24 September 2009
On September 22, 2009, the Office of Chief Counsel of the Internal Revenue Service (the “Service”) issued a memorandum to the Director of Field Operations for Financial Services in Manhattan (the “Memorandum”) setting forth its position and legal analysis with respect to certain lending activities undertaken by foreign corporations. The Memorandum concludes that a foreign corporation has income that is effectively connected with a banking, financing, or similar business activity within the United States (and thus is subject to net basis US federal income tax) when origination activities are performed in the United States by an agent of the foreign corporation.
In the Memorandum, the Service concludes that:
- The foreign corporation is engaged in a banking, financing, or similar business because its activities (through its agent, a US corporation) include making loans to the public; and
- The US source interest income that the foreign corporation receives from the loans solicited by the US corporation is effectively connected with such banking, financing, or similar business because the interest income is attributed to an office in the United States that materially participated in the acquisition of those loans.
Under the facts of the Memorandum, a foreign corporation engaged a US corporation to solicit loans to US borrowers within the United States on its behalf but had no office or employees in the United States. The US corporation did not have the authority to conclude any contracts in the name of the foreign corporation, and the foreign corporation performed all loan approval and contract execution functions through its own employees operating from an office outside of the United States. The US corporation was paid an arm’s-length fee for its services.
The Service concluded that the activities conducted by the foreign corporation through the US corporation constituted a trade or business because such activities were conducted on a “considerable, regular and continuous basis with the intention of earning a profit.” Because those business activities included regularly and continuously originating loans to customers, the trade or business of the foreign corporation was held to be a banking, financing, or similar business. The Service then concluded that the foreign corporation’s lending business did not constitute trading or investing activities for purposes of the “trading in securities” safe harbor provided under Section 864 of the Internal Revenue Code. As a result, the Service applied the special rules for determining whether income with respect to the loans was effectively connected with a banking, financing, or similar business contained in Treasury Regulations Section 1.864-4(c)(5).
Under the special rules in Treasury Regulations Section 1.864-4(c)(5), income is effectively connected to a banking, financing, or similar business activity if the securities giving rise to such income are “attributable to the U.S. office through which such business is carried on” and “only if such office actively and materially participates in soliciting, negotiating, or performing other activities required to arrange for the acquisition of the stock or security.”
The Service noted that some taxpayers may argue that Treasury Regulations Section 1.864-4(c)(5) does not provide for attribution of an agent’s office to the foreign corporation, and that the better interpretation of the US office test is that the activities must be conducted through the foreign corporation’s own US office. In the Service’s view, however, such an interpretation “misapplies both the statute and the regulations,” notwithstanding the Tax Court’s interpretation and application to the contrary in Inverworld v. Comm’r, T.C. Memo 1996-301.
The Memorandum ends with a somewhat cryptic final warning stating: “We understand that foreign corporations and non-resident aliens may have used other strategies to originate loans in the United States giving rise to effectively connected income. We encourage you to develop these cases, and we stand ready to assist you in the legal analysis.”
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