SPECIAL REPORT - Akin Gump

Rationalizing Inbound Taxation ofPassive Portfolio Investments

By Stuart E. Leblang, Robert P. Rothman, andDaniel J. Paulos

Table of Contents

I. Introduction . . . . . . . . . . . . . . . . . . . . . . . 693II. Overview of the Regime . . . . . . . . . . . . . . 694

A. Gross-Basis Taxation . . . . . . . . . . . . . . . 694B. Net-Basis Taxation . . . . . . . . . . . . . . . . 696C. General Observations . . . . . . . . . . . . . . 696

III. Situations Leading to InappropriateTaxation . . . . . . . . . . . . . . . . . . . . . . . . . 697A. Gross Tax on Positions With High

Expenses . . . . . . . . . . . . . . . . . . . . . . . 697B. Investments in Operating Partnerships . 699

IV. Proposed Changes to the Regime . . . . . . . 700A. Reduction of Gross Tax Rate . . . . . . . . 700

B. Election to Avoid Certain InappropriateResults . . . . . . . . . . . . . . . . . . . . . . . . 701

C. Partnerships Engaged in a U.S.Business . . . . . . . . . . . . . . . . . . . . . . . 702

V. Conclusion . . . . . . . . . . . . . . . . . . . . . . . 704

I. Introduction

The subject of this article is the tax regime applicableto non-U.S. persons that receive passive portfolio-typeincome from U.S.-connected investments.1 In general, theset of rules that comprise this regime are the same rulesapplicable to passive nonportfolio investments, althoughthere are some special modifications in the portfolioinvestment context. It is the authors’ belief that applica-tion of the same rules in the context of passive portfolioinvestments as applied in other contexts is not necessar-ily good tax policy, and that the existing rules, as appliedto passive portfolio investments, do not always producesound results. This article identifies some of the problemsthat exist under the current system (specifically as ap-plied to passive portfolio investments) and sets forthproposals to alleviate those problems.

Before addressing specific issues with the applicationof the existing regime to passive portfolio income, a fewwords are in order concerning a threshold issue of taxpolicy. The existing regime is a ‘‘source-based’’ tax sys-tem; that is, it imposes a tax on persons who receiveincome which derives from the United States, even ifthey are not U.S. citizens or residents and have noconnection to the United States other than receiving thatincome. This is consistent with the tax system used bymany countries, and is based primarily on the notion thatsomeone who receives income from U.S. sources benefitsfrom the physical, legal or financial infrastructure in theUnited States, and hence should bear a portion of the costof maintaining that infrastructure. However, there is noinherent reason why the United States — or any othercountry — needs to adopt a source-based system, and

1As used herein, the term ‘‘passive portfolio investments’’refers to situations in which an investor’s participation andinvolvement in a transaction is limited to furnishing capital, andin which the investor possesses only a very limited economicand control interest in the entity that is the source of thepayments made in respect of the investment. No attempt ismade to craft a precise definition of how much participation ineconomics or governance represents the upper limit of passiveportfolio investment. However, as a general matter, it may beuseful to treat any person who owns less than 10 percent of theeconomics and vote of the entity in which it invests as a passiveportfolio investor. See section 871(h)(3) of the Internal RevenueCode of 1986, as amended (the code). Unless otherwise noted,all ‘‘section’’ references are to the code.

Stuart E. Leblang is a partner, Robert P. Rothman issenior counsel, and Daniel J. Paulos is an associate inthe New York office of Akin Gump Strauss Hauer &Feld LLP. The authors wish to thank Marek M.Grabowski for his assistance in preparing this article.Significant portions of this report (including the corepolicy prescriptions) are adapted from a paper au-thored by Stuart E. Leblang and presented by him toThe Tax Review in February 2004.

The current system of taxation of U.S.-source in-come received by foreign persons does not alwaysoperate in a sensible fashion when applied to passiveinvestors whose equity interest in an enterprise isrelatively small. In particular, the imposition of gross-basis tax on types of income for which there aresignificant costs can result in a level of tax which isconfiscatory when measured by reference to economicincome. In addition, the rule which subjects anyinvestor in an entity which is treated as a partnershipto full net-basis taxation does not seem warranted forsmall passive investors.

The authors explore some of these problems andsuggest some approaches to improving the taxation ofthese types of investors.

Copyright 2008 Stuart E. Leblang, Robert P. Rothman,and Daniel J. Paulos.All rights reserved.

tax notes®

SPECIAL REPORT

TAX NOTES, November 10, 2008 693

(C) T

ax Analysts 2008. A

ll rights reserved. Tax A

nalysts does not claim copyright in any public dom

ain or third party content.

some commentators have argued in favor of eliminating(or at least significantly limiting) source-based taxation infavor of a ‘‘residence-based’’ system that looks to theconnection the taxpayer (rather than the income) haswith the jurisdiction as a basis for taxation.2

A detailed discussion of source- versus residence-based taxation is beyond the scope of this article. Rather,this article addresses some approaches for improving theway the current system operates, assuming that theUnited States is not willing to cede taxing jurisdiction onpassive portfolio income entirely to the jurisdiction ofresidence.

In addition, U.S. taxation of income and gain fromnonportfolio investments of foreign persons raises differ-

ent policy concerns, and is not addressed in this article. Inparticular, the tax rules applicable in the non-portfolioinvestment context are essential for purposes of prevent-ing affiliated persons from employing financial arrange-ments (including transfer pricing and other mechanisms)that seriously erode the U.S. business tax base.3

II. Overview of the Regime

A. Gross-Basis TaxationThe centerpiece of the tax regime applicable to foreign

passive portfolio investors is a 30 percent U.S. federalwithholding tax4 on the gross amount of U.S.-source‘‘fixed or determinable annual or periodical’’ income(so-called FDAP income).5 Gross-basis taxation ofpassive-type income reflects the assumption that in gen-eral, there are likely to be few or no expenses incurred inthe production of such income. It also eliminates theadditional administrative and enforcement burdens thatwould arise if foreigners that received such income wererequired to file U.S. tax returns setting forth applicableexpenses.

Several aspects of the definition of FDAP income aresignificant. First, although the literal meaning of the termwould seem to denote a limited class of paymentspayable on a regular or periodic basis, the regs clarifythat the term encompasses effectively all gross incomeother than capital gains (as well as a narrow class ofinsurance premiums paid to a foreign insurer), regardlessof whether payment of the item is made in a series ofrepeated payments or in a single lump sum.6 Second,although some early authorities suggested that FDAPincome should be limited to types of income that are notlikely to have significant expenses associated with pro-ducing the income,7 the broad definition reflected in this

2Those commentators generally assert several reasons whyresidence-based taxation of passive income is a fairer and moreefficient system to collect taxes on an international basis. Inparticular, residence-based taxation satisfies the ‘‘ability to pay’’principle, since taxation in the residence jurisdiction can moreeasily take into account the net accession to wealth of a taxpayerdetermined on a worldwide basis. Those advocates also point tothe widespread use of various strategies and financial productsto avoid source-based tax on portfolio investments, as well asthe limited amount of tax collected relative to the administrativeand compliance burdens associated with the tax. They alsopoint to the mobility of capital to suggest that taxation of thistype of income may be counterproductive and the cost of the taxwill generally be economically borne by the domestic payorrather than the payee. It is also argued that elimination ofsource-based taxation of passive portfolio income of foreignpersons would represent a significant simplification of theoverall international tax regime. See, e.g., Reuven S. Avi-Yonah,‘‘The Structure of International Taxation: A Proposal for Simpli-fication,’’ 74 Tex. L. Rev. 1301 (1996); Hugh J. Ault and David F.Bradford, ‘‘Taxing International Income: An Analysis of the U.S.System and Its Economic Premises,’’ NBER Working Paper No.3056 (August 1989); Michael J. Graetz, ‘‘Taxing InternationalIncome: Inadequate Principles, Outdated Concepts, and Unsat-isfactory Policies,’’ The David R. Tillinghast Lecture, NYUSchool of Law (Oct. 26, 2000) in 54 Tax L. Rev. 261 (2001); RobertA. Green, ‘‘The Future of Source-Based Taxation of the Incomeof Multinational Enterprises,’’ 79 Cornell L. Rev. 18 (1993);Treasury Dep’t, Blueprints for Basic Tax Reform 99 (1977).

For the arguments in favor of retaining a source-basedsystem, see, e.g., Stephen E. Shay, J. Clifton Fleming Jr. andRobert J. Peroni, ‘‘‘What’s Source Got to Do With It?’ SourceRules and U.S. International Taxation,’’ The David R. TillinghastLecture in 56 Tax L. Rev. 81 (2002); American Law Institute,Federal Income Tax Project, International Aspects of UnitedStates Income Taxation, Proposals on United States Taxation ofForeign Persons and of the Foreign Income of United StatesPersons 6 (1987); Restatement (Third) of the Foreign RelationsLaw of the United States sections 411-412 (1987); Hugh J. Ault,Comparative Income Taxation: A Structural Analysis 367 (1997);Charles H. Gustafson, Robert J. Peroni, and Richard CrawfordPugh, Taxation of International Transactions 14 (2d ed. 2001); PeterA. Harris, Corporate/Shareholder Income Taxation and AllocatingTaxing Rights Between Countries 313 (1996); Roy Rohatgi, BasicInternational Taxation 132-133, 154 (2002); Julie Roin, ‘‘Competi-tion and Evasion: Another Perspective on International TaxCompetition,’’ 89 Geo. L.J. 543, 590-591 (2001); Klaus Vogel,‘‘World-Wide vs. Source Taxation of Income — A Review andReevaluation of Arguments,’’ in Influence of Tax Differentials onInternational Competitiveness 115, 119 (1990).

3See Avi-Yonah, supra note 2, at 1332-1333.4Although the gross tax on fixed, determinable, annual, or

periodical (FDAP) income is generally referred to as a withhold-ing tax, it actually represents a substantive income tax liabilityon the income of the recipient that is collected through amechanism involving withholding at source. See sections 871(a)and 881 (substantive imposition of tax); sections 1441 and 1442(withholding mechanism for tax collection). Any withholding iseffectively credited against the recipient’s income tax liability,and the recipient is relieved of an obligation to file a U.S. taxreturn for FDAP income subject to tax, provided that the fullamount of the tax has been withheld at source and remitted tothe IRS. Reg. section 1.6012-1(b)(2)(i) and (g)(2)(i). However, arecipient remains fully liable for the tax and U.S. tax filingrequirements in the event the full amount of the tax liability hasnot been satisfied through withholding at source.

5A 30 percent gross tax is also imposed on limited types ofgains, including (i) gains from sales subject to section 631, whichinclude gains from sales of timber, coal, or iron ore when theseller retains an economic interest in the property, (ii) gains fromthe sale or exchange of intangible property where the sale priceis contingent on use, productivity, or disposition of the subjectproperty, and (iii) certain payments on, or other amounts fromthe sale or retirement of, original issue discount obligations.

6See reg. section 1.1441-2(b).7See I.T. 1359, I-1 C.B. 292 (1922). (‘‘It was not the intent of

Congress to require withholding of gross income where . . . little

COMMENTARY / SPECIAL REPORT

(Footnote continued on next page.)

694 TAX NOTES, November 10, 2008

(C) T

ax Analysts 2008. A




current regulation includes no such limitation.8 This isextremely significant. The imposition of gross-basis taxa-tion on types of income with significant associated ex-penses is inconsistent with the fundamental assumptionunderlying the system of gross-basis taxation, and, asdiscussed below, can often result in a confiscatory level oftax.9

Certain types of income are specifically exemptedfrom the gross-basis tax regime. The most important ofthese (from an economic perspective) are (i) ‘‘portfoliointerest’’10 (generally defined as non-contingent interestreceived by a foreign taxpayer (other than a bank) thatdoes not own a 10 percent or more (measured by votingpower) equity interest in the payor11) and (ii) most ‘‘gainsderived from the sale of property.’’12 Interest on bankdeposits13 and short-term original issue discount14 arealso exempt. In addition, income derived from mosttypes of derivative contracts is also effectively exemptfrom U.S. taxation15 (although these rules — or at leasttheir application in what is perceived as abusive transac-tions — are under attack, particularly where a derivative

is effectively a substitute for ownership of an underlyingasset the income from which would be subject to tax16).

The broad exceptions for gains and most types ofinterest mean that the key economic component of thegross-basis tax on foreign passive portfolio investors isthe tax on U.S.-source portfolio dividend income. Therehas been significant recent focus on the prospects for aspecific exemption from tax for portfolio dividends,along the lines of the current exemption for portfoliointerest.17 The case for this exemption has strengthenedsignificantly with the enactment, in 2003, of a 15 percentmaximum rate on qualified dividend income of U.S.taxpayers.18

The broad definition of FDAP income means that thetax is also applicable to a plethora of other important,albeit less economically significant, types of cross-borderfinancial payments such as rents, royalties, proceeds fromannuities and insurance policies, structured settlements,lotteries, and other types of fixed or variable incomeflows. As discussed below, these other types of cross-border income flows are growing in importance as inter-national capital markets expand beyond traditional debtand equity securities, and begin to encompass manytypes of assets backed by U.S.-source cash flows. Asignificant expansion in the type of assets that are subjectto securitization transactions has reinforced this trend bymaking a wide variety of U.S.-source cash flows availableto foreign investors in the form of equity interests insecuritization vehicles. In fact, secondary markets withinternational participation have emerged for such diversetypes of financial assets as real property, rental payments,royalty streams, payouts on various types of insurancepolicies, structured settlements payouts, and deferredlottery payments.

The U.S. system of gross-basis taxation is not unique;most other nations impose similar types of gross-basistax on at least some types of domestic source portfolioinvestment income of foreign persons. Consistent withinternational norms, the U.S. gross tax may be reduced oreliminated on certain types of income under the terms ofan applicable U.S. tax treaty. However, modern taxtreaties and domestic law incorporate a variety of anti-abuse rules designed to limit the ability of foreigninvestors to reduce or eliminate gross withholding taxthrough the inappropriate use of tax treaties.19 In addi-tion, narrow rules exist to prevent these investors from

income (and sometimes even a loss) is derived there-from. . . . The intent was to include only such kinds of grossincome as have a very high content, so to speak, of net income.’’)See also Rev. Rul. 80-222, 1980-2 C.B. 211.

8Under the broad definition of FDAP, various types ofU.S.-source income not specifically listed in the regulations havebeen held by the IRS or the courts to constitute FDAP includingalimony, gain on surrender of a life insurance policy, gamblingwinnings, horse race winnings, and compensation for a non-compete agreement. See, e.g., Howkins v. Commissioner, 49 T.C.689 (1968) (alimony); Rev. Rul. 64-51, 1964-1 C.B. 322 (lifeinsurance policy); Barba v. United States, 2 Cl. Ct. 674 (1983)(gambling winnings; no deduction or offset for gambling losses)and Rev. Rul. 58-479, 1958-2 C.B. 60 (commissions, prizes,gambling winnings), but see section 871(j) (exempting proceedsfrom blackjack, baccarat, craps, roulette, or big-6 wheel fromwithholding tax); Rev. Rul. 85-4, 1985-1 C.B. 294 (horse racing;but see section 872(b)(5) (exempting from withholding tax, anyincome from a legal wagering transaction initiated outside theUnited States in a parimutuel pool with respect to a live horserace or dog race in the United States)); TAM 199947031, Doc1999-37301, 1999 TNT 228-10 (compensation for a noncompeteagreement).

9Foreign investors may avoid patently unfair results inconnection with certain passive U.S. real property-related in-vestments by electing to be subject to net taxation for U.S.-source rents received in connection with those investments (i.e.,to obtain the benefit of depreciation, interest expense and otherdeductions appropriately associated with such investments).However, the election is narrow and inappropriately requiresforeign corporations to become subject to branch profits taxa-tion on both income and gain from those U.S. passive realproperty-related investments.

10See sections 871(h) and 881(c).11See sections 871(h)(3) and 881(c)(3).12See reg. section 1.1441-2(b)(2).13See section 871(i)(3)(A); reg. section 1.861- 2(b)(1)(i)(a).14See sections 871(g)(1)(B)(i), 881(a)(3); reg. section 1.1441-

1(b)(4)(iv) and -2(a)(3).15See reg. section 1.863-7(b).

16See ‘‘Dividend Tax Abuse: How Offshore Entities DodgeTaxes on U.S. Stock Dividends,’’ Staff Report of PermanentSubcommittee on Investigations of the United States SenateCommittee on Homeland Security and Governmental Affairs(Sept. 11, 2008) (hereinafter Dividend Report).

17See Avi-Yonah, supra note 2; David Hariton, ‘‘Equity De-rivatives, Inbound Capital and Outbound Withholding Tax,’’Tax Lawyer, Vol. 60, No 2. (Winter 2007); Yaron Z. Reich, ‘‘TaxingForeign Investors’ Portfolio Investments: Developments andDiscontinuities,’’ Tax Notes, June 15, 1998, p. 1465, Doc 98-19132,or 98 TNT 114-71.

18See section 1(h)(11).19Antiabuse rules include the hybrid entity rules promul-

gated pursuant to section 894(c), anti-conduit rules issued




(C) T

ax Analysts 2008. A




avoiding the gross tax by using certain types of deriva-tive arrangements effectively to change the source ofU.S.-source FDAP income.20

B. Net-Basis TaxationAnother key element of the overall regime imposes net

income taxation on income that is effectively connectedwith the conduct of a trade or business in the UnitedStates.21 Application of these rules requires a two-stepinquiry. First, it is necessary to determine whether aforeign taxpayer is engaged in a trade or business in theUnited States. If so,22 the inquiry becomes whetherparticular items of income are effectively connected withthat trade or business. Once it has been determined thata foreign taxpayer is engaged in a trade or business,generally all U.S.-source income that is neither FDAP norcapital gains is considered effectively connected.’’23 Thisprinciple is generally referred to as the ‘‘residual force ofattraction’’ principle.

In the context of a passive portfolio investor, the mostsignificant point about this regime is that any foreignperson who is a partner in a partnership engaged in aU.S. trade or business is treated as so engaged.24 Thus,even a totally passive investor owning a small economicinterest (i.e., a passive portfolio investor, in the parlanceof this article) in a partnership engaged in a U.S. trade orbusiness becomes subject to U.S. net-basis taxation. Thisrequires such an investor to file U.S. tax returns, and as aresult of the ‘‘residual force of attraction’’ principle, cansubject other income, unrelated to the partnership’s busi-ness, to U.S. net-basis tax.25

There is a hybrid collection mechanism for net-basistax on income from partnerships. A partnership is re-quired to withhold, at the highest marginal tax rate foreach type of taxpayer, on each foreign partner’s share ofeffectively connected income.26 This generally applieswhether or not income is distributed; however, in thecase of publicly traded partnerships, withholding is onlyrequired on distributions.27 Unlike gross-basis withhold-ing, however, there is no expectation that the amountwithheld will match the taxpayer’s substantive tax liabil-ity, and, even if it does, the taxpayer is not relieved of theobligation to file returns.

In order to avoid becoming subject to these rules,foreign investors in partnerships with U.S. businessactivities frequently hold their partnership intereststhrough a ‘‘blocker’’ corporation, so that the corporation,rather than the investor itself, is treated as engaged in aU.S. trade or business. However, this is somewhat cum-bersome, and as discussed below, frequently results intwo levels of U.S. tax.

C. General ObservationsIn general, the overall U.S. tax regime applicable to

foreign portfolio investors is taxpayer-favorable andreflects, in part, an explicit goal of attracting foreignportfolio investment. It also reflects the administrativedifficulty of taxing certain types of U.S. connectedincome, such as gains. The regime effectively exemptsfrom tax passive gains from the sale of personalproperty, other than gain from certain partnership andreal estate-related investments, (which are treated likeactive income subject to tax at applicable net income taxrates).28 The exemption from tax for gains, together with

pursuant to section 7701(l), and the various limitation of ben-efits provisions that appear in all modern U.S. income taxtreaties.

20See reg. sections 1.861-2(a)(7), -3(a)(6); 1.864-5(b)(2)(ii);1.871-7(b)(2); and 1.881-2(b)(2).

21Even for taxpayers that are not otherwise engaged in a U.S.trade or business, net-basis taxation applies to gains from thesale of U.S. real estate (or stock of corporations whose assetsconsist primarily of real estate) under the Foreign Investment inReal Property Tax Act. See section 897. These rules are beyondthe scope of this article.

22In limited circumstances, a taxpayer who was formerlyengaged in a U.S. trade or business but is no longer so engagedcan be subject to net-basis taxation on certain income. See section864(c)(6) and (c)(7).

23See section 864(c)(3). Whether U.S.-source FDAP income orcapital gains are effectively connected is determined undersection 864(c)(2) and reg. section 1.864-3. Also, certain limitedcategories of foreign-source income may, in some circumstances,be treated as effectively connected. See section 864(c)(4).

24See section 875(1).25The IRS takes the position, in general, that any gain on

disposition of an interest in such a partnership is effectivelyconnected (Rev. Rul. 91-32, 1991-1 C.B. 107), although thestatutory basis for this conclusion has been questioned. Thisposition is quite controversial. See William W. Bell & David B.Shoemaker, ‘‘Revenue Ruling 91-32: Right Result For the WrongReasons,’’ 9 J. Partnership Tax’n 80 (1992); Edwin J. Reavey &Richard M. Elliott, ‘‘Sales of U.S. Partnership Interests byForeign Partners: New Rules After Rev. Rul. 91-32?’’ 91 TNI 50-27 (Dec. 1991); Kimberly S. Blanchard, ‘‘Rev. Rul. 91-32: Extra-statutory Attribution of Partnership Activities to Partners,’’ Tax

Notes Int’l, Sept. 15, 1997, p. 854, Doc 97-25288, 97 TNI 174-24;Alan R. Hollander, ‘‘Is a Sale of a Partnership Interest ‘Attrib-utable’ to the Partnership’s Place of Business? The MissingAnalysis in Rev. Rul. 91-32,’’ Tax Notes, Sept. 9, 1991, p. 1321;Kenneth L. Harris & Francis J. Wirtz, ‘‘The Interplay BetweenPartnership and International Tax Rules in the Internal RevenueCode: Revenue Ruling 91-32,’’ 20 Tax Management Int’l J. 345(No. 8, Aug. 9, 1991). We note that the facts of Rev. Rul. 91-32 didnot involve a publicly traded partnership, and it is not clearwhether the IRS would seek to apply it in that context. Inter-estingly, tax disclosure for some recent offerings of publiclytraded partnerships, to the extent it addresses consequences toforeign persons, has not taken a clear position on the applicationof the principle of Rev. Rul. 91-32 to sales of interests in thosepublicly traded partnerships, where application of that prin-ciple would be even more troublesome. See, e.g., ‘‘Material U.S.Federal Income Tax Considerations,’’ Form S-1A for The Black-stone Group L.P. (June 21, 2007).

26See section 1446.27See reg. section 1.1446-4.28This tax exemption for gains on personal property dates

back to 1936, and has become a fundamental part of the overalltax regime applicable to foreign investors in the United States.The exemption (which is consistent with international norms)provides an important inducement for cross-border investmentand eliminates significant administrative hurdles related tocollection of such a tax. In particular, in order to collect such agains tax through a fair and efficient withholding mechanism, itwould be necessary for foreign investors to document andreport their historic cost (i.e., basis) for an investment to the


(Footnote continued in next column.) (Footnote continued on next page.)


(C) T

ax Analysts 2008. A




the rules that exempt most types of interest, are the mosttaxpayer favorable aspects of the regime. However,significant types of passive portfolio income remainsubject to tax, including portfolio dividends and periodicincome from other types of portfolio investments, as wellas gains from portfolio interests in U.S. real propertyholding companies and interests in passive real estatepartnerships. Income and gains from portfolio interestsin operating partnerships (including publicly tradedpartnerships) also remain subject to tax.

III. Situations Leading to Inappropriate Taxation

A. Gross Tax on Positions With High Expenses

1. General. A major problem in the operation of the grosswithholding tax is that because the gross income tax basefails to take into account those expenses and lossesclosely or directly associated with an investment, it oftenserves as an extremely poor measure of economic incomerelated to that investment. The fact that the gross tax rateof 30 percent has historically been lower than the highestmarginal U.S. net income tax rates has had the effect ofmitigating the economic distortions caused by not takinginto account associated expenses and deductions.29 How-ever, over time, the maximum rate of regular tax has beenreduced, while the 30 percent rate of gross-basis taxationhas remained the same, with the result that the currentdiscount between the highest marginal net tax rate andthe gross withholding rate is small on an historic basis. Infact, with the maximum rate of tax on qualified divi-dends received by U.S. individual taxpayers at 15 per-cent,30 there is actually a negative spread in the case ofdividends. With the reduction in regular tax rates overtime, therefore, the distortive effect of not allowingexpense deductions has increased.

The distortion is further exacerbated for types ofpassive portfolio investments where recovery of ex-penses (and other costs which, under a net-basis regime,would be deductible) represent a significant portion ofthe gross income received from an investment. In thisconnection, three general types of investments are par-

ticularly troublesome. Significantly, in the modern busi-ness environment, those types of investments havebecome more prevalent than they once were.

The first type of investment that exacerbates thedistortion is any leveraged purchase of a financial instru-ment that generates FDAP. Because the cost of carryingthe leverage (that is, the interest) is not deductible to aforeign taxpayer, the effective tax rate on economicincome is far higher than the nominal 30 percent, and itis not difficult for that effective tax rate to exceed 100percent.

A similar and sometimes more serious problem arisesin connection with income flows from passive portfolioinvestments derived from wasting assets. Examples ofthis are depreciable real property, various forms of intel-lectual property (including patents and term interests incash flows from the use of copyrights and trademarks),structured settlement payments, and deferred lotterypayouts.

In the authors’ experience, investments of those typeshave become increasingly prevalent as international capi-tal markets have expanded, and as the number and typeof asset securitizations have increased. International mar-kets have emerged for nontraditional types of investmentassets such as investments in royalty streams and struc-tured settlement payments. For example, the authorshave observed the formation of several large pooledinvestment vehicles to acquire the right to streams ofroyalty payments that are determined based on theexploitation of pharmaceutical patents and other types ofintellectual property (including copyrights) in the UnitedStates. A significant secondary market has also devel-oped for unusual types of cash flow investments, includ-ing structured settlement payments from settlements oflawsuits and deferred payments to lottery winners.31 Thesignificant feature of all of these types of investments isthat, economically, a portion of the amount received byan investor represents a return of capital. However, in aworld of gross-basis taxation, no allowance is made forthis.

For example, consider a foreign taxpayer who pur-chases a stream of structured settlement payments for $1million. Under the terms of the settlement, he has theright to receive $176,984 per year for 10 years. Thus, overthe life of the deal, he will receive a total of $1,769,840, ofwhich, economically, $1 million represents a return ofcapital and $769,840 represents a 12 percent return oninvestment. However, if such an arrangement is taxedunder the gross-basis regime, unless it is characterized asa debt instrument, the entire $1,769,840 will be subject totax even though the economic profit is only $769,840.

purchaser of the investment. Alternative withholding mecha-nisms, such as the mechanism required under section 897 forcertain real property-related investments, which generally re-quires withholding on the amount realized (i.e., gross proceedsrather than gain), creates significant administrative hurdles forforeign investors who would need to file for a refund to claimtax withheld in excess of the appropriate tax on gain. There havebeen various proposals over the years to impose gross taxationof a foreign person on gain from the sale of U.S. equitysecurities. See, e.g., H.R. Rep. No. 2491, 104th Cong., 1st Sess.(1995); H.R. Rep. No. 5270, 102d Cong., 2d Sess. (1992); and H.R.Rep. No. 3150, 100th Cong., 1st Sess. (1989). However, theseproposals generally have excluded portfolio investments in U.S.companies (i.e., less than 10 percent interests). One drawback ofthe exemption for tax on such gains is that it provides both anincentive and opportunity for foreign persons to convert U.S.-source FDAP income that would be subject to gross taxation tonon-taxable capital gains.

29See Ault and Bradford, supra note 2, at 16.30See section 1(h)(11).

31In general, a structured settlement is an arrangementwhich is established by judgment or settlement agreement forthe unconditional periodic payment of damages by a defendantfor personal injury which are excludible from income undersection 104(a)(2). It is not unusual for payments under astructured settlement to extend for a term of many years and forperiodic payment amounts to vary over the term of the arrange-ment.



(C) T

ax Analysts 2008. A




From the perspective of the taxpayer, such an arrange-ment is very similar to a debt instrument, and a respect-able argument can be made that it should be so treated. Ifit were, even putting aside the fact that portfolio interestis exempt from withholding tax, the amount subject totax would be limited to the economic profit. It seems oddthat, in order to achieve this economically correct result,a taxpayer should have to argue for characterizing anarrangement in a way that is not consistent with itsform.32

A third type of transaction in which the distortioncaused by gross-basis taxation can be particularly acute isa hedging or arbitrage transaction. Generally, this in-volves a taxpayer acquiring a ‘‘long’’ position in oneasset, and taking a ‘‘short’’ position in another asset, thevalue of which is expected to be correlated, to someextent, to the value of the first asset. A taxpayer engagingin these sorts of transactions does not make his money asa return on capital; indeed, the net investment may bequite small. Such a taxpayer also does not make moneyby correctly predicting which way the value of thepositions will move; indeed, often an investor engaged inthese strategies expects to earn a profit regardless ofwhich way the market moves. The key to strategies ofthis type lies in identifying market inefficiencies in thepricing of the two positions. This allows the investor tobuy cheap and sell dear, based on the relative prices ofthe two positions at the time of their acquisition. If theassumptions as to the degree of correlation between thevalues of the two positions are correct, the profit shouldeconomically be locked in at that time, and should belargely unaffected by whether the values thereafter moveup or down.

From the perspective of gross-basis taxation, such aninvestment is highly problematic. Economically, the loss33

on one side represents a cost of earning the profit on theother side, and the investor’s net economic profit may beonly a tiny fraction of the gross profit on the ‘‘winning’’side. Thus, to the extent that the income on the ‘‘win-ning’’ side is in the form of FDAP income, gross-basistaxation is likely to be highly distortive, and can easilybecome confiscatory.

We have identified three types of transactions inwhich the distortion caused by a gross-basis transactionis likely to be particularly troublesome. The distortioncan get even worse where an investment combines morethan one of these features. For example, a foreign tax-payer who makes a leveraged purchase of a wasting

financial asset will, if income from this asset is subject togross-basis taxation, have to pay tax not only on eco-nomic profit, but also on the amount that represents areturn of capital, as well as on the amount he doesn’t getto keep because he has to pay it to the lender as interest.2. Techniques for avoiding the imposition of a punitivelevel of gross taxation. In light of the potentially confis-catory level of taxation that could flow from gross-basistaxation on income from some types of transactions, thereis a strong incentive to use structures that reduce the taxburden. One approach is to take advantage of treatyrelationships. For example, it may be possible to reducethe rate of withholding tax on certain types of income byrouting the income through an intermediary corporationorganized in one of the few remaining jurisdictions withwhich the United States has a tax treaty that does notcontain a ‘‘limitation on benefits’’ clause. Alternatively,sometimes an overall reduction in taxes can be achievedby using a chain of intermediate entities, taking advan-tage of the treaty relationships between the countries, aswell as peculiarities of internal tax law that may differfrom country to country.

The ability to use tax treaties to minimize U.S. with-holding tax is not unlimited. In particular, care must betaken to avoid running afoul of the ‘‘anti-conduit’’ regu-lations.34 However, many transactions can be structuredaround these rules.

Nonetheless, treaty planning is sometimes cumber-some and, invariably, some portion of the U.S. tax that issaved is instead paid to another jurisdiction (or toadvisors in that other jurisdiction).

Another technique for reducing the burden of gross-basis taxation is the use of derivative contracts. In gen-eral, income received on a ‘‘notional principal contract’’ issourced by the residence of the taxpayer.35 Therefore, if aforeign taxpayer, instead of holding an asset directly,holds it synthetically through the use of a derivative thatqualifies as a notional principal contract, income receivedon the derivative would be foreign-source, and hence notsubject to gross-basis taxation. In recent years, this tech-nique has been used aggressively to avoid dividendwithholding, and it has been the subject of intensescrutiny. Most recently, on September 11, 2008, the SenatePermanent Subcommittee on Investigations, a subcom-mittee of the Committee on Homeland Security andGovernmental Affairs, held a hearing on the use of thosetechniques. A report released in advance of the hearingconcluded that some taxpayers were using derivativecontracts to avoid dividend withholding in transactionsthat the report described as abusive, and recommendedaction on the legislative, regulatory and enforcementfronts to combat such perceived abuses.36 As discussed inthis article however, there are some fundamental prob-lems in the gross-basis taxation regime, and simplyclosing a perceived ‘‘loophole’’ without addressing thosemore fundamental issues does not seem appropriate. If

32Interestingly, a U.S. taxpayer holding an identical instru-ment would prefer that it not be characterized as debt. Anondebt intangible asset with a fixed life would generally beamortized over that life on a straight-line basis (see, e.g., section167). On the other hand, if it were treated as debt, incomeinclusions would be calculated using the constant-yield method(see, e.g., section 1272), which would effectively back-load basisrecovery.

33The term ‘‘loss’’ in this context is not meant to imply a lossrealized on disposition; rather, it refers to the overall economicloss on one side of the overall position. Thus, it may includesuch out-of-pocket expenses as dividend-equivalent paymentson the short position.

34See reg. section 1.881-3.35See reg. section 1.863-7(b).36Dividend Report, supra note 16.



(C) T

ax Analysts 2008. A




Congress acts to foreclose techniques used to avoid thesystem, it should also consider making the system itselfwork in a fair manner.

Another approach to avoiding the punitive effects ofgross-basis taxation is to structure one’s affairs so as tocome within the net-basis regime by holding investmentsin connection with a U.S. trade or business. Ironically,however, the ability to take advantage of this in thecontext of passive portfolio investment has been mademore difficult by what was intended to be a taxpayer-friendly provision of the code. Section 864(b)(2)(A)(ii)generally provides that a foreign taxpayer is not deemedto be engaged in a U.S. trade or business as a result oftrading for one’s own account in securities. Before 1997,this rule applied only if the taxpayer’s ‘‘principal office’’was not in the United States.37 The repeal of the principaloffice requirement in 1997 eliminated a tax planningopportunity for foreign persons who formerly couldeffectively elect to be treated as engaged in a U.S. trade orbusiness as a result of U.S. stocks and securities tradingactivities by deliberately failing the principal office re-quirement.

Even if a foreign person can arrange his affairs so as tobe engaged in a U.S. trade or business, such status cangive rise to significant administrative and complianceburdens. Furthermore, a foreign corporation that is ableto employ this technique would become subject to asecond level of U.S. taxation as a result of the applicationof the U.S. branch profits tax and branch level interesttax.38

Another mechanism for achieving net taxation is tohold passive portfolio assets through a U.S. corporatesubsidiary. Aside from the administrative costs, thissolution generally gives rise to a second level of U.S.taxation for both individual and corporate foreign inves-tors (a U.S. corporate level tax and a withholding tax ondividends paid by the subsidiary). In certain cases, aforeign corporate owner of a U.S. corporation may avoida second level of U.S. tax by retaining earnings in the U.S.corporation until a final liquidation. However, retentionof earnings until liquidation runs the danger of incurringa penalty tax under the accumulated earnings tax39 orpersonal holding company40 rules. Moreover, any incomeor gains realized on the reinvestment of retained earningswould be subject to U.S. corporate net income tax.

Another possible approach to avoiding punitive levelsof gross-basis taxation is to invest through a specialconduit vehicle, such as a regulated investment companyor a real estate investment trust. However, this techniquehas significant limitations since RICs and REITs havestrict limitations on ownership, investments, and opera-tions. Accordingly, RICs and REITs can only be used inlimited circumstances and cannot be used to achievenet-basis taxation for investments in various asset classes(such as royalties, insurance, settlement,s and lotterywinnings) or for certain leveraged and arbitrage-basedinvestment strategies.41

The planning solutions available to deal with theinability of a gross tax system to deal with income fromleveraged, hedged, and wasting assets are inadequate,and the planning option of requiring foreign investors toincur two levels of U.S. tax on income from passiveportfolio investments is neither practical nor fair. From afairness and neutrality point of view, it makes little senseto require foreign persons to become subject to two levelsof U.S. taxation on passive portfolio income to remedyissues associated with imposition of the single level grossbasis taxation of such income.

B. Investments in Operating PartnershipsThe net-basis tax regime also suffers from serious

flaws as applied to passive portfolio investors. Specifi-cally, if a partnership is sufficiently active so as to betreated as engaged in a U.S. trade or business, a foreignpartner becomes subject to the net-basis regime even ifthat partner is a totally passive portfolio investor.42

Moreover, under the IRS’s view, this almost alwaysresults in taxing the investor not only on operatingincome of the partnership itself, but also on gain from thesale of the partnership interest.43 This is significantlydifferent than the rule applicable to corporations, wherea sale of stock by a foreign person generally is not subjectto U.S. tax.

Presumably the theory underlying this concept is theassumption that there should be at least a single level ofU.S. tax on all active business income generated in theUnited States and that this conclusion is consistent withinternational norms.44 However, this conclusion is not

37The principal office requirement was informally referred toas the ‘‘Ten Commandments’’ because it required a foreignperson engaged in the active conduct of a securities or stocktrading business in the United States to conduct all or asubstantial portion of 10 listed functions at an office outside ofthe United States.

38See section 884. Net taxation of branch operations can alsolead to over-taxation of highly leveraged or hedged transactionsas the result of the imputation of equity to a foreign taxpayer’seffectively connected assets, under the special rule for determin-ing the deductible interest expense of a foreign corporationengaged in U.S. trade or business as well as potential stateincome taxation of a foreign corporation’s worldwide income ona formulary allocation basis. See Reich, supra note 17.

39See section 531.40See section 541.

41Before 2004, using a RIC had an additional disadvantage inthat interest and short-term capital gains were effectively trans-formed into dividend income subject to 30 percent withholdingtax (even though they would have been free of withholding taxif they had been earned directly by the taxpayer). Under currentlaw interest income and short-term capital gains of RICs retaintheir character on distribution from the vehicle. See section871(k). However, this rule will sunset on December 31, 2009,unless extended by Congress. See section 206, H.R. Rep. No.1424, 110th Cong., 2d Sess. (2008).

42See supra note 24 and accompanying text.43See supra note 25 and accompanying text.44In the area of operating income, since there is no entity-

level tax the income would escape U.S. tax entirely if it were nottaxed to the foreign partner. In the case of gain on sale of apartnership interest, if an election is made under sections 743and 754 the buyer will receive a basic step-up in his share of thepartnership’s assets to reflect the price paid for the partnershipinterest. This will result in less gain on ultimate sale and, to the




(C) T

ax Analysts 2008. A




inevitable, especially on income generated from passiveportfolio investments in U.S. businesses. As notedabove,45 full residence-based taxation of income andgains from passive portfolio investments in active U.S.businesses is a realistic alternative. In fact, the UnitedStates has already ceded taxation over most incomeearned in connection with active U.S. businesses involv-ing the trading of stocks, securities and commodities.Furthermore, the exemption from tax on portfolio interestincome means that the United States has ceded full taxingjurisdiction of business income that is paid to foreignpersons in the form of portfolio interest, which is notsubject to any taxation in the United States.

Even if one accepts the notion that a single level of taxshould be paid on all income of a U.S. business, thecurrent system goes far beyond what is needed to ensurethat result. As a result of the residual force of attractionprinciple, U.S.-source income that is totally unrelated tothe partnership’s business can become subject to tax.Moreover, the partner is required to file U.S. tax returns.While this may seem like a mere administrative inconve-nience, its practical implications are quite important. Formany foreign investors, filing U.S. tax returns — orhaving any contact at all with U.S. taxing authorities — issimply unacceptable.

As a practical matter, most foreign persons investingin operating partnerships do so through a ‘‘blocker’’corporation. This, however, generally results in not one,but two levels of U.S. tax, even if the actual foreigninvestor is an individual.46

The plethora of investment vehicles and financialinstruments available today mean that it is more likelythan ever that an investment partnership may engage inactivities that may fall outside the ‘‘trading for one’s ownaccount’’ safe harbor,47 and that may therefore constitutea U.S. trade or business. Thus, in today’s environment,the overbreadth of the net-basis taxation regime is trou-bling.

IV. Proposed Changes to the RegimeAs discussed above, there may be strong arguments in

favor of eliminating substantially all U.S. taxation ofpassive portfolio income of non-U.S. taxpayers, espe-cially U.S. taxation of portfolio dividend income.Whether or not one agrees with these arguments, it isclear that the current rules applicable to this type ofincome are in need of significant overhaul. It is difficult todefend such a costly and complicated tax regime thatpresents at the same time that economic distortion, ampleopportunities for avoidance, and painful traps for thosewho are either unlucky enough to become subject to aconfiscatory level of taxation or who are uninformed (orsmall enough) such that they are unable to take advan-tage of opportunities to avoid the tax or mitigate punitiveand unfair results.

The following is a description of several proposals forchange to the tax regime applicable to the taxation ofpassive portfolio income of non-U.S. persons that seemworthy of consideration. The first is a proposed change inthe rate of tax on U.S.-source FDAP (and, in particular,portfolio dividends) to take into account changes in thebroader U.S. income tax system and the global economy.The second category involves introduction of a new netincome tax election designed to permit avoidance ofpatently unfair and inappropriate results that can resultfrom gross taxation. Finally, we set forth some proposalsto overhaul the taxation of passive portfolio investmentsin partnerships operating U.S. businesses.

A. Reduction of Gross Tax Rate1. General reduction in 30 percent statutory rate. Asdiscussed above, the current 30 percent U.S. gross with-holding tax rate is extraordinarily high relative to themaximum tax rate imposed on domestic taxpayers andothers subject to net-basis taxation. This is inconsistentwith the theory that gross-basis taxation represents a‘‘rough justice’’ substitute for net-basis taxation, withoutthe administrative burden that would ensue if foreignportfolio investors had to substantiate actual expenses.

At least one commentator has suggested that the highrate is based on an implicit recognition that the tax willnot often be paid, and is likely maintained purely as abargaining chip in tax treaty negotiations.48 The argu-ment that a high rate is important in the context of taxtreaty negotiations seems weak, at least regarding ratesapplicable to portfolio type income. The U.S. has success-fully negotiated tax treaties that provide for zero taxationof interest even though the U.S. exempts portfolio inter-est.49 Other countries successfully negotiate tax treatieswith favorable rates for dividends even though theyimpose no tax on dividends paid to foreign investorspursuant to domestic law.50

extent allocable to depreciable or amortizable assets, it willgenerate future deductions that will reduce taxable operatingincome. Thus, an argument can be made that allowing a foreignperson to sell his partnership interest without paying U.S. tax onthe gain would effectively allow appreciation in the assets toescape the U.S. tax system entirely. Interestingly, the IRS’sposition in Rev. Rul. 91-32, supra note 25, does not appear todepend on whether a section 754 election is in effect.

45See supra note 2.46If a foreign blocker is used, it will be subject to regular

corporate tax as well as branch profits tax. If a U.S. corporationis used, it will be subject to regular corporate tax, and theshareholder will be subject to withholding tax on any dividends.A taxpayer that attempts to avoid a second level of tax by usinga U.S. blocker and making no distributions currently may runinto the accumulated earnings or personal holding companytax, and will also incur regular corporate-level tax on incomefrom reinvested funds, even if that reinvestment income is of atype (for example, interest) that would have escaped U.S.taxation entirely if a blocker corporation had not been used.

47See Part II.A. of this article.

48See Avi-Yonah, supra note 2, at 1374.49See, e.g., 2001 U.K.-U.S. Income Tax Treaty; 1996

Luxembourg-U.S. Income Tax Treaty; Australia-U.S. Protocol,signed Sept. 27, 2001, to the 1982 Australia-U.S. income taxtreaty.

50See, e.g., supra note 49; see also 2002 Protocol, signed Nov.26, 2002, to the 1992 Mexico-U.S. Income Tax Treaty.



(C) T

ax Analysts 2008. A




One proposal, therefore, would be to reduce the rate ofgross-basis tax so that its relationship to the maximumnet-basis tax rate is closer to historical rates.2. Elimination or reduction in tax rate for portfoliodividends. It seems especially difficult to rationalize thecurrent system of gross-basis taxation as applied toportfolio dividend income. As a result of the reduction ofthe maximum tax rate (for domestic individual taxpay-ers) on qualified dividend income to 15 percent in 2003,we have a somewhat bizarre situation in which foreignpersons pay twice as much tax as domestic taxpayers payon the same type of income. A second reason why the 30percent tax on dividend income is difficult to justify is theexistence of the portfolio interest exception. Portfoliointerest income earned by a foreign owner of most typesof debt issued by a U.S. corporation will not be subject toany tax in the United States, while dividend incomeearned by a foreign owner of an equity interest in a U.S.corporation will effectively bear two levels of taxation inthe United States (a tax at the corporate level and asecond level withholding tax when paid to the foreigninvestor). In contrast, the discrepancy between income ondebt and income on equity held by U.S. taxable investorsis only a single level of tax (that is, a single level of tax oninterest income compared to two levels of taxation ondividend income).

The U.S. tax system provides an obvious economicbias in favor of debt investments over equity investmentin U.S. corporations. The inherent disparity in taxation ofportfolio interest and portfolio dividends exacerbates thisdisparity and creates a significant incremental bias infavor of debt financing of U.S. corporations by creatingan incremental incentive for foreign persons to hold debtrather than equity issued by U.S. corporations.

Strong arguments, therefore, can be made that thewithholding tax on dividends should either be elimi-nated or that the rate should be significantly reduced.

B. Election to Avoid Certain Inappropriate ResultsAs discussed above, imposition of gross-basis tax on

income from portfolio investments with a high expense/cost component may lead to unfair and punitive taxationthat can serve as a trap for the uninformed or animpediment to passive portfolio investment in the UnitedStates. One solution to this problem would be to permitforeign taxpayers to elect to be taxed on a net basis, evenfor transactions that would otherwise give rise to FDAPincome.

Precedent for such an election exists under sections871(d) and 882(d), which allow just such an election forforeign investors in passive real estate investments.51

However, one important change should be made to thesystem that exists under sections 871(d) and 882(d).Specifically, corporations that elect into the regime (in-

cluding foreign pooled investment vehicles treated ascorporations for U.S. tax purposes) should not be subjectto branch profits taxation. It is unclear why corporationsthat make the section 882(d) election are subject to branchprofits taxation on amounts other than gain from the saleof the property.52 The branch profits tax ostensibly wasdesigned to create rough parity between taxation of activeU.S. subsidiaries and active U.S. branch operations offoreign corporations,53 and therefore imposes a secondlevel of taxation on the foreign corporation on an amountof profits deemed repatriated from a branch (somewhatequivalent to the withholding tax on dividends remittedfrom a U.S. subsidiary).54 The policy of collecting asecond level of U.S. tax does not seem warranted in thecontext of passive investments, especially passive port-folio investments.55 The U.S. tax system provides variousspecial rules, such as the RIC, REIT, and publicly tradedpartnership rules, designed to exempt passive-type in-vestment income of domestic taxpayers from multiplelevels of taxation. A net income election available toforeign corporations that would permit avoidance of thebranch profits tax would be consistent with the taxtreatment provided to foreign corporations that makepassive portfolio investments through U.S. RICs andREITs. The passive portfolio income earned by foreigncorporations through those vehicles is effectively subjectto only a single level of U.S. net taxation (collected in theform of a dividend withholding tax on distributions ofnet earnings from investments).

If the basic concept of a net-basis election were to beenacted, various choices present themselves in terms ofoperational details. One issue is whether the electionwould be available for all types of passive portfolioinvestments, or whether it would only be permitted forspecific types of investments (presumably, those types forwhich the distortion from the inability to claim deduc-tions is particularly egregious). While either approachwould be an improvement over the present system, theauthors see no reason not to make the election availablefor all types of passive portfolio investments. Taxpayerswould always be free not to make the election forinvestments in which the associated expenses are suffi-ciently small that the administrative inconvenience of

51Ironically, the effect of the current system, which allows anet-basis election for real estate but not for other types ofinvestments, is that a foreign person who is looking to make aninvestment in the United States may have a tax incentive toinvest in real estate rather than something else. This seemscontrary to the purpose of FIRPTA, which generally makes realestate a less attractive investment for foreign persons.

52FIRPTA effectively mandates branch taxation of real prop-erty gains of foreign corporations, regardless of whether thosegains are actually connected with a real property trade orbusiness.

53See H.R. Rep. No. 841, 99th Cong., 2d Sess. II- 647 (Conf.Rep. 1986).

54See section 884.55The second-level tax has been rationalized by at least one

commentator as a charge on U.S. business activity of the typethat can give rise to significant value in the form of goodwill,which, in part, offsets the tax benefit that flows from allowingdeductions for the costs (for example, advertising expenses) thatcreate such goodwill. See Robert Cassanos, ‘‘Single Taxation ofPublicly Traded Entities,’’ Tax Notes, June 16, 2003, p. 1663, Doc2003-14516, or 2003 TNT 116-37. The authors’ proposal toexempt foreign corporations that make the proposed electionfrom the second level of tax is consistent with that rationale,since goodwill is not a factor for passive portfolio investment.



(C) T

ax Analysts 2008. A




documenting the expenses and filing returns outweighsthe benefit.56 A second issue is whether to require thistype of election to apply to all investments of a foreignperson that generate U.S.-source FDAP income, orwhether, instead, the election would apply only forincome and gains realized on specific investments iden-tified as subject to the election at the time of acquisition.The authors favor the latter approach. Eligible invest-ments would be limited to investments that generateU.S.-source FDAP income (base asset) and closely asso-ciated investments such as assets held to hedge the baseasset or held in connection with the base asset as part ofa broader arbitrage strategy. The election could not applyto payments received for nonportfolio investments andwould not otherwise cause the foreign person to besubject to U.S. net taxation.

Yet another issue would be whether a taxpayer mak-ing the election would be entitled to claim all deductionsallowable under the regular net-basis tax regime, orwhether only limited deductions, to alleviate the mostegregious aspects of gross taxation of U.S.-source FDAPincome, would be permitted. The latter approach wouldsacrifice some degree of precision in the interest ofsimplicity. If this approach were adopted, an electingtaxpayer should, at a minimum, be permitted deductionsfor depreciation and amortization on the base asset, andloss or expense for amounts directly associated withassets that are specifically identified as held in connectionwith the ownership of the base asset (that is, an invest-ment held to hedge the base asset or held together withthe base asset as part of a broader arbitrage strategy). Adeduction should also be provided for interest expensesto third parties incurred on debt that is collateralizedsolely with property associated with the U.S. investment.An argument could be made for denying deductions forrelated party indebtedness — indebtedness that is gen-erally recourse to the borrower or guaranteed by theborrower (except where the debt is incurred by a bor-rower that has no assets or activities other than holdingproperty subject to the election). The normal antiabusetax accounting rules would apply, including restrictionson losses from straddles, wash sale rules and constructivesales.

A major drawback of this type of regime is that itwould require foreign portfolio investors to file a U.S. taxreturn, which many foreign investors would consider tobe a substantial burden. In many cases, the electionwould be made by a fund or other pooled investmentvehicle that has aggregated investments from manyforeign persons. Nonetheless, in order to make the elec-tion more accessible to foreign persons who do not investthrough a fund or pooled investment vehicle, and to easethe administrative complexities in identifying which po-sitions are subject to net-basis elections, we would pro-pose that consideration be given to the establishment of anew type of U.S. special purpose entity to hold passiveportfolio investments. The vehicle would be establishedexclusively for use by foreign persons who are not

engaged in a U.S. trade or business, and the vehicle itselfwould not be permitted to engage in any activity thatwould cause the vehicle to be treated as engaged in a U.S.trade or business if such vehicle were a foreign person.The vehicle would be subject to U.S. corporate netincome tax at the highest marginal tax rates on all netincome and gains, and provide for tax-free dividends toinvestors. Moreover, it would not be subject to either theaccumulated earnings tax or the personal holding com-pany tax.57 As with the proposed net income tax election,a single level of U.S. net tax is consistent with the fact thatonly a single level gross-basis tax is imposed undercurrent law. In order to preserve the taxation of gains,tax-free liquidations of the vehicle would not be permit-ted.

The use of this type of single tax vehicle wouldprovide substantially the same results as a net-basiselection, while simplifying administration issues. Itwould also allow foreign persons to remain subject toU.S. gross taxation for assets acquired outside the vehicle.In addition, foreign investors reluctant to file U.S. taxreturns might be more likely to make use of this type ofsingle tax vehicle, instead of a direct net tax election,because the special vehicle rather than the foreign inves-tor would file the return. Requiring that such a vehicle beorganized in the United States is not inherently necessary,but would presumably facilitate administration and col-lection of tax by the United States.

The existence of a net income tax election or provisionof a new special purpose vehicle to facilitate passiveportfolio investment by foreign persons would add acertain amount of additional administrative burden onthe IRS, but would also facilitate additional passiveportfolio investment in the United States. Either optionwould presumably reduce the incentive for foreign per-sons to engage in aggressive tax planning to exploitloopholes in the current gross-basis regimes (includingtreaty shopping, use of derivatives, conduit structures,etc.). Accordingly, it might increase U.S. tax receipts.

C. Partnerships Engaged in a U.S. Business1. Eliminate taxation of business income and/or gainfrom passive portfolio stakes in partnerships that areengaged in a U.S. trade or business. An importantopportunity to simplify the U.S. international tax regimeconcerns the taxation of passive portfolio stakes in part-nerships that are engaged in a U.S. trade or business,including partnership interests that trade publicly (forexample, oil and gas master limited partnerships). Asdiscussed above, under current law a foreign person whoinvests in such a partnership is treated as engaged in aU.S. trade or business, and accordingly is subject to nettaxation on such person’s share of income from thepartnership (whether or not distributed), as well as onother U.S.-source income that is treated as effectivelyconnected under the residual force of attraction principle.

56As discussed below, this assumes that the election ispermitted to be made on an investment-by-investment basis.

57Because these ‘‘penalty’’ taxes are designed to preventavoidance or undue deferral of the second level of taxation, theyshould have no application to a type of vehicle that is specifi-cally designed to result in only a single level of tax.



(C) T

ax Analysts 2008. A




In addition, the current position of the IRS is that such ataxpayer is also subject to net taxation of gains realizedon the sale of an interest in the partnership (at least to theextent that gain is attributable to assets associated withthe trade or business), although it is not entirely clearwhether this position extends to publicly traded partner-ships.58 A regular U.S. tax return must be filed. There isno exception for small portfolio interests in those part-nerships. This system raises obvious administration andenforcement issues, especially because there is no with-holding mechanism to collect tax on gains from the saleof partnership interests (except in the case where thosegains are attributable to gain inherent in the U.S. realproperty interests held by the partnership).

Net taxation of passive portfolio investments in oper-ating partnerships can be justified based on a desire toensure at least one level of U.S. taxation of active businessprofits, although we note that the United States has cededtaxation on all business earnings paid to foreign personsin the form of interest. As discussed above, there aresignificant policy arguments in support of residence-based taxation generally, and significant administrativeand simplification benefits to exempting tax on incomefrom small portfolio interests in U.S. operating partner-ships. At the minimum, an exception should be consid-ered for the imposition of tax on gains from the sale ofsmall portfolio stakes in publicly traded partnerships thatare engaged in a U.S. trade or business. An exemptionfrom tax on current income from these partnershipswould provide incremental simplification benefits, and itis the authors’ suspicion that the impact on tax collectionswould be relatively small.2. Eliminate return filing requirement for passive port-folio interests in partnerships. If the United States is notwilling to cede taxing jurisdiction entirely for operatingincome from partnerships engaged in a U.S. trade orbusiness, it should still be possible substantially to sim-plify the administration and collection of tax on suchincome for passive portfolio investors. As discussedabove, under current law becoming a partner, no matterhow small, in a partnership which is engaged in a U.S.trade or business has two important collateral effects, inaddition to net-basis taxation of income from that tradeor business. Specifically, other U.S.-source income of theinvestor could become effectively connected (and hencesubject to net-basis U.S. taxation) under the residual forceof attraction principle, and the investor becomes respon-sible for filing U.S. tax returns. Eliminating those twocollateral effects would simplify administration, andwould also remove two major impediments to directinvestments (that is, not through blocker corporations) inpartnerships; at the same time, it would preserve taxrevenues on income from the partnership’s business. Themechanical implementation of the proposal would berather simple, particularly given that section 1446 alreadyrequires withholding on a foreign partner’s share ofincome from a partnership’s U.S. trade or business. Theproposal would be to eliminate the trade or businessattribution principle of section 875, as applied to passive

portfolio investments. Instead, a separate tax (imposed atthe maximum marginal rate) would be imposed, but onlyon the net income from the partnership’s trade or busi-ness (without a force of attraction principle). The taxwould be collected by means of withholding (the mecha-nism for which already exists under section 1446). How-ever, unlike current law, withholding would be the solemeans of collection, so that foreign passive portfolioinvestors would not have to file U.S. tax returns.59

There could be some practical difficulties in imple-menting a pure withholding-based collection system inthe context of publicly traded partnerships. The reason isthat in practice, withholding for publicly traded partner-ships is usually done not by the partnership itself, but bythe brokerage houses or other financial institutionsthrough which partnership units are held. However,those institutions have no way of knowing about, orwithholding from, undistributed income. In practice,when they receive a distribution from a publicly tradedpartnership on behalf of a foreign investor, in the authors’experience they simply withhold 35 percent of the distri-bution.

Under current law, withholding on the basis of theamount distributed (rather than on all earnings, whetherdistributed or not) is specifically allowed by regulationsapplicable to publicly traded partnerships.60 However,because all partners are responsible for filing a tax returnand paying the full amount of tax, the fact that nowithholding is imposed on undistributed effectively con-nected income of a publicly traded partnership does notfundamentally change the timing of tax collections onsuch income — it just means that it is collected directlyfrom the foreign partner, rather than withheld and remit-ted by the partnership (or a financial institution in thepayment chain).

Under the authors’ proposal to make withholding thesole (or at least the primary) means of collection for taxon effectively connected income from passive portfolioinvestment in partnerships, this issue becomes moresignificant. Either (i) we would have to switch to a systemin which foreign partners in publicly traded partnershipsare only taxed when income is distributed (at which timethe tax would be collected by withholding), or (ii) thefinancial community would have to develop a mecha-nism for handling withholding on undistributed incomefrom publicly traded partnerships. Based on experience

58See supra note 25 and accompanying text.

59In theory, return filing (and direct payment of tax) could berequired as a back-up mechanism if the partnership does notsatisfy the obligation to withhold. This is analogous to thesystem currently in effect for FDAP withholding (i.e., return notrequired, if the substantive tax liability has been fully satisfiedby withholding). However, given the reluctance of many foreigninvestors to engage in transactions that might require that theyfile U.S. tax returns, and given the likely small revenue effect,the authors believe that such a contingent return filing require-ment is not warranted.

60See supra note 27 and accompanying text. Interestingly,there is no such rule for section 1441 (FDAP) withholding, andthe system that the financial community has developed forwithholding does not appear to work properly in the case ofpublicly traded partnerships which have FDAP income.



(C) T

ax Analysts 2008. A




with section 1441 withholding, it may very well turn outthat, regardless of what the tax law says, the marketmight not develop such a system.

V. ConclusionThere are a number of aspects of the U.S. system of

taxation of foreign persons who receive income frompassive portfolio investment that can result in unfair(and sometimes bizarre) consequences for transactionscommonplace in today’s economy. The authors suggestthat the time has come to rethink some of thefundamental concepts underlying this system. Assumingthat the United States is not willing to abandon

source-based taxation entirely on income from passiveportfolio investments, the authors suggest some basicapproaches to improving the operation of the system.

The authors also suggest that, if Congress enactslegislation to prevent what may be perceived as abuses ofthe current system, it should also take the opportunity toexamine improvements that could be made to the systemitself. In particular, any legislation that made it moredifficult for taxpayers to avoid the system, without alsoproviding relief in those situations in which the systemproduces a patently unfair result, would not be wise taxpolicy.

SUBMISSIONS TO TAX NOTES

Tax Notes welcomes submissions of commentary andanalysis pieces on federal tax matters that may be ofinterest to the nation’s tax policymakers, academics,and practitioners. To be considered for publication,

articles should be sent to the editor’s attention [email protected]. A complete list of submission guide-lines is available on Tax Analysts’ Web site, http://www.taxanalysts.com/.



(C) T

ax Analysts 2008. A




SPECIAL REPORT - Akin Gump

Documents

Transcript of SPECIAL REPORT - Akin Gump