Chapter 2 - INTEREST INCOME
This chapter covers the U.S. statutory rules for characterization of income as interest income, how interest income is sourced to the United States, how interest is taxed in the United States, and the various exceptions and exclusions from U.S. taxation of interest on various types of interest income including bank deposits, short term obligations, and interest qualifying for a special portfolio interest exclusion.
The banking and finance industry are currently devising new financial instruments, faster than ever before. As a result, the range and diversity of interest rate sensitive instruments has grown in availability and popularity and so has the level of difficulty increased in determining the tax characterizations of these various instruments. For a review of the more common types of debt instruments generating interest type income, see ¶ 235 below.
205: Source of Interest Income is based upon the residence of the obligor.
(A) In General
Interest income is sourced based on the residence of the obligor. Interest income on interest bearing obligations is classified as income from sources within the U.S., if received from a resident of the United States, a domestic U.S. corporation, the U.S. government or any of its subdivisions, a State or any of its political subdivisions or the District of Columbia. Code Sec. 861 (a)(1).
A resident of the United States includes:
(1) An individual who at the time of payment of interest is a resident of the U.S.;
(2) A domestic corporation;
(3) A domestic partnership, which at any time during its taxable year is engaged in a trade or business in the United States; and
(4) A foreign corporation or foreign partnership, which at any time during its taxable year is engaged in a trade or business in the United States. Reg. § 1.861-2(a)(2).
Example 1: Mrs. NRA lends Mr. U.S.A. money individually. The payment of interest on this loan to Mrs. NRA is U.S. source interest.
Example 2: Ms. NRA purchases AAA bonds of a U.S. corporation which pay interest. The interest on these U.S. corporate bonds is U.S. source.
Example 3: Foreign Co. finances the receivables of a U.S. partnership which is solely engaged in a U.S. trade or business and receives interest from such financing. The interest on this financing is U.S. source.
Example 4: Mr. NRA purchases a bond from Foreign Co. and Foreign Co. is engaged solely in a U.S. trade or business. The payments of interest on the Foreign Co. bonds will be U.S. source interest.
The method by which, or the place where, payment of the interest is actually made is immaterial in determining whether interest is derived from sources within the United States. Reg. § 1.861-2(a)(3).
Caution: There exists a common misconception that where the payment is made outside the United States, for example from a Swiss bank account, that the source of income changes from U.S. to foreign source income; this is not correct. Interest paid by a U.S. obligor, no matter where it is paid, retains its character as U.S. source interest.
Example 5: Mrs. NRA receives interest which is paid from USCO’s Swiss bank account and she receives the payment denominated in her home currency which is other than the U.S. Dollar. Payments of interest from the Swiss bank account will be U.S. source interest.
Interest received on deposits with persons carrying on banking or insurance business or savings and loans institutions in the United States is also U.S. source income. However such amounts may be exempt from U.S. taxation, where they are not effectively connected with a nonresident alien or a foreign corporation’s U.S. trade or business. Code Secs. 871(i)(2)(A) and 881(d).
(B) Exceptions to In General.
(1) 80 Percent Foreign Business Rule.
Interest from a resident alien or domestic corporation is not treated as U.S. source income if 80 percent or more of its income is from the active conduct of a foreign trade or business. Interest paid to an unrelated person by a person meeting the 80 percent foreign business test is treated as 100 percent foreign source income. Code Sec. 861(a)(1)(A).
Example 6: USCO has 87% of its business earned from business which it does in the U.K. Payment of interest from USCO in the United States or from its foreign bank account will be 100% foreign source income.
Interest paid to related persons by a person meeting the 80 percent foreign business test is treated as foreign source on a look through basis. The percentage that will be treated as foreign source income is equal to the same percentage of foreign source gross income of the payor is to the total gross income of the payor. The ratio of foreign source income is determined for the three-year period ending with the close of the taxable year of the payor preceding the year of payment. Code Secs. 861(a)(1)(A) and 861(c)(2). A person is related if such person is an individual, corporation, partnership, trust, or estate which owns 10 percent or more of the payor or is owned 10 percent or more by the individual or corporation making the payment.
Example 7: Mr. NRA owns 100% of USCO and Foreign Co. USCO has 83% of its earnings from its business operation in Japan. Therefore, interest paid by USCO to Foreign Co. is 83% foreign source and 17% U.S. source as Foreign Co. and USCO are related parties.
A more than 10 percent direct, indirect or constructive ownership interest is applied to determine if the requisite ownership exists. Code Sec. 861(c)(2)(B).
Example 8: Mr. NRA owns 100% of Foreign Co. and 15% of USCO. USCO earns 94% of its income from foreign sources. Foreign Co. has made an interest-bearing loan to USCO. The interest paid by USCO to Foreign Co. will be 94% foreign source and 6% U.S. source subject to U.S. gross basis withholding tax, since Foreign Co. and USCO are related. Code Sec. 861(c)(2)(B).
A resident alien or domestic corporation meets the 80 percent foreign business test if at least 80 percent of its gross income was derived from sources outside the United States and was attributable to the active conduct of a trade or business outside the U.S. during the testing period. Code Sec. 861(c)(1).
An upper tier U.S. corporation will be attributed foreign business income for payments which it receives from its U.S. or foreign subsidiaries. Code Sec. 861(c)(1)(B). For this purpose a subsidiary includes any company, domestic or foreign, where at least 50% of the vote and value of the lower tier corporation’s stock is owned directly or indirectly by the U.S. upper tier corporation. Code Sec. 861(c)(1)(B). Therefore, where any lower tier corporation makes any type of distribution to an upper tier U.S. corporation, the active foreign business character of the lower tier corporation’s income flows through to the U.S. upper tier parent corporation.
The determination of whether a corporation has met the 80% foreign business rule, is determined based on the facts of the paying corporation, without regard to the fact that the paying corporation joins in filing a consolidated return with other domestic members. The consolidated return rules and the affiliated group rules do not impact the determination of whether any particular separate paying member meets the 80% active foreign business income test. Rev. Rul. 72-230, 1972-1 CB 209. Therefore, any particular member of an affiliated group may qualify for the 80% test, even though the affiliated group as a whole does not.
Where a domestic corporation is a surviving corporation in a statutory merger, it must take into account the total gross income of the surviving and the merged entity for purposes of applying the 80% foreign active business income test. Rev. Rul. 76-300, 1976-2 CB 217.
The testing period means a three-year period ending with the close of the taxable year proceeding the year of payment. If the individual or corporation had no gross income for such three-year period, the testing period shall be the taxable year in which the payment is made. Code Sec. 861(c)(1)(C).
A U.S. tax treaty may override the 80 percent foreign source income exception to the general rule for sourcing of interest expense. Tax treaties override U.S. law. Tax treaties often have their own rules for defining sourcing of interest income and also have their own rules as to whether the U.S. gross basis withholding tax is reduced or eliminated.
(2) Interest received from a Foreign Corporation engaged in a U.S. Trade or Business.
(a) In General
For purposes of determining U.S. Withholding Tax, Interest paid by a Foreign Corporation engaged in a U.S. trade or business is treated as paid by a Domestic Corporation to the extent the interest is allowed as a deduction in computing effectively connective income of the Foreign Corporation’s U.S. trade or business. Code Sec. 884(f)(1). As a result, such interest is generally U.S. source under the above-mentioned rules and subject to a gross basis withholding tax.
A U.S. Branch of a Foreign Corporation will generally determines its effectively connected income by deducting an amount for interest expense determined under the interest expense provisions provided in Reg. § 1.882-5. Although Code Sec. 861 provides special rules for allocating interest expense, they do not apply to the determination of a foreign corporation’s U.S. interest deduction for purposes Code Sec. 882. Reg. § 1.861-8f(1)(iv). Interest allocated to the U.S. Branch of a foreign corporation pursuant to Reg. § 1.882-5 is treated as paid by a U.S. Company. Code Sec. 884(f)(1)(A).
Example 9: Foreign Co. conducts business around the world including United States. 13% of Foreign Co.’s interest is allocated pursuant to U.S. tax rules to its U.S. trade or business. Therefore, 13% of foreign interest payments are U.S. source.
(b) Calculating U.S. Branch Interest Expense.
On March 8th, 1996, Treasury released Reg. § 1.882-5, which is effective for all taxable years beginning after June 6th, 1996. T.D. 8658, 61 FR 9326, March 8, 1996. This regulation requires a three-step process in determining a foreign corporation’s interest expense as effectively connected with its branch’s U.S. trade or business. Under this three-step process, the interest deduction is calculated on the basis of the actual interest expense paid by the U.S. branch on the liabilities shown on the books of the U.S. branch. This actual interest expense is adjusted upward or downward depending upon whether the U.S. book liabilities of the branch are more or less than the amount of U.S. effectively connected liabilities. Reg. § 1.882-5.
First a determination of the foreign corporation’s U.S. assets has to be made for the taxable year. Then the foreign corporation can multiply its U.S. assets by its debt to asset ratio for that year (total worldwide liabilities divided by total worldwide assets) in determining the foreign corporation’s effectively connected liabilities.
Finally, the amount of interest expense paid or accrued on U.S. booked liabilities is determined by comparing the amount of U.S. effectively connected liabilities for the taxable year, with the average total amount of U.S. book liabilities. If the average total amount of U.S. book liabilities equals or exceeds the amount of U.S. connected liabilities, the adjustment to the interest expense on U.S. book liabilities is determined under Reg. § 1.882-5(d)(4). Where the amount of U.S. effectively connected liabilities exceed the average total amount of U.S. book liabilities, the adjustment to interest expense paid or accrued on the U.S. book liabilities is determined under Reg. § 1.882-5 (d)(5). Reg. § 1.882-5(d)(1). For more information regarding branch profit rules and determination of branch profit interest see Stand Fed. Tax REP. (CCH) ¶
The interest allocation rules provided in Reg. § 1.882-5 may provide the foreign corporation with effectively connected interest expense in excess of the interest, which that business actually pays. Any such excess interest is treated as though it was paid by such foreign corporation on the last day of the foreign corporation’s taxable year. Code Sec. 884(f)(1). Therefore, any excess interest will cause the foreign corporation to pay a withholding tax on this excess interest, which is treated as a U.S. source interest payment, since it was allowed as an effectively connected interest expense of the foreign corporation. The foreign corporation will be responsible for withholding taxes on this deemed payment of U.S. source interest income, unless this U.S. source interest income is otherwise exempted. Code Sec. 881.
A foreign corporation may elect to reduce the amount of its U.S. connected liabilities as of a branch profit tax determination date. Reg. § 1.884-1(e)(3). The reduction of U.S. connected liabilities also has the effect of reducing the amount of interest treated as U.S. source.
(c) Tax Treaties Sourcing Rules.
Many tax treaties contain source rules for interest which treat interest paid by a foreign corporation as U.S. source, only if fifty percent (50%) or more of the foreign corporation’s income is connected with a U.S. trade or business. This will override the above-mentioned rules for resourcing a foreign corporation’s income as U.S. source, where less than 50% of the foreign corporation’s income is effectively connected with its U.S. trade or business. Furthermore, many treaties contain articles which prohibit the U.S. from imposing a secondary withholding tax on the payment of interest regardless of its source. Secondary Withholding Tax refers to a U.S. Withholding Tax imposed on a Foreign Corporation with respect to interest deducted by the Foreign Corporation in computing it is U.S. tax liability.
Therefore where a corporation is organized in a country, which has a tax treaty with the United States, which treats earnings as foreign source when the company earns less than fifty percent (50%) of its income from a U.S. trade or business or it earns more than fifty percent (50%) of its income from a U.S. trade or business but whose tax treaty prohibits a secondary withholding tax; then in the first case none of the interest paid by the foreign corporation will be U.S. source income or in the second case the interest income will be U.S. sourced income but will be exempt from U.S. gross basis withholding tax. Code Sec. 884(e).
Example 10: Foreign Co. #1 has 30% of its income from a U.S. trade or business and Foreign Co. #2 has 65% of its income from a U.S. trade or business. Foreign Co. #1 is organized in a country which has a tax treaty with the United States exempting resourcing its income as U.S. source where less than 50% of Foreign Co. #1’s income is effectively connected with a U.S. trade or business. Foreign Co. #2 is incorporated in a country whose tax treaty with the United States prohibits any distribution in the form of interest from Foreign Co. #2 from being subject to U.S. source gross basis withholding tax. Therefore, Foreign Co. #1’s 30% U.S. sourced income will be resourced as foreign income pursuant to the treaty override of U.S. law. Foreign Co. #2 will have 65% U.S. source income, but it will not be subject to U.S. source gross basis withholding tax pursuant to its country’s treaty override of the U.S. gross basis withholding tax provisions.
(3) Foreign Banking Branches of Domestic Corporation or Partnership.
Interest on deposits in a foreign banking branch of a domestic corporation engaged in a commercial banking or savings and loan business is treated as foreign source income. Code Secs. 861(a)(1)(B)(i) and (ii).
It is immaterial whether:
(a) The domestic corporation or partnership is carrying on a banking business in the United States;
(b) Whether the recipient of interest is a Citizen or Resident of the United States;
(c) The interest is effectively connected with a U.S. trade or business; or
(d) Whether the deposits in the Branch located outside the U.S. are payable in a foreign currency. Reg. § 1.861-2(b)(5).
Example 11: USCO is engaged in the business of providing banking services in Germany. USCO receives “deposits” in Germany and pays interest to German depositors. The interest paid by USCO’s German banking branch is foreign source interest.
(4) Interest on Deposits in United States Banks.
Interest on Deposits with United States Banks are not exempted from being sourced as United States interest income; however, they are exempted from U.S. gross basis withholding tax. See ¶ 225(B) below.
(5) Bankers Acceptances.
Interest received by a foreign central bank of issue from banker’s acceptances shall be treated as income from sources without the United States. A foreign central bank of issue is a bank which by law or government sanction is the principle authority, other than government itself, issuing instruments intended to circulate as currency. Reg. § 1.861-2(b)(5).
215: Who is United States resident obligor.
Interest paid by an individual is U.S. source income if, at the time of payment, the individual is a resident of the United States. Reg. § 1.861-2(a)(2). Code Sec. 7701(b) defines who is a U.S. resident for all purposes of the Internal Revenue Code. There does not appear to be any statutory definition with respect to whether a U.S. citizen is deemed to be a U.S. Resident for purposes of sourcing interest payment as U.S. source. The regulations under Code Sec. 7701(b) address this issue by extending the scope of Code Sec. 7701(b) statuary rules defining U.S. residence to U.S. citizens. Reg. § 301.7701(b)-1(a). Therefore where a U.S. citizen or a U.S. resident alien individual pays interest, the interest from these obligors will be U.S. source.
There are two tests that determine whether a foreign individual will be treated as a U.S. resident alien:
(1) Green card test and
(2) Substantial presence test.
The first test deals with the individual’s immigration status. A foreign individual who is a lawful permanent resident of the United States, with permanent immigration status under U.S. immigration law (i.e. has a green card for his U.S. immigration status and is lawfully admitted to the United States) is deemed a U.S. resident alien regardless of how much time he spends in the United States each year. Code Sec. 7701(b)(1)(A)(i).
The second objective test is the substantial presence test. If the foreign individual is present in the United states for at least thirty one (31) days during any calendar year and if the sum of those days plus the days present in the two (2) preceding years, when each is multiplied by a specific multiplier, equals or exceeds one hundred and eighty three (183) days; then the foreign individual is considered to be a U.S. resident alien for that calendar year. Code Sec. 7701(b)(3).
Example 1: Where Mr. Europo was in the United States one hundred and twenty (120) days for the last three (3) years, he would not be considered a U.S. resident alien since his total days present, when multiplied by the applicable fraction, would not equal or exceed one hundred and eighty three (183) days:
Current Year (Y)
120 days x 1
First Preceding Year (Y-1 year)
120 days x 1/3
Second Preceding Year (Y-2 years)
120 days x 1/6
Total U.S. Days During Test Period
A general rule of thumb is where an individual is not present more than four (4) months (120 days) a year, they will most likely not be classified as U.S. resident aliens under the substantial presence test.
(B) U.S. Corporations.
A corporation that is incorporated in or under the laws of one of the fifty states of the United States or the District of Columbia is deemed to be a U.S. corporation. Code Sec. 7701(a)(4). Interest paid by a domestic corporation at any time is U.S. source income, unless it meets the eighty percent active foreign business test. See ¶ 205(B)(1) above.
A corporation that is not organized in the United States or the District of Columbia is a Foreign Corporation. A Foreign Corporation’s payment of interest should be considered as Non U.S. source, unless the Foreign Corporation is engaged in a U.S. trade or business. To the extent the foreign corporation is engaged in a U.S. trade or business, the portion of its interest which is deductible from its U.S. trade or business will be characterized as U.S. source interest to the recipient. See ¶ 205(B)(2) above.
(C) U.S. Partnerships.
A partnership is considered a resident of the United States for sourcing of interest income purposes if it is a domestic partnership organized in the United States which at any time during the taxable year is engaged in a U.S. trade or business or if it is a foreign partnership which at any time during the year is engaged in a trade or business in the United States. Code Sec. 7701(a)(4). Therefore, a partnership is considered a resident of the United States, for sourcing of interest income purposes, if it is engaged in a U.S. trade or business at any time during its taxable year. The nationality or residence of its members or the place where it was created or organized is irrelevant for purposes of characterizing a partnership as a U.S. resident for sourcing interest payments. Reg. § 301.7701-5. Where a partnership has both a U.S. trade or business and foreign trade or business, it would deem to be dual resident partnership. However, the regulations appear to provide that once a partnership has any U.S. trade or business then all of its interest payments are deemed to be U.S. sourced.
Example 2: A partnership consisting of two U.S. partners organized in the United States which conducts 100% of its trade or business outside the U.S., is not deemed to be a U.S. partnership and interest payments by this partnership will be foreign source.
Example 3: A foreign partnership organized in France with two individual French Citizens as partners conducts 20% of its business in the United States. The regulations would indicate that any interest payment from this partnership should be U.S. source.
Comment: A more reasonable interpretation would be to treat as U.S. source interest that amount of interest which is deductible by the partnership on its U.S. tax return.
There is an additional issue where the partnership makes an interest payment to partners. That issue is the characterization of the payment as interest or as a distributive share of his partnership income. This issue will turn upon whether the loan by the partner to the partnership is deemed to be bona fide. Code Sec. 707.
(D) U.S. Trusts and Estates.
A Trust will be a United States person, the interest on which will be United States source where:
(1) A Court within the United States is able to exercise primary supervision over the administration of the Trust and
(2) One or more United States persons have authority to control all substantial decisions of the Trust. Code Sec. 7701(a)(30)(E).
All other Trusts which do not meet the two requirements stated above will be deemed to be foreign Trusts. Code Sec. 7701(a)(31)(B). Prior to this, the distinction between domestic and foreign Trusts was based upon the underlying facts and circumstances like the situs of the Trust corpus, situs of the Trust’s administration and residence of the Trustees. However, the Small Business Job Protections Act in 1996, P.L. 104-188, substituted the two objective factors stated above for determining the residence of a Trust. For further discussion, see Stand. Fed. Tax Rep. (CCH) ¶ 43,097(E).03.
While the above mentioned standard may be vague, to ensure that a Trust is not characterized as a U.S. Trust, we suggest that a NRA make sure that his Trust has the following characteristics:
(a) The Trust is administered outside the U.S.;
(b) The Trustees are all NRAs;
(c) The Trust assets and records are kept outside the United States; and
(d) The Trust is formed pursuant to and governed by the laws of a non U.S. jurisdiction.
Where all these items are met, a Trust should be a non U.S. Trust. Where any one of the items mentioned above is actually U.S. rather than foreign or there is a combination of several of the above mentioned factors as U.S., then there is an issue as to whether the Trust is U.S.
Caution: With the evermore astringent rules and sophistication of the U.S. government, a NRA would be well advised to hire offshore corporate agents and corporate trustees to administer their foreign organized trusts in order not to have an issue of characterizing their trust as a U.S. Trust.
(E) Taxation of Estates.
Determination of whether an Estate is a U.S. Resident first requires a determination of the definition of an Estate. An estate has been defined as something which requires both property of the decedent and a fiduciary to administer it, whether it is administered in reference to provisions of a will or requires services of an executor for such administration. Reg. § 1.641(a)-2 and Comr. v. Beebe, 67 F.2d 662 (1st Cir. 1933). A decedent can only have one Estate even where they have multiple wills which are probated in multiple states. Rev. Rul. 64-307, 1964-2 C.B. 163.
Once you have determined that there is an Estate, the next requirement is to determine whether it is U.S. or foreign for purposes of sourcing interest payments. A foreign estate is one which the income is from sources without the United States and which the income is not effectively connected with the conduct of a trade or business within the United States. Reg. § 7701(a)(31)(A).
Planning Note: There are many ways for an estate not to have U.S. sourced income, one of which is to make sure that all of the items held within the United States or which produce U.S. source income are owned by a foreign corporation and that the NRA’s estate only holds assets of foreign corporations or has a beneficial interest in foreign trusts.
(F) Special Rules for Identifying “The Obligor”
A guarantee of an instrument is a secondary and a collateral promise to pay the amounts due under the instrument in the event the primary obligor defaults. Zappo v. Comr., 81 T.C. 77 (1983). Where the Guarantor is required to pay on an obligation of the primary obligor, the source of this payment will be the residence of the primary obligor where the guarantee is part of the original obligation. Tonopah and Tide Water Railroad Co. v. Comr., 39 B.T.A. 1043 (1939). However, where the guarantee is deemed to be a separate obligation independent of the loan, then the guarantor will be treated as the true obligor. Rev. Rul. 78-118, 1978-1 C.B.219.
Example 4: Where NRA makes a loan to Foreign Co. and then pays a separate guarantee fee to a U.S. Insurance Company to guarantee the loan to Foreign Co., then this guarantee for which the NRA paid a premium to the U.S. Insurance Company would be treated as independent of the loan and where the insurance company pays the interest it will be U.S. source.
Example 5: Where NRA makes a loan to Foreign Co. which loan is guaranteed by Mr. U.S.A., a wealthy 30% shareholder, then where Mr. U.S.A. has to pay the guarantee, the interest paid by Mr. U.S.A. on the guarantee should be foreign source income based on the source of the original obligor.
Caution: In a situation where the guarantor and the obligor are related and the obligor has not been able to obtain a loan on its own due to its lack of credit worthiness, then it may be found that the guarantor was the actual obligor, as no one would lend money directly to the other related party. Plantation Pattern Inc. v. Comr., 462 F. 2d 712 (5th Cir. 1972).
(2) Joint Obligors.
There does not appear to be any specific rules dealing with joint obligors. The most reasonable interpretation would be that the source of the income would be the residence of the obligor which actually makes payments on the obligation. Therefore, it is possible that where both obligors make payments, the interest income on a joint obligation may be partially U.S. and partially foreign source.
Example 6: Ms. NRA makes a loan to two brothers, Mr. U.S.A. and Mr. NRA. The loan provides that they are both joint and severably liable for the loan. In year 1, Mr. U.S.A. pays 80% of the interest due. In year 2, Mr. U.S.A. 50% of the interest due. Ms. NRA will have 80% U.S. source interest in year 1 and 50% U.S. source interest in year 2.
The source of interest payment made by agents depends upon the residence of the actual borrower rather than the residence of the agent. Reg. § 1.861-2 (a)(3).
Example 7: M, a domestic bank, underwrites bonds, notes or other obligations of a foreign government. These obligations are payable at M’s office in the United States. M, as paying agent pays the interest due and owed by the foreign government on such obligations, to nonresident aliens and foreign corporations. These interest payments are on foreign source income. Rev. Rul. 71-516, 1971-2 C.B. 264.
Example 8: USCO owns a number of foreign subsidiaries. USCO appointed a U.S. bank as agent for purposes of making loans to USCO’s foreign subsidiaries. The arrangement requires for such loans to be made directly between the bank’s main U.S. office in the United Stated and the foreign subsidiaries. The payment of interest by the foreign subsidiaries to the U.S. bank is considered to be foreign source interest income. Rev. Rul 72-514, 1972-2 C.B. 440.
225: United States Source Interest – Exclusion from the United States Taxation.
(A) In General.
Interest income paid by United States obligors to foreign taxpayers is generally subject to a 30 percent gross basis withholding tax. The United States excludes from this gross basis tax, the following types of U.S. source interest income:
(1) Interest on United States Bank Deposits;
(2) Original issue discount on short term obligations; and
(3) Interest paid on qualified portfolio indebtedness.
While all of the above mentioned types of interest are U.S. source interest, they are excluded from U.S. source gross basis withholding tax where they are earned by nonresident aliens or foreign corporations which are not engaged in a U.S. trade or business. Code Secs. 871 and 881.
(B) United States Bank Deposits.
To encourage foreign persons to invest in U.S. banks, the United States does not tax U.S. source interest on deposits with U.S. banks. Code Sec. 871(i). This exemption generally applies to time deposits, certificates of deposit and other amounts held by persons engaged in the banking business, deposits or with drawable accounts with certain savings institutions and amounts held by insurance companies under agreement to pay interest thereon. Code Secs. 871(i) and 881(d).
This exemption from taxation of U.S. source interest on “deposits” is only available to nonresident aliens and foreign corporations that are not engaged in a U.S. trade or business. Where a foreign taxpayer earns interest on deposits which are effectively connected with a U.S. trade or business, they will be taxed at the normal graduated rates after the deductions for associated expenses.
The following type of deposits have been held to qualify as exempt deposits:
(1) Time Certificates of Deposit;
(2) Open Account Time Deposits;
(3) Multiple Maturity Time Deposits;
(4) Deposits requiring 24 hour notice prior to payment; Rev. Rul. 72-104, 1972-1 C.B. 209;
(5) Eurodollar Certificates of Deposit; and
(6) Deposits with a Federal Savings and Loan Associations. Rev. Rul. 81-30, 1981-1 C.B. 388.
The IRS has also held that a simple Trust, whose funds are invested solely in U.S. BANK certificates of deposit, shall have its U.S. source interest income exempt on the distribution to its nonresident alien beneficiary. Isidro Martin – Montis Trust v. Comr., 75 T.C. 381 (1980).
(C) OID On Short Terms Obligations.
In general, obligations which mature within 183 days or less are not considered original issued discount (OID) obligations for purposes of the gross basis withholding tax. Code Sec. 871(g)(1)(B) or 881(a)(3). OID is equal to the excess, if any, of the stated redemption price at maturity over its issue price. Code Sec. 1273. The issue price is generally the price paid by the first buyer of such debt instrument or the initial offering price where the debt instrument is publicly offered. Code Sec. 1273(b).
Example 1: A U.S. corporate bond is issued with a face amount of $100, at an original issue price of $85, which matures in 183 days; the $15 ($100-$85) OID is not subject to U.S. gross basis withholding tax.
Where an obligation matures in more than 183 days, then the gross basis withholding tax will apply to such original issued discount when the obligation is sold, exchanged, or redeemed. Code Secs. 871(g) and 881(a)(3).
Example 2: Mrs. NRA purchases a $1,000 zero coupon bond of USCO for $720. When Mrs. NRA receives the $1,000 in year five, she will have $280 of OID which is U.S. source interest subject to U.S. gross basis withholding tax.
(D) Qualified Portfolio Indebtedness.
(1) In General.
U.S. source interest which qualifies as portfolio indebtedness is exempt from United States gross basis withholding tax. Code Secs. 871(h) and 881(c). Portfolio indebtedness can either be registered or in bearer form. Generally, portfolio interest exemption is not available for the following:
(a) 10 percent or more shareholders of the obligor. Code Secs. 871(h)(3) and 881(c)(3)(B).
(b) Bank Loans. Code Sec. 881(c)(3)(A).
(c) U.S. controlled foreign corporations. Code Sec. 881(c)(3)(C) and
(d) Nonresident aliens and foreign corporations where the interest is effectively connected to a U.S. trade or business. Code Secs. 871(h)(1) and 881(c)(1).
The portfolio interest exemption is designed to encourage nonresident aliens and foreign corporations to make loans to U.S. persons and U.S. trade or businesses. Thus, the essential qualifications for portfolio indebtedness are to insure that foreigners are making these loans and that U.S. persons and U.S. resident aliens are not, directly or indirectly, the beneficiaries of the interest on these loans which is being exempt from U.S. gross basis withholding tax.
(2) Registered Portfolio Indebtedness.
Portfolio indebtedness will qualify as registered portfolio indebtedness where:
(a) The obligee of the debt instrument is registered as the owner of the debt instrument (e.g. Note, Bond, etc.) by the issuer of the obligation both as to principal and interest thereon and the transfer of this obligation for repayment can only be effected by the surrender of the old debt instrument and the reissuance of a new instrument from the obligor to the new registered obligee; or
(b) Where the right to principle and interest on the obligation may only be transferred by registering on the books and registry of the obligor/U.S. payor as to who is entitled to the interest and principle on a particular debt instrument.
Where the obligation is in registered form, the U.S. obligor must also receive a statement that the beneficial owner is not directly or indirectly a U.S. person. Code Secs. 871(h)(2)(B)(ii) and 881(c)(2)(B)(ii). The statement must be received from the beneficial owner directly or from a financial institution that holds the customer securities in ordinary course of its trade or business. Code Sec. 871(h)(5).
(3) Bearer Portfolio Indebtedness.
Where the obligation for payment is made out to bearer, then to qualify as qualified portfolio indebtedness, the obligation must:
(a) Be subject to an arrangement that is reasonably designed to insure that the obligation will be sold (or resold) in connection with the original issue, only to persons who are not United States persons;
(b) The interest must be payable only outside the United States; and
(c) There must be a statement on the face of the obligation that any U.S. person holding the obligation is subject to U.S. income tax. Code Sec. 163(f)(2)(B).
(4) Contingent Interest.
Contingent interest will not qualify for the portfolio interest exemption. Contingent interest is defined as any interest, the amount of which is determined by reference to:
(a) The sales receipts or other cash flow of the debtor or related person;
(b) Any income or profits of the debtor or related person;
(c) Any change in value of property of the debtor or related person; or
(d) Any dividend, partnership distribution, or similar payment made by a debtor or related person.
Interest is not contingent solely because payment of the interest is dependent upon cash availability.
Example 3: USCO borrows $100,000 payable at x percent interest for 3 years. The Note provides further that USCO will not have to make a payment in any year where it does not have cash available and that any interest payment which accrues and is unpaid shall be added to principle for a computation of the next year’s interest payment. Where USCO could not make a payment in year 1, but makes a payment of year 2 and year 1’s accrued interest at the end of year 2, this interest payment is not contingent interest and the entire payment will qualify as exempt portfolio indebtedness.
It is possible for a Note to have a fixed portion, which will qualify as portfolio indebtedness and a contingent portion dependent upon profits, which will not qualify. In that case, only the contingent portion of the interest will be subject to the U.S. gross basis withholding tax. See ¶ 835 below for further discussion of portfolio indebtedness exemption.
235: Types of Investments Classified as Interest.
(A) In General.
Interest is an amount which is paid for the use or forbearance of use of money. Old Colony R.R. Co. v. Comr., 284 U.S. 552 (1932). Interest also includes OID, which is the excess of the stated redemption price at maturity over the issue price of any indebtedness. However, OID on any Note maturing in 183 days or less is exempted from U.S. taxation. In today’s market there are many different types of compensation for the use or forbearance of use of money, which are classified as interest for U.S. tax purposes. The range and the multiple variations of financial products available to investors are limited solely by what financiers believe the market will embrace. Below we have listed the more common types of financial arrangements, which produce interest income. The types of financial arrangements are generally divided between Short Term Obligations (183 days or less), Long Term Obligations (greater than 183 days) and Collateralized Obligations.
(B) Short Term Obligations.
(1) Banks and Savings Loans.
Deposits with Banks and Savings and Loans, where there is a contractual obligation for the Bank to pay interest on deposits, is one of the more common types of investments generating U.S. source interest income. These deposits do not have a minimum time during which the deposit must remain with the Bank and can usually be withdrawn upon a request by the depositor. Where a nonresident alien or foreign corporation is not engaged in a U.S. trade or business, the interest which they earn on deposits with Banks and Savings and Loans should be exempt from U.S. tax. Code Secs. 871(i) and 881(d). The deposit must create a debtor creditor relationship. The IRS has included such items as certificates of deposit, open account deposits, multiple maturity time deposits, and deposits that require notice prior to withdrawal as deposits exempt from U.S. tax.
Example 1: Mr. NRA, who is not engaged in a U.S. trade or business, opens a bank account in the United States. The Bank has a stated rate of interest which it pays all depositors. The Bank does not require any Notice prior to withdrawal. This payment on this deposit would qualify as exempt interest paid by a U.S. Bank.
(2) Certificates of Deposit (CD).
Certificates of Deposit are usually issued by a Bank as evidence of a time deposit. The terms of the Certificate of Deposit usually require that the deposit remain with the Bank for a certain minimum period of time (usually 6 months). The Certificates of Deposit specify a rate of interest which is payable at the maturity of the debt instrument. Certificates of Deposit will be classified as interest on Bank Deposits. Rev. Rul. 72-104, 1972-1 C.B. 209.
Example 2: F Co. having excess cash desires to invest its excess cash in U.S. dollar denominated obligations. F Co. purchases CDs from a U.S. Bank, which mature annually. The payments of the interest annually on these CDs will qualify as an exempt interest payments on a deposit by a U.S. Bank.
(3) Bankers Acceptance.
Banker’s acceptances are bills of exchange draft payable by a Bank at maturity at face value. They are given by a Bank to a creditor who is owed sums by other debtors. They are comparable to short term government securities (for example: U.S. treasury bills) and may be sold in the open market at a discount. Bankers acceptances issued by other than a foreign central bank, where the payor is U.S. or the expense from the issuance of a bankers acceptance is an effectively connected deduction with a U.S. trade or business will qualify as original issue discount characterized as interest for U.S. withholding tax purposes.
Since most of these banker's acceptances are for less than 183 days, most of them will qualify for exemption from U.S. tax as OID on debts under 183 days. See ¶ 225(C) above.
(4) Commercial Paper.
Commercial Paper is a promissory note, generally issued by a corporate borrower, which may be in registered or bearer form, negotiable or nonnegotiable. The majority of commercial paper is short-term indebtedness, with a maturity of 183 days or less, and is therefore not subject to U.S. gross basis withholding tax. Code Sec. 871(g)(1)(B)(i).
Example 3: Ms. UK purchases a USCO Note due in 183 days with a face value of $100 at $96; the $4 of interest payable at maturity will not be subject to U.S. tax. Where Ms. UK reinvests her $100 and purchases a $105 USCO Note due in 183 days; the $5 of interest on this Note also will not be subject to U.S. gross basis withholding tax.
Planning Note: A sophisticated foreign investor can continually have a total portfolio of U.S. debt obligations invested with U.S. obligors totally exempt from U.S. gross basis withholding tax, where their total portfolio matures every 183 days. The fact that the same proceeds are reinvested in similar short term debt obligations is irrelevant and does not effect the associated interest from qualifying for the short term exemption from gross basis withholding tax.
(5) Repurchase Agreements (Repos).
Repos involve the sale of securities to an investor with the understanding that the securities will be repurchased at a later fixed date and at a predetermined higher price. Repos are treated as collateralized loans, since the seller has an unconditional obligation to repurchase the securities. Rev. Rul. 74-27, 1974-1 C.B. 24 and Rev. Rul. 77-59, 1977-1 C.B. 196. Therefore, the income earned from Repos (the different between the sales price and the higher repurchase price for the shares) will be treated as interest income. Where the seller of securities is U.S. person, this recharacterized interest income will be U.S. source income which is subject to U.S. gross basis withholding tax, unless otherwise exempt (e.g. short term indebtedness, portfolio indebtedness, etc.).
(6) U.S. Government Securities.
The United States Government issues many types of different government debt obligations including:
(a) Treasury Bills.
Treasury Bills are discounted obligation issued with coupons for a period of one year or less. They are most commonly issued for periods of 3 months and 6 months. Treasury Bills are therefore generally, exempt from U.S. gross basis withholding tax as short-term obligations with OID.
(b) Treasury Notes.
Treasury Notes are coupon obligations bearing a fixed interest rate, payable semiannually with a maturity of greater than 183 days. Interest on treasury notes is generally subject to U.S. gross basis withholding tax.
(c) Treasury Bonds.
Treasury Bonds are coupon obligations bearing fixed interest rates, payable semiannually, with an original maturity date of more than 7 years. Treasury Bonds are generally subject to U.S. gross basis withholding tax.
(d) State and Local Bonds.
Bonds issued by state and local governments of the United States (e.g. New York State), the interest on which is exempt pursuant to Code Sec. 103, are exempt from U.S. gross basis taxation, regardless of the term of such obligations. Code Secs. 871(g)(1)(B)(ii) and 881(a).
(e) Ginnie Mae, Fannie Mae, and Freddie Mac.
In order to influence investors to provide money for home mortgages, the U.S. Government guarantees pools of mortgages compiled by Government National Mortgage Association (GNMA), the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC). These mortgage investment pools have nicknames of Ginnie Mae, Fannie Mae, and Freddie Mac. Since these mortgage pools are guaranteed by the U.S. government, the chances of default are negligible. Ginnie Mae, Fannie Mae, and Freddie Mac purchase residential mortgages from lenders, package them in the mortgage pools and then sell an interest in the mortgage pools to investors. These bonds issued by Ginnie Mae, Fannie Mae, or FHLMC pay interest on a monthly basis and do not return principle until the maturity date of the bond. Interest from a Ginnie Mae, Fannie Mae, and Freddie Mac are U.S. source interest income which is subject to U.S. gross basis withholding tax.
(C) Long Term Obligations.
(1) In General.
Long Term Obligations are generally investments with a duration of greater than 183 days. As a result of being long term investments, they do not qualify for the short term interest and OID exceptions to U.S. withholding tax on instruments maturing in 183 days or less. The types and variation of long term debt available in the U.S. market are numerous. Below we mention some of the more common types of long term debt and their characteristics.
(2) Convertible Debt.
Convertible Debt is corporate debt, which at some point in the future is convertible into corporate stock. As a general rule, any interest paid on convertible debt will be treated as U.S. source interest up until the date on which the debt is converted into stock. Upon converting the debt into stock, any accrued but unpaid interest will be deemed to be paid upon a conversion equal to the fair market value of the stock received above the purchase price of such indebtedness on the date of conversion.
(3) Multiple Currency Debt.
U.S. Companies can issue notes payable in any type of currency.
Example 4: MMM Co., a U.S. corporation, can issue notes payable in Italian Lira. This would be advisable where MMM Co. anticipates the Dollar to be stronger against the Italian Lira in the future than it is currently; thereby allowing the company to pay its interest obligation (and possibly its principle obligation) with cheaper Italian Lira in the future.
Multiple Currency Debt could also have the interest payable in one currency and the principle in another. Regardless of what currency the debts are issued in or the interest is payable in; the interest will be converted into U.S. Dollars on the dates which it is paid and will be subject to U.S. gross basis withholding tax.
(4) Debt with Warrants or Puts and Calls.
A debt can also have warrants to purchase additional stock or warrants to sell the instruments back to the company at a prearranged price. The issue here is allocating the original purchase price between the debt and the warrants or puts and calls. The difference between the original issue price of the debt and what you receive upon the payment of the debt would constitute original issue discount taxable as interest. The lapsing of a put or a call may have a different character and result in U.S. capital loss, which is not available to offset the taxable interest income otherwise created from the ownership of the debt. There are additional issues upon exercising any of the put or call options or a warrant dealing with the cost basis of the stock acquired with these warrants or options and for determining gain or loss on the sale or disposition of these warrants or options.
(5) Zero Coupon Bonds.
A Zero Coupon Bond is a bond, which an investment banker has removed the coupons that entitle the owner of the bond to periodic interest payments. The investment banker will then sell the bond at a discounted price and thereby keep the periodic interest payments and sell to the investor solely the promise to obtain a face amount of the bond at some future period. Zero coupon bonds have achieved a phenomenal acceptance among issuers and individual investors. There are various types of zeros which a foreign investor can buy which include: government back zeros, corporate zeros, even zero coupon certificate of deposits. Zeros are particularly popular because they give the investor a valuable planning tool, in that they know precisely how much they will receive when the bond matures and there is no obligation for reinvesting the periodic coupons in purchasing further investments. Typically, zeros tend to provide a somewhat higher yield than similarly rated bonds with the same maturity.
(6) Collateralized Bonds.
(a) In General.
These derivative type bonds give the investor additional security in the form of collateral. The backing can range from home mortgages to cars loans, boat loans, or even credit card receivables. Perhaps the most popular form, at least as far as individuals are concerned, is the Collateralized Mortgage Obligation (CMO), which are derivatives created from government backed mortgage bonds such as Ginnie Mae or Fannie Mae Securities. A U.S. issuer of CMOs can have the various U.S. Government bonds as collateral and then reissue its obligations with the actual indebtedness to nonresident aliens and foreign corporations qualifying as portfolio interest exempt indebtedness. Therefore the foreign investor obtains the benefit of the full faith and credit in the United States Government or the other collateral which secures the indebtedness, while at the same time receive the payment of U.S. source interest on the actual indebtedness issued by the investment banker in a form which is exempt from U.S. gross basis withholding tax.
(b) Passthrough Certificates.
A passthrough certificate is a percentage of an undivided interest in a pool of government guaranteed mortgages. Rather than an actual promise to pay a fixed amount of interest and principle, as in the CMOs mentioned above; with a passthrough certificate, the investor gets his proportionate part of whatever funds were earned by the U.S. pool. Usually the U.S. pool is in the form of a U.S. grantor trust, the income upon which is taxed directly to each foreign investor. Here again this investment can be structured where the underlying indebtedness qualifies as portfolio indebtedness, then each individual foreign investor should have its portion of interest exempt from U.S. taxation pursuant to the portfolio interest exemption.
(c) Real Estate Mortgage Investment Conduits (REMIC).
In general, a REMIC is a fixed pool of mortgages with multiple classes of interests held by investors. It is treated like a partnership with its interest allocated to and taken into account by the holders of the interest in the REMIC. Code Sec. 860(D). A REMIC may be required to withhold gross basis tax on amounts paid to foreign holders of regular or residual interest. Substantially, all the assets of a REMIC must consist of “qualified mortgages” and “permitted permanent investments”. Code Sec. 860(D).
Permanent investments are:
(i) Cash Flow Investments;
(ii) Qualified Reserved Assets; and
(iii) Foreclosure Property. See Stand. Fed. Tax Rep. (CCH) ¶ 26, 662.01.
(D) Substitute Payments and Factoring Income.
(1) Substitute Payments.
A substitute interest payment is a payment, made to the transferor of a security in a securities lending transaction or a sale–repurchase transaction, of an amount equivalent to an interest payment, which the owner of the transferred security is entitled to receive during the term of the transaction. A securities lending transaction is the transfer of securities that is described in Code Sec. 1058 (a) or a substantially similar transaction. A sale–repurchase transaction is an agreement under which a person transfers a security in exchange for cash and simultaneously agrees to receive substantially identical securities from the transferor in the future in exchange for cash.
In determining the character of substitute payments, the regulations adopt a look-through principal, where payment on the borrowed securities has the same character as the payment received by the borrower. Reg. §§ 1.861-2 and 1.864-5. Where the securities borrowed generate interest income, then the payment to the lender of the securities shall be treated as interest income. Where the securities borrowed produce dividend income, then payment to the lender of these securities will receive dividend income.
This look-through approach results in the lender of a security retaining the same source and the same character of the income from the loan securities as though they retain such securities. This look-through approach is solely for the sourcing and character of income generated from loaned securities and does not impact the characterization of substitute payments in a domestic context. Rev. Rul. 80-134, 1980-1 C.B. 187.
(2) Related Party Factoring Income.
Where a person acquires (directly or indirectly) a trade or service receivable from a related party, any income from the acquired trade or service receivable shall be treated as interest on a loan from the obligor of the receivable. Code Sec. 864(d)(1). Related party for purposes of this provision is any person who is related within the meaning of Code Sec. 267(b). Code Sec. 864(d)(4). There is an exception from treating factoring income as interest income, where the related party acquirer of the account receivable is organized under laws of the same foreign country and the related purchaser has a substantial portion of its assets used in the active trade or business in the same foreign country. Code Sec. 864(d)(7).
245 Resourcing Interest.
(A) Resourcing Interest upon Subsequent Payment to Beneficial Owner.
Where interest is received by an entity and then re-distributed to the ultimate beneficiary, the source rules that are applied to the beneficiary depend on the type of entity that originally received the interest.
Interest income received by a C corporation is taxable to it as either U.S. or foreign source income. When the foreign corporation pays interest to its shareholders, the interest loses its U.S. source character. The source of interest income to the shareholder is then determined according to the appropriate source of interest income rules. A foreign corporation which is not engaged in a U.S. trade or business and which receives U.S. source interest income, acts as a converter for such income because the interest paid by it is generally considered foreign source. However, where there is no substantial economic purpose for the intervening corporation, other than the conversion of the interest payments, the intermediate corporation may be ignored and the payment to the ultimate beneficial owners may retain the character and source of income, which was originally paid to the intervening corporation. Aiken Industries, Inc. v Comm., 56 TC 925 (1971). For further discussion of financing intermediaries, see ¶245 (B) below.
A partnership is not a taxable entity and, as such, items of gross income are treated as belonging to the partners in accordance with their respective “distributive shares.” Code Sec. 702(a). When a partnership receives interest income, each partner must report its distributive share of such income and the source of such income carries over to each individual partner. Code Sec. 702(b). Accordingly, a partner’s distributive share of the partnership’s U.S. source interest income, is U.S. source interest income to that partner.
(3) Trusts and Estates.
Trusts are divided into the two categories of trusts: grantor trusts and ordinary trusts. Grantor trusts are ignored for federal income tax purposes and the trust income is taxed directly to the grantor. Code Sec. 671. Where a grantor trust receives interest income, the grantor is deemed to have received that income directly from the source which the trust received it. Rev. Rul. 59-245, 1959-2 C.B. 172.
Ordinary trusts may be simple or complex. A simple trust is one that must currently distribute all of its income to the beneficiaries. Code Secs. 651-652. With a complex trust, the trustee has discretion or may be required, to accumulate income that is taxed to the trust and not the beneficiaries. Code Sec. 661. Distributions from simple trusts have the same character in the hands of the beneficiary as in the hands of the trust. Code Sec. 652(b). Interest from foreign corporations, received by a simple trust and then distributed to its beneficiaries, is foreign source income in the hands of the beneficiaries. Interest received from U.S. corporations, received by a simple trust and then distributed to its beneficiaries is U.S. source income in the hands of the beneficiaries.
The same rule applies to current distributions from complex trusts. Code Sec. 661(b). Distributions of accumulated income do not retain their character in the hands of an NRA or foreign corporate beneficiary, unless the beneficiary is taxed under the throwback rules. Code Secs. 662(b), 667(e) and 665-668. The rules relating to complex trusts apply equally to estates, except that beneficiaries of estates are not taxed upon the distribution of accumulated income. Code Secs. 641, 661 and 667.
(B) Financing Intermediaries.
Where a non U.S. intermediary is imposed between the U.S. obligor and the foreign recipient and there is no substantial economic purpose other than to recharacterize the interest payments from the U.S. as foreign sourced, there exists multiple rules which will recharacterize the payments, from a foreign intermediary, as U.S. source interest.
Prior to 1984, there existed a tax strategy which allowed interest to be paid from the United States to a foreign intermediary tax-free pursuant to a tax treaty or under the portfolio interest exemption. The foreign corporation would then repay the interest payment to the ultimate beneficial owner of the interest income. These foreign companies were used as finance conduits to take advantage of either a tax treaty between the U.S. and the country where the foreign intermediary is organized or the portfolio interest exemption for stripping out interest from the United States tax-free. The subsequent second payment from the foreign intermediary paid to the ultimate beneficial owner of the interest would then be converted from U.S. source to foreign sourced interest income which is not taxable in the United States.
Commencing in 1984, the IRS began issuing pronouncements that such conduit arrangements would be ignored and the interest would be treated as paid directly from the United States to the ultimate beneficial owner and therefore retains its U.S. source character which is subject to U.S. gross basis withholding tax. See Rev. Rul. 84-153, 1984-2 C.B. 383.
Example 1: USCO #1 owned 100% of USCO #2 and 100% of Netherlands Antilles (NACO). Desiring to obtain financing which was less expensive than in the U.S., NACO sold bonds to foreign persons in public offerings. NACO then charged an interest rate 1% greater than its cost of borrowing to USCO #2. NACO claimed that it could receive the interest payments from USCO #2 without any gross basis withholding tax subject to the Netherlands Antilles/U.S. tax treaty. The IRS ruled that even though NACO netted 1% above the cost of its borrowing that it did not “derive the income” from interest paid by USCO #2 but merely temporarily obtain physical possession of the interest which was repaid to other third party foreigners. The IRS also concluded that any intermediary whose primary purpose is to recharacterize interest income that would otherwise be U.S. sourced is to be ignored.
Caution: The above facts are the facts in Rev. Rul. 84-153, 1984-2 C.B. 383. They indicate a willingness by the IRS to ignore financial intermediaries even where there is some economic justification for their existence (e.g. net earnings of 1% remained in NACO).
Between 1984 and 1995, taxpayers and tax planners alike continuously attempted to structure conduit finance arrangements, which had slightly more economic justification than the facts in each prior IRS pronouncement.
After several years of addressing conduit financing arrangements on a case-by-case basis, the Internal Revenue Service in 1995 began revoking the earlier case-by-case rulings. Rev. Rul. 95-56, 1995-2 C.B. 332. They also began their own pronouncements in the form of regulations dealing with arrangements that would be considered conduit finance arrangements, including reserving a Regulation Section solely for future pronouncements by the service as to how they intend to regulate conduit financing arrangements. Reg. § 1.7701(l)-1. They also issued rules defining U.S. source interest subject to gross basis withholding tax, which provide that where there are one or more intermediate entities in financing arrangements and where such entities are acting as conduit entities, such conduit financing arrangement may be ignored and recast as a direct payment from the U.S. source obligor to the foreign source beneficial owner. Reg. § 1.881-3 and Reg. § 1.1441-3(g).