Interesting article in today’s Wall Street Journal: Hedge Funds See Tax Issue; Offshore Entities Seek Guidance on Levies Related to Loan Deals, by Arden Dale:
Offshore hedge funds are concerned that their growing business in bank loans could trigger U.S. taxes. Hedge funds are engaged in complex deals that can resemble the business of originating loans, rather than simply trading loans on the secondary market. Should the activity trigger U.S. taxes, it would be a big change for these funds, which generally present themselves to non-U.S. investors as tax havens.
The IRS in August added lending by foreign investors to the list of issues it needs to address. Tax attorneys and accountants say they aren’t sure, however, whether or when guidance will be coming. The IRS wasn’t available to comment.
At issue for offshore hedge funds that deal in loans is Section 864 of the tax code, which exempts foreign taxpayers from U.S. tax if they are engaged in trading a variety of securities. The exemption doesn’t include regular lending under its umbrella.
Mr. Leeds in a 2005 paper outlined a typical revolving loan in which a hedge fund becomes involved: A U.S. bank makes a loan to a rated U.S. corporate borrower, which is paying interest on the outstanding bank loan at the London interbank offered rate plus 0.4 percentage point annually on any amounts drawn down. It will pay a 0.15% fee annually on any unused commitment. The loan has a maximum five-year term and a maximum face amount of $100 million. To the extent that any amounts are drawn and repaid by the borrower, it remains free to borrow those amounts again. A hedge fund might enter the picture because it wants to get so-called synthetic exposure to the loan through a swap with the bank that is still holding the loan for the borrower. The bank essentially passes through the credit risk to the hedge fund, oftentimes without the borrower even knowing that a hedge fund is involved. Lee Sheppard, a tax attorney and contributing editor to Tax Notes, published by nonprofit publisher Tax Analysts, said hedge funds "want to be able to argue that buying exposure to a bank loan through a derivative contract is just like having a derivative contract on any other investment asset, that is, covered by the securities-trading safe harbor."
