The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
By Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP, New York, NY
Foreign persons are generally subject to net basis tax in the United States on income effectively connected with the conduct of a trade or business in the United States (ECI). Although this concept has been part of U.S. tax law since 1966, there is very little guidance on what it means to be "engaged in a trade or business" (ETB). In the vacuum of guidance or meaningful case law, conspiracy theories generated by idle minds seem to appear with increasing regularity.
There was a time when most people had a pretty good idea of what ETB meant — it meant you produced widgets, or hung out a shingle as in the case of a commercial bank. But now that most of the widget-producing has moved offshore and the traditional banking business has become fractionalized, specialized, and taken private, the IRS and the tax bar have turned their attention to nontraditional activities, trying to divine what rises to the level of a trade or business and what does not.
The hot button issues today are whether activities such as loan origination, distressed debt investing, and promotion of businesses are businesses, and, if so, where these activities can be said to take place geographically. Hardly a day passes without a new article on the subject.1 The attention devoted to these issues is a product of the growth in private equity investing, but the issues are not limited to private equity. Worldwide, passive investors such as sovereign and pension funds seeking enhanced returns have taken advantage of loosened regulatory laws to engage in these and other activities that they would not have dreamed of undertaking even 25 years ago. And they are doing so in the face of great uncertainty concerning the U.S. tax consequences of doing so.
This commentary sets out my simple thesis: Despite all the hoopla, one either is an investor or is in business. There is no middle ground. There is no such thing as a "trader." Loan origination outside the conduct of traditional banking is usually not a business; distressed debt investing and "promotion" most certainly never rise to that level. While drawing lines is always hard, the line between investing and business exists, and can be understood in a way that lends simplicity and predictability to what has become a legal morass producing no revenue other than for tax professionals and tax-related publications.
The wonder is, we already know how to draw the line, and have been doing so since 1969, since Congress acted to stop New York University from making spaghetti. The rules respecting unrelated business income, set out in §§511-513 of the Code, are really all one needs to know. The regulations are fairly clear, and the case law relatively well-developed. The touchstone is, as it is and should be under §864, competition. The safe harbors in §512(b) may be only safe harbors, but they tell us a great deal about where the line is drawn. And they even make sense!
It might be objected that the Code should cast a wider net to tax the activities of foreign persons than it does to tax domestic tax-exempt investors, because the act of taxing foreign persons should be limited only by jurisdictional constraints and not by any other policy concerns. It is not clear that this distinction is a part of the law, and in fact the words Congress has chosen to tax foreign persons are remarkably similar to the words used in the unrelated business provisions. More to the point, foreign persons are not exempt on U.S.-source income: If an item of U.S.-source income is not connected with a U.S. trade or business, it will ordinarily be taxable under §871 or §881 as ordinary income and subject to withholding on a gross basis.
To be certain, not every rule in §512(b) is applicable to foreign investors. For example, the exclusion of real property rents in §512(b)(3) was a policy choice and very clearly does not lead inexorably to the conclusion that renting real property cannot be a business.2 Nevertheless, the rules relating to unrelated business taxable income (UBTI) contain many useful illustrations of what a business is, and is not. Their focus is always on whether the tax-exempt organization is leveraging its exempt status to compete unfairly with for-profit taxpayers. Perhaps most important, they clearly require that, to be engaged in a business, a taxpayer must engage in the activity on a regular and continuous basis.3
Banking is clearly a business, but it earns returns — interest mostly — that look a lot like returns on passive investments. It is for this reason that §864 has special rules to deal with it. Neither the Code nor the regulations attempt to define what a banking business is; the regulations define it only in terms of a foreign taxpayer already determined to be ETB, and then only for the purpose of determining what types of investment returns should be treated as effectively connected with such a business. Somewhere along the line — probably amidst the welter of confusing opinions generated by the infamous InverWorld case4 — some in government and even the private sector got it into their heads that those regulations actually define what it is to be in the banking business generally. Worse still, they drew the wholly unsupportable inference that if a foreign taxpayer is described in those regulations, it cannot rely on the §864(b) safe harbors for any unrelated activity. And to cap off all this nonsense, some apply those regulations without regard to their express limitation to persons with regular "customers" (you know, the kind that walk up to the teller's window and ask for a bank check).
We have lost sight of what these §864 banking regulations were about. They were about two things, and two things only. First, Treasury did not want foreign banks to compete unfairly with domestic banks. Second, Treasury was sympathetic to the pleas of foreign banks that they not be subject to 30% gross-basis withholding tax on their U.S.-source interest income. (This was before the portfolio interest exception, and anyway banks qua banks can't rely on the exception, for exactly these reasons.) This is why the regulations go to great lengths to ensure that the net interest income of banks is ECI.
When investment funds with foreign (and U.S. tax-exempt) investors participate with banks in loan syndications, they are not competing with banks for banking business — they are making money available for a return and spreading risk, an activity that the banks are only too happy to have them perform. There is no difference between making those funds available upfront, at the time the loan is originated, and buying into it as a part of a syndication afterwards, whether or not "pre-wired." It is a ludicrous waste of government and private resources to pretend that such "loan origination" presents any ETB risk. Simply because banks do a thing, and banks are in a business, does not logically mean that anyone who does that thing is in a business. To argue in this fashion is illogical — it equates a subset with the whole factual picture. If I make a loan to my brother-in-law, I am not in a business; §166 tells me so, and we know it to be true instinctively. The distinction between a true banking business and investing is actually made fairly well in the new rules that we all fondly refer to as "FATCA." Section 1471(d)(5) defines a new term, "financial institution," to encompass three distinct types of entities: The first "accepts deposits in the ordinary course of a banking or similar business." That is, clearly a bank in the banking business. The second "holds financial assets for the account of others as a substantial portion of its business." This looks more like a trust company or custodian. Finally, the definition includes an entity that is "engaged (or holding itself out as being engaged) primarily in the business of investing, reinvesting, or trading securities" and other similar assets. In other words, investment funds. With respect to this last category of financial institution, the IRS has stated: "Although the statute refers to the `business' of investing, reinvesting, or trading, the concept of `business' as used in §1471(d)(5)(C) is different in scope and content from the concept of a `trade or business' as used in other sections of the Code. For example, isolated transactions that might not give rise to a trade or business for other purposes may cause an entity to be engaged primarily in the business of investing, reinvesting, or trading in securities, depending on such factors as the magnitude and importance of the transaction in comparison to the entity's other activities." Notice 2010-60, 2010-37 I.R.B. 329, Part II, A. This is an important acknowledgment that investment funds aren't in a business — they are pools of money that individual investors seek to have professionally managed. The managers may be in a business, but the owners of the fund are not.
This observation holds true even more clearly when one considers whether the activity of investing in distressed debt is a business. The argument has been made that if the buyer of distressed debt is in the "business" of pounding the table at creditor's committee meetings to maximize his return, this somehow converts vulture investing (bottom fishing) into a business. But this argument has no support whatsoever in law, and the people who make it cite no such support. Even more ridiculous is the claim that a person who invests in multiple businesses in order to improve their profitability and sell them at a gain is in some kind of "business." While the courts may have strained to find individual stock traders in a business in order to give them ordinary losses, no court has ever held that a mere promoter is engaged in a business or can claim ordinary losses upon failure.
So what about those stock traders? I said earlier that there is no such thing as a trader, in the sense that this is not some third prong of ETB. The courts invented trader status to give individual taxpayers ordinary losses in a world where capital losses of individuals are extremely limited. And Congress reacted to those cases by making clear, in §864(b), that whatever some sentimental judge might think to do to bend the law for an individual trader, trading is certainly not a business in the ETB sense. The presence of a safe harbor does not imply its opposite. The notion that if a foreign person engages in some activity that is not "trading," then it must be a business, is illogical and false.
The UBTI rules are not the only long-established guidance we have for divining where the line between investing and business is involved. We have acres of rules for distinguishing active businesses from passive investing in subpart F, the PFIC rules, and their predecessors. None of these rules would treat mere loan origination, distressed debt investing, or promotion as a business.5 It might be objected that the purpose of our outbound foreign tax provisions is very different from that of our inbound rules. And that would be the point.
The function of the distinction between ECI and other U.S.-source income earned by a foreign person is not to penalize foreign persons that engage in business activities. It is, and has always been, to tax business income on a net basis while taxing passive investment income on a gross basis. Once this basic function is understood, it will be clear that income from investing — whether it be loan origination, distressed debt, promotion of portfolio companies, or what have you — is not income from a business. These activities have little or no "net income" component, but are investments to earn a return. The income from these types of investments is properly taxed on a gross basis, under U.S. domestic rules such as §§871, 882, 1441, and 1442, and under the fixed income provisions of treaties.6 We can and should stop trying to fit square pegs into round holes by calling these activities ETB.
This commentary also will appear in the March 2011 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Katz, Plambeck, and Ring, 908 T.M., U.S. Income Taxation of Foreign Corporations, and in Tax Practice Series, see ¶7130, Foreign Persons — Effectively Connected Income.
1 See, e.g., Sheppard, "Neither a Dealer Nor a Lender Be: Collateralized Debt Obligations Raise New Questions," 91 Tax Notes 1038 (5/14/01), and "Neither a Dealer Nor a Lender Be, Part 4 – Vulture Fund Self Help," 52 Tax Notes 523 (11/17/08); Sicular and Sobol, "Selected Current Effectively Connected Income Issues For Investment Funds," 56 Tax Law. 719 (Summer 2003); New York City Bar Association, "Report Offering Proposed Guidance Regarding U.S. Federal Income Tax Treatment of Certain Lending Activities Conducted Within the U.S.," 2007 TNT 88-51, Doc. 2007-11142 (5/7/07); Furci, "U.S. Trade or Business Implications of Distressed Debt Investing," unpub. Tax Review Paper #264 (2009); Leblang, Rothman and Paulos, "Neither a Dealer Nor a Lender Nor a Promoter Be," unpub. monograph 2010; Shapiro & Maddrey, "The Importance of a `Customer Relationship' in Loan Origination," 126 Tax Notes 659 (1/19/10).
2 But note the parallel safe harbor at Regs. §1.892-5T(b)(3) for foreign governmental pension funds; if an activity produces only income that would be exempt from the tax on unrelated business income, it will not cause such a foreign investor to be treated as a "controlled commercial entity."
3 Section 864(c)(5)(B) contains a similar requirement — that the business be "regularly carried on" — for finding that non-U.S.-source income of a foreign person is effectively connected with its conduct of a U.S. trade or business. The regulations under this section state that the income or gain must be "realized in the ordinary course of the trade or business carried on" by the foreign person in the United States. Regs. §1.864-6(b)(1).
4 See InverWorld, Ltd. v. Comr.,T.C. Memo 1996-301; InverWorld, Ltd. v. Comr., 979 F.2d 868 (D.C. Cir. 1992); other related cases. The various opinions in this case are so incoherent that it can be, and has been, cited for almost any proposition imaginable. In GLAM 2009-010 (9/22/09), for example, the Tax Court memorandum decision in InverWorld is cited six times — mostly in support of a principle the case nowhere espoused, and one time as a case to be ignored. InverWorld, by the way, was clearly in a business, that of managing money; the only question in the case was where, and through whose offices. Any statements in the opinions about what is or is not ETB were thus wholly dicta.
5 The additions of §954(h) and (i) were needed precisely because there was serious doubt as to whether even very active financing businesses or insurance businesses would qualify as active businesses.
6 No other country that I know of would treat income from the types of activities discussed in this commentary as income from a business, with the exception of Germany, which tends to treat almost all income as business income under a special "deeming" rule. The purpose of this deeming rule, which is beyond the scope of this commentary, is unique to Germany's tax framework and related to its exemption system for taxing global income of German taxpayers.
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