Absent a Code exemption or treaty rate reduction, the U.S. imposes, 30% withholding tax on the payment to non-U.S. lenders of U.S. source interest.  No withholding applies, however, to "portfolio interest" paid with respect to obligations that are in registered form where the non-U.S. lender does not own 10% or more of the equity of the borrower, either directly or by attribution.

Under current law, where the lender is a U.S. or non-U.S. partnership that owns 10% or more of the equity of the borrower, it is not clear whether payments of interest to the partnership qualify as portfolio interest.  If the 10% ownership threshold is tested at the partner level, many or all of the partners may be considered to own less than 10% of the borrower.  If, instead, the 10% ownership is tested at the partnership level, none of the interest could qualify as portfolio interest.

The U.S. Internal Revenue Service (the "IRS") recently proposed regulations that would provide for measurement of ownership of the borrower to be applied at the partner (rather than the partnership) level.  As a result, if a partnership owns a debt obligation and also owns 10% or more of the voting power of the debtor corporation (or 10% or more of the capital or profits of debtor partnership), each partner is treated as owning only its pro rata equity interest in the debtor corporation for purposes of determining whether interest paid to such partner through the partnership qualifies as portfolio interest.  As a result, a partner that owns an interest in the partnership such that its pro rata ownership of the debtor is less than 10% can receive portfolio interest tax-free, even though the partnership itself owns more than 10% of the debtor.  The preamble to the proposed regulations indicates how the approach being adopted is consistent with both the objective of facilitating cross-border capital flows and the legislative history accompanying the portfolio interest exemption.

The proposed regulations would apply similar rules to the beneficiaries of simple and grantor trusts.
As proposed, the regulations would not be effective until they are finalized and then only with respect to obligations issued after the effective date.  We expect that the approach of the proposed regulations to be immediately and widely embraced by the tax and business community.  We also expect pressure to be applied to the Treasury Department and the Internal Revenue Service, however, to expand the instruments to which the new rules would apply and to permit taxpayers to rely on the approach of the proposed regulations for prior instruments and prior taxable periods.

Any questions about this development should be directed to Peter Glicklich at 212-588-5561  (pglicklich@dwpv.com), or Scott Semer at 212-588-5538  (ssemer@dwpv.com) in our New York office,  Elie Roth  at 416-863-5587 (eroth@dwpv.com) in our Toronto office or Nat Boidman at 514-841-6409 (nboidman@dwpv.com) in our Montréal office. 

Davies Ward Phillips & Vineberg LLP, with over 235 lawyers, practices nationally and internationally from offices in Toronto, Montréal, New York and an affiliate in Paris and is consistently at the heart of the largest and most complex commercial and financial matters on behalf of its North American and overseas clients.

The information and comments herein are for the general information of the reader and are not intended as advice or opinions to be relied upon in relation to any particular circumstance. For particular applications of the law to specific situations, the reader should seek professional advice.