The Total Return Swap Business Expands to Bank Loans

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analyzed above the swap should not be considered to be acquired in the conduct of a U.S. trade orbusiness, that income should not be considered to be U.S.-source income. Thus, any such income shouldnot be subject to U.S.-source-based withholding taxation.IV. Substance Over Form?It is axiomatic that the form of a transaction will not determine its federal income tax consequences if thesubstance of the transaction does not comport with that form. 38 In case of a TRS entered into with respect toa bank loan, the most likely recharacterization of the arrangement would be that the Hedge Fund is theowner of the loan itself and that Bank A is acting as an agent of the Hedge Fund in holding and servicing theloan. In that case, the Hedge Fund would not be considered to receive income from a swap, but insteadwould be considered to receive U.S.-source interest income on the loan itself. The tax consequences of thatrecharacterization will depend on whether the Hedge Fund is engaged in the trade or business of lending orsimply being an investor or trader in debt instruments.The leading case in which a cross-border relationship not cast as an agency was treated as such for federalincome tax purposes is Inverworld. 39 Although the deemed agent in Inverworld was a wholly ownedsubsidiary of the deemed principal, the court analyzed the issue as though the parties were not related. Inthat case, the U.S. subsidiary, on behalf of the deemed principal and its clients: (i) used guidelines providedby the foreign corporation to determine which U.S. financial products to purchase, (ii) performed brokerageservices, and (iii) generated client statements and effected currency exchange transactions. Those activities,conducted on a continual basis over several years, were sufficient for the court to find that the U.S.subsidiary was acting as an agent of the foreign corporation.The issue as to whether a TRS will be respected as a swap is not unique to the bank loan area. It alsoarises in connection with collateralized debt offerings and lending by off-shore distressed opportunity funds.In those contexts, professional firms and financial institutions have identified a number of factors that wouldmake an agency recharacterization more likely to be found. Many hedge funds follow guidelines based onthose criteria to avoid the consequences of being considered to be engaged in the conduct of trade orbusiness in the United States. It is important to note that no single factor should be determinative.• Does the total return recipient (the Hedge Fund) receive a fee from the borrower for an extension ofcredit?• Does the total return recipient (the Hedge Fund) participate in the negotiation of the underlying bankloan?• Does the total return recipient have communication with the corporate bank loan borrower (other thannormal due diligence)?• Does the total return recipient hold itself out as being in the business of extending credit, that is, does theHedge Fund actively solicit customers/borrowers?• Is the total return recipient obligated to enter into the TRS before the total return payer has extended theunderlying bank loan?• Does the total return recipient have any rights with respect to the underlying bank loan documents,including, for example, with respect to the enforcement thereof or amendments thereto?• Is the TRS entered into substantially at the same time that the total return payer extends the bank loan?Greenberg Traurig, LLP
• Does the initial notional amount of the TRS represent the initial principal amount (as opposed to the thenfairmarket value) of the underlying bank loan?• Does a substantial portion of the total return recipient’s activities consist of entering into TRSs over debtinstruments?• Is the duration of the TRS the same as the stated term of the underlying bank loan?• Does the TRS cover the entire principal amount of the bank loan rather than only a percentage thereof?• Is the TRS part of a significant number of similar transactions involving extensions of credit to U.S.borrowers?• Does the Hedge Fund place collateral with Bank A that is equal to the full notional amount of the swap?• Does the swap require Bank A to actually hold the bank loan?To the extent the factors enumerated above are present (the questions are answered in the affirmative), thatmay tend to support an argument that Bank A should be considered to be an agent of the Hedge Fund inholding the bank loan. Courts have held that acts of unrelated agents can result in the foreign principal beingtreated as engaged in the conduct of a trade or business in the United States. 40 As analyzed in thesucceeding sections, however, even if the Hedge Fund is considered to hold a direct interest in the loan, itmay not result in any net adverse federal income tax consequences to the Hedge Fund. That happy resultstems from the conclusion that even if Bank A is acting as an agent of the Hedge Fund, it should remainunlikely that the Hedge Fund would be considered to be engaged in the conduct of a U.S. trade or businessor would be subject to withholding tax -- provided that the Hedge Fund is considered a secondary marketpurchaser and not the originator of the loan.V. Consequences if Hedge Fund Owns Bank LoanAs discussed above, there are two bases on which a foreign corporation can be subjected to U.S. taxation,net income taxation on the ground that it is engaged in the conduct of a trade or business in the UnitedStates or source-based taxation if it is not. Unless the Hedge Fund (total return recipient) engages in bankloan TRSs on a regular and continuous basis, and meets a substantial number of the other factorsenumerated above, it is unlikely that even directly acquiring interests in bank loans in the manner positedwould amount to a U.S. trade or business. Concomitantly, regarding withholding tax, the portfolio interestexception should exempt any interest income from taxation in the hands of the Hedge Fund.A. Net Income TaxationIf the form of the TRS is not respected and the swap is instead treated as an ownership interest in theunderlying loan itself, the question becomes whether the activities of the Hedge Fund regarding theunderlying loan are sufficient to amount to the conduct of a trade or business in the United States. Theresolution of that ultimate issue depends on two subsidiary issues: (i) whether the bank loan activities areprotected from trade or business status by reason of either of the securities trading safe harbors and (ii)whether, if they are not so protected, they are so sporadic so as not to constitute the conduct of a financingbusiness in the United States.Greenberg Traurig, LLP
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The Total Return Swap Business Expands to Bank Loans

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