Structuring Solutions for U.S. Loan Origination Funds Offered to Non-U.S. Investors

Private credit funds involved in loan origination in the United States face unique tax challenges, particularly for non-U.S. investors. If a non-U.S. investor is engaged, or deemed to be engaged, in a trade or business within the U.S., such an investor will generally be subject to taxation of income that is “effectively connected” with the U.S. trade or business (“ECI”) and return filing obligations in the U.S. In the view of the U.S. Internal Revenue Service, regularly making loans to the public in the U.S., whether directly or indirectly through a U.S. agent (such as a U.S. investment manager), constitutes a financing business and, therefore, a U.S. trade or business. Consequently, structuring solutions are often necessary to mitigate the risk that non-U.S. investors in a private credit fund with U.S.-originated loans will earn ECI. This article outlines four primary structuring solutions that are intended to mitigate such risk: (i) leveraged blocker; (ii) “season and sell”; (iii) income tax treaties; and (iv) business development companies. Each structuring solution offers unique benefits and considerations, requiring investors to carefully evaluate their options and choose the structure that best aligns with their tax and investment objectives.

Leveraged Blocker

The leveraged blocker strategy typically involves using a feeder fund (or a parallel fund) treated as a partnership for U.S. federal income tax purposes, which invests in ECI-generating assets through one or more U.S. blocker corporations. The U.S. blocker corporations generally act as ECI blockers but will themselves be subject to U.S. income taxation. This entity-level tax drag may be reduced by capitalizing the U.S. blocker with a combination of both equity and debt, assuming an entity-level deduction is available for interest paid on the debt. Additionally, interest paid from U.S. blockers could potentially qualify for the “portfolio interest” exemption, which provides a statutory exemption from U.S. withholding tax on U.S. source interest, if the investor pool in the fund is sufficiently diversified.

“Season and Sell”

The “season and sell” strategy typically employs two fund structures: (i) an onshore vehicle that directly engages in U.S. loan origination and (ii) an offshore fund vehicle that acquires a portion of the loans after a seasoning period. The strategy is designed to provide non-U.S. investors the benefit of U.S. statutory trading safe harbors and therefore minimize U.S. tax leakage. It requires the onshore vehicle to adhere to tax guidelines designed to reduce the possibility that U.S. loan origination activities are attributed to non-U.S. investors. The strategy also requires a source of funding in the U.S. (e.g., through the onshore vehicle or another U.S. loan origination enterprise) that is at least as significant as the funding through the offshore fund. Non-U.S. investors typically invest in the offshore fund through a non-U.S. corporate feeder that serves as an ECI backstop.

Income Tax Treaties

The tax treaty strategy is generally available for eligible non-U.S. investors or eligible non-U.S. fund vehicles resident in jurisdictions that have an income tax treaty with the United States. Any intermediary vehicles through which a treaty claimant invests must be considered fiscally transparent in the jurisdiction of the treaty claimant. Many, but not all, U.S. income tax treaties provide for a zero rate of withholding on interest income. As such, the treaty-based fund structure could minimize U.S. federal income tax leakage for treaty-eligible non-U.S. investors. However, the strategy requires satisfaction of stringent anti-treaty shopping provisions and avoidance of a U.S. permanent establishment. Generally, it requires a greater than 50 percent U.S. investor base, and U.S. investors supporting the tax structure do not share the same tax sensitivities addressed by the structure. A U.S.-based manager may be deemed to be a U.S. permanent establishment unless acting as an independent agent in the ordinary course of business. Independent agent status requires both legal and economic independence, which generally warrants a detailed factual analysis. Careful planning and structuring are required to ensure that the relevant non-U.S. fund vehicle or the investors are treaty eligible and entitled.

Business Development Companies (BDCs)

This strategy involves a U.S. fund vehicle organized as a business development company (“BDC”) that complies with certain U.S. SEC requirements and operates to qualify as a regulated investment company (“RIC”) for U.S. federal income tax purposes. A BDC that qualifies as a RIC is generally not subject to entity-level income tax on its distributed income and gains if it meets certain tests with respect to income, asset diversification and distribution. A BDC blocks ECI and is efficient from a U.S. withholding tax perspective since, generally, distributions of interest income from loans to U.S. borrowers and capital gains may be paid by a BDC to non-U.S. investors free of U.S. withholding tax.