The Total Return Swap Business Expands to Bank Loans

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1. The general securities trading safe harbor. Section 864(b)(2)(A)(i)provides that a taxpayer is not engaged in a trade or business in the United States by virtue of trading insecurities through an independent agent. That exception applies only if the foreign person does not maintainan office in the United States through which these transactions are carried out. 41 Applicable regulationsmake clear that the term “securities” as used in this exception includes “any note, bond, debenture, or otherevidence of indebtedness or any evidence of an interest in or right to subscribe for or purchase any of theforegoing.” 42 An independent agent is a person of independent status, acting in the ordinary course of itstrade or business in that capacity. 43 A foreign corporation is not considered to have an office in the UnitedStates “merely because a person controlling that corporation has an office . . . from which generalsupervision and control over policies of the foreign corporation are exercised.” 44 If, however, the day-to- dayU.S. trading of the foreign corporation is conducted through a U.S. office, that office will be attributed to theforeign corporation. 45In appropriate cases, the independent agent trading safe harbor may offer a basis for concluding that ahedge fund that acquires an interest in a bank loan should not be considered to be engaged in the conductof a trade or business in the United States. The bank loan itself should be considered to be a security. BankA, the loan originator, should be considered to be an independent agent of the Hedge Fund in those casesin which Bank A originated the loan without any involvement of the Hedge Fund. When the Hedge Fund wasnot involved in negotiating the loan, the issue as to whether the Hedge Fund should be considered to haveoriginated the loan in the ordinary course of a financing business should not be present. 46 Perhaps the mostdifficult hurdle that the Hedge Fund will encounter in attempting to take advantage of the general safe harboris asserting that the office of its U.S.-based manager should not be imputed to it. As noted, that conclusioncan be established only if the Hedge Fund manager does not conduct the day- to-day business of the fundfrom its U.S. office. In practice, that may be difficult to sustain if the manager actively manages the HedgeFund’s activities from its U.S. office. As analyzed below, however, that fact will not preclude the Hedge Fundfrom taking advantage of the “trading for its own account” exception.2. The proprietary trading safe harbor.Foreign persons who are not dealers in securities may trade in securities through their own employees in theUnited States or through a U.S. agent (independent or not) without being considered to be engaged in aU.S. trade or business. 47 In contrast to the general exception, for nondealers there is no requirement thatthose activities be conducted through an office outside of the United States. 48 Section 475(c)(1) defines theterm “dealer in securities” to include a taxpayer who regularly purchases securities from or sells securities tocustomers in the ordinary course of a trade or business. 49 Applicable regulations parenthetically treat theorigination of loans in the same manner as the purchase of loans. 50 In all cases, however, a person cannotbe a dealer in securities unless it purchases securities from, or holds securities for sale to, customers. 51Even if loan origination can be considered to be a purchase of a debt instrument, the point at which loanorigination rises to the level of a financing business rather than mere trading in securities is unclear at best. 52If the Hedge Fund is not involved with the origination of the bank loans (using the criteria enumeratedabove), it should have a strong position that the proprietary trading safe harbor precludes a finding that it isengaged in the conduct of a U.S. trade or business with respect to bank loans. The fact that the HedgeFund’s activities were conducted by an investment manager located in the United States is irrelevant to thedetermination of whether the fund is engaged in a trade or business under this safe harbor. The acquisitionGreenberg Traurig, LLP
of an interest in a bank loan should be treated as an acquisition of a “security.” The Hedge Fund is unlikelyto be treated as a dealer in securities because it is neither buying from, nor selling to, customers.Accordingly, unless the activities rise to the conduct of a financing business (and not the trading ofsecurities), the Hedge Fund should not be considered to have generated a taxable nexus to the UnitedStates.3. Banking, financing and similar activities.Treas. reg. section 1.864-4(c)(5)(i) provides that a foreign corporation is engaged in a banking, financing, orsimilar business in the United States if, inter alia, it is engaged at any point during the tax year in one ormore of six “financing functions” in the United States, including making loans to the public. In Pasquel v.Comm’r, 53 a Mexican national entered into a transaction that had elements of being both a loan and a jointventure with a U.S. corporation. The U.S. corporation acquired two boats with funds supplied by the Mexicannational, resold the boats, and split the substantial profits with the Mexican national. The court held that,regardless of whether the transaction was a loan or a joint venture, a single transaction was an insufficientbasis for concluding that the Mexican national was engaged in a trade or business in the United States. Incontrast, in Inverworld, a Mexican financial institution that regularly engaged in five of the six enumeratedfinancing functions on a regular basis over a number of years was found to be engaged in the conduct of abanking or financing business in the United States. Although the IRS had issued a public ruling in 1973concluding that a captive foreign finance company was engaged in a financing business in the UnitedStates, it subsequently revoked the ruling because it did not apply the law to the facts. 54 Accordingly, there isno existing tax authority on the vast gray area between the two extremes represented by Pasquel andInverworld.In addition to the question of whether lending constitutes a trade or business when conducted by a foreigncorporation, the question whether lending constitutes a business for a domestic taxpayer has tax relevanceand has been extensively litigated. 55 As in the cross-border area, lending businesses have been found whenthe lending activities are frequent and continuous and conducted over a number of years. For example, ataxpayer who made eight or nine loans over a four-year period was held not to be in the lending business. 56Conversely, a person who made more than 100 loans over a five-year period was considered to be engagedin the lending business. 57 That case law supports the conclusion that sporadic lending activities do notconstitute a trade or business. 58Several of the factors enumerated could assist in an analysis of whether the activities of the Hedge Fund areregular and continuous enough to amount to the conduct of a trade or business. Although untested, it isworth noting that Treas. reg. section 1.864- 4(c)(5)(i) contains a limitation specifying that the loans must bemade “to the public” in the United States for lending to constitute a trade or business. In no event will aHedge Fund be willing to acquire bank debt from a wide array of borrowers that would constitute the “public”in the commonly accepted definition of that word. 59 Instead, at least in the author’s experience, hedge fundsare very selective about which corporations they will take exposure to. In this context, a portfolio swap maypresent greater risk of net U.S. taxation to a Hedge Fund than a one- off swap or several one-off swaps. Theheightened risk stems from the fact that there is a pattern of loan origination sometimes obligating theHedge Fund to take a credit that meets defined parameters without a veto right. In that case, the economicdefeasance engaged in by Bank A could more readily be imputed to the Hedge Fund as lending. In the vastmajority of cases, however, the Hedge Fund activities will not be substantial enough to amount to theconduct of a financing business in the United States.Greenberg Traurig, LLP
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The Total Return Swap Business Expands to Bank Loans

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