Tax policy is fascinating – really. Although according to the Tax Policy Center 45.3% of the US adult population pays no income tax, tax touches most people’s lives. As discussed in this article, the rules are complex because they need to cover the many ways in which people and corporations act in the pursuit of profit and even philanthropy. Tax laws need to deal with individuals, corporations and hybrid entities such as partnerships and trusts. They also need to deal with the foreign interests of domestic taxpayers and the domestic interests of foreign taxpayers.
Tax laws are the subject of intense lobbying and a great deal of political effort. The Taxpayer Advocate Service estimates that around six billion hours a year are spent preparing taxes. The Tax Code and Regulations now exceed ten million words. For most people, taxes are a frustrating maze of complexity. And yet, there is a logic and coherence, which if explained properly can emerge as a roadmap to everyday understanding.
Portfolio interest is an obscure term but extremely important for foreign investors lending money to US borrowers, including the US government. It is like a signpost to heaven written in small font.
To understand portfolio interest, it is important to recall the political and economic conditions in 1984. Ronald Reagan was elected for the first time in 1980. His policies – tax reduction, an increase in military spending, increasing budget deficits, tight control of the money supply – were associated with (some would say “caused”) soaring government borrowing to fund a growing budget deficit, high unemployment and very high-interest rates (approaching 20% at their peak).
While the economic recovery that began in 1983 reduced unemployment and inflation, deficits and interest rates remained high and, because US domestic savings rates were low, deficits were largely financed by foreign lenders. Interest rates overseas were attractive not only to the US government but also to domestic corporations.
The growth in the size of the Eurobond market had for years made it the target of capital markets-led lobbying for relief in the tax treatment of interest payments to foreign lenders. The need to finance growing government borrowing and the re-election of Ronald Reagan in 1984 gave the necessary impetus for reform.
The Withholding Tax Problem
The problem was that interest payments to foreign lenders were subject to 30% tax withheld at the source of payment. To be competitive with other avenues of lending, US interest rates needed to be 43% higher. US corporations had a solution to the problem: they set up financing subsidiaries in the Netherlands-Antilles to issue the Eurobonds and relied on the favourable treaty between the US and the Netherlands-Antilles to level the playing field with non-US issuers of Eurobonds.
This solution worked but was only practical for larger corporations and was not something the US government could use. Accordingly, tax reform legislation was passed in 1984 that created an exception to the withholding tax on interest paid to foreign lenders. This exception was called the “portfolio interest exception”.
In summary, if a non-US lender that is unrelated to the US borrower, is not a bank, is not a CFC (controlled foreign corporation), and is not engaged in the conduct of a US trade or business, lends money to a US borrower documented in the form of a registered debt instrument paying a fixed rate of interest, then the interest payable on the loan should qualify for the portfolio interest exemption (no 30% tax withheld), provided the non-US lender provides adequate documentation as to its non-US status.
The measure has been successful. Treasury reports show total US securities held by foreign investors have grown from $363bn in 1984 to $17.1trn in 2016.
The Bottom Line
Foreign investors in the US have no interest in being taxed in the US on the interest income they receive. Nor do they want to file US tax forms relating to their investments. The interest of the IRS in collecting the maximum amount of revenue from the economic activity that occurs in the US is sometimes overridden by other macroeconomic interests. Government debt has continued to grow since the Reagan era. The need for the US government and US domestic borrowers to source capital from foreign sources remains paramount in the design of US tax policy. The portfolio interest exception has been a key part of this capital raising initiative.
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