“Does the Bank Loan Exception Apply to Non-U.S. Banks that Pledge Cash Collateral in Derivative Transactions?”
A singularly important question in derivatives transactions between a non-U.S. investor and a U.S. counterparty is whether the non-U.S. investor will be eligible for the portfolio interest exemption from the U.S. foreign withholding tax. The question is particularly important for investors from jurisdictions that either do not have a tax treaty with the U.S. or have a tax treaty that does not eliminate the U.S. withholding tax completely.
This question is complicated by an ambiguity in the U.S. tax law, which creates the possibility that a non-U.S. bank’s pledge of cash collateral in a derivative transaction with a U.S. counterparty may be deemed to constitute a loan made in the ordinary course of the non-U.S. bank’s banking trade or business. In this situation, commonly referred to as the “bank loan exception,” U.S. source interest payments on the cash collateral would not be eligible for the portfolio interest exemption (and consequently would be subject to the U.S. withholding tax).
This article focuses on two important questions raised by the bank loan exception for transactions using documentation standardized by the International Swaps and Derivatives Association, Inc (“ISDA”): (1) under what circumstances can the bank loan exception result in the application of the U.S. withholding tax regime to interest payments on cash collateral in derivative transactions, and (2) which party –U.S. pledgee or non-U.S. pledgor – bears the risk for any U.S. withholding taxes.