Proposed Modification of the Portfolio Interest Exemption

• October 10, 2021
• Carey M. Heyman, CPA

Omitted from our post titled “Recap of Where We Stand Today,” but definitely on the minds of CLA’s Global Tax Services team, was the House Ways and Means Committee’s proposed modification to the Portfolio Interest Exemption (PIE). Under current federal tax law, a nonresident alien individual or foreign corporation that receives U.S. source interest from a domestic borrower is exempt from a 30% federal withholding tax if the interest falls within the PIE. There are numerous requirements that must be met for an interest to qualify for the PIE, but let’s dig into the details of why this is relevant to real estate investments.

A common strategy for a foreign investor to acquire an interest in U.S. real estate is to capitalize a domestic C-corporation (“Blocker Corp.”) with debt and profit participating, non-voting equity, the proceeds from which are used by the Blocker Corp. to acquire the desired real property. The Blocker Corp.’s voting equity is often held by a transaction sponsor. Over the life of the investment, the foreign investor collects interest and principal on the Blocker Corp.’s debt free from federal withholding tax and, when the property is sold, the Blocker Corp. will make a liquidating distribution to the foreign investor in redemption of its non-voting equity. The liquidating distribution is treated as a capital gain transaction rather than a dividend and, thus, escapes federal withholding tax (including withholding under the Foreign Investment in Real Property Tax Act). The federal withholding tax rate on dividends and interest paid by a U.S. corporation is 30%, unless a lower rate applies under an applicable U.S. tax treaty.

In the context of the Blocker Corp. arrangement described above, a key requirement is that the foreign lender cannot be a “10% shareholder” in the domestic corporate borrower. Generally, in the case of an obligation issued by a corporation, a 10% shareholder is any person who owns 10% or more of the total combined voting power of all classes of stock of such corporation.

The House Ways and Means Committee’s proposal would modify the definition of a 10% shareholder to include a foreign lender that holds 10% or more of the total combined voting power or value of all classes of stock of such corporation. This modification would apply to debt instruments issued after the enactment of this proposal (existing debt instruments would be grandfathered in).

If this legislation is passed:

• The non-voting equity tranches in corporate blocker structures will need to be more widely-held and sponsors will need to pay closer attention to how such equity is valued at closing and throughout the life of the investment.
• Transaction sponsors may need to consider alternative investment vehicles or revised capital structures.
• In debt workout situations, foreign lenders and domestic corporate borrowers will need to carefully review whether modifications to grandfathered portfolio debt are significant enough to result in a deemed reissuance of such debt under federal income tax law, thereby implicating the new PIE rules.

A PIE-sized thank you Mike Smith for co-authoring this post and David Springsteen for his continued Global Tax Services support. Stay tuned to CLAconnect.com for future developments.

Tags: Blocker Corp., Foreign Investor, Portfolio Interest Exemption, Ways and Means Committee, Federal and state taxation, including proposed regulations, Industry trends/analysis, Year-end tax planning | 1 Comment »