Revisions to Regulations Relating To Repeal of Tax on Interest of Nonresident Alien Individuals and Foreign Corporations Received From Certain Portfolio Debt Investments, 34047-34050 [E6-9151]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 71, Number 113 (Tuesday, June 13, 2006)]
[Proposed Rules]
[Pages 34047-34050]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E6-9151]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-118775-06]
RIN 1545-BF64


Revisions to Regulations Relating To Repeal of Tax on Interest of 
Nonresident Alien Individuals and Foreign Corporations Received From 
Certain Portfolio Debt Investments

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations under sections 871 
and 881 of the Internal Revenue Code (Code) relating to the exclusion 
from gross income of portfolio interest paid to a nonresident alien 
individual or foreign corporation. These regulations clarify how the 
portfolio interest rules apply with respect to interest paid to a 
partnership (or simple or grantor trust) that has foreign partners (or 
beneficiaries or owners). This document also provides notice of a 
public hearing.

DATES: Written or electronic comments must be received by August 14, 
2006. Outlines of topics to be discussed at the public hearing 
scheduled for Thursday, September 7, 2006, at 10 a.m., must be received 
by August 24, 2006.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-118775-06), room 
5203, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions also may be hand-delivered Monday 
through Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR 
(REG-118775-06), Courier's Desk, Internal Revenue Service, 1111 
Constitution Avenue, NW., Washington, DC, or sent electronically, via 
the IRS Internet site at https://www.irs.gov/regs or via the Federal 
eRulemaking Portal at https://www.regulations.gov (IRS REG-118775-06). 
The public hearing will be held in IRS Auditorium, Internal Revenue 
Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Jason Kleinman, (202) 622-3840; concerning the submissions of comments, 
the hearing, and/or to be placed on the building access list to attend 
the hearing, Richard Hurst, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    Section 871(a) of the Code imposes a tax of 30 percent on United 
States (U.S.) source fixed or determinable annual or periodic (FDAP) 
income received by a nonresident alien individual to the extent the 
amount so received is not effectively connected with the conduct of a 
trade or business within the U.S. Section 881(a) imposes a similar tax 
with respect to FDAP income received by a foreign corporation. Pursuant 
to these sections, U.S. source interest generally is considered FDAP 
income and is subject to tax. See sections 871(a)(1)(A) and 
881(a)(1)(A). This tax generally is collected by means of withholding 
under sections 1441 and 1442, which require a payor of FDAP income to 
withhold 30 percent of the gross amount of such payment, unless the 
beneficial owner claims a reduced rate of tax on such interest under an 
applicable Code or treaty provision. See Sec. Sec.  1.1441-1(b)(4) and 
1.1441-6.
    Notwithstanding the general imposition of tax on U.S. source 
interest under sections 871(a) and 881(a), sections 871(h) and 881(c), 
respectively, provide that no tax is imposed in the case of portfolio 
interest received by a nonresident individual or foreign corporation. 
Under section 871(h)(2) and section 881(c)(2), respectively, portfolio 
interest includes any interest (including original issue discount) that 
would be subject to tax under section 871(a) or section 881(a) but for 
section 871(h) or section 881(c).
    However, both sections 871(h)(3)(A) and 881(c)(3)(B) provide, among 
other limitations, that portfolio interest does not include interest 
received by a 10-percent shareholder, as defined in section 
871(h)(3)(B). Section 871(h)(3)(B) provides that the term 10-percent 
shareholder means, in the case of an obligation issued by a 
corporation, any person who owns 10 percent or more of the total 
combined voting power of all classes of stock of such corporation 
entitled to vote, or, in the case of an obligation issued by a 
partnership, any person who owns 10 percent or more of the capital or 
profits interest in such partnership.
    Section 871(h)(3)(C) provides that the attribution rules of section 
318 apply, with three modifications, for purposes of determining 
whether a person is a 10-percent shareholder (the 10-percent 
shareholder test) of the obligor. The first modification provides that 
the attribution of stock from a corporation is made without regard to 
the 50 percent threshold set forth in section 318(a)(2)(C). The second 
modification provides that the attribution of stock to a corporation is 
made without regard to the 50 percent threshold set forth in section 
318(a)(3)(C), but if a corporation would not be attributed a 
shareholder's stock in another corporation but for the removal of the 
50 percent threshold, then the corporation is only attributed that 
portion of the shareholder's stock in such other corporation as the 
value of the shareholder's stock in the corporation bears to the value 
of all stock in the corporation. The third modification provides that 
if a person is treated as owning stock after the application of section 
318(a)(4) (relating to options to acquire stock being treated as stock 
actually owned), then such stock shall not be treated as actually owned 
by such person for purposes of attributing ownership to other persons 
under section 318(a)(2) or (3). The flush language of section 871(h)(3) 
also provides that, under regulations, rules similar to the rules 
described above shall apply when determining the ownership of the 
capital or profits interest in a partnership obligor for purposes of 
applying the 10-percent shareholder test.
    Notwithstanding the general definition of a 10-percent shareholder 
and the application of section 318 described in section 871(h)(3), 
neither the Code nor the legislative history applicable to section 
871(h)(3) specifically addresses how the 10-percent shareholder test is 
to apply when interest is paid to a partnership that has foreign 
partners. That is, neither the Code nor the legislative history 
explicitly provides whether the 10-percent shareholder test should be 
applied at the foreign partner level, the partnership level, or both 
levels.

Explanation of Provisions

1. In General

    These proposed regulations address the application of the 10-
percent shareholder test in section 871(h)(3) when a nonresident alien 
individual or foreign corporation is a partner in a partnership that is 
paid interest. In doing so, the proposed regulations address the two 
key points needed to apply the test. First, the regulations address the 
issue of which person ``receives'' interest for purposes of the 10-
percent shareholder test. Second, the

[[Page 34048]]

proposed regulations address the time at which a withholding agent must 
determine if the person who receives the interest is a 10-percent 
shareholder. Because similar issues arise with respect to interest paid 
to a simple trust or grantor trust, the proposed regulations also 
provide rules for that context.

2. Person Who ``Receives'' Interest for Purposes of the 10-Percent 
Shareholder Test

    Section 871(h)(3) generally provides that interest received by a 
10-percent shareholder is not considered portfolio interest exempt from 
taxation. When a partnership with foreign partners holds a debt 
instrument, the issue arises as to whether the withholding agent should 
apply the 10-percent shareholder test at the partner level (because 
such partner is the beneficial owner of the interest within the meaning 
of Sec.  1.1441-1(c)(6)), at the partnership level (because the 
partnership holds the debt instrument), or at both levels. The 
conclusion as to the level or levels at which the 10-percent 
shareholder test is applied is necessarily a conclusion as to the 
person or persons considered to ``receive'' the interest for purposes 
of the test. As mentioned, neither section 871(h) nor the legislative 
history explicitly addresses this issue. However, the IRS and the 
Treasury Department have previously stated that, based upon the 
authority of subchapter K and the policies underlying a particular 
provision of the Code, a partnership may be treated as an aggregate of 
its partners or as an entity separate from its partners, depending on 
which characterization is more appropriate to carry out the purpose of 
the Code or regulatory provision. See TD 9008, 2002-2 CB 335 [67 FR 
48020]; Rev. Rul. 89-85, 1989-2 CB 218; H.R. Conf. Rep. No. 2543, 83rd 
Cong., 2d Sess. 59 (1954); See also TD 9240, 2006-7 IRB 454 [71 FR 
2462].
    After considering the alternatives, the IRS and the Treasury 
Department conclude that the 10-percent shareholder test should apply 
at the foreign partner level to the nonresident alien individual or 
foreign corporation that is the beneficial owner of the income. 
Accordingly, the proposed regulations provide that when interest is 
paid to a partnership, the persons who receive the interest for 
purposes of applying the 10-percent shareholder test are the 
nonresident alien individual partners and the foreign corporations that 
are partners in the partnership. The 10-percent shareholder test is 
then applied by determining each such person's ownership interest in 
the obligor. No inference is intended as to whether other limitations 
set forth in the definition of portfolio interest should be considered 
at the partner level, partnership level, or at both levels (section 
881(c)(3)(A)).
    The approach taken in the proposed regulation 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 (ten percent) equity investments in 
U.S. operations. See S. Rep. No. 98-169, 98 Cong., 2d Sess. 416 (1984); 
H.R. Rep. No. 98-861, 98 Cong., 2d Sess. 936 (1984); See also, Staff of 
the Joint Comm. on Tax'n, 98th Cong., General Explanation of the 
Revenue Provisions of the Deficit Reduction Act of 1984, at 391-394. 
With regard to the statute, it is clear from subchapter K, section 871, 
and section 881 that, in the absence of the portfolio interest 
exception, the tax on interest paid to a partnership is substantively 
imposed on the nonresident alien individual or foreign corporation that 
is a partner in the partnership. That is, the beneficial owner with 
respect to interest paid to a partnership is the foreign partner (other 
than a partner that is itself a passthrough entity) and not the 
partnership. Based upon this fact, the IRS and the Treasury Department 
believe that applying the 10-percent shareholder test in section 
871(h)(3) at the partner level is consistent with the statutory 
framework of sections 871(h)(1) and 881(c)(1) which provide that 
portfolio interest ``received by a nonresident individual'' or 
``received by a foreign corporation'', respectively, from sources 
within the U.S. is exempt from taxation under sections 871(a) and 
881(a).
    Further, notwithstanding the general regime for imposing tax under 
sections 871 and 881, the IRS and the Treasury Department do not 
believe that in enacting the 10-percent shareholder test, Congress 
intended for the test to be applied at the partnership level. Such an 
interpretation would condition a foreign beneficial owner's entitlement 
to the portfolio interest exception on the ownership in the obligor 
held by either a person that is not a taxpayer (the partnership) or a 
person who is wholly unrelated to the beneficial owner (another partner 
in the partnership). The practical effect of this interpretation would 
be to characterize interest payments made to a partnership as being 
received by a 10-percent shareholder in many cases where there is no 
apparent abuse, thereby disallowing a tax benefit to foreign persons, 
and impairing the free-flow of foreign capital to U.S. business, solely 
because a foreign person acted indirectly rather than directly with its 
U.S. borrower. For example, if 100 unrelated nonresident alien 
individuals and foreign corporations invest in a partnership that holds 
10 percent of a domestic corporation, and such domestic corporation 
pays U.S. source interest to the partnership, each of the foreign 
partners in the partnership would be denied the benefit of the 
portfolio interest exception if the 10-percent shareholder test is 
applied at the partnership level. The same result occurs if unrelated 
U.S. persons that are partners in the partnership hold, in combination 
with the partnership, 10-percent of the domestic corporate obligor. The 
IRS and the Treasury Department believe that such a result is 
inapposite to the statutory framework and underlying purpose of the 
statute, especially considering that section 871(h) invokes the 
attribution rules of section 318 for the purpose of policing the 10-
percent shareholder prohibition, and generally liberalizes the 
application of such rules to reach more subtle ownership arrangements.

3. Time When 10-Percent Shareholder Test Is Applied

    Section 871(h)(3) does not explicitly provide the time at which the 
10-percent shareholder test is applied. Thus, an issue arises as to 
whether the test is applied at the beginning of the year, on each 
interest payment date, at the end of the year, at all times during the 
year, or at some other time. Consistent with the withholding regime 
under sections 1441 and 1442, the proposed regulations provide that the 
10-percent shareholder test is applied with respect to a nonresident 
alien individual or foreign corporation that is a partner in the 
partnership at the time that a withholding agent, absent any 
exceptions, would otherwise be required to withhold under sections 1441 
and 1442 with respect to such interest. See Sec.  1.1441-3(b). For 
example, in the case of U.S. source interest paid by a domestic 
corporation to a domestic partnership or withholding foreign 
partnership (as defined in Sec.  1.1441-5(c)(2)), the 10-percent 
shareholder test is applied on the earliest of when the interest is 
distributed by the partnership to the foreign partner, the date that 
the statement under section 6031(c) is mailed or otherwise provided to 
such partner, or the due date for furnishing such statement. See 
Sec. Sec.  1.1441-5(b)(2) and 1.1441-5(c)(2)(iii).

[[Page 34049]]

4. Application of the 10-Percent Shareholder Test to Interest Paid to a 
Simple or Grantor Trust

    Under subchapter J of the Code, a trust generally computes it 
taxable income in the same manner as an individual. See section 641(b). 
However, subchapter J contains rules that generally permit a trust 
required to distribute all of its income currently (simple trust) a 
deduction for the amounts it is required to distribute. See section 
651. To the extent a simple trust claims a deduction for amounts it is 
required to distribute to its beneficiaries, the trust acts as a 
passthrough entity because such amounts are generally subject to 
taxation in the hands of the beneficiaries of the trust under section 
652.
    Further, subchapter J contains so called grantor trust rules 
pertaining to trust arrangements where a grantor or other person has 
retained rights or powers with respect to trust property or trust 
income. See sections 671-679. Pursuant to the grantor trust rules, the 
grantor or other person may be considered the owner of all or a portion 
of the trust. To the extent that the grantor or other person is 
considered the owner of any portion of a trust, the grantor or other 
person (and not the trust) is required to take into account those items 
of income, deduction, and credit attributable to the portion owned when 
computing the grantor or other owner's taxable income. See section 671.
    When interest is paid to a simple trust or a grantor trust, an 
issue arises as to whether the 10-percent shareholder test should be 
applied at the trust or beneficiary or owner level. Accordingly, the 
proposed regulations provide rules for that context. Under the proposed 
regulations, when interest is paid to a simple trust or grantor trust 
and such interest is distributed to or included in the gross income of 
a nonresident alien individual or foreign corporation that is a 
beneficiary or owner of such trust, as the case may be, the withholding 
agent is to apply the rules of the proposed regulations with respect to 
determining whether a 10-percent shareholder has received interest, at 
the beneficiary or owner level. Further, the 10-percent shareholder 
test is applied with respect to a nonresident alien individual or 
foreign corporation that is a beneficiary of a simple trust or an owner 
of a grantor trust at the time that a withholding agent, absent any 
exceptions, would otherwise be required to withhold under sections 1441 
and 1442 with respect to such interest.

Effective Date

    These proposed regulations apply to interest paid on obligations 
issued on or after the date that the regulations are issued as final 
regulations.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It has also 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations, and, because 
the regulations do not impose a new collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Code, this notice of proposed 
rulemaking will be submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) or electronic comments that are submitted timely 
to the IRS. The Treasury Department and the IRS request comments on the 
clarity of the proposed rules and how they can be made easier to 
understand. All comments will be available for public inspection and 
copying.
    A public hearing has been scheduled for September 7, 2006, 
beginning at 10 a.m., in the IRS Auditorium, Internal Revenue Building, 
1111 Constitution Avenue, NW., Washington, DC. Due to building security 
procedures, visitors must enter at the Constitution Avenue entrance. In 
addition, all visitors must present photo identification to enter the 
building. Because of access restrictions, visitors will not be admitted 
beyond the immediate entrance area more than 30 minutes before the 
hearing starts. For information about having your name placed on the 
building access list to attend the hearing, see the FOR FURTHER 
INFORMATION CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit electronic or 
written comments and an outline of the topics to be discussed and the 
time to be devoted to each topic (a signed original and eight (8) 
copies) by July 13, 2006. A period of 10 minutes will be allotted to 
each person for making comments. An agenda showing the scheduling of 
the speakers will be prepared after the deadline for receiving outlines 
has passed. Copies of the agenda will be available free of charge at 
the hearing.

Drafting Information

    The principal author of the proposed regulations is Jason Kleinman, 
Office of Associate Chief Counsel (International).

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.871-14 is amended as follows:
    1. Paragraphs (g) and (h) are redesignated as paragraphs (h) and 
(i), respectively.
    2. New paragraph (g) is added.
    The addition reads as follows:


Sec.  1.871-14  Rules relating to repeal of tax on interest of 
nonresident alien individuals and foreign corporations received from 
certain portfolio debt investments.

* * * * *
    (g) Portfolio interest not to include interest received by 10-
percent shareholders--(1) In general. For purposes of section 871(h), 
the term portfolio interest shall not include any interest received by 
a 10-percent shareholder.
    (2) Ten-percent shareholder--(i) In general. The term 10-percent 
shareholder means--
    (A) In the case of an obligation issued by a corporation, any 
person who owns 10-percent or more of the total combined voting power 
of all classes of stock of such corporation entitled to vote; or
    (B) In the case of an obligation issued by a partnership, any 
person who owns 10-percent or more of the capital or profits interest 
in such partnership.
    (ii) Ownership--(A) Stock ownership. For purposes of paragraph 
(g)(2)(i)(A) of this section, stock owned means stock directly or 
indirectly owned and stock owned by reason of the attribution rules of 
section 318(a), as modified by section 871(h)(3)(C).
    (B) Ownership of partnership interest--(1) For purposes of 
paragraph

[[Page 34050]]

(g)(2)(i)(B) of this section, rules similar to the rules in paragraph 
(g)(2)(ii)(A) of this section shall be applied in determining the 
ownership of a capital or profits interest in a partnership.
    (2) Special rules. [Reserved].
    (3) Application of 10-percent shareholder test to partners 
receiving interest through a partnership--(i) Partner level test. 
Whether interest paid to a partnership and included in the distributive 
share of a partner that is a nonresident alien individual or foreign 
corporation, is received by a 10-percent shareholder, shall be 
determined by applying the rules of this paragraph (g) only at the 
partner level.
    (ii) Time at which 10-percent shareholder test is applied. The 
determination of whether a nonresident alien individual or foreign 
corporation that is a partner in a partnership is a 10-percent 
shareholder under the rules of section 871(h)(3), section 881(c)(3), 
and this paragraph (g) with respect to interest paid to such 
partnership shall be made at the time that the withholding agent, 
absent the provisions of section 871(h), 881(c) and the rules of this 
paragraph, would otherwise be required to withhold under sections 1441 
and 1442 with respect to such interest. For example, in the case of 
U.S. source interest paid by a domestic corporation to a domestic 
partnership or withholding foreign partnership (as defined in Sec.  
1.1441-5(c)(2)), the 10-percent shareholder test is applied on the 
earliest of when the interest is distributed by the partnership to the 
foreign partner, the date that the statement under section 6031(c) is 
mailed or otherwise provided to such partner, or the due date for 
furnishing such statement. See Sec.  1.1441-5(b)(2) and (c)(2)(iii).
    (4) Application of 10-percent shareholder test to interest paid to 
a simple trust or grantor trust. Whether interest paid to a simple 
trust or grantor trust and distributed to or included in the gross 
income of a nonresident alien individual or foreign corporation that is 
a beneficiary or owner of such trust, as the case may be, is received 
by a 10-percent shareholder, shall be determined by applying the rules 
of this paragraph (g) only at the beneficiary or owner level. The 10-
percent shareholder test is applied with respect to a nonresident alien 
individual or foreign corporation that is a beneficiary of a simple 
trust or an owner of a grantor trust at the time that a withholding 
agent, absent any exceptions, would otherwise be required to withhold 
under sections 1441 and 1442 with respect to such interest.
    (5) Effective date. The rules of this paragraph (g) apply to 
interest paid on obligations issued on or after the date these 
regulations are issued as final regulations.
* * * * *
    Par. 3. Section 1.881-2(a)(6) is added to read as follows:


Sec.  1.881-2  Taxation of foreign corporations not engaged in U.S. 
business.

    (a) * * *
    (6) Interest received by foreign corporations pursuant to certain 
portfolio debt instruments is not subject to the flat tax of 30 percent 
described in paragraph (a)(1) of this section. For rules applicable to 
a foreign corporation's receipt of interest on certain portfolio debt 
instruments, see sections 871(h), 881(c), and Sec.  1.871-14.
* * * * *

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. E6-9151 Filed 6-12-06; 8:45 am]
BILLING CODE 4830-01-P