Funds run the risk of being considered engaged in a trade or business in the U.S. if they engage in lending activities and create “effectively connected income” for their non-US investors. IRC Sec 864 has a safe harbor provision for “trading in securities.” Investing in stock, securities and commodities does not result in a trade or business. However, it is generally accepted that a “lending, financing or similar” business does not fit within the trading safe harbor of 864(b)(2)A(ii).
There is limited authority on when loan origination results in a trade or business.
- One loan does not create a trade or business (Pasquel 12 TCM 1425).
- Investing in stock, securities and commodities does not result in a trade or business.
- PLR9701006 – In a very unique situation, 5 or fewer loans per year was not a finance business under Section 7704.
There are several factors to consider in determining if loan origination results in a trade or business
- Number and frequency of loans – lending needs to be “extensive and continuous;” “considerable, continuous and regular.”
- Whether the taxpayer holds itself out as a lender – advertising, solicitation and reputation.
- Type and quality of activities, e.g., sourcing and negotiation vs. mere due diligence.
- Whether there is a market for loans acquired (other potential sources of capital).
- Receipt of fees (what type of fees?).
On November 15, the U.S. Tax Court issued its decision in YA Global Investments, LP v. Commissioner. The facts state that YA Global provided direct capital to portfolio companies by purchasing convertible bonds and entering into standby equity distribution agreements. The IRS’s issue was that they believed YA Global was not an investor but in the lending business, causing it to be in a trade or business. In making this determination, the court employed a three-part analysis to determine that YA Global was engaged in a trade or business.
- Were the YA Global transactions continuous, regular and engaged in for profit?
- Were the YA Global transactions limited to the management of its investments?
- Did the YA Global transactions constitute trading in securities within the meaning of the Code Section 864(b)(2) safe harbor?
In addition to the above criteria, the court also looked into another court case that described what a promotor was.
- Compensation sought is other than the normal investor's return, and income received is the direct product of the taxpayer's services and not primarily from the deployment of capital.
- The activity is conducted for a fee or commission or with the immediate purpose of selling the securities at a profit in the ordinary course of the taxpayer’s business.
- The taxpayer had a reputation in the community for promoting, organizing, financing, and selling businesses.
The court's view was that YA Global was receiving additional income and acting as an agent and therefore not merely an investor in securities (receiving capital gains from sales) but engaged in a trade or business. The court ultimately also ruled YA Global was a dealer in securities and subject to the Section 475 rules.
The ultimate impact of YA Global is still unclear and each situation needs to be analyzed under its own set of facts and circumstances. The rules are complex and should be discussed with your tax advisor.
This blog article has been prepared for general guidance on matters of interest only and does not constitute professional advice. You should not act upon the information contained in this article without obtaining specific professional advice.
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Written by David Helprin
Managing Director, Tax Services