U.S. Real Estate Development: Mezzanine Financing by Non-U.S. Persons

U.S. real estate development projects are generally conducted in the form of a joint venture or partnership for U.S. tax reasons. The players in such an operation include the developer and the equity investor, both of whom are partners in the partnership, and lenders, both senior and mezzanine lenders. While mezzanine lenders are often U.S.-based, foreign investors are increasingly seeking to make such loans.

Portfolio Interest Exemption

In the case of foreign mezzanine lenders who are residents of countries that do not have income tax treaties with the United States (or are not entitled to treaty benefits by reason of failing to qualify under the limitation on benefits provision in the applicable treaty of the country of residence), interest derived from U.S. sources would typically be taxable at 30% unless another exemption can be relied on. The portfolio interest exemption set forth in sections 871(h) and 882(c) of the U.S. Tax Code is usually looked to in these cases.

To qualify for this exemption, the following principal requirements, among others, must be satisfied:

(i) the documentation evidencing the loan must have certain registration language (this is a relatively simple requirement);

(ii) the mezzanine lender must provide the partnership with a Form W-8BEN-E certifying ownership by a non-U.S. person; and

(iii) the holder of the loan instrument must not be a “10% owner.”

Requirement (iii) is most often the reason for this exemption being unavailable. Specifically, mezzanine lenders often seek “equity kickers.” Thus, in addition to earning interest on the underlying debt, mezzanine lenders often negotiate with the borrower to receive partnership units and/or warrants to acquire such units.

What is 10% Ownership?

In cases where a loan is made by a foreign person (for example, a Cayman corporation making a loan to a Delaware corporation), 10% ownership is tested on the basis of voting power. However, where the loan is being made to a partnership instead of a corporation, the 10% ownership test would be based on the lender’s interest in the partnership’s capital or profits. As mentioned, 10% ownership of partnership units by the lender will disqualify portfolio interest treatment.

In determining 10% ownership, certain attribution of ownership rules apply for purposes of determining whether the person making the loan is to be treated as a 10% owner. For example, if the Cayman corporate lender were owned by a related entity that was acquiring partnership units in that partnership, that ownership interest could be attributed to the lender and the exemption would be lost. Also, an option to acquire such an ownership interest held by the lender itself would be treated as exercised for this purpose. Thus, the lender’s having a conversion right into a 10% ownership interest would suffer the loss of the portfolio interest exemption.

Interestingly, a partnership interest attributed to the option holder under the option attribution rule is not attributed further to or from a partnership, estate, trust, or corporation. Thus, the portfolio interest exemption should not be denied the lender if the option were held by a different entity than the one that holds the loan. For example, if the option were issued to an affiliate of the lender, such as a parent or brother-sister company, the potential ownership interest in the partnership represented by the option held by the affiliate should not be attributed to the lender. Obviously, in structuring these transactions, care must be taken in making certain that the related entity holding the option is treated as its beneficial owner and not the agent of the lender.

Treasury Regulations recently adopted and related to “noncompensatory options” also need to be taken into account. Essentially, these regulations could treat certain options not yet exercised as having been exercised. If this were to occur, the plan described in the preceding paragraphs would not work, since we would not be dealing with options but with actual partnership interests.