Portfolio Interest Exemption Investments

Qualified non-US Investors May Earn 6% to 12% Annually in the US Free of Tax Withholding

Qualified non-US Investors May Earn 6% to 12% Annually in the US Free of Tax Withholding

 

Portfolio Interest can be broadly defined as the interest on specified debt obligations paid to certain foreign persons. Since 1984, Portfolio Interest has been tax exempt as described in IRC Sections 871(h) and 881(c) for the cases of non-resident aliens and corporations, respectively.

A quick summary and reference of the Portfolio Interest Exemption:

  • The issuer must be a U.S. person. [IRC § 871(h)(2)(B)(ii)(I)]
  • The holder must be a foreign person that:The underlying obligation must be in “registered form.” [IRC §§ 871(h)(2)(B)(i), 881(c)(2)(B)(i),as defined by IRC §§ 163(f), 871(h)(7), 881(c)(7)]
    1. provided proof of its foreign status [IRC §§ 871(h)(2)(B)(ii)(I) & (II), 881(c)(2)(B)(ii)(I), (II), 871(h)(5)], and that is:
    2. not a bank extending credit in the course of its ordinary trade or business (except if buying U.S. obligations) [IRC § 881(c)(3)(A)]
    3. not related to the issuer, if the foreign person is a Controlled Foreign Corporation (CFC) [IRC § 881(c)(3)(C)]; and
    4. not a “10-percent shareholder” in the issuer at the time the interest is received. [IRC §§ 871(h)(3), 881(c)(3)(B)]
  • The underlying obligation must be in “registered form.” [IRC §§ 871(h)(2)(B)(i), 881(c)(2)(B)(i), as defined by IRC §§ 163(f), 871(h)(7), 881(c)(7)]
  • The interest must not be contingent interest (with some exceptions). [IRC §§ 871(h)(4), 881(c)(4)]
  • Before the obligation is issued, the Secretary must not have determined in writing (and published a statement) that the foreign country of the creditor has inadequate information exchange with the U.S. [IRC §§ 871(h)(6), 881(c)(6)]
  • The interest must be Fixed, Determinable, Annual or Periodic income (FDAP), and cannot be income “effectively connected” to the U.S. trade or business (ECI). [IRC §§ 871(a), 881(a), 871(h), 881(c)]

The main goals of these provisions are to ensure that (1) U.S. persons do not benefit from the tax free interest, and (2) the underlying debt is not like equity in the hands of the holder.