Citigroup negotiated an SRT transaction on a corporate loan portfolio of around $8bn just as the Big Beautiful Bill Act was being debated and eventually signed into law on 4 July.

Earlier versions of the Big Beautiful Bill included a provision that would raise withholding tax for non-US investors. That provision was ultimately omitted from the bill, and even in the original version, it may have not impacted SRT investors.

Nonetheless, Citi included language in its SRT documents which asked investors to take on this potential tax risk.

In the event that that the bank would have ended up responsible for paying a withholding tax on the transaction with foreign investors, Citi did not agree to gross up the transaction, meaning investors would ultimately have to bear the cost.

This follows more conservative language Citi included in that SRT regarding restrictions on financing, as reported by 9fin.

In Europe, it is more common to find provisions in deals in which issuers either agree to gross up transactions in the event of a tax law change, or a put option for investors if the bank declines to gross up.

US regulators do not allow US banks to use any type of regulatory calls in their deals.

The tax law change of section 899 would have increased federal income and withholding tax rates on foreign entities in countries with “unfair foreign taxes,” but it was ultimately removed from the final bill.

Most market participants argue SRT investors should not be subject to withholding tax to begin with, and though there were perceived risks, it was effectively a non-issue. We explore some of the complex tax issues in US SRTs below.

Non-US investor burdens

The concerns over withholding tax were a reminder of the complicated tax questions which have dogged transactions between US issuers and non-US investors in the past.

The issue of whether non-US investors needed to pay withholding taxes on SRT investments became more salient around 2018 when more US banks entered the market and some lawyers worried that payments from SRTs could be viewed as US-sourced income.

Some banks preferred to work only with US investors to avoid the risk, and as many more of these have entered the market, there’s been less need for US issuers to appeal to non-US investors.

Nonetheless, non-US investors can invest via a US partnership entity, and some non-US investors do participate in large US deals in some form or other.

Investors like PGGM, which manages the portfolio of the PFZW Dutch pension fund, have participated in deals with banks like Citi. PGGM invested in a 2021 Terra deal, referencing a $4bn global corporate loan portfolio, and in JP Morgan’s 2023 Appia $3.8bn corporate loans SRT.

The tax hurdle is one barrier for international investors into US SRTs, but regulation creates others. For European or UK investors to participate in the US deals, the issuer or originator has to retain a 5% material net economic interest in the transaction. This is not always the case in US deals, especially the more widely syndicated transactions, as in a recent US Bank deal.

European investors also need to make sure that issuers comply with the onerous ESMA due diligence disclosure templates, which are already a requirement for European issuers, but an additional burden for US issuers who do not otherwise have to comply.

The thickness of US tranches has also been an issue for investors, which either require retranching, a practice that can come with regulatory issues, or finding a lot of cheap leverage, which can come with its own restrictions.

Tax deep dive

SRT structures matter greatly when it comes to credit event determination, as discussed by 9fin. The structures have to navigate a complex regulatory matrix but they also impact US tax law considerations, especially when it comes to working with non-US investors.

An SRT can be issued as a direct credit-linked note (CLN), a special purpose vehicle (SPV) issued CLN or via a collateralised credit default swap (CDS) for credit protection.

Via the SPV issued CLN route, the issuer will often enter into a CDS agreement with the SPV and that SPV will then issue notes to the investor, while either placing the cash in a custodian account or with the bank directly.

Non-US entities are subject to withholding tax of 30% on a gross basis on US-sourced income unless an exemption or reduction applies, for example portfolio interest exemption or an exemption or reduction under a tax treaty. Income that is connected to the conduct of a trade or business within the US is not subject to withholding tax but subject to a net tax on effectively connected income (ECI), with some exceptions.

The withholding tax is paid on payment unless the transaction falls under the portfolio interest exemption.

The responsibility for this tax falls on the issuer if it makes a payment to non-US person or someone who receives a payment on behalf of a non-US person and to avoid the risk of being responsible for the tax an issuer may choose to transact only with US entities.

Some international investors will set up a US partnership to do US SRT deals. In this case the tax risk shifts from the issuer to the US partnership.

The US partnership will have to prove that it is not engaged in a trade or business within the US (so it cannot be in the business of acting as a dealer of derivatives within the US) to also avoid the ECI net tax for its non-US partners.

If the SRT is a directly issued CLN, the more senior portion of the first loss or second loss piece is likely to be considered as debt for US tax purposes, based on the relatively high credit rating of the bank and the underlying portfolio.

The more junior piece might also be debt but could also be treated as a financial derivative. “Essentially, if there is too much risk, it might not be debt for tax,” said James Gouwar, partner at Clifford Chance.

If the investor is receiving interest payments on debt, then the transaction can qualify for the portfolio interest exemption. To qualify, the interest payments cannot be contingent, though reduced interest payments due to credit losses is permitted.

The instrument could be considered a financial derivative as would be the case if the SRT is structured as a CDS agreement or issued via an SPV.

If the instrument is considered a financial derivative, then it can fall into a number of categories.

It can qualify as a notional principal contract (NPC), an agreement where parties exchange payments on an underlying notional amount, such as most swaps.

If an NPC is owned by a non-US person, then payments received by such person are foreign sourced; the source is determined by the recipient, not by the payor. If the payment is non-US sourced then there is no withholding tax.

The instrument could also count as some sort of guarantee payment. If the guarantee is treated as having a non-US sourced payment, then there will be no withholding tax.

How guarantees are treated are somewhat complex, with previous legal precedents debating whether the payment is foreign-sourced.

If the payment for a guarantee comes from interest connected to a US trade or business then it may be US -sourced and subject to withholding tax.

If the guarantee is shown to be done on a pool of loans rather than a single credit, then the payment may count as non-US sourced under a similar logic that is applied to NPCs.

As SRT interest payments come from a bank, in return for a guarantee on a pool of loans, determining which treatment applies can be complex.

But there is thus a risk a that the CDS is characterized in a way where the withholding tax applies.

Direct CLNs are the safest structures in terms of avoiding withholding tax because they will likely be considered debt but their use is limited to an aggregate outstanding reference portfolio principal amount of the lower of 100% of the bank’s total capital or $20bn, per the Fed.

“I like the direct CLN structure, it’s one more hurdle for the IRS to clear, which is a positive,” said Gouwar.

Either debt, NPCs or a non-US sourced guarantee should avoid the withholding tax.

Many investors understand that withholding tax does not apply to SRTs at all, but in Citi’s case potential tax law changes warranted additional language to cover any potential new risk, which would be passed on to investors, if it materialised.

Although the proposed bill would not have affected the portfolio interest exemption, its impact was debated.

As this provision was dropped in the final bill, this removed any incremental risk, though there may have been minor legal costs involved in adding this language into the deal.

The tax “issue” is largely agreed to be less of a concern, “but it clearly needs work and paying lawyer fees to get it right,” said an investor.

Citi declined to comment.