Interest is normally FDAP, so 30% withholding. But Congress wanted foreign money to keep buying US debt, so “portfolio interest” is exempt. This one rule is the reason offshore credit funds work at all.
The catches: the lender can't own 10% or more of the borrower (by vote for a corporation, by capital or profits for a partnership); a bank can't use it on loans made in its ordinary lending business; the debt must be in registered form; and interest that depends on the borrower's profits (“contingent interest”) doesn't qualify. Fail any of these and you're back to 30% unless a treaty helps.
Worked example
A Cayman credit fund lends $20m at 9% to a US company it has no equity in. Interest of $1.8m a year comes through with nothing withheld, provided the fund has given the borrower a valid W-8BEN-E. If the same fund also held warrants that pushed it over 10%, that $1.8m would suffer $540k of withholding.
Where you'll see it: Credit agreements (the tax gross-up clause), W-8 collection, and equity kickers that quietly break the 10% test.
See all 53 terms in the glossary
This glossary is general information, simplified for learning. It is not tax, legal or investment advice, and real structures turn on facts and documents not shown here.