On April 11, the Internal Revenue Service issued final regulations clarifying how the portfolio interest rules will apply to interest paid to a partnership that has foreign partners.  The regulations are effective as of April 12, 2007.

Generally, pursuant to Sections 871 and 881 of the Internal Revenue Code, U.S. federal income tax is required to be withheld at a rate of 30% on interest payments to non-resident aliens and foreign corporations, unless a lesser rate applies under an applicable income tax treaty.  A significant exception to the withholding requirement applies to "portfolio interest".   Portfolio interest includes interest paid on a any obligation in registered form if the payor receives the appropriate information statement (such as W-8BEN) and on certain obligations that are not in registered form but have features which prevent them from being held by U.S. persons.

Portfolio interest, however, does not include, inter alia, payments of interest to a person who holds greater than a 10% interest in the payor (a "10% shareholder").  (In the case of a corporation, this 10% amount is measured by the voting power of all classes of stock entitled to vote.)  Until the finalization of these regulations, the application of the 10% shareholder test to interests held by a partnership with foreign partners was unclear.   The portfolio interest rules did not specify if the 10% calculation was to be made for partnerships at the entity level or on a look-through basis.  If the 10% shareholder test were applied on an entity basis, a payor would be required to withhold on a payment to any partnership holding a 10% or greater interest in the payor if a minimal amount of the partnership interest was held by a foreign person.  Conversely, if a look-through rule applied, the portfolio interest exception would only be eliminated for those foreign partners who indirectly, through the partnership, held a 10% interest in the payor (subject to certain attribution rules). 

The final regulations provide that the 10% shareholder test applies only at the partner level, i.e., on a look-through basis.  The test is applied when any distributions that include the interest are made to a foreign partner and, to the extent that a foreign partner's distributive share of the interest has not actually been distributed, on the earlier of the date that the partnership information return is mailed to the partner or is due.

The final regulations also retroactively remove interest and penalties charges based on hypothetical understatements of tax when a withholding agent has failed to withhold tax and no actual tax has been imposed.

The final regulations apply for any interest paid after April 12, 2007 with respect to any instruments, whenever issued.  Taxpayers may elect to apply the regulations to any taxable year that is not closed by the statute of limitations as long as the taxpayer does so consistently for all partnerships with respect to the relevant periods.

The foregoing is a summary of a recent development in U.S. federal income tax law.  If you would like additional information about this topic or any aspect of U.S. federal income tax law, please do not hesitate to contact Abraham Leitner (212-588-5503), Scott Semer (212-588-5538), or Candice M. Turner (212-588-5588) in our New York office , Brian Bloom (514-841-6505) in our Montréal office or Elie Roth (416-863-5587) in our Toronto office if you would like further information.

Davies Ward Phillips & Vineberg LLP, with over 235 lawyers, practises 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.

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