To help US companies raise capital, for decades the United States has provided tax incentives to encourage foreign investment in the US marketplace--for example, the longstanding exemption from the 30 percent withholding tax otherwise applicable to interest on portfolio debt held by foreign investors. Proposed regulations issued on June 13, 2006 (REG-11875-06) finally settle the treatment of a debt instrument issued by a US entity and held by a foreign partnership or trust.

The portfolio debt exemption requires that the foreign investor cannot have a 10 percent or more ownership interest in the US issuer (a corporation or a partnership). Various attribution rules determine the 10 percent owner status, but it was unclear how the limitation applied to a debt instrument held by a partnership (or trust): is the test applied at the partnership (or trust) level, or at the level of the partners (or owner or beneficiary)? The issue stimulated a significant body of commentary from practitioners, particularly with respect to partnerships: rather than each investor holding a direct interest in the investment vehicle, a group of investors often forms a partnership to participate in the investment.

The Treasury and the IRS concluded that the 10 percent owner limitation applies at the partner level, even though the partnership is the debt instrument's legal owner, because the choice of treating a partnership as an aggregate of its partners or as an entity separate from its partners depends on which characterization is more appropriate to carry out the law's purposes. The Treasury noted that "[t]he approach taken . . . is supported by the statute and legislative history which convey Congress' desire to facilitate the efficient and effective flow of foreign capital to U.S. borrowers while distinguishing true portfolio investors in the obligor from foreign persons making direct (10 percent) equity investments in U.S. operations." The proposed reg notes that for tax purposes, the partner is the beneficial owner of the interest paid to the partnership, because the partner, not the partnership, is taxed on the income. Furthermore, imposing a 10 percent ownership limitation at the entity level is likely to "impair the free flow of foreign capital to U.S. business." Often the individuals or other entities that are partners in a partnership are unrelated and are using the partnership investment vehicle solely for non-tax reasons; thus, there is "no apparent abuse" in such arrangements. The Treasury concluded that it would be "inapposite to the statutory framework and underlying purpose of the statute" to apply the 10 percent owner limitation at the entity level.

The proposed reg reaches a similar result for interest paid to a simple or grantor trust. A simple trust is required to distribute all income currently to the beneficiary, who is taxed on the income. Special rules treat the person who has settled a grantor trust as the trust's owner for tax purposes and tax the settlor on income received by the trust. As in the partnership ruling, the Treasury concluded that the 10 percent ownership limitation should apply at the beneficiary or owner level, not at the trust level.

The certainty provided by the proposed regs--assuming that they are finalized--is widely applauded by practitioners. Many types of investment vehicles characterized as partnerships, grantor trusts, or simple trusts hold US-issuer debt obligations. The uncertainty previously surrounding the portfolio debt exemption's availability for foreign investors posed significant concerns to investors and their tax advisers. The proposed regs conform to the realities of a modern marketplace in which unrelated investors often join together in entities to further investment objectives, and they recognize the non-abusive nature of these investment combinations.