What I Learned Helping a Private Credit Fund Lend Across Borders?

I was requested to look at a deal by a private credit fund that is headquartered in Singapore a few years ago. They wished to make a $10 million loan to a developer of U.S. real estate. The interest rate was very good. Collaterals were adequate. No one had considered the tax aspect of it. I asked the fund manager how he would deal with the U.S. withholding tax, but he didn't respond. He didn't realize that until you have it set up correctly, the U.S. government is taking 30% of the interest payments that you're making to foreign lenders. That's when the conversation began, and a long partnership began. Since then, I have been very involved in helping dozens of private credit funds, family offices and individual investors structure loans efficiently, obtaining a withholding tax exemption foreign loan framework. This article is a compilation of some things I have learned from practical situations on how to save money and not incur unnecessary expenses.

The Shocking phone call that changed my investment counseling practice

The Singapore fund was to sign the loan documents, but with virtually no tax planning. Had they, the U.S. borrower would have taken 30% off all the interest payments. That's $240,000 that's being lost annually on a $10 million loan at 8% interest. The fund manager assumed that as the fund was run outside of the U.S. there would be no tax levied. It's a misconception that is widespread and costly. In fact, most interest received by foreign persons is subject to a 30% withholding tax by U.S. law. But there's an exception. I informed the fund that they could be eligible for full withholding tax exemption foreign loans if we construct it properly. The important thing was to make sure that the fund did not own 10% of the borrower, it was a fixed rate instead of an adjustable one, and ensure that the paperwork was in order. The deal has been restructured prior to closing. In the first year alone, the fund was able to save almost $250,000.

The design of Private Credit Funds for efficient lending to the U.S. borrowers

There are several issues that private credit funds are likely to encounter when lending across the border. A fund makes numerous loans as part of a business, as opposed to an individual making one loan to a relative. The importance of this is that the portfolio interest exemption has special rules for those lenders that are "in the trade or business" of lending. I was involved with one fund that lent money to a number of U.S. companies, and the fund made 30 loans per year. The fund was professional, well capitalized and was well on its way to growth. However, each of their structures was threatening to compromise all of their loans. We have taken a deep-dive into their complete operations and restructured their lending platform. The answer was to establish a special purpose vehicle for every loan and be sure to make sure that the fund was not a "bank" as defined by the tax law. This is the type of private credit fund tax planning foreign lender doesn't miss. With the fund now lending with confidence, knowing that every deal is protected, this is good news for the fund.

A Fund that Forgot to get Tax Advice – a Cautionary Tale

Not all stories come to an end. I had a call from a European private credit fund with whom I already had five closed loans with U.S. borrowers. They had applied for a conventional loan form that they had downloaded from the Internet. No one had looked at the provisions of tax. At time of first interest payments borrowers had withheld 30%. The fund had a net loss of more than $400,000 in the five loans. Not only did the fund fail to be able to demand a ‘gross up' from the borrowers, the loan documents did not allow it to do so. So much money was lost and never to be seen again. It seemed that the fund manager said to me, "We'll worry about that later, when it comes to taxes. This blunder of theirs resulted in actual losses. I assisted them to restructure loans for the future but there was no way of recuperating the losses. The lesson is that foreign lending to the private credit fund industry must be done in advance of the loan, not afterward, and in the process of planning for the loan, planners must take into account the tax considerations of the foreign investor. With some help from the experts, hundreds of thousands of dollars could have been saved in a few hours.

My tips and tricks for each and every cross-border loan!

I have built this checklist up over the past 20+ years that I have been in practice that safeguards my clients. First, make sure that the foreign lender has no stake of 10% or more in the U.S. lender. This involves searching family relationships, partnerships and trusts. Secondly, make sure that the interest is not based on the borrower's income or profits. Secure rates, referred to as fixed rates, or indexed rates are safe. Thirdly, make the loan in "registered form," so that a record is kept of the ownership of the loan. Fourth, get a valid IRS Form W-8 from the lender prior to the payment of interest. Fifthly, renew that form once every three years. The basic rule of a foreign loan withholding tax is that it be adhered to. This individual lender checklist has been used by myself for dozens of countries with individual lenders, family offices and private credit funds. It will work if used correctly. However, taking shortcuts and making up rules for yourself, will result in the types of losses I mentioned earlier.

Experienced Counsel is important because

The tax law is not easy to understand. While the portfolio interest exemption has been in existence for years, it is very complex and requirements are tough. Loans have been denied due to the absence of one sentence of a promissory note. There are foreign lenders that I have seen lose their exemption as they were not aware that a relative was included in the 10% threshold. I've seen funds think that they were eligible when they weren't. The following errors can be prevented. If carefully planned, cross border lending can be very tax efficient. If it were not for this, all the returns would be washed out and there would be tension between the borrowers and lenders because 30% of the returns would be taken off. So, my words of advice are quite simple: If you're at the stage where you're considering a loan agreement with a U.S. borrower and foreign lender, seek expert counsel. The price of guidance is a drop in the bucket in comparison to the tax savings.

Conclusion

The possibilities of cross-border lending are great for private credit funds, family offices and individual investors alike. However, the tax regulations are involved. If a profit is made on the loan, the 30% withholding tax can make it a less than satisfactory experience. Fortunately, there is a way to get the tax completely off the portfolio: the portfolio interest exemption. Correct structuring from the get-go is the key. These are the rules I've been assisting clients for more than two decades from China, South East Asia, Hungary and around the world with success. I have been acknowledged as having expertise by Bloomberg Tax and specialize in cross-border lending and International tax planning. Contact Leticia Balcazar if you are a foreign lender interested in lending in the U.S. market, or a private credit fund foreign lender tax fund interested in entering the U.S. credit market. You and I can work together to design your deal in a most tax-efficient manner as well as for complete compliance. Give my office a call today to schedule an appointment!

Foreign asset reporting remains one of the most complex areas of U.S. tax compliance. Whether you hold overseas accounts, own foreign entities, inherit international assets, or participate in cross-border lending arrangements.