Tax Considerations for Contingent Interest and Convertible Debt in Cross-Border Lending Transactions

When it comes to paying interest on debt and converting debt into shares, there are different tax rules that can apply. These rules can get pretty complicated and may have different meanings, depending on the situation. For example, there are special tax rules for debt that makes payments that depend on certain conditions. There are also rules for when foreign lenders can avoid paying U.S. taxes on the interest they earn. And there are rules for when foreign people invest in U.S. real estate. Most U.S. tax treaties also have rules for when interest payments depend on certain conditions. These rules make sure that the income from debt is taxed properly and that the timing lines up with when the issuer of the debt gets a tax deduction. The regulations for contingent payment debt instruments mainly apply to debt that makes one or more payments that depend on certain conditions. These regulations don’t really distinguish between payments of the principal amount of the debt and interest payments. If a CPDI is issued for cash or publicly traded property, the noncontingent bond method applies to the instrument. This means that interest accrues based on the comparable yield, which is the rate at which the debtors could issue a fixed rate debt instrument with similar terms and conditions.

Certain contingencies are not considered when determining if a payment is contingent for qualifying the debt instrument as a CPDI. These include the risk of insolvency or default, remote and incidental contingencies.

Debt instruments with contingent payments, such as variable-rate debt instruments and foreign currency debt, are governed by separate regulations. For example, variable-rate debt instruments are governed by VRDI regulations, while nonfunctional currency borrowing is not considered contingent. This section of the tax code talks about different kinds of debt and when they are exempt from certain rules. It says that if a debt has alternative payment schedules based on certain events, it might not be subject to certain rules. It also says that if a debt has contingent payments, but always results in the same fixed yield, it might not be subject to the rules. Other exceptions include inflation-indexed debt, U.S. savings bonds, short-term taxable obligations, certain loans between people, prepaid tuition plans, REMIC regular interests, certain other debt with prepayment contingencies, and debt with an issue price determined under a specific section of the tax code. Convertible debt instruments may have contingent interest under certain rules. If a debt instrument allows for the option to convert into stock or other assets, it may not be considered contingent unless there are other payments that are not remote or incidental. The tax consequences for foreign holders of these instruments depend on whether they are considered contingent or not, and the interest is calculated based on the comparable yield of similar fixed-rate debt instruments. If the actual payments on a certain type of debt are more or less than expected, there will be adjustments made for the excess or shortfall. These adjustments will be treated like interest for the holder of the debt and will be deductible for the issuer. If the value of the underlying stock is higher than expected when the debt is converted, it will create additional income for the holder and additional expenses for the issuer. If the value of the stock is lower than expected, there will be adjustments made according to the rules mentioned above. If a foreign person holds a U.S. debt, they might not have to pay U.S. taxes on the interest they earn. But if they don’t qualify for this exemption, they could end up paying taxes on the entire amount of interest, even the part that would normally be tax-free. To qualify for the exemption, the foreign holder must meet certain requirements, like not owning a big chunk of the company’s stock and providing the right paperwork. If they meet these requirements, they can avoid paying U.S. taxes on the interest they earn. Portfolio interest rules do not include certain types of interest payments called contingent interest. Contingent interest is interest that depends on things like the company’s sales or profits, changes in the value of its property, or payments like dividends. For example, if a company pays interest based on the value of its property, it’s considered contingent interest. But if the interest is based on the value of its stock or the S&P 500 index, it’s not considered contingent interest. The rules for portfolio interest exemptions have exceptions for contingent interest, which is when the timing of the interest payment is uncertain. Convertible debt, which can be turned into stock, also has extra rules to follow. For foreign lenders, debt investments that qualify for the exemption mean they don’t have to pay U.S. taxes or have money withheld. If a foreign person holds a debt investment in the U.S., the interest income may be subject to U.S. taxation and withholding at a 30% rate. If the debt investment also meets the definition of CPDI, then the entire return on the investment could be subject to U.S. taxation and withholding. Additionally, if the debt investment is convertible or has shared appreciation rights, the gains from selling it may also be subject to U.S. taxation.

In simple terms, if a foreign person invests in U.S. debt, they may have to pay U.S. taxes on the interest they earn and on any profit they make if they sell the investment. If you own convertible debt that can turn into ownership in a company, and the company owns real estate in the US, you may have to pay taxes when you sell the debt. However, if the interest payments on the debt qualify for a special exemption, you won’t have to pay taxes on them. Also, according to US tax treaties, if the interest payments on the debt are not tied to how well the company is doing, they won’t be taxed at a higher rate. The US has tax treaties with other countries to manage how taxes are paid on things like interest payments. Some treaties have provisions on how to handle interest that may or may not be paid. For example, the treaty with Mexico doesn’t have specific rules for contingent interest, so it’s treated like regular interest. The treaty with Chile, which took effect in 2023, sets a maximum tax rate for interest payments for the first five years and a lower rate after that. There are also special rates for certain types of interest. The treaty with Chile has a similar definition of contingent interest as US tax law, but it’s not clear if it includes all the exceptions to that definition. If a Chilean bank gives a loan to someone in the U.S. and the loan has interest that depends on the value of something that is actively traded, the U.S. will take 30% of the interest as taxes. But, because of a treaty, the tax will be lower, but it’s not clear how much lower. This is because the treaty doesn’t specifically talk about this kind of interest. Overall, this shows how complicated it can be to understand the rules for loans and how they can change into something else. A ruling discussed a type of bond that can be converted into stocks. The company that issued the bond might not be able to deduct the interest they pay on the bond. There are rules about how much tax needs to be paid on the interest earned from the bond. Some proposed laws might change the rules about how much voting power the bondholder needs to have in the company. There are also rules about when the interest on the bond can be paid. If a partnership holds the bond and has foreign partners, they might still be able to avoid paying taxes on the interest. This article talks about the importance of understanding U.S. real property holding corporations, especially for companies facing financial trouble. It also discusses the treaty for withholding taxes with Chile and defines contingent interest. The authors are tax law specialists at a law firm in Miami. They submitted this article on behalf of the Tax Section.

Source: https://www.floridabar.org/the-florida-bar-journal/tax-considerations-for-contingent-interest-and-convertible-debt-in-cross-border-lending-transactions/