Investment Management Update

Lending v. Investing in Securities - the IRS is Interested!

Thursday, August 17, 2006

The rules for determining when a foreign person is engaged in a business in the U.S. - and so is taxable in the U.S. - were developed for an economy that bears little resemblance to today’s world of hedge funds, mezzanine funds, derivatives and other financial products. The “rule” is simple: trading (but not dealing) in stock or securities, whether through an employee or agent in the U.S., does not cause a foreign person to be engaged in a business in the U.S. The capital gains realized and generally the interest earned is not subject to U.S. taxation in the hands of the foreign person. (The interest does need to meet the test for portfolio interest to be statutorily free of tax, but that is generally available.) This raises the metaphysical question - when is a person trading in debt securities, and when is a person engaged in a lending business? If the foreign person is involved in the lending business in the U.S., there would be U.S. tax imposed on the taxable income of the business.

The issue has been vetted among tax practitioners who have agreed that there is little controlling law and no real guidance. As the segment of the economy that faces the issue grows, the issue has been receiving more and more exposure. Now the IRS has identified it as a priority item to address. Each year the IRS presents a business plan that identifies the items that it believes need specific regulatory or other administrative attention. This year, the specific issue of when a foreign person is in a lending business or trading in securities is on the list.

In the past, taxpayers have been reluctant to address the issue with the IRS on the theory that sleeping dogs should be left alone. The dog is no longer sleeping. If trade organizations want to weigh in with their thoughts, now would be a good time to help frame the coming discussion.

If you have any questions regarding this information, please contact Joan C. Arnold.

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This article is informational only and should not be construed as legal advice or legal opinion on specific facts.