foreign partners deserve their share of the p.i.e.: the portfolio...

FOREIGN PARTNERS DESERVE THEIR SHARE OF THE P.I.E.: THEPORTFOLIO INTEREST EXEMPTION AS APPLIED TO PARTNERSHIPSBy Annie H. Jeong

Table of Contents

I. Introduction . . . . . . . . . . . . . . . . . . . . . . . 635II. Overview of the Portfolio Interest

Exemption . . . . . . . . . . . . . . . . . . . . . . . . 635A. Basic Portfolio Interest Exemption . . . . . 636B. IRS Field Advice . . . . . . . . . . . . . . . . . . 636

III. Analysis Under Current Law . . . . . . . . . . 637A. Ownership Limitation at the Partner

Level . . . . . . . . . . . . . . . . . . . . . . . . . 637B. Withholding on Portfolio Interest . . . . . . 638C. Treaty Benefits . . . . . . . . . . . . . . . . . . . 640

IV. Conclusion . . . . . . . . . . . . . . . . . . . . . . . 641

I. Introduction

In 1994 the IRS issued a field service advice indicatingthat it would take an aggregate approach in applying the10 percent ownership limitation in section 871(h)(3)(A)with respect to the portfolio interest exemption.1 Thus,the determination of whether interest is received by a ‘‘10

percent shareholder’’ for purposes of disallowing theportfolio interest exemption would be made at the part-ner level as opposed to the partnership level.2 As isapparent from the legend on field service advice andprivate letter rulings, however, determinations made inthat limited authority ‘‘may not be used or cited asprecedent.’’

Since then, the IRS has been silent on whether the 10percent ownership limitation should be applied at thepartnership or the partner level. This article provides abasic overview of the portfolio interest exemption andconcludes that the 10 percent ownership limitationshould be applied at the partner level.3 Partner-levelapplication of the 10 percent ownership limitation wouldnot only be in accord with the withholding rules regard-ing portfolio interest (which provide a look-through rulefor determining whether withholding is required onportfolio interest) and the general purpose underlyingthe portfolio interest exemption, but would prevent pe-nalizing taxpayers that choose to pool their resources andlend money through a partnership vehicle. Regardless ofwhat position the IRS ultimately takes, the importance ofcertainty cannot be discounted. Without it, taxpayers andwithholding agents are left to their own musings as towhat the correct answer is or should be.

II. Overview of the Portfolio Interest Exemption

Nonresident aliens and foreign corporations that arenot engaged in a U.S. trade or business and that receiveU.S.-source interest are generally subject to tax undersections 871(a)(1) and 881(a)(1) (at a current rate of 30percent), unless an applicable income tax treaty reducesor eliminates the tax or an exception under domestic law

1Internal Revenue Code of 1986, as amended (the code). Allsection references herein are to the code unless otherwiseindicated.

2Unnumbered field service advice dated Feb. 2, 1994, 1994WESTLAW 1866354, 1994 LEXIS 430.

3This article, however, is limited to the application of the 10percent ownership limitation to the portfolio interest exemptionand is by no means intended to imply that the determination ofwhether a foreign bank operating in partnership form, orthrough a partnership, receives interest described under section881(c)(3)(A) should be applied at the partner level or thepartnership level. For additional discussion on the rationale forapplying the 10 percent ownership limitation at the partnerlevel, see ABA Section of Taxation, ‘‘The Need for Guidance onthe Portfolio Interest Exemption,’’ Tax Notes, May 10, 2004, p.701.

Annie H. Jeong is an associate at Wachtell, Lipton,Rosen & Katz. She is grateful to Peter C. Canellos,David M. Einhorn, and Jodi J. Schwartz for theirhelpful comments and suggestions.

In this article, the author provides a brief overviewof the 10 percent ownership limitation under theportfolio interest exemption and proposes that thelimitation be applied at the partner level. The authorbelieves that the limitation as applied at the partner-ship level creates unjust and unintended results,whereas, if applied at the partner level, the limitationwould adequately prohibit the use of the portfoliointerest exemption by persons owning 10 percent ormore of the obligor, while allowing those who prop-erly deserve to qualify under the portfolio interestexemption to benefit from the exemption.

Copyright 2006 Annie H. Jeong.All rights reserved.

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applies.4 One exception, commonly referred to as the‘‘portfolio interest exemption,’’ can be found in sections871(h) and 881(c). Under those provisions, U.S.-sourceinterest received by nonresident individuals and foreigncorporations that would otherwise be subject to U.S. taxunder sections 871(a)(1) and 881(a)(1) will not be subjectif the interest qualifies as ‘‘portfolio interest.’’

A. Basic Portfolio Interest ExemptionThe definition of portfolio interest is relatively broad,

and generally includes interest (including original issuediscount) on a debt obligation (A) in registered form,provided the relevant withholding agent receives propercertification that the beneficial owner of the obligation isnot a U.S. person and (B) in unregistered form (that is,obligations in bearer form), provided that the obligationis described in section 163(f)(2)(B). Section 163(f)(2)(B)requires that interest on an unregistered obligation bepayable only outside the United States and its posses-sions, that a statement appear on the face of the obliga-tion that any U.S. person holding the obligation will besubject to limitations under the income tax laws of theUnited States, and that arrangements are in place reason-ably designed to make certain that the obligation willonly be sold (or resold in connection with original issue)to a person other than a U.S. person.

The definition of portfolio interest, however, is subjectto some exceptions. Portfolio interest does not includeinterest received by (a) a ‘‘10 percent shareholder’’ (the 10percent ownership limitation),5 (b) a bank with respect toan extension of credit that is made under a loan agree-ment entered into by the bank in its ordinary course oftrade or business (other than interest on an obligation ofthe United States),6 and (c) a controlled foreign corpora-tion from a related person.7 Some kinds of contingentinterest will also fail to qualify for the portfolio interestexemption.8

If an obligation is issued by a corporation, a 10 percentshareholder is ‘‘any person who owns 10 percent or moreof the total combined voting power of all classes of stockof such corporation entitled to vote,’’9 and if the obliga-tion is issued by a partnership, a 10 percent shareholderis ‘‘any person who owns 10 percent or more of the

capital or profits interest in such partnership.’’10 Theplain language of the statute seems relatively clear, butthe devil is in the details. Constructive ownership rules insection 318 apply (subject to a few exceptions particularto the portfolio interest exemption) for purposes ofdetermining the ownership of stock and partnershipinterests.11 Thus, under the constructive ownership rulesof section 318, a partnership is treated as owning all ofthe stock that is owned directly or indirectly by or for apartner,12 but a partner is treated as owning only thestock owned directly or indirectly by a partnership inproportion to the partner’s interest in the partnership.13

The constructive ownership rules as applied to andfrom partnerships can be illustrated by the followingexample. Assume each of W, X, Y, and Z is a partner inWXYZ partnership, owns 8 percent of the stock ofcorporation A, and has a 25 percent interest in the capitaland profits of WXYZ partnership. WXYZ also ownsdirectly 8 percent of corporation A stock. Under theattribution rules of section 318, each of W, X, Y, and Z istreated as owning 10 percent of corporation A stock,because each of W, X, Y, and Z is treated as owning hisproportionate share of the stock owned directly or indi-rectly by WXYZ partnership (that is, 2 percent of corpo-ration A stock) in addition to his 8 percent direct stockinterest in corporation A. WXYZ partnership, on theother hand, is treated as owning 40 percent of corpora-tion A stock because under the attribution rules, WXYZpartnership is deemed to own all of the corporation Astock owned by each of W, X, Y, and Z (that is, 8 percentowned by each partner (or 32 percent) of corporation Astock) in addition to its 8 percent direct ownershipinterest in corporation A stock.

B. IRS Field Advice

In 2003 the IRS made available a field service advice,issued in 1994, that applied the 10 percent ownershiplimitation at the partner level and concluded that section871(h)(3)(C)(iii) prevented attribution of options ownedby a partnership from the partnership to its partners.14 Inthe field service advice, a foreign partnership made aloan to several domestic partnerships that was convert-ible into a 10 percent or more equity interest in each of the

4Interest is generally treated as ‘‘U.S. source’’ if it is paid oraccrues on a debt obligation of a U.S. person. Section 861(a)(1).

5Sections 871(h)(3)(B) and 881(c)(3)(B).6Section 881(c)(3)(A).7Section 881(c)(3)(C).8Sections 871(h)(4) and 881(c)(4). For purposes of the portfo-

lio interest exemption, contingent interest includes (1) interest ifthe amount is determined by reference to (A) any sales, receipts,or other cash flow of the borrower or a person related to theborrower within the meaning of section 864(d)(4) (a relatedperson), (B) any profits or income of the borrower or a relatedperson, (C) any change in the value of property of the borroweror a related person, or (D) any partnership distributions, divi-dend, or other similar payments made by the borrower or arelated person, and (2) any other kind of contingent interest thatthe Treasury secretary identifies by regulation, when to deny theportfolio interest exemption would be appropriate or necessaryto prevent federal income tax avoidance. Section 871(h)(4).

9Section 871(h)(3)(B)(i)

10Section 871(h)(3)(B)(ii).11Section 871(h)(3)(C). Specifically, the exceptions are that the

50 percent limitations under section 318(a)(3)(C) and318(c)(2)(C) are ignored for purposes of determining attributionto and from corporations, respectively, except that if attributionto a corporation would not have applied had the 50 percentlimitation been ignored, the corporation will be treated asowning only the stock in another corporation that is owned byor for any shareholder in the same proportion that the value ofthe stock held by the stockholder bears to the total value of allstock in the corporation.

12Section 318(a)(3)(A).13Section 318(a)(2)(A).14Supra note 2. For further discussion of the ruling and the

position that the 10 percent ownership limitation should beapplied at the partnership level, see Entin, ‘‘Partnerships andthe Portfolio Interest Exemption,’’ Tax Notes, Sept. 1, 2003, p.1171.

COMMENTARY / SPECIAL REPORT

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partnerships. It appears that because the loan was con-vertible into a 10-percent-or-greater equity interest ineach of the domestic borrowers, the borrowers took theposition that the interest was not portfolio interest and sothe portfolio interest exemption from withholding wasunavailable to a foreign partner in the foreign partner-ship — even though the foreign partner did not directlyown an equity interest in the domestic borrowers —because the foreign partnership itself should be deemedto own a 10-percent-or-greater equity interest in each ofthe borrowers under the constructive ownership rules.Thus, the borrowers took an entity approach regardingthe 10 percent ownership limitation and withheld U.S.tax on the foreign partner’s allocable share of interestincome paid under the loan. The foreign partner chal-lenged the borrowers’ determination and claimed a re-fund of the tax withheld, asserting that the portfoliointerest exemption applied.

The IRS agreed with the foreign partner, determiningthat the 10 percent ownership limitation should be ap-plied at the partner level. The IRS reasoned that to applythe 10 percent ownership limitation at the partnershiplevel would effectively attribute the entire partnership’sequity interest in the partnership to each individualpartner. That result would be inconsistent with the ap-plication of section 318(a)(2), which limits attributionfrom partnerships to the partner’s proportionate interestin the partnership. Although the IRS admitted that theconstructive ownership rules in section 318 literally ap-ply an entity approach, the rationale behind the IRS’sdetermination was that a partner is generally the benefi-cial owner of income received by a partnership and,unlike a corporation, a partnership is not a taxpayer. TheIRS stated that the application of the 10 percent owner-ship limitation at the partner level was ‘‘consistent withthe overall policies embodied in the portfolio interestexception; to provide U.S. borrowers with access toforeign capital, but to distinguish foreign lenders fromforeign persons making direct (10 percent) equity invest-ments in U.S. operations.’’ The IRS also stated thatventure capital firms generally lend money to domesticentities through partnership vehicles, which implies thatthe IRS believed that the application of the 10 percentownership limitation at the partnership level could nega-tively affect foreign investment in domestic business.

III. Analysis Under Current Law

A. Ownership Limitation at the Partner Level

The determination and result of the field serviceadvice should be applauded and followed. Under currentlaw, however, it is unclear whether the 10 percent own-ership limitation would be applied at the partnershiplevel or the partner level. Indeed, under a literal readingof section 871(h)(3), a partnership could be a 10 percentshareholder such that payments made by a domesticobligor to a partnership would not constitute ‘‘portfoliointerest.’’ As discussed above, a 10 percent shareholder isdefined as ‘‘any person’’ owning 10 percent or more ofsome equity interests in a domestic obligor, and the term‘‘person’’ is defined in the code to mean ‘‘an individual,a trust, estate, partnership, association, company or cor-

poration.’’15 Thus, it is possible that the IRS would takethe position that the 10 percent ownership limitationshould apply at the partnership level. That position couldproduce unjust and unintended results.

For instance, assume six foreign individuals — A, B, C,D, E, and F — form partnership Y, a foreign partnership,and contribute $100 to Y in exchange for a partnershipinterest. Each of A, B, C, D, E, and F agrees to shareequally in the profits and losses of Y. Y then uses the $600to acquire registered notes of corporation X, a publiclytraded corporation that has only one class of stock —common voting stock — outstanding. Each of A, B, C, D,E, and F owns 2 percent of X common stock. If the 10percent ownership limitation were applied to Y and Y —but for the inbound partnership attribution rules —would have otherwise qualified for the portfolio interestexemption, the individual partners would be barred fromclaiming the portfolio interest exemption on interestpayments made by X to Y, despite the fact that none ofthe individual partners owns more than 10 percent of Xstock and that each of the individual partners of Y couldhave qualified for the portfolio interest exemption hadshe acquired the notes directly, because Y would bedeemed to own 12 percent of X voting stock under theconstructive attribution rules.

That is particularly troubling for foreign investmentpartnerships (especially publicly traded foreign partner-ships) that invest in debt obligations of publicly tradedcorporations, when foreign partners could own in theaggregate 10 percent or more of the voting stock of apublicly traded corporate borrower but no individualpartner owns more than a fraction of a percent of thestock of that borrower. Foreign partners exit and enterinvestment partnerships, sometimes on a daily basis, andthe administrative burden of having to determinewhether the 10 percent ownership limitation has beenviolated seems patently unfair. Partnerships would thenhave to determine the percentage of equity interestsowned by its partners in any obligors of the partnershipand require that the partners notify the partnership if anysuch equity interest is sold or acquired. It is doubtful thatany investor would freely supply this information to apartnership rather than forgo investing in the partnershipaltogether. Even if an individual did want to supply theinformation, determining equity ownership could provean impossible task given the broad sweep of the construc-tive ownership rules, particularly when the individualinvests in a partnership through higher-tier partnershipsor passthrough entities. Similarly, for the individualpartner claiming the portfolio interest exemption, it isdoubtful whether such a partner would have informationreadily available to ascertain the equity ownership inter-ests of all other partners of the partnership. While theburden is less troublesome for small partnerships, toapply the 10 percent ownership limitation (assuming itspartners could determine what stock they directly andconstructively own) at the partnership level in today’sworld of investment funds and large partnerships seems

15Section 7701(a)(1).



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an unwieldy and overly burdensome task, especiallywhen higher-tier partnerships are involved.

Moreover, to prevent foreign partners from benefitingfrom an exemption that was originally intended to pro-mote foreign investment in the United States simplybecause the foreign partner decides to invest through aforeign partnership vehicle runs contrary to the verypurpose behind the portfolio interest exemption. When,as here, there is no abuse, the application of the 10percent ownership limitation to partnerships could pre-clude individual investors from investing through for-eign partnerships. Arguably, a partner that is not a 10percent shareholder of an obligor would choose to ac-quire debt obligations of the obligor directly rather thantaking the risk of suffering a 30 percent tax cost (assum-ing no treaty or other exception applies) on interestpayments made by the obligor to the partnership.

Given the proliferation of securities investments madeby investment partnerships and the access that thoseinvestment partnerships have to investment opportuni-ties, compared with the difficulty of (and often preclusionfrom) investing in those investments as an individualinvestor, it seems unfortunate that a foreign partnercould be effectively precluded from making investmentsthat are, in practice, only available to large investmentpartnerships and major financial institutions. The resultseems unjustified and would favor some investors (thatis, persons that do not make equity investments) overothers. Even if an individual could gain access to equallyattractive debt investments, information and transactioncosts could preclude the foreign investor from investingin U.S. obligations and cause the investor to take herbusiness elsewhere. Similarly, it seems unjustified thatthe equity ownership of a domestic partner in a foreignpartnership could preclude foreign partners from claim-ing the portfolio interest exemption, particularly whennone of the foreign partners own an equity interest in adomestic borrower.

It is interesting to note that if the 10 percent ownershiplimitation were to apply at the partnership level, thepartners could arguably form a domestic partnership andthe portfolio interest exemption would be available tothose same partners (assuming each partner did notdirectly, indirectly, or constructively own more than a 10percent interest in the obligor). It seems an anomaly toburden foreign partners by preventing the application ofthe portfolio interest exemption merely because partnersdecide to invest in a foreign partnership rather than adomestic partnership.

B. Withholding on Portfolio InterestThe portfolio interest exemption, if applied at the

partner level, would also conform to the current with-holding rules regarding interest received by foreign per-sons.1. Current withholding rules generally. Interest thatqualifies as portfolio interest is generally exempt fromwithholding, subject to a specific knowledge exception.In particular, no tax must be deducted or withheld frominterest that qualifies as portfolio interest unless thewithholding agent knows, or has reason to know, that theinterest is not portfolio interest because the interest iseither contingent interest (within the meaning of sections

871(h)(4) and 881(c)(4)) or received by a disqualifiedrecipient.16 If the 10 percent ownership limitation weredetermined at the partnership level so as to disallow theportfolio interest exemption, one would have to look tothe general rules applicable to withholding on interestpayments. To apply the 10 percent ownership limitationat the partnership level is counterintuitive to the currentframework of the withholding rules, which generallyprovide a look-through rule regarding withholding oninterest payments made to foreign partnerships.

The code provides that a withholding tax (currently ata rate of 30 percent) applies to payments of interest thatis not effectively connected income made to nonresidentalien individuals and foreign partnerships and corpora-tions, unless a treaty applies (to either reduce or eliminatethe tax) and except as otherwise provided in the regula-tions. Whether withholding is required on payments ofinterest made to a partnership based on the aggregate orentity approach generally depends on the status of thepartnership as either domestic or foreign, and if thepartnership is foreign, whether the partnership is a‘‘nonwithholding foreign partnership’’ or a ‘‘withholdingforeign partnership.’’ The withholding rules regardingpayments made to partnerships, however, generally fa-vor a look-through approach. Domestic partnerships aregenerally treated as withholding agents with respect tointerest that is not effectively connected income in thehands of its partners and must withhold tax on anyinterest paid to foreign partners to the extent the interestis includable in the gross income of the foreign partnerand subject to withholding.17

Regarding foreign partnerships that are nonwithhold-ing foreign partnerships, the withholding rules under thecode provide that interest paid to a foreign partnership isgenerally treated as paid to its partners if ‘‘the withhold-ing agent can reliably associate a partner’s distributiveshare of the [interest] with a valid Form W-8, or otherappropriate documentation, [certifying that] the partneris a payee that is a foreign beneficial owner.’’18

Interest payments made to a foreign partnership thatis a ‘‘foreign withholding partnership’’ are not subject towithholding, although the withholding agent may treatthe payments as made to the foreign partnership, so longas the withholding agent can reliably associate the inter-est payment with a withholding foreign partnership

16Sections 1441(c)(9) and 1442(a).17Treas. reg. section 1.1441-5(b)(2).18Treas. reg. section 1.1441-5(c)(1)(i). A withholding agent

may treat a foreign partnership as a ‘‘nonwithholding foreignpartnership’’ as long as it receives a valid nonwithholdingforeign partnership withholding certificate from the partner-ship. A nonwithholding foreign partnership withholding certifi-cate is valid to the extent that (a) it is furnished on a Form W-8(or acceptable substitute or other form as the IRS prescribes), (b)it is signed under penalties of perjury by a partner withauthority to sign for the partnership, (c) its validity has notexpired, (d) it contains the information required under theregulations, and (e) all withholding certificates and other ap-propriate documentation for all persons to whom the certificaterelates are associated with the certificate. Treas. reg. section1.1441-5(c)(3).



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withholding certificate.19 Foreign withholding partner-ship status, however, can be obtained only if the foreignpartnership enters into an agreement with the IRS (sub-ject to the IRS’s discretion) regarding distributions andguaranteed payments that the partnership makes to itspartners. Also, if a foreign partnership obtains status as aforeign withholding partnership, it becomes subject to aseries of withholding and reporting provisions generallyapplicable to withholding agents, unless the agreementwith the IRS provides otherwise.20

In the absence of proper documentation regarding aforeign partnership’s status as either a nonwithholdingforeign partnership or a foreign withholding partnership,some presumptive rules in Treas. reg. section 1.1441-1(b)(3)(ii) apply to the classification of the partnership.21

If, under those presumptive rules, the partnership istreated as a foreign partnership, the partnership is nottreated as the recipient of the interest payments; rather,the beneficial owners of the interest (generally the part-ners, or if a particular partner is a look-through entity, theultimate beneficial owners of the interest payments) aretreated as the recipients of the interest.22 Thus, in theabsence of those complex rules regarding withholdingobligations for nonwithholding and withholding foreignpartnerships, foreign partnerships that are treated assuch under the presumptive rules would necessarily betreated as look-through entities for purposes of determin-ing the amount of withholding required with respect tointerest paid to the partnership.2. Withholding rules as applied to the portfolio interestexemption, assuming the 10 percent ownership limita-tion applied at the partnership level. Assuming the 10percent ownership limitation were applied at the part-nership level, the determination of whether withholdingis required under the current withholding rules wouldproduce incongruous results. If the partnership weretreated as a 10 percent shareholder, the partners would beprecluded from claiming the portfolio interest exemp-tion. The language of the withholding regulations, on theother hand, specifically requires that a withholding agentof a partnership (other than a withholding foreign part-nership) treat the partners, and not the partnership, asthe recipients of interest income. Thus, for purposes ofdetermining whether withholding is required, the port-folio interest exemption would be applied at the partnerlevel, and as a result, it is possible that no withholdingwould be required on interest that qualifies as portfoliointerest at the partner level, even though the partnerswould ultimately be precluded from claiming the port-folio interest exemption if the partnership owned a10-percent-or-greater equity interest in the U.S. borrower.As a result, partners would benefit from a timing differ-ence because no withholding would be required, al-though ultimately the partners could be responsible fortax on the interest (assuming no treaty or other exceptionapplied).

That peculiar result becomes further complicated de-pending on whether the partnership is foreign or domes-tic, and if foreign, is a withholding foreign partnership ora nonwithholding foreign partnership. If the beneficialowner of a domestic partnership is treated as the recipi-ent of interest payments, then for purposes of determin-ing the domestic partnership’s withholding obligation,the 10 percent ownership limitation would be appliedonly at the partner level and the domestic partnershipwould not be required to withhold tax on any interestincome that qualifies as portfolio interest in the hands ofthe foreign partner, is received by the partnership from adomestic obligor, and is allocated by the partnership tothe foreign partner.

If the partnership were a nonwithholding foreignpartnership, the determination of whether the foreignpartnership would be subject to withholding would alsobe determined based on each particular partner, becausethe partner is treated as the recipient of the paymentunder the withholding rules. Thus the 10 percent own-ership limitation would apply only at the partner level,not the partnership level, and as described above, foreignpartners would benefit from a timing difference becauseno withholding would be required — although ulti-mately, the partners would be liable for tax on the interest(assuming no treaty or other exception applied).

On the other hand, if the foreign partnership were awithholding foreign partnership, the withholding agentcould choose to treat the interest payments as made to theforeign partnership or its partners. Assuming the with-holding agent treated the payments as made to theforeign partnership and the 10 percent ownership limi-tation would be violated at the partnership level, a 30percent withholding tax would apply to interest paid tothe partnership (in the absence of a treaty or otherexception). Alternatively, if the withholding agent treatedthe payments as made to the foreign partners, arguablyno withholding by the withholding agent would berequired because the interest would qualify as portfoliointerest (assuming the other requirements under theportfolio interest exemption are satisfied) for purposes ofdetermining the withholding agent’s withholding obliga-tions. The foreign partnership would then be obligated towithhold and would also treat the interest payments asmade to the partners, so that the 10 percent ownershiplimitation would apply at the partner level. Thus, thepartners would not be subject to withholding, althoughthe partners could ultimately be subject to tax becausethe partnership owned a 10-percent-or-greater equityinterest in the U.S. obligor.3. Withholding rules as applied to the portfolio interestexemption, assuming the 10 percent ownership limita-tion applied at the partner level. Now assume that the 10percent ownership limitation were applied at the partnerlevel. This application would be consistent with theframework of the current withholding rules. A domesticpartnership that owned securities of a domestic corporateobligor would not be required to withhold on interestpayments made to a foreign partner who did not directlyor indirectly own a 10-percent-or-greater equity interestin the borrower. If the partnership owned 100 percent ofthe debtor corporation, and the foreign partner owned a10 percent equity interest in the partnership, upstream

19Treas. reg. section 1.1441-5(c)(1)(ii).20Treas. reg. section 1.1441-5(c)(2).21Treas. reg. section 1.1441-5(d).22Treas. reg. section 1.1441-1(b)(3(ii).



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attribution would preclude the partner from benefitingfrom the portfolio interest exemption and the partnerwould be subject to withholding tax at a 30 percent rate(assuming no treaty or other exception applied).

Similarly, if the partnership were a nonwithholdingforeign partnership, the look-through approach wouldapply so that withholding obligations and the availabilityof the portfolio interest exemption would be determinedat the individual partner level. Thus, if a particularpartner qualified for the portfolio interest exemption, thepartner would not be subject to tax on the portfoliointerest and, in keeping with the principles underlyingthe withholding rules, no withholding would be re-quired. If any particular partner did not qualify for theportfolio interest exemption, both withholding and the 30percent tax on interest payments would apply.

The same result would occur if, with respect to awithholding foreign partnership, the withholding agentof the partnership chose not to withhold on paymentsmade to the foreign partnership. The foreign withholdingpartnership would then have the obligation to withholdon payments of interest that qualified as portfolio inter-est, and depending on the availability of the portfoliointerest exemption to each particular partner, the foreignpartnership would be obligated to withhold only whenthe particular partner did not qualify for the portfoliointerest exemption. If a partner were also a partnership,the look-through rules could arguably apply up thechain, assuming each of the partnerships is a withholdingforeign partnership, so that the 10 percent ownershiplimitation would be applied only to the ultimate benefi-cial owner.

If, on the other hand, the withholding agent of thewithholding foreign partnership decided to treat theforeign partnership as the payee, the withholding agentcould presumably withhold tax on interest paid to thepartnership. The foreign partnership, as the withholdingagent for its partners, would determine the ultimate taxliability of each partner. If some or all of the partnerswere entitled to the portfolio interest exemption, thepartnership could itself claim a refund of amounts thatwere erroneously withheld by the withholding agent.While there may be a timing mismatch with respect toamounts overwithheld by the withholding agent, thatresult is not particular to the portfolio interest exemption,because the withholding agent is generally permittedunder the regulations to treat the foreign partnership asthe payee with respect to U.S.-source income paid to aforeign partnership.

In each instance, the withholding rules track the actualavailability of the portfolio interest exemption, so that aforeign partner who is not subject to withholding wouldnot later have an obligation to pay tax on the interest.Such a result is fair, reasonable, and in keeping with theprinciples underlying the 10 percent ownership limita-tion — to preclude some persons related to the domesticborrower from claiming an exemption intended to pro-mote foreign investment. Such a system is also in keepingwith the purpose behind the withholding rules, whicheffectively require foreign persons to pay tax on receipt ofU.S.-source income rather than requiring the governmentto track down foreign persons in other jurisdictions andattempt to impose U.S. tax. Moreover, to impose incon-

sistent withholding rules and tax obligations by applyingthe 10 percent ownership limitation at the partner levelseems inappropriate and unjustified, particularly giventhe proliferation of foreign partnerships since the dawnof the check-the-box era.4. Possible concern with the application of the 10percent ownership limitation at the partner level. Oneconcern with applying the 10 percent ownership limita-tion to partners of a partnership may have been thatabusive transactions could result if a partnership owning100 percent of the equity interests of, or a controllingstake in, a domestic obligor could somehow adjust thepartnership allocations so that interest payments weremade to a foreign partner owning less than 10 percent inthe partnership, whereas other income would be allo-cated to another partner. However, the current regula-tions dealing with shifting and transitory allocationsshould prevent that result. If the IRS were still concernedabout potential abuse, one solution could be to limit theapplication of the portfolio interest exemption to partnerswho do not have effective control of the borrower basedon the facts and circumstances surrounding the transac-tion, and with respect to a withholding obligation, theIRS could apply a ‘‘reason to know’’ rule similar to thatunder section 1441(c)(9). In any event, such a rule couldbe applied generally to the portfolio interest exemptionand need not be dealt with solely with respect to part-nerships.

C. Treaty BenefitsThe application of the 10 percent ownership limitation

at the partnership level also seems inconsistent with theapplication of income tax treaties. Like the portfoliointerest exemption, treaty benefits provide an additionalmeans by which foreign persons can receive an exceptionfrom, or a reduced rate of, tax on the receipt of interestpayments from a domestic obligor.

Income tax treaties to which the United States is aparty generally provide that partnerships and otherpassthrough entities are not entitled to claim treatybenefits.23 Rather, a look-through rule generally appliesfor purposes of determining who is an ultimate beneficialowner of the income received by a partnership or otherpassthrough entity. Thus, if a reduced rate of, or no, U.S.federal income tax is due on interest because treatyapplies, the partner (or other ultimate beneficiary of suchincome) must claim the treaty benefit, rather than thepartnership. That rule is generally intended to preventforum shopping and to prevent persons from claimingbenefits of a particular treaty with the United States bysimply becoming a partner in a partnership located in ajurisdiction different from that of the particular partner.

Like the treaty exception to U.S. tax on interest pay-ments, the 10 percent ownership limitation should be

23There are, however, some exceptions. For instance, onAugust 26, 2005, the competent authorities of the United Statesand Mexico signed an agreement regarding when somepassthrough entities (for example, partnerships and limitedliability companies) would be entitled to treaty benefits. SeeAnn. 2005-72, 2005-41 IRB 692, Doc 2005-20508, 2005 TNT 195-15(Oct. 7, 2005).



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applied at the partner level. That approach would pro-vide parity for foreign persons entitled to claim eithertreaty benefits or the portfolio interest exemption withrespect to payments of interest by a domestic obligor.

IV. ConclusionThe portfolio interest exemption should be applied at

the partner level so that individual partners are notpenalized for choosing to invest in foreign partnershipsthat purchase debt obligations. While it is understand-able that the 10 percent ownership limitation should beapplied to a corporation, there is a distinct differencebetween partnerships and corporations. As stated in the1994 field service advice, a corporation, unlike a partner-ship, is a taxpayer. Thus, to deny the portfolio interestexemption to a corporation that owns 10 percent or moreof the equity interests in a domestic borrower wouldpreclude the interest payments made to the corporateborrower from qualifying for the portfolio interest ex-emption. That outcome does not unjustifiably harm for-eign shareholders, because corporations are separatetaxpayers and payments made to those shareholderswould generally be in the nature of dividends, notinterest. The double taxation that results from that ap-

proach, and the preclusion from claiming the portfoliointerest exemption, is within the purpose and structure ofthe portfolio interest exemption. Foreign partners, on theother hand, would suffer an unwarranted detriment,because the foreign partnership is not a taxpayer, and todeny the portfolio interest exemption to a foreign part-nership effectively denies the portfolio interest exemp-tion to the foreign partner.

There is no policy justification for that result, and thecurrent rules effectively prohibit the unwarranted appli-cation of the portfolio interest exemption. Under thecurrent rules, each particular partner ultimately will besubject to U.S. tax and withholding on nonportfoliointerest. The only result obtained if the 10 percent own-ership limitation were applied at the partnership level isthat foreign partners who choose to invest in a foreignpartnership, and would qualify for the portfolio interestexemption on an individual basis, would be penalizedfor their choice. To protect foreign partners who invest indomestic businesses, the portfolio interest exemptionshould be applied to promote foreign investment in U.S.business, and therefore the 10 percent ownership limita-tion should be applied only at the partner level, or thebeneficial owner level.



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Doc 2006-1148 (7 pgs)

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foreign partners deserve their share of the p.i.e.: the portfolio...

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