Consider this scenario: Mr. Ferringhi has recently arrived in the U.S. and settled in your town. He has opened checking and savings accounts at your bank and has purchased a sizable certificate of deposit. He tells you he is a nonresident alien and has signed an Internal Revenue Form W-8 to that effect. He also tells you that his family will live full-time in your community, but that he will retain his foreign citizenship and spend most of his time in his country of origin, which has no tax treaty with the U.S.
One day, Ferringhi comes to you for a $1 million loan to acquire commercial real estate for that amount. He has incorporated a new business that will be an extension of his family business, run by his father, back in his home country. At this stage, the only asset on the new company's books is the $10,000 that he invested in the company. Being new to the U.S., Ferringhi has very few assets and no credit history here. His personal financial statement and income statement from his home country are reportedly substantial but cannot be verified.
You advise Ferringhi that the bank cannot grant a loan on the basis of the family's offshore holdings. In turn, he suggests that the loan be secured by his certificate of deposit. He notes that this will solve the bank's problem and that he can begin building his business. You agree to this, and because the loan is collateralized by cash, Ferringhi is able to negotiate a substantial discount from the bank's usual loan rate.
In addition, it is agreed that the loan will be in the form of a five-year term loan with a balloon payment. Accordingly, the certificate of deposit is extended to a five-year maturity.
The deal is completed, and it seems that the bank has a good asset with no credit exposure. Ferringhi is completely satisfied with the attractive pricing of the loan.
In time, his business prospers, the loan interest is paid promptly every month, and the Ferringhi family fits into the community. You suggest to your valued client that the bank would be pleased to assist others who might find themselves in the same situation as Ferringhi. He assures you that he knows many such people and would be pleased to introduce them to you.
The outlook for your loan marketing objectives (and your bonus) seems rosy. Everyone is happy--that is, everyone except the U.S. Internal Revenue Service (IRS).
Some months after the transaction, you receive a telephone call from a fellow lunch club member and full-time IRS agent. He says he would like to talk to you about a targeted audit of potentially abusive lending practices at your bank. When you meet, he begins to speak of U.S. withholding tax, back-to-back loans, collapsing loan transactions and Revenue Ruling 87-89, thin capitalization, and earnings stripping.
U.S. Withholding Tax
Some nonresident aliens may, in good faith, attempt to collateralize their loans with deposits to compensate for the lack of a U.S. credit history and verifiable assets and income. Unfortunately, there are other nonresident aliens who attempt to borrow from a U.S. bank in this manner, rather than borrowing directly from a foreign parent company or its shareholders. The express purpose is to avoid U.S. withholding taxes: Interest paid by a U.S. corporation on a loan from a non-U.S. citizen is subject to a 30% U.S. withholding tax in the absence of a specific exemption under the Internal Revenue Code or a tax treaty reduction or exemption. However, interest on a bank deposit is exempt from the 30% withholding tax, provided it is not connected to a U.S. trade or a U.S. business.(1)
Why should this be a concern to lenders? Because the IRS may collapse the loan and deposit transaction and treat them as a direct loan by the offshore parent to the U.S. subsidiary. The IRS may then hold the bank jointly responsible as a collecting agent of withholding tax on behalf of the U. …