Internal Revenue Service Guidance on the U.S. Federal Income Taxation of Loan Origination Activities of Foreign Persons

September 25, 2009

I. Introduction

In a general legal memorandum (the “Memorandum”) issued on September 23rd to the Financial Services division of the Manhattan office of the Internal Revenue Service (the “IRS”), the IRS Office of Chief Counsel concluded that a foreign corporation that made “considerable, regular and continuous” loans to U.S. persons (“U.S. Borrowers”) derives income effectively connected with a U.S. trade or business (“ECI”) when its agent in the U.S. performed all of the substantive lending activities (e.g., soliciting U.S. Borrowers, negotiating loan terms, analyzing the credit of U.S. Borrowers, etc.) in the U.S. on behalf of the foreign corporation, even though the foreign corporation’s employees finally approved and executed the loan documentation outside of the United States.

While the legal conclusion reached in the Memorandum is not surprising given the particular facts involved, the Memorandum is significant because:

  1. it is the first written guidance that the IRS has issued in some time regarding the U.S. taxation of “loan origination” activities engaged in by foreign persons ; and
  2. the Memorandum expresses the Chief Counsel’s understanding that foreign persons may have used other strategies to originate loans in the United States giving rise to ECI and encourages the IRS Manhattan office “to develop these cases, and we stand ready to assist you in the legal analysis.”

II. Summary of the Memorandum

The Memorandum involved a corporation incorporated in a foreign jurisdiction which does not have a bilateral income tax treaty with the U.S. and which has no U.S. shareholders and no U.S. offices or employees (the “Foreign Corporation”). The Memorandum states that “Foreign Corporation makes loans to U.S. [Borrowers] within the United States.” To originate such loans, Foreign Corporation engages a U.S. corporation (“Origination Co.”), pursuant to a service contract to engage in all of the origination activities in exchange for an arm’s-length fee. The Memorandum does not state (i) whether the Foreign Corporation is engaged in any activities other than making loans, or (ii) whether the Origination Co. is related to the Foreign Corporation.

The activities performed by Origination Co. include soliciting the U.S. Borrowers, negotiating loan terms, analyzing the credit of the U.S. Borrowers, and all other activities relating to loan origination other than the final approval and signing of the loan documents. Origination Co. conducts these activities on a “considerable, continuous, and regular basis” from an office located in the United States. However, Origination Co. is not authorized to conclude contracts on behalf of Foreign Corporation. Foreign Corporation’s employees, who work in an office located outside of the United States, give final approval for the loans and physically sign the loan documents on behalf of Foreign Corporation.

Based on these facts, the Memorandum concludes that Foreign Corporation is engaged in a lending business within the United States and is not entitled to rely upon the statutory “safe harbor” exemption applicable to foreign persons engaged in “trading” in stocks or securities for their own account. The IRS notes that although Origination Co. acts on behalf of Foreign Corporation pursuant to a service contract and does not have authority to conclude contracts, Origination Co. performs important activities that are a component of Foreign Corporation’s lending activities. Therefore, the IRS treats Origination Co. as the agent of Foreign Corporation and attributes the activities of Origination Co. to Foreign Corporation in determining whether the Foreign Corporation is engaged in a U.S. trade or business. Because the lending activities of Foreign Corporation, which are carried on by Origination Co., are “considerable, continuous and regular,” the IRS concludes that Foreign Corporation is engaged in a “lending” business within the United States.

The Memorandum finally concludes that the interest income that Foreign Corporation receives from the U.S. Borrowers constitutes ECI because the U.S. office of Origination Co. is attributed to Foreign Corporation and Origination Co.’s U.S. office actively and materially participates in the origination of Foreign Corporation’s loans to U.S. Borrowers.1

We will continue to update you on further developments regarding the IRS’ actions relating to the lending activities of foreign persons.

Please contact Peter Pront (212-574-1221), Ronald Cima (212-574-1471), Daniel Murphy (212-574-1210) or Jim Cofer (212-574-1688) if you have any questions regarding the implications of the Memorandum.


1 In analyzing the ECI nature of the interest income derived by Foreign Corporation, the IRS noted that different rules are contained in the applicable Treasury regulations with respect to U.S. source income and foreign source income regarding whether income is attributable to a U.S. office maintained by a foreign person. In this regard, the applicable Treasury regulations relating to foreign source income do not attribute a U.S. office of an agent to a foreign principal if the agent does not have, and habitually exercise, the authority to regularly negotiate and conclude contracts on behalf of the foreign principal. Therefore, the analysis adopted by the IRS in determining whether the interest income derived by Foreign Corporation constitutes ECI indicates that the Memorandum would have reached a different result if Foreign Corporation had derived interest income from loans to non-U.S. Borrowers (i.e., foreign source income)