Category: International; Deductions & Credits; Individuals; Estate & Gift
Subject: Interest Paid to Foreign Lender/Gifts by Nonresidents
Title: Various Issues
IRC Sections: 102, 267(a)(3), 1442, 1441, 2501(a)(2)
Filename: 1362.html
Date Produced: 06/93

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

Facts

Taxpayers (TP's) are husband and wife, both of whom are resident aliens for U.S. tax purposes. TP's have filed joint income tax returns in the past. Wife resides in California. Although Husband has a U.S. work permit (a "green card"), he lives and works in Hong Kong.

TP's own a residence in California which is encumbered by a mortgage of approximately $430,000. TP's also own California rental property which is encumbered by a mortgage of approximately $130,000. In addition, TP's have personal loans of approximately $60,000. Thus in total, TP's have approximately $620,000 of indebtedness.

TP's are contemplating the following ways of either reducing the amount or the carrying costs of the indebtedness.

1. Refinance the debt through a foreign financial institution in order to get a lower rate.

2. Refinance the debt through a foreign individual in order to get a lower rate.

3. Repay the indebtedness in whole or in part with funds obtained as a gift from Husband's father, a citizen and resident of Hong Kong.

Issues

1. If the indebtedness is refinanced with a foreign financial institution or individual, will interest paid on the loans be deductible by TP's for U.S. tax purposes?

2. If the indebtedness is refinanced with a foreign financial institution or individual, will interest paid on the loans be subject to U.S. withholdings?

3. What are the U.S. gift and income tax consequences to TP's and Father if Father makes a cash gift of $620,000 to TP's?

4. What are the U.S. gift and income tax consequences to TP's if Father loans $620,000 to TP's at arm's-length rates and terms and subsequently forgives principal and unpaid interest on such loans?

Findings

1. There is nothing to restrict U.S. deductibility of interest paid by a cash basis individual taxpayer to a foreign lender solely because of the lender's situs. The same is true whether the lender is an individual or a financial institution. It is important to note that all the normal restrictions and requirements for deductibility of interest still must be met irrespective of the situs of the lender.

2. U.S. income tax withholding at the rate of 30% (or lower if established by treaty) should generally apply to interest payments made either to a foreign financial institution or foreign individual.

3. Father can make a cash gift of any amount to TP's without any U.S. gift or income tax consequences. Gifts of intangibles by nonresident aliens are specifically exempt from U.S. gift tax. Gifts are nontaxable to recipients under §102.

4. Under the same reasoning as stated in Finding 3, above, gratuitous forgiveness of principal and unpaid interest on loans from Father should not give rise to any U.S. gift or income tax consequences for either Father or TP.

Discussion

Issue 1
There is no indication in the tax literature that interest payments are restricted as to deductibility simply by virtue of being made to a foreign lender. There are a number of provisions that speak to interest deductions related to foreign loans; however, these provisions deal with the timing of the deduction for accrued but unpaid interest owed to a related foreign lender (§267(a)(3)) or with the deductions of corporate taxpayers §163(j)). Since TP's are cash basis individuals who will pay interest to a foreign lender, there does not appear to be any restrictions on deductibility resulting solely from the lender's foreign situs.

It is important to emphasize that all other requirements and restrictions on the deductibility of interest payments still exist notwithstanding the situs of the lender. These requirements and restrictions include but are not limited to:

1. the nondeductibility of consumer interest;

2. the requirements for deductibility of home mortgage interest;

3. passive loss restrictions related to the rental house;

4. the interest tracing regulations; and

5. whether debt between related parties is in fact bona fide debt.

Issue 2
§§1442 and/or 1441 clearly require U.S. income tax withholding on payments of interest made to nonresident aliens or foreign corporations. If the loan were made by a non-U.S. person and the interest from the loan were effectively connected with that person's U.S. trade or business, then withholding would not required provided that the lender is able to produce appropriate exemption certificates. Otherwise, withholding is clearly necessary.

The normal rate of withholding is 30% unless a lower rate is established by treaty. Given the relationship TP's have with Hong Kong, I assume that a Hong Kong financial institution or individual would be the most likely source for a loan of this type. Hong Kong is not a party to an income tax treaty with the United States; accordingly, withholding at the general rate of 30% would be required on interest paid to a Hong Kong financial institution or individual.

Issue 3
Under §2501(a)(2), U.S. gift tax does not apply to gifts of intangible property made by a person who is neither a citizen nor a resident of the United States. Accordingly, Father can make a cash gift to TP's without incurring U.S. gift taxes. It should be noted that gifts of U.S. situs tangible property made by nonresident aliens are subject to gift tax. There are a number of cases in which taxpayers have unsuccessfully attempted to avoid U.S. gift taxes on transfers of U.S. tangible property by restructuring the gifts as a transfer of intangible property. For example, in Davies v. Comr., 40 T.C. 525 (1963), the taxpayer, a resident of the U.K., gave cash to his son. The son immediately returned the cash to his father as a down payment on real property in Hawaii. The court held that the transaction was simply a disguised means of transferring the realty and thus was subject to U.S. gift tax. I urge you to review all the facts surrounding TP's acquisition and ownership of the home and the rental dwelling in order to evaluate whether there is exposure based on TP's facts to a recharacterization of a cash gift from Father.

Under §102, gifts to not give rise to taxable income to the donee. Accordingly, TP's are not subject to tax on a bona fide cash gift of any amount from Father.

Issue 4
Based on the same reasoning as set forth above, Father's forgiveness of principal and unpaid interest should not give rise to gift tax to Father or cancellation of indebtedness income to TP's.