tax on any interest not effectively connected with U.S. trade or business and paid on:

(A) deposits with persons carrying on the banking business,

(B) deposits or withdrawable accounts with savings institutions chartered and supervised as savings and loan or similar associations under Federal or State law, but only to the extent that amounts paid or credited on such deposits or accounts are deductible under section 591(determined without regard to sections 265 and 291) in computing the taxable income of such institutions, and

(C) amounts held by an insurance company under an agreement to pay interest thereon.

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Conclusion

For most of us, the news that non-resident aliens do not pay income tax on U.S. source interest income comes as a surprise, especially now, in the time of rising tax rates and precipitating sequestration...

Barring some drastically evolving macroeconomic considerations, the policy most likely will stay in place for the foreseeable future. There is, however, an observable trend to tighten it, mainly in the direction of increasing U.S. (and worldwide, for that matter) tax compliance. The 2010 repeal of the foreign targeted obligations exception limited the PI universe and came in a package with a host of other "offset provisions" (i.e., revenue raisers) primarily addressing tax evasion...

* Dmitriy Kustov, CPA, EA, MS Tax (Golden Gate University) has more than fifteen years of experience in tax return preparation and tax consulting. He runs a boutique San Francisco accounting firm specializing in various tax issues concerning small and medium size businesses.

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