ETB or not ETB?

Are mezzanine firms engaged in lending or investing?
It’s a rather annoying question, but with potentially significant implications for foreign LPs of US mezzanine debt funds. According to US tax law, non-US people and entities tied to financial activities in the US can be taxed under two circumstances: first, if they have income from the US in the form of interest and/or dividends, and second, if they are deemed to be engaged in trade or business (ETB) in the US.
An important safe harbor has been created for foreign entities that exempts them from the definition of ETB. According to the US tax code, trade or business is not “effecting, through a resident broker, commission agent, or custodian, of transactions in the United States in commodities… or in stocks or securities.”
Traditionally, the IRS and the US Treasury Department have viewed investing as not a “trade or business,” while lending – the primary business of banks – is indeed ETB.
In recent years however, non-bank institutions have become important sources of debt finance to the US market, and the legal community serving these groups have struggled to include them in the tax code’s safe harbor. Hedge funds, for example, frequently will buy syndicated debt, but because they have not originated the loan, these transactions are generally not seen as ETB.
Other non-bank entities, however, do indeed frequently originate loans, and as such run the risk of being labeled lenders, which would expose their foreign investors to “effectively connected income” (ECI).
Then there are mezzanine debt firms, which provide subordinated financing to many private equity deals. Are their mezzanine funds, hence limited partners, engaged in lending, or are they investing in securities? According to a recent report on this topic put out by the New York City Bar Association, many forms of debt instruments are already defined as “securities” for the purposes of this safe harbor.
But mezzanine investment activity is not clearly defined by the code. “The law is simply not settled,” says Daniel Dunn, a partner in the tax practice of law firm Dechert. “While the markets have developed guidelines for practice in the area, there is little guidance from the government to provide any real certainty.” Dunn notes that the IRS and possibly the Treasury Department are currently weighing whether or not to further define the line between lending and investing, given the shifts in the market.
The stakes are high for non-US limited partners. Being tagged with ETB can mean a tax of as much as 35 percent –enough, perhaps, to make an LP think twice before backing a US mezzanine fund.