In CCA 201501013, the IRS found that an offshore fund making loans to U.S. borrowers was engaged in a U.S. trade or business where multiple loans owned by the fund were originated by an agent of the fund.  This conclusion is consistent with an earlier 2009 memorandum that similarly found that the activities of agents were attributed to the lending company.

The discussion in the CCA puts foreign investors in loan funds on notice that the IRS intends to apply heightened scrutiny to these funds, where agents of the fund are involved in loan origination activities.  If those activities are sufficiently extensive, the IRS is expected to contend that the portfolio interest exception (eliminating withholding taxes) and treaty rate reductions will not be available and the interest income will be subject to taxation in the U.S. at graduated income tax rates (i.e., effectively connected income, or “ECI”).

Key takeaways:

• Increased Risk of IRS Audit.  In the CCA, the IRS has encouraged its agents to pursue on audit the issue of whether the lending activities of an offshore fund constitute a U.S. trade or business taxable as ECI and to obtain guidance from the IRS National Office to assist in case development.  Although the facts in the CCA did not appear to include common “seasoning” of loans by another party, this is likely to be an area of focus for U.S. tax auditors.
• Protective Tax Return Filing.  An offshore fund that raises capital from foreign persons to acquire interests in loans to U.S. borrowers typically tries to operate so as to avoid U.S. trade or business treatment and, as a result, does not file U.S. income tax returns.  This means that the statute of limitations for assessment does not run.  Further, where the foreign fund or its partners are treated as corporations under U.S. tax law, the IRS can disallow any deductions related to the fund’s income, unless an IRS Form 1120-F is filed within 18 months of the due date of the normal annual corporate return.  See Treasury Regulation 1.882-4(a)(3).  To protect against the loss of all deductions where there is an ECI risk, foreign entities taxed in the U.S. as corporations should consider filing protective U.S. corporate income tax returns, which also starts the running of the statute of limitations.

The CCA also offers a detailed analysis to support the IRS conclusion that the lending and underwriting activities of the foreign fund did not qualify under the exception for “trading in stocks or securities” under Code Section 864(b).