The Portfolio Interest Exception

You are funding your U.S. company from abroad and someone has suggested debt rather than equity, on the basis that interest to a foreign lender can escape U.S. withholding entirely. That exception is real and it is in the Code. It is also written with a set of exclusions that, in most closely held structures, land squarely on the person asking the question.

The rule the exception carves out of

U.S.-source interest paid to a foreign person is fixed or determinable annual or periodical income. A nonresident alien individual is taxed on it at 30 percent under IRC §871(a)(1)(A). A foreign corporation is taxed at 30 percent under IRC §881(a)(1). The U.S. payer is a withholding agent under IRC §1441 or IRC §1442 and is liable for the tax it fails to withhold.

Where an income tax treaty applies, the interest article may reduce that rate, sometimes to zero. Where no treaty applies, and the United States has no income tax treaty with the United Arab Emirates, Saudi Arabia, Qatar, Singapore, Hong Kong, or Brazil, among others, there is no treaty rate to reach for. That is the setting in which the portfolio interest exception becomes interesting, because it is a provision of domestic law and does not depend on a treaty at all.

What §871(h) and §881(c) provide

IRC §871(h)(1) provides that in the case of portfolio interest received by a nonresident individual from sources within the United States, no tax is imposed under paragraph (1)(A) or (1)(C) of IRC §871(a). IRC §881(c)(1) does the same for a foreign corporation with respect to paragraphs (1) and (3) of IRC §881(a).

The term is defined, not descriptive. Under IRC §871(h)(2), portfolio interest is interest that would otherwise be subject to the 30 percent tax, paid on an obligation in registered form, where the U.S. payer receives a statement that the beneficial owner is not a United States person, or the Secretary determines such a statement is unnecessary. Everything else in this article is a gate that sits between that definition and your facts.

Gate one: registered form

The obligation must be in registered form. Treas. Reg. §1.871-14(c) treats an obligation as registered where it is registered with the issuer and transferable only by surrender and reissuance, or transferable through a book entry system maintained by the issuer, or registered so as to permit transfer by either route. A convertible obligation does not qualify if conversion into a form that is not registered remains possible.

Bearer instruments are no longer a route. The regulation confirms that interest on a bearer obligation is portfolio interest only where the obligation was issued after July 18, 1984 and before March 19, 2012. Anything issued after that date must be registered.

For a private loan this gate is usually cleared without difficulty, provided the note actually exists and its terms restrict transfer as described. A wire from a founder's personal account with no instrument behind it does not clear it, because there is no obligation to register.

Gate two: the exclusion that decides most founder cases

This is the one to read first, before spending anything on structuring.

IRC §871(h)(3) excludes from portfolio interest any interest received by a 10-percent shareholder of the payer. For a corporate borrower, a 10-percent shareholder is any person who owns 10 percent or more of the total combined voting power of all classes of stock entitled to vote. For a partnership borrower, it is any person who owns 10 percent or more of the capital or profits interest. IRC §881(c)(3)(B) applies the same exclusion to foreign corporate lenders by reference to IRC §871(h)(3)(B).

An illustration with round numbers. A founder resident in a country with no U.S. income tax treaty owns 100 percent of the voting stock of a Delaware C corporation. She lends the company $500,000 on a registered note at 8 percent, producing $40,000 of interest a year. She is a 10-percent shareholder. The interest is not portfolio interest. IRC §871(a)(1)(A) applies at 30 percent, the corporation withholds $12,000 under IRC §1441, and there is no treaty article available to reduce it. Nothing about the loan documentation changes that outcome, because the exclusion turns on her shareholding, not on the note.

Rerouting the loan does not usually help either. IRC §871(h)(3)(C) applies the attribution rules of IRC §318(a) with modifications that widen them: the 50 percent limitation in IRC §318(a)(2)(C) is disregarded, IRC §318(a)(3)(C) is applied without its 50 percent limitation and additionally treats a corporation as owning stock owned by its shareholders in proportion to the value of their holdings, and stock attributed under IRC §318(a)(4) cannot be reattributed under IRC §318(a)(2) or (3). In practice that draws in family members and entities up and down the ownership chain. A loan from the founder's wholly owned offshore holding company, or from a family member who is themselves a shareholder, is tested on the attributed ownership.

This is the honest answer to the question founders usually arrive with. The portfolio interest exception was written for genuine third-party and portfolio lending. It was not written to let an owner recharacterize their own funding as tax-free interest, and it says so.

There is a narrow space where the voting power formulation matters, since the corporate test is stated in terms of voting power rather than value. Whether a particular holding falls under 10 percent of voting power after the modified attribution rules is a facts question, and the surrounding consequences of holding only nonvoting stock reach well beyond this provision. It is not a structure to adopt on the strength of a general article.

The other three exclusions

Related controlled foreign corporations. IRC §881(c)(3)(C) excludes interest received by a controlled foreign corporation from a related person within the meaning of IRC §864(d)(4). Where the group already has a CFC in the chain, intercompany lending through it is outside the exception.

Bank loans. IRC §881(c)(3)(A) excludes interest received by a bank on an extension of credit made pursuant to a loan agreement entered into in the ordinary course of its trade or business. A foreign bank lending to a U.S. borrower typically looks to a treaty interest article rather than to this exception.

Contingent interest. IRC §871(h)(4) excludes interest determined by reference to the receipts, sales, or other cash flow of the debtor or a related person, to income or profits, to changes in the value of property, or to dividends or partnership distributions. Exceptions preserve portfolio treatment in defined cases, including contingencies as to the timing of payment, interest on certain nonrecourse debt, interest determined by reference to other qualifying interest, hedging transactions, and amounts determined by reference to the yield on actively traded property or an index of it. The practical consequence is that revenue-share notes, profit participating loans, and convertible instruments with economics tied to company performance need to be tested against this paragraph before anyone assumes the exception applies.

What the withholding agent actually needs to hold

The statutory condition is that the U.S. payer receives a statement that the beneficial owner is not a United States person. In practice that is a Form W-8BEN from an individual lender or a Form W-8BEN-E from an entity lender, obtained before payment and held by the borrower. Where the obligation is held through a financial institution, Treas. Reg. §1.871-14 allows the institution to hold the certificate and pass the required statement up the chain, and it requires the beneficial owner to notify the institution within 30 days when the information changes.

Documentation is a condition, not a formality. Without it the borrower is exposed as withholding agent, and it is the borrower rather than the lender that the IRS collects from. The borrower also reports the payment on Form 1042-S and files Form 1042, generally by March 15 of the following year, whether or not tax was withheld.

Qualifying is not the same as deducting

The exception addresses the lender's U.S. tax on receiving the interest. It says nothing about the borrower's deduction, and three other regimes may.

IRC §163(j) limits the deduction for business interest expense. The 2025 reconciliation act restored the calculation of adjusted taxable income without regard to deductions for depreciation, amortization, and depletion, on a permanent basis, effective for taxable years beginning after December 31, 2024. That is a more favorable base than the rule that preceded it, but the limitation still operates.

IRC §267A denies a deduction for interest or royalties paid to a related party pursuant to a hybrid transaction or by or to a hybrid entity, where the amount is not included in income in the recipient's jurisdiction or is deductible there. A group with a fiscally transparent entity somewhere in its chain should test this before assuming an interest deduction survives.

And the threshold question is whether the instrument is debt at all. An advance with no fixed maturity, no enforceable repayment schedule, and no realistic prospect of repayment from operations can be recharacterized as a contribution to capital, in which case the payments are distributions and the interest analysis never begins.

Testing your own facts

Test in this order, and stop at the first failure. Who is the lender, and after attribution do they own 10 percent or more of the borrower's voting power or partnership interest. Is the instrument in registered form. Is any part of the return contingent on the borrower's performance. Only if all three answers are favorable does the documentation question arise.

If the lender is the owner, which is the common case, the productive analysis is a different one: how the U.S. entity is capitalized, how it is classified, where its income is sourced, and whether a treaty is available through anyone in the structure. A capital structure review with the firm covers that ground, alongside your attorney for the instruments themselves.

This is general information about how IRC §871(h) and IRC §881(c) operate. It is not an opinion on any particular loan, and outcomes depend on facts this article cannot see.

Related material sits on the international tax matters pillar.