Loan Origination as an Asset Class — What Tax Issues Do I Need To Be Aware of?
August 15, 2017
By Simcha David, CPA, JD
In Hollywood, everyone you meet in a café is a director or producer in the film industry. Today in the asset management industry, everyone you meet is interested in direct lending. Many times the origination fees associated with a direct lending opportunity make for stellar returns on these investments. Direct lending, however, can lead to unanticipated tax consequences for certain limited partners. There are ways for both hedge funds and private equity funds to engage in such loan origination activity and to minimize the impact that this asset class may have on their non-U.S. and tax- exempt limited partners. The purpose of this article is to give a brief overview of the issues and possible consequences of engaging in loan origination.
There have long been debt funds that have relied on purchasing debt on the secondary market. After the collapse of the debt markets in 2008, distressed debt assets were a very common asset class in hedge and private equity funds. As the availability of these assets began to become scarcer, some of the larger funds started to purchase distressed assets in Europe and Asia. Others began to focus on the U.S. lending markets to help fill a void that large banks had left in the loan origination space post the 2008 financial crisis.
Purchasing debt on the secondary market from a tax perspective is like purchasing any other security. For a non-U.S. limited partner in a fund, the interest income would most likely not be subject to withholding under the portfolio interest exception and the ultimate sale of the debt instrument would be a capital gain sourced to the domicile of the non-U.S. investor. Technically, one could buy and sell debt on the secondary market on a regular and continuous basis and not generate income effectively connected with a U.S. trade or business. This is due to the Internal Revenue Code Section (“IRC”) 864(b)(2) safe harbor provision that excludes from the definition of the term “trade or business within the United States” trading for one’s own account through a U.S. broker or manager so long as the activity does not rise to that of a dealer in stocks and securities.1
Loan origination on the other hand is not protected under the Section 864(b)(2) safe harbor. Over the years, courts have focused on certain attributes to distinguish between origination activities that rise to the level of a lending or financial trade or business and the act of simply purchasing debt securities on the secondary market. Some of the common attributes of a lending trade or business include: Interaction and or negotiation with borrowers or issuers; solicitation of customers; receipt of fees for lending (i.e., “origination” or similar fees); performance of ancillary services; and the activity being considerable, continuous and on a regular basis.
What is interesting about the court cases on loan origination is that at times it is more advantageous for the government to argue that a taxpayer is not in a trade or business and other times it is more advantageous for the government to conclude that it is in a trade or business. With regard to U.S. taxpayers, if a debt investment goes bad, the bad debt expense will be an ordinary loss rather than a capital loss if the taxpayer was engaged in a trade or business. The government would rather not give a taxpayer an ordinary loss which would offset ordinary income as opposed to a capital loss which can only offset a minimal amount of ordinary income. On the other hand, where a non-U.S. taxpayer is involved, the government would rather conclude that the taxpayer is in a trade or business and is in receipt of effectively connected income (“ECI”) to a U.S. trade or business subject to withholding, and, if not structured properly, may also be subject to an additional branch profits tax bringing the effective tax rate to over 50%.
How many loans need to be originated to be considered engaged in a U.S. trade or business? In Pasquel vs. Commissioner, the Tax Court concluded that one loan from a foreign individual to a U.S. taxpayer did not rise to the level of a trade or business.2 Many service providers tell their clients that a fund can safely originate up to five loans before having to be concerned that it is going to be treated as engaged in a lending trade or business. The magic number “five” comes from a private letter ruling issued by the IRS in the context of whether income from the loan origination activities of a particular fund could qualify for the “qualifying income” exception that hedge funds utilize to keep from being treated as a publicly traded partnership (“PTP”) that would be treated as a corporation.3 In that letter ruling, the taxpayer represented that it would not originate on average more than five new mortgages per year over any five-year period. The ruling concludes that this activity did not rise to the level of a financial business and as such the interest income generated would be “qualifying income” which includes simple interest income but does not include interest income from a financial or insurance business.4 In the private equity fund context where a fund lends money to an investment in which they also own equity, the U.S. Supreme Court concluded in Whipple vs Commissioner that such lending activity is not considered the activity of a lending trade or business as there is already a pre-existing relationship with the “customer” and the loan is made to enhance the equity investment.5
Direct lending takes on many forms. There is traditional lending, there is loan syndication, there is buying borrower dependent notes or trust certificates from a lending platform, there is buying loans from a third-party originator with or without a prior commitment to the originator and many other variations on the above. In addition, even when purchasing a loan from a non-related third-party originator, the originator may be deemed the agent of the fund if the relationship is not properly structured. Also, in the distressed debt area, caution is prudent where the terms of a loan may be renegotiated with the borrower and be considered a significant modification resulting in a new loan for tax purposes. While not all of these scenarios will result in a fund being considered in a U.S .trade or business, prudence requires that a conversation be had with one’s accountant and attorney.
If a hedge fund is found to be engaged in a lending trade or business, it will result in ECI withholding on income attributed to the offshore feeder (which is generally set up as a Cayman corporation) and a branch profits tax at the offshore feeder. In the private equity context, where the offshore feeder is generally a pass-through entity for U.S. tax purposes, not only will there be withholding but the offshore investors will now have a U.S. filing requirement.
There are ways to structure the loan origination activity so that some of the adverse tax consequences are mitigated. It is important to be aware of the tax consequences of being in a lending trade or business so that proper steps can be taken, depending on each fund’s particular circumstances.
- IRC Section 864(b)(2)
- Pasquel vs. Commissioner of Internal Revenue, 12 T.C.M. 1431 (1953)
- PLR 9701006, 01/03/1997
- IRC Section 7704(d)(1) and (d)(2)
- Whipple vs. Commissioner, 373 U.S. 193 (1963). In this case, it was better for the government to argue that the activity did not rise to the level of trade or business as it was a capital vs. ordinary loss that was at issue. By concluding that Whipple was not in a trade or business, the bad debt gave rise to a capital rather than an ordinary loss.
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- The Risk of Hedge Fund Herding and its Role in Today's Financial Markets
- Trends in Fund Administration: Consolidation, Fee Alignment and Market Transformation
- Loan Origination as an Asset Class – What Tax Issues Do I Need To Be Aware of?
- The Operational and Compliance Benefits that Establishing an Irish Fund May Have for U.S. Managers
- Alternative Investment Industry Outlook for Q3 and Beyond in 2017
- Focus on Private Funds: SEC Enforcement Priorities