US tax uncertainty remains for foreign distressed debt buyers

The distinction between distressed debt investing and running a lending business remains unclear after a recent IRS memorandum.

The US Internal Revenue Service has issued a new memorandum on US lending activities by foreign entities, which does little to clarify how the activities of offshore investment funds will be characterised for tax purposes.

The memorandum sheds light on how to draw the line between investment activities and the active conduct of a finance business. The distinction is sometimes difficult to make, and there is little case law to look to for guidance.  

The memorandum lays out a hypothetical case where a foreign company has no office or employees in the US, and has contracted a third party to solicit loans from US borrowers, negotiate the terms of those loans and perform credit analysis – everything except the final approval and signing of loan documents.  The IRS concludes that interest income received by a foreign corporation from loans originated on its behalf by an “agent” is effectively connected income, or ECI, and thus is subject to US income tax.

In this case, the income from the loans would generate ECI for the foreign company. The analysis further muddies the waters for foreign distressed debt buyers, who often acquire US distressed debt for the purpose of changing its terms or even converting it into equity interest. Modifying fund terms could be interpreted by some as a form of origination. If a foreign fund engages a servicer or other agent to work out the terms of modifications for it, the fund could be dangerously close to the scenario outlined in the memorandum.

“The IRS is taking a very expansive view,” said Willys Schneider of law firm Kaye Scholer. “They’re basically saying, if an offshore fund that’s investing in distressed debt has an agent in the US that’s acting on its behalf, even if they don’t have the power to bind it, but they are picking investments for it and getting involved with working out the terms of the investments, then there is definitely a concern that that income could be brought onshore.”

However, she said that she believes such funds could still make a strong case for not being characterised as running a lending business, particularly if they are very careful in structuring their operations in a way that makes it clear that they are not holding funds out to borrowers.

“What’s important is it’s still kind of a gray area,” she said. “The fund is buying in the secondary market to begin with, so it can argue it’s not really originating and so it’s not really in a lending business. That argument is still available even after this memorandum.”