In CCA 201501013 (1/2/2015) the Office of Chief Counsel of the IRS ruled that the lending and underwriting (stock distribution) activities of a foreign partnership (Fund) were considerable, continuous and regularly carried on, and therefore that such activities, conducted on its behalf through its U.S. agent (Fund Manager) under the particular facts before it, constituted the carrying on of a U.S. trade or business and the activities. The Fund did not, in its view, qualify under the “trading in stocks and securities” safe harbor exceptions under Section 864(b)(2)(A). This resulted in a foreign corporation that is a partner of the Foreign Feeder Fund as also being engaged in a U.S. trade or business.

Facts Involved

Fund was organized in a State within the U.S. and then in the subsequent year, converted from a State A limited partnership to a foreign jurisdiction exempted limited partnership. During year 1 and 2, the Fund constituted a partnership for U.S. income tax purposes. During the same two years, Foreign Feeder, a foreign entity treated as a corporation for U.S. income tax purposes, was a limited partner in the Fund. The foreign corporation (FC) was organized in a jurisdiction which does not have a bilateral income tax convention with the U.S.

The Fund had no employees during years 1 and 2. The management of Fund was vested exclusively in Fund Manager. Fund and Fund Manager entered into a management agreement pursuant to which Fund appointed Fund Manager as Fund’s agent and irrevocable attorney-in-fact with power to buy, sell, and deal in securities and related contracts for the Fund’s account. Fund further granted Fund Manager the power and authority to perform every act necessary and proper to be done. Pursuant to that grant of authority, Fund Manager conducted an extensive lending and stock distribution business on behalf of Fund. Fund Manager conducted these business activities and otherwise managed Fund primarily through an office in the United States. Fund Manager provided similar services for other investment entities, and no employees of Fund Manager worked exclusively for Fund.

Fund Manager held Fund out to the markets as a lender and underwriter, generating business for Fund in a variety of ways. Fund Manager had many investment professionals who used their extensive business and personal relationships to generate lending and stock distribution deals for Fund. As a result of the efforts of these investment professionals, accounting firms, securities attorneys, and third-party investment bankers referred potential borrowers and stock issuers to Fund. In marketing materials, Fund touted its Fund Manager also sponsored and attended industry conferences relating to deal origination to generate lending and stock distribution opportunities for Fund.

Fund Manager, acting on Fund’s behalf pursuant to the management agreement, committed extensive time and resources to Fund’s lending activities. During years 1 and 2, Fund held a redacted number of convertible debt instruments and redacted number of promissory notes. Fund made many of the loans associated with those convertible debt instruments and promissory notes during years 1 and 2. Presumably the scale of the economic activity involved was substantial.

Fund Manager negotiated directly the loan agreements with borrowers. Before agreeing to make a loan, Fund conducted extensive due diligence on each potential borrower. Often, Fund lent borrowers money in return for debt instruments that were convertible into the borrowers’ stock at a future date. Typically, the conversion prices were discounted from the trading prices of the borrowers’ stock, determined at the time of conversion. After converting a debt instrument into stock at a discount, Fund sought to earn a spread by quickly disposing of the stock. Fund often received other property in connection with its lending agreements, including warrants to purchase additional shares of borrowers’ stock. Borrowers also paid Fund various fees. Aside from Fund Manager, no other entity participated in Fund’s lending activities.

Fund Manager, acting on Fund’s behalf pursuant to the management agreement, also committed extensive time and resources to conducting Fund’s stock distribution, or underwriting, activities. It entered into Distribution Agreements with unrelated issuers and negotiated the terms of each Distribution Agreement directly with the issues. A typical Distribution Agreement entitled an issuer to periodically issue and sell to Fund shares of stock in an amount equal to a total specified purchase price (“Fund’s commitment amount”). However, an issuer could typically only request a portion of the commitment amount (referred to as an advance) at any given time. The issuer was prohibited from requesting an advance until the issuer had filed with the Securities and Exchange Commission a registration statement registering the issuer’s stock for resale by the Fund, and the registration statement had become effective. An issuer requested an advance by providing Fund with a written notice. After the issuer provided notice, Fund was irrevocably bound to purchase stock from the issuer after a specified number of business days (the “[Redacted Text] Period”). During the [Redacted Text] Period, Fund endeavored to pre-sell an amount of the issuer’s stock that would generate enough cash to fund the advance requested by the issuer. Typically, Fund succeeded. Fund’s sales of stock included sales to U.S. purchasers.

At the end of the [Redacted Text] Period, the issuer sold stock to Fund at a discounted price (generally [Redacted Text] percent below the stock’s lowest daily trading price during the [Redacted Text] Period). Because Fund sold the stock at the current market price, but received stock from the issuer at a discount, Fund earned a spread on each share sold. Usually, an issuer also paid fees to Fund, including commitment, structuring, and due diligence fees.

General Tax Background

Taxation of Foreign Corporations Engaged in a Trade or Business Within the United States

A foreign corporation which engages in a trade or business within the United States is taxable on a net basis on its taxable income which is effectively connected with the conduct of a trade or business within the United States. §882(a)(1). Important to recognize in this case is that a foreign corporation who is a member of a partnership that is engaged in a trade or business within the United States it deemed to also be engaged in a trade or business within the United States. §875(a)(1).

The term “trade or business within the United States” includes the performance of personal services at any time within the taxable year for example but does not include certain de minimis personal service activity and does not include, in certain instances, “trading in stock or securities” or trading in commodities. §864(b)(2)(A).

The determination of when a foreign person is engaged in a trade or business in the United States is a question of fact based on review of all relevant facts and circumstances concerning the foreign corporation’s profit activities. Such profit-oriented activities within the U.S. must be considerable, continuous and regular. De Amodio v. Comm’r, 34 T.C. 894 (1960), aff’d, 399 F.2d 623 (3rd Cir. 1962); Pinchot v. Comm’r, 113 F.2d 718 (2nd Cir. 1940). Mere managerial activities associated with investments is insufficient to cause a foreign person to be engaged in a trade or business within the U.S. This is based from the Supreme Court’s landmark decision in Higgins v. Comm’r 312 U.S. 212 (1941). Similarly ministerial activities or activities ancillary to a business conducted outside of the United States are also insufficient to result in a finding of the conduct of a trade or business within the U.S. Scottish American Investment Co. v. Comm’r, 12 T.C. 49 (1949).

In Pinchot, supra, the Second Circuit held that a nonresident alien’s management of real estate constituted a trade or business within the United States rather than “investment and re-investment of funds in real estate” based on the nature and degree of activity necessary to manage real estate. The level of management activity “required regular and continuous activity of the kind which is commonly concerned with the employment of labor; the purchase of materials; the making of contracts; and many other things which come within the definition of business… and within the commonly accepted meaning of that word.” Isolated or occasional activities, on the other hand, generally do not give rise to a trade or business. Pasquel v. Comm’r, 12 T.C.M. 1431 (1953) (holding that a nonresident alien was not engaged in a trade or business within the United States on account of the nonresident alien’s limited involvement in a single, isolated loan transaction); See Linen Thread Co. v. Comm’r, 14 T.C. 725 (1950) (holding that two small, isolated transactions did not give rise to a trade or business within the United States).

The activities of agents on behalf of a foreign person must be carefully examined since the acts of the agent are imputed or deemed to be performed by the foreign person regardless of the degree of control the foreign person exercises over the agent. Adda v. Comm’r, 10 T.C. 273 (1948), aff’d, 171 F.2d 457 (1948)(nonresident alien engaged in U.S. trade or business when non-resident granted a U.S. resident agent authorization to engage in trading commodity futures for the non-resident alien’s account); Lewenhaupt v. Comm’r, 20 T.C. 151 (1953), aff’d, 221 F.2d 227 (9th Cir. 1955).

Safe Harbors Under Section 864(b)(2)(A) For Certain Trading Activities

There are two statutory safe harbors pursuant to which certain trading activities conducted by or for a foreign person are treated as not being a trade or business within the United States. One requires that the foreign person not conduct those activities through an agent who has been granted discretionary authority or through a U.S. office of the foreign person. The other permits trading through an agent with discretionary authority or through the foreign person’s U.S. office but requires that the foreign person not be a dealer.

1. The First Trading Safe Harbor.

The §864(b)(2)(A)(i) or first Safe Harbor provides that the term “trade or business within the United States” does not include “[t]rading in stocks or securities through a resident broker, commission agent, custodian, or other independent agent.” § 864(b)(2)(A)(i). Any foreign person, including a foreign dealer in stocks or securities, may use the (A)(i) Safe Harbor. Treas. Reg. § 1.864-2(c)(1). The first Safe Harbor does not apply if the foreign person has an office or other fixed place of business in the United States at any time during the taxable year through which the transactions in stocks or securities are effected. § 864(b)(2)(C).

2. The Second Trading Safe Harbor

The §864(b)(2)(A)(ii) or second Safe Harbor provides that the term “trade or business within the United States” does not include “[t]rading in stocks or securities for the taxpayer’s own account, whether by the taxpayer or his employees or through a resident broker, commission agent, custodian, or other agent, and whether or not any such employee or agent has discretionary authority to make decisions in effecting the transactions.” § 864(b)(2)(A)(ii). A dealer in stocks or securities may not use the (A)(ii) Safe Harbor. However, the (A)(ii) Safe Harbor may apply to a foreign person who has an office or other fixed place of business in the United States.

B. The Meaning of “Trading in Stocks or Securities” for Purposes of the Trading Safe Harbors

Both Trading Safe Harbors broadly define, by regulation, what is meant by “trading in stocks or securities.” It includes “buying, selling (whether or not by entering into short sales), or trading in stocks, securities, or contracts or options to buy or sell stocks or securities, on margin or otherwise[.]” Treas. Regs. §§ 1.864-2(c)(2)(i) and (ii). The volume of stock or security transactions effected during a taxable year is not taken into account in determining whether a taxpayer’s activities qualify for the Trading Safe Harbors. See Treas. Regs. §§ 1.864-2(c)(1) & (2). The term “securities” means any note, bond, debenture, or other evidence of indebtedness, or any evidence of an interest in or right to subscribe to or purchase any of the foregoing. Treas. Reg. § 1.864-2(c)(2).

C. The Meaning of “Dealer in Stocks or Securities” For Purposes of the (A)(ii) Safe Harbor

The §864 regulations define a “dealer in stocks or securities” as “a merchant of stocks or securities, with an established place of business, regularly engaged as a merchant in purchasing stocks or securities and selling them to customers with a view to the gains and profits that may be derived therefrom.” Treas. Reg. § 1.864-2(c)(2)(iv)(a). A person that buys and sells, or holds, stocks or securities solely for investment or speculation is not a dealer. A person’s transactions in stocks or securities effected both in and outside the United States are taken into account to determine whether the person is a dealer in stocks or securities.

The regulations provide two exceptions to the definition of the term “dealer in stocks or securities.” A foreign person that otherwise may be considered a “dealer in stocks or securities” is not considered a dealer: (1) solely because he acts as an underwriter, or as a selling group member, for the purpose of making a distribution of stocks or securities of a domestic issuer to foreign purchasers of such stocks or securities, irrespective of whether other members of the selling group distribute the stocks or securities of the domestic issuer to domestic purchasers, or (2) solely because of transactions effected in the United States in stocks or securities pursuant to his grant of discretionary authority to make decisions in effecting those transactions, if he can demonstrate to the satisfaction of the Commissioner that the broker, commission agent, custodian, or other agent through whom the transactions were effected acted pursuant to his written representation that the funds in respect of which such discretion was granted were the funds of a customer who is neither a dealer in stocks or securities, a partnership described in subdivision (ii)(b) of this subparagraph, or a foreign corporation described in subdivision (iii)(b) of this subparagraph. Examples are contained in the regulations. See Treas. Reg. §1.864-2(c)(2)(iv)(b).

CCA’s Finding of Conduct of U.S. Trade or Business Under the Facts

Fund’s position before the Service is that the Fund’s lending and stock distribution activities in years 1 and 2 constituted mere investment activity, and did not constitute a trade or business within the United States. Alternatively, Fund argued that its lending and stock distribution activities constituted “trading in stocks or securities,” and that Fund qualifies for the Trading Safe Harbors.

The CCA concluded that during year 1 and 2: (1) the nature and extent of Fund’s lending and underwriting, which were conducted by Fund Manager acting as Fund’s agent, caused the Fund to be engaged in a trade or business within the United States and therefore under §875(1), FC was engaged in a trade or business within the U.S. as well; (2) Fund’s lending and underwriting did not constitute “trading in stocks or securities” for purposes of the Trading Safe Harbors; and (3) even if Fund’s lending and underwriting had constituted “trading in stocks or securities” for purposes of the Trading Safe Harbors, Fund would not have qualified for the Trading Safe Harbors.

The Fund would have failed the first Safe Harbor on the basis that the U.S. Fund Manager had discretionary authority to conduct the lending and stock underwriting activities for the Fund and was not an independent agent. The second Safe Harbor in the view of the Service was also left unsatisfied because its underwriting activities made it a “dealer in stocks or securities”.

The government concluded that the foreign corporation as a member of the Fund was subject to U.S. income tax on income effectively connected with its U.S. lending and underwriting business.

So, it looks like the Service has its sights on challenging foreign funds conducting investment and/or lending activities in the U.S. from successfully taking the position that its activities within the U.S. do not constitute the carrying on of a trade or business or otherwise qualify under one of the two safe harbors for securities trading under Section 864(b)(2)(A).