Opportunities for the Foreign Investor in U.S. Real Estate If Planning Comes First

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1 Opportunities for the Foreign Investor in U.S. Real Estate If Planning Comes First by Michael Hirschfeld and Shaul Grossman Appeared in January 2001 edition of RIA s Journal of Taxation Copyright 2003 RIA. All rights reserved.

2 WG&L Journals INTERNATIONAL Opportunities for the Foreign Investor in U.S. Real Estate If Planning Comes First Author: By Michael Hirschfeld and Shaul Grossman MICHAEL HIRSCHFELD is a partner, and Shaul Grossman is an associate, in the New York City office of the international law firm of Dechert. Mr. Hirschfeld is a member of the ABA Tax Section s committees on Real Estate (of which he is the past Chair), Foreign Activities of US Taxpayers, and US Activities of Foreigners & Tax Treaties, among others, and has written for The Journal on many occasions. Copyright 2000, Michael Hirschfeld and Shaul Grossman. The complexities of FIRPTA and the even broader withholding scheme that backs it up require that a nonresident acquire a thorough understanding of the rules before making an investment in real estate. The choice of whether to use an entity and which one or to hold the investment directly, as well as the type of investment equity or debt can have significant and sometimes expensive consequences. Edited By Sanford H. Goldberg, J.D., and Herbert H. Alpert, J.D. The global economy is a fact of life at the start of the new millennium. One consequence is that cross-border investments in real estate will expand significantly. Twenty years have elapsed since Congress enacted the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) to ensure that foreign investors are subject to at least one level of federal income tax when they dispose of U.S. real estate investments. Notwithstanding FIRPTA s simple, clear-cut directive, foreign investors still face a host of planning opportunities and potential problems. Before any decisions are made to invest in the U.S., certain essential ingredients should be understood: Who is a foreign investor. What activities rise to the level of a trade or business. The estate and gift tax ramifications of U.S. investments. The basic tenets of tax liability under FIRPTA and the withholding mechanism that ensures collection of the tax. As will be seen below, some planning structures remain that a foreign investor can use to minimize, to the fullest extent possible, the sometimes harsh grip of U.S. federal income, estate, and gift tax laws. 1 Copyright 2003 RIA. All rights reserved.

3 FOREIGN INVESTOR OR U.S. RESIDENT? FIRPTA, embodied in Section 897, applies to dispositions of U.S. real property interests (USRPIs, as defined later in this article) made by nonresident alien individuals and foreign corporations. 2 A nonresident alien is defined in Section 7701(b)(1)(B) as an individual who is neither a U.S. citizen nor a U.S. resident. Citizenship is generally a yesor-no proposition, but residency may not be so simple. Foreign individuals who buy U.S. vacation homes, for example, easily may become U.S. resident aliens if they spend too much time in the U.S. Crossing this line will cause them to become, among other things, subject to U.S. federal income tax on their worldwide income. 3 The Code s definition of a U.S. resident individual includes a person who is a U.S. permanent resident (a green card holder under U.S. immigration law) 4 or an individual who spends a substantial amount of time in the U.S., determined under a test known as the substantial presence test. 5 This test has two components, the first of which creates an irrebuttable presumption that a foreign individual is a resident if he or she spends more than 183 days in the U.S. The second test creates a rebuttable presumption that a foreign individual is a U.S. resident if he or she spends too much time in the U.S. over a three-year period, determined by applying a complicated test based on days spent in the U.S. over the three-year period. 6 Any foreign individual who makes frequent visits to the U.S. should monitor the days spent in the U.S., and document the time spent in the U.S. in a written diary or calendar. This can help the investor avoid becoming a U.S. resident and also serve as supporting documentation in the event of an IRS challenge. U.S. TRADE OR BUSINESS The U.S. tax system taxes foreign investors investing in the U.S. under one of two possible tax regimes. If the investor is engaged in a U.S. trade or business, any income that is effectively connected with such trade or business will be taxed on a net basis at the regular graduated tax rates applicable to a U.S. citizen or resident (the trade or business tax ). 7 If the U.S. activity of the investor does not rise to the level of a U.S. trade or business, any passive U.S. source income paid to that foreign investor generally will be subject to a 30% tax on the gross amount of such income (the passive income tax ). 8 The passive income tax is generally paralleled by a withholding obligation imposed on the U.S. payor. 9 Applicable tax treaties can reduce or eliminate this tax liability. 10 Equity vs. debt. Thus, the first question is whether an investment in U.S. real estate will cause the foreign investor to be engaged in a U.S. trade or business. The investor generally would want to be engaged in a U.S. trade or business with respect to any equity position, i.e., where the investor owns the U.S. real estate or is a partner in a U.S. partnership or LLC that owns the project

4 As noted above, any U.S. source income effectively connected with a trade or business will be subject to the trade or business tax only after taking into account all applicable deductions, such as depreciation and interest. This can significantly reduce, if not eliminate, any U.S. tax exposure. 12 By contrast, if a U.S. trade or business does not exist, any U.S. source income paid to the investor with respect to a U.S. real estate project, such as rents from the project, will be subject to the 30% passive income tax that applies to the gross amount of the payments with no offsetting deductions. 13 With respect to equity positions that involve the receipt of rent, this passive income tax on gross income is typically far more onerous than the tax imposed on net income if the investor is engaged in a U.S. trade or business. 14 Ownership of a single parcel of U.S. real estate that is triple net leased out to a single tenant would not constitute the conduct of a trade or business, and therefore, would subject the foreign investor to the passive income tax. 15 While leasing a project to a significant number of tenants (such as 15 tenants) will constitute the conduct of a U.S. trade or business, the exact line where an investor passes from being passive to active is not clear. A taxpayer-friendly option (sometimes overlooked, to the taxpayer s subsequent dismay) allows a foreign investor to elect to be engaged in a U.S. trade or business with respect to its holding of U.S. realty that generates rental income. 16 This election is highly recommended and any doubts generally should be resolved in favor of making it. In contrast to the foregoing, a foreign investor holding a debt position such as a mortgage on U.S. real estate generally will want to come under the passive income tax regime, to take advantage of the broad-based exemption for portfolio interest paid to foreign investors. 17 Portfolio interest is defined quite broadly. The principal categories of interest income not eligible for this tax exemption are (1) interest paid to foreign banks lending in the ordinary course of their business, (2) interest paid to foreign investors who hold a 10% or greater equity stake in the payor entity, whether it be a U.S. corporation or partnership, and (3) contingent interest such as that based on the income or profits from the project. 18 Notwithstanding these limitations, the portfolio interest exemption is quite extensive and offers a simple way to invest in the U.S. with no adverse tax ramifications. Even where the portfolio interest exemption does not apply, U.S. tax treaties can eliminate or significantly reduce the passive income tax on interest. 19 Nevertheless, reliance on a tax treaty to reduce or eliminate the tax on interest paid to related parties could trigger the earnings stripping rules, which can reduce or eliminate the tax deduction that otherwise would be available to the corporate payor. 20 Notwithstanding that fact, assuming that the debt instrument qualifies as true debt under traditional tax rules, 21 a foreign investor may find being a lender to be far more advantageous from a U.S. tax viewpoint than being an equity participant in the project

5 Branch Level Taxes Consider the foreign investor in a U.S. corporation that owns U.S. real estate. The corporation will find that its ability to repatriate funds to its shareholder may be subject to two levels of tax. First, the basic corporate income tax imposed on the corporation s worldwide earnings; second, the 30% passive income tax imposed on dividends paid by that corporation to its foreign shareholder. 22 If, however, the foreign investor uses a foreign corporation to hold its investment, that investment is subject to a different and more complicated system of taxation. Where the level of investment in U.S. real estate rises to the level of the conduct of a U.S. trade or business (or an election is made to be treated as engaged in a U.S. trade or business), the foreign corporation will be subject to the trade or business tax and generally will be treated similarly to a U.S. corporation holding the investment. But, whereas a potential second level of tax may be imposed when a U.S. corporation pays dividends to its foreign shareholders, no such withholding tax obligation is imposed on a foreign corporation engaged in a U.S. trade or business. Rather, as a substitute for such withholding tax, most of the foreign corporation s effectively connected earnings are likely to be subject to a second level of tax known as the branch profits tax (BPT). The BPT generally imposes a second layer of tax on the after-tax business income of foreign corporations engaged in a U.S. trade or business and, by analogy to the passive income tax on U.S. corporations, operates as if phantom dividends were distributed to shareholders and subjects such dividends to a 30% tax. Most important, while the passive income tax is applicable only when dividends are paid by a U.S. corporation to its foreign shareholders, the BPT is imposed on a current basis regardless of whether any distributions have been remitted to the corporation s shareholders. The BPT is computed on the foreign corporation s dividend equivalent amount, which generally takes into account the corporation s taxable income that is effectively connected to the U.S. trade or business. Adjustments include allowing a deduction from such amount for corporate income taxes (but not the BPT itself or the branch level interest tax (BIT), discussed below), and for amounts reinvested in the U.S. trade or business. 23 While the BPT was modeled after the 30% passive income tax imposed on dividends paid by U.S. corporations to foreign investors, the copy can be viewed as harsher than the original. As noted above, the passive income tax applies only to actual dividends distributed by U.S. corporations to foreign shareholders, whereas the BPT is imposed regardless of any current distributions to shareholders. Thus, acceleration of tax liability may result under the BPT. In addition, the 30% passive income tax on dividends does not generally apply to a liquidating distribution by a U.S. corporation to a foreign shareholder. 24 While there is no similar exception for the BPT in the Code, Temp. Reg T(a) attempts to provide one. Use of the exception, however, requires satisfaction of four conditions that sometimes can be hard to meet (such as the requirement that none of the assets of the liquidated foreign corporation can be used by the shareholder or any related person in a U.S. trade or business until the lapse of a three-year period that starts at the end of the year of termination). Other differences exist that also can make the BPT - 4 -

6 more disadvantageous. Nevertheless, the BPT may turn out to be less harsh than the passive income tax where the foreign corporation is eligible for tax treaty benefits. Treaties. The BPT, like the passive income tax, is subject to reduction or elimination by treaty. While no tax treaty totally eliminates the passive income tax that is imposed on dividends paid by U.S. corporations (generally, at best there is a reduced 5% withholding rate), many treaties provide for a complete ban on the BPT. 25 The Code, however, contains very comprehensive anti-treaty-shopping provisions whose purpose is to prevent non-treaty residents from taking advantage of treaty-based entities so as to attain treaty relief. These provisions can override the treaty and prevent reliance on a treaty exemption from (or reduction in) the BPT. 26 By contrast, no such broad-based targeted treaty override applies to the passive income tax. 27 Thus, while treaty benefits may initially indicate an advantage for using a foreign corporation over a U.S. corporation to hold U.S. realty, care must be taken so that the purported treaty benefits are truly available. Branch level interest taxes. As noted above, in addition to the BPT a U.S. branch of a foreign corporation also faces the complementary BIT. Like the BPT, the BIT treats the foreign U.S. branch as if it were a U.S. corporation, and thus any interest paid by the foreign branch to foreign lenders is sourced in the U.S. and subject to the passive income tax and to 30% withholding. 28 The BIT is broader in scope, however, as it applies even if no interest is actually paid by the foreign branch. In general, the BIT allocates a certain percentage of the foreign corporation s global interest expense to the U.S. branch and treats that interest as paid by a U.S. corporation, even if that interest was not deductible by the U.S. branch in its computation of its U.S. tax liability on its effectively connected income. 29 Section 884(f)(1) first treats any interest paid by the U.S. branch as if it were paid by a U.S. corporation, then treats any excess interest (the amount by which the foreign corporation s interest allocable to the branch exceeds any interest actually paid by the branch, if any) as if it were paid by the U.S. branch (in its deemed capacity as a U.S. subsidiary) to the foreign corporation (in its deemed capacity as the foreign parent of its deemed U.S. subsidiary). 30 The portfolio interest exemption from the application of the passive income tax that otherwise would be imposed on interest paid by a U.S. person to a foreign investor applies as well to the BIT, which may undercut some of its severity. 31 For example, if a foreign corporation is deemed to have paid interest that is allocable to its U.S. effectively connected income (and thus potentially subject to the BIT) to two of its shareholders, one the holder of a 5% voting interest and one the holder of a 15% voting interest, the amount of interest payable to the 5% shareholder will be exempt from withholding under the portfolio interest exemption. As with the BPT, the BIT may be reduced or eliminated by treaty. One may look for relief to both the payor s tax treaty with respect to the aggregate branch interest as well as the recipient s tax treaty with respect to interest paid to that recipient. Again like the BPT, however, limitations on treaty relief in the Code can override such benefits if treaty shopping is found. Reliance on a treaty to reduce or eliminate the BIT or BPT cannot be undertaken without careful review of these provisions as well as the treaty itself

7 U.S. ESTATE AND GIFT TAXES U.S. federal estate tax applies to the worldwide estate of U.S. residents. 32 The definition of resident for estate tax purposes is different from what it is for income tax purposes, however. A person will be a U.S. estate and gift tax resident if the U.S. is that person s domicile, which generally is defined as the permanent home to which that person ultimately intends to return. 33 The objective tests for determining federal income tax residency that put special emphasis on days spent in the U.S. do not apply here. Thus, an individual could become a resident for federal income tax purposes by spending too much time in the U.S. but if care is exercised in the conduct of his or her affairs still could be a nonresident for federal estate and gift tax purposes. Even if a person is not a U.S. estate and gift tax resident, his or her estate still would be subject to U.S. estate tax on any U.S.-situs property that the person owned at death. 34 With a maximum current rate of 55%, 35 the potential impact of the U.S. estate tax should not be overlooked when structuring any real estate investment for foreign individual investors. Furthermore, while U.S. citizens get an unlimited marital deduction for any assets that pass at death to a surviving spouse, the ability of a non-u.s. citizen surviving spouse to take advantage of that exclusion is severely limited unless the assets pass at death to a qualified domestic trust. 36 Included in the scope of the taxable estate of a nonresident is U.S. real estate as well as stock in U.S. corporations. 37 While debt instruments issued by U.S. persons are also within the scope of the taxable estate, a major exclusion exists for debt obligations, the interest on which is exempt under the portfolio interest exemption discussed earlier. 38 This is another advantage for such debt instruments. In addition, stock in a foreign corporation is not included in a nonresident s gross estate and thus is not subject to U.S. estate tax, even if the foreign corporation s sole asset is U.S. real estate or the stock of a U.S. company. As discussed below, this is helpful in planning acquisition structures for foreign individuals who buy U.S. real estate. The treatment of interests in partnerships as U.S.-situs property is less clear. Take, for example, an interest in a Cayman Islands partnership managed outside the U.S. whose sole asset is income-producing U.S. real estate. The argument could be made that the partnership interest is an intangible whose situs is outside the U.S. and thus is not subject to estate tax. The more compelling argument, however, would be that the situs of the intangible investment in the partnership should be the U.S., where the real estate lies, and thus U.S. estate tax would apply. This is the position that the IRS espouses, along with some courts. 39 U.S. federal gift tax has a far more limited applicability to nonresidents than the estate tax. It does apply to a gift of U.S. real estate, but does not extend to gifts of intangibles such as the stock in U.S. companies. 40 This latter point will again be helpful in optimizing acquisition structures for foreign individuals who are desirous of minimizing both their U.S. estate and gift tax exposure

8 FIRPTA TAX LIABILITY Section 897(a)(1) states the general rule that gain or loss realized by a nonresident alien or a foreign corporation from the sale of a USRPI, as defined below, will be recognized and subject to the U.S. trade or business tax. The tax under FIRPTA is imposed on the foreign investor by first treating the investor as engaged in a trade or business within the U.S. during the tax year of the sale and then treating the gain or loss from the disposition as effectively connected with such trade or business. Section 1445 provides a comprehensive withholding system for collecting the FIRPTA tax liability. Under Section 897(c), a USRPI is an interest in U.S. real property held not solely as a creditor, and held directly or through certain entities when specified requirements are met. Reg (d)(1) provides that fee ownership, co-ownership, or leasehold ownership interests are all USRPIs. The same is true for time-sharing interests, life estates, remainders, and reversionary interests. Real property includes land and unsevered natural deposits such as mines, wells, and timber. 41 The real property must be located in the U.S. or the U.S. Virgin Islands. Reg (b)(3) explicitly provides that improvements to land, such as buildings or other permanent structures, generally also are considered real property. Options to acquire land or improvements thereon are also included, even if not presently exercisable. Options to acquire any noncreditor interest in real property, including a right of first refusal, also will constitute a noncreditor interest in real property. 42 Certain personal property that is associated with the use of real property, such as some construction equipment, is included as well. Reg (b)(4) provides special rules to determine when such property should be considered to be associated with the use of real property. Indirect interests. Apart from direct interests in real estate, interests in entities that hold USRPIs are treated as if they themselves are USRPIs. As with USRPIs, only interests in these entities that are held not solely as a creditor are considered USRPIs. 43 The basic types of noncreditor interests in an entity that holds USRPIs are generally: (1) Stock of a corporation (Reg (d)(3)(i)(A)). (2) A partnership interest (Reg (d)(3)(i)(B)). (3) A beneficiary s interest in a trust or another ownership interest in a trust (Reg (d)(3)(i)(C)), typically a grantor s interest. 44 (4) Rights to share in the appreciation of the interests in the above entities or in the appreciation in value of the assets of, or gross or net proceeds or profits derived by one of those entities. These rights include contingent interests such as stock appreciation rights (even if the holder owns no stock in the corporation) 45 but not rights exclusively contingent on and exclusively paid out of (a) revenues from either sales of personal property (tangible or intangible) or from services or - 7 -

9 (b) the resolution of claims (by persons unrelated to both the entity and the holder) against the entity. USRPHCs A USRPI includes any interest in a domestic corporation that qualifies as a U.S. real property holding corporation (USRPHC). As with USRPIs, as mentioned above, a noncreditor interest as well as an option to acquire a noncreditor interest in a corporation that is a USRPHC is an interest in a USRPHC. 46 A U.S. corporation generally is a USRPHC if the FMV of the USRPIs held by such corporation is at least 50% of the FMV of the corporation s assets that comprise USRPIs, foreign real property interests, and trade or business assets of the corporation at any time during the five-year period preceding the sale of its stock. 47 USRPHC status does not apply to a foreign corporation notwithstanding that all its assets may be USRPIs; thus, a sale of the stock of a foreign corporation is not taxed by FIRPTA. 48 The definitional test for a USRPHC poses serious problems for corporations because it basically would require them to constantly appraise their classes of assets to determine whether they are USRPHCs. To alleviate this burden, Reg (b)(2) allows corporations to determine their status based on an alternative book value, which is fairly easy to determine. 49 If a corporation s book value of its USRPIs is 25% or less of the total book values of the three classes of assets otherwise taken into account in determining USRPHC status, the corporation is presumed not to be a USRPHC, although the Service may rebut this presumption. Five-year cooldown. Another rebuttable presumption treats any interest in a U.S. corporation as an interest in a USRPHC unless the taxpayer establishes that the corporation was not a USRPHC during the shorter of the taxpayer s holding period for the interest or the five-year period ending at the date of the disposition of the interest. 50 Thus, an interest in a U.S. corporation cannot escape the taint of being an interest in a USRPHC by acquiring more foreign real estate or more trade or business assets prior to its sale. Even after the corporation ceases to be a USRPHC, a five-year cooling-off period still would be required before a disposition of an interest in such corporation would not be considered a disposition of an interest in a USRPHC. 51 The requirement that a corporation cease to be a USRPHC for five years before its stock may be sold free of FIRPTA taxation can lead to somewhat harsh results. Consider the example of a successful start-up company whose main asset in its first year of operation was its manufacturing facility, which is primarily real estate. Three years later, the company s value has grown immensely due to its business operations, and its real estate accounts for a very nominal part of its aggregate value. Despite the fact that the company is no longer a USRPHC, 52 an interest in the company is still a USRPI until five years after the date the company ceased to be a USRPHC. Thus, the sale of its stock would generate tax under FIRPTA. By contrast, if the company had never held U.S. real estate of any significant value (for example, it had leased its plant at a market rental), the stock - 8 -

10 could be sold by foreign investors with no U.S. tax being imposed. 53 If this scenario is a possibility, a prospective investor may wish to use a separate company to hold and lease the real estate to eliminate the FIRPTA taint to the underlying business. A special exclusion from USRPHC status exists for stock in a publicly held company where the selling stockholder owns no more than 5% of its stock. 54 This exclusion is useful for foreign investors holding stock in publicly traded real estate investment trusts (REITs), which are discussed in more detail below. The status of a corporation as a USRPHC also would cease to exist, however, if the corporation held no USRPIs on the date of its sale and all dispositions of USRPIs in the previous five years were in taxable transactions. 55 The need to get rid of all USRPIs may make this a hard exclusion to fall under as a practical matter. Technically, the five-year period would require testing the status of the corporation on each and every day in that five-year period. Reg (c)(1), however, reduces this potential administrative burden to some degree by only determining USRPHC status at one of the following dates: (1) The last date of the corporation s tax year. (2) The date on which the corporation acquires any USRPIs. (3) The date on which the corporation disposes of any foreign real estate or any assets used or held for use in its trade or business. (4) The date an entity (whose ownership of USRPIs is attributed to the USRPHC) acquires any USRPIs or disposes of any foreign real estate or any assets used or held for use in its trade or business. The inquiry as to whether the stock of a U.S. corporation is an interest in a USRPHC, as well as the corporation s acquisition plans, should be critical to any foreign investor considering the purchase of stock in a U.S. corporation, as the differences in tax consequences on disposition of the stock may be severe. On one hand, if the corporation is not a USRPHC at the time of purchase and will not become a USRPHC prior to the sale of its stock by the foreign purchaser, the gain from the sale of its stock generally will not be subject to U.S. tax. 56 On the other hand, if the corporation is a USRPHC or becomes a USRPHC prior to the sale of its stock, the gain on the sale of the stock will be subject to FIRPTA. In that instance, the only options available for the foreign investor who wants to sell the stock without subjecting the gain to FIRPTA would be (1) to wait until the corporation ceases to be a USRPHC and then wait an additional five years, or (2) to sell immediately after the U.S. corporation ceases to be a USRPHC because it sold all of its USRPIs in taxable transactions (or because entities held by it that caused it to be a USRPHC sold all their USRPIs in taxable transactions) and on the date of disposition of its stock it held no USRPIs

11 Transfers to Corporations Special Considerations One recurring problem for tax advisors is after-the-fact structuring, where a foreign individual seeks advice after already having purchased a parcel of U.S. real estate directly, and now wants to move the property into an entity such as a foreign or U.S. corporation. In this situation, the traditional tax-free incorporation provisions of Section are partially overridden by FIRPTA s own special nonrecognition rule in Section 897(e). As fleshed out in Temp. Reg T, a foreign transferor may rely on a nonrecognition provision of the Code only where the following three conditions are met: (1) The foreign transferor receives a USRPI in exchange for the transferred USRPI (sometimes called the USRPI-for-USRPI requirement). (2) The USRPI received would be subject to tax on its ultimate disposition. (3) The transferor complies with certain filing requirements. 59 If the U.S. real estate were to be transferred to a foreign corporation, the foreign individual would then own stock that could be disposed of without triggering FIRPTA (because a foreign corporation owning USRPIs is not a USRPHC). Therefore, FIRPTA would tax the investor on the transfer of the U.S. real estate to the foreign corporation. By contrast, if the U.S. real estate were to be transferred to a U.S. corporation and the U.S. corporation is (or would become as the result of the transfer) a USRPHC, no FIRPTA tax should result on the transfer because the later sale of the corporation s stock by the foreign individual would trigger FIRPTA. Partnerships, Trusts, and Estates A partnership interest itself could be considered a USRPI whose sale would result in tax under FIRPTA if the partnership holds significant U.S. real estate. In particular, a partnership will be a USRPI if it satisfies both of the following (the 50/90 test ): (1) 50% or more of the value of the partnership s gross assets are USRPIs. (2) 90% or more of the value of partnership s gross assets consists of USRPIs plus cash or cash equivalents. Disposition of an interest in a partnership that satisfies the 50/90 test is a disposition of a USRPI, but is treated differently for tax and withholding purposes. Only the gain attributable to USRPIs held by the partnership is taxed under the substantive FIRPTA tax regime. 60 All of the gain from the disposition of the partnership interest is subject to withholding, however. 61 Interests in partnerships or trusts that are regularly traded on an established securities market are generally treated as interests in publicly traded corporations and are not

12 governed under these partnership rules. 62 As discussed above, only foreign persons who own a greater than 5% interest in publicly traded corporations (that also are USRPHCs) are taxed on dispositions of those interests. The same rules generally are applicable to publicly traded partnerships and trusts. Disposition of interests in trusts and estates that hold USRPIs are taxed under Section 897(g). Only the gain attributable to the USRPIs held is taxed. The interests themselves, however, apparently are not USRPIs. 63 Creditor s Interests and Loans With Equity Kickers An interest in real property solely as a creditor is not a USRPI. 64 The underlying concept followed by the Regulations in determining whether an interest is other than solely as a creditor is whether the interest paid on a purported debt obligation is affected by changes to the property s value. For example, Reg (d)(2)(ii)(D) allows an interest rate to be tied to an index, so long as the index does not have the principal purpose of reflecting changes in real property values. Nonetheless, a classic equity kicker type loan where part of the interest paid on the loan is determined by a percentage of proceeds or profit from the sale of the underlying property will typically be classified as a USRPI. A loan classified as a USRPI will result in taxation only if the debt instrument itself is sold; if the instrument is not sold, FIRPTA has no impact. Fixed interest paid on the loan will be exempt from the passive income tax, pursuant to the portfolio interest exemption. By contrast, contingent interest likely will be subject to the 30% withholding tax (although a tax treaty might reduce or eliminate that liability). On balance, even with USRPI status for the instrument and the potential taxability of contingent interest payments, loans with equity kicker features still may be an advantageous alternative to direct investment in real estate. If equity kicker debt instruments are to be used, care must be exercised to avoid the transaction s being treated as a disguised joint venture. To sustain the treatment of the instrument as a debt instrument for tax purposes it is recommended that, at a minimum, advisors not use equity kicker in their documents; rather, a term such as contingent interest should be used for those payments. In addition, advisors should verify that no fixed or contingent interest will be paid after all principal is extinguished. Finally, advisors should consider adding a reasonable limitation on the overall amount of fixed and contingent interest that may be paid on the loan. All these elements can provide support for the taxpayer s position and can be structured to have minimal or no effect on the underlying business deal

13 Installment Obligations The tax deferral available from installment reporting may be beneficial for both the seller who wants to avoid current cash and for the purchaser who is unable or unwilling to obtain external financing. As described further below, the installment method, when permitted, also is available for the sale of USRPIs. The use of the installment method as a way of deferring tax was dealt a harsh blow for all taxpayers, domestic as well as foreign, when the Tax Relief Extension Act of 1999 prohibited the use of the installment sales method for sales by accrual-method taxpayers after 12/16/ Legislation to repeal this restriction on the installment method has not yet been enacted. 66 If the installment sales technique is available, investors deciding whether to take advantage of it must be aware of the two issues that still arise where an installment obligation is received as payment, in whole or in part, for a USRPI. First, is the obligation itself a USRPI, to be taxed on disposition? Second, should the corresponding payments on the obligation be considered as payment for a USRPI? The answers to both questions depend largely on the method used by the seller to report the gain on the USRPI sold. Sellers not entitled to use the installment method, or who elect out, must recognize gain in the year of sale as if the USRPI were sold for cash. As a result, the installment obligation received for the USRPI becomes a mere creditor s interest and thus is not treated as an interest in real property. 67 Likewise, each installment payment will not be tracked to any FIRPTA gain. By contrast, for sellers entitled to use the installment method and who have not elected out, the obligation remains a USRPI and dispositions thereof (other than certain transfers to related persons) are taxed under FIRPTA. 68 Likewise, the portion of each principal payment that represents gain is treated as gain from the disposition of a USRPI. 69 One important measure all sellers wishing to report the gain on the installment method must take is to apply for a withholding certificate. Absent such certificate, the entire sale proceeds will be subject to FIRPTA withholding. 70 An application for a withholding certificate, if approved, generally should allow for a reduced withholding of 10% (or less, as determined by the Service) on each installment payment. 71 FIRPTA WITHHOLDING While FIRPTA tax liability applies only to sales of USRPIs by nonresident aliens and foreign corporations, the Section 1445 withholding mechanism is broader in scope. Thus, FIRPTA withholding applies to any disposition of a USRPI by a foreign person, which Section 1445(f)(3) defines as any person other than a U.S. person. Under Section 7701(a)(4), a U.S. person includes a domestic partnership, which is one created or organized in the U.S. or under the laws of the U.S. or any state. 72 Thus, a

14 partnership created or organized abroad is a foreign partnership regardless of where it does business or the identity of its partners. 73 A foreign trust any trust other than a U.S. trust disposing of a USRPI also is subject to the withholding mechanism. Under Section 7701(a)(30)(E), a trust is a U.S. trust if a U.S. court is able to exercise primary supervision over its administration, and one or more U.S. persons have the authority to control all substantial decisions of the trust. As a general rule, Section 1445(a) imposes the FIRPTA withholding obligation on the purchaser or transferee of the property. The transferee is required to deduct and withhold 10% of the amount realized on the transfer not simply the gain from the sale. The result is that a sale at a loss potentially triggers withholding responsibilities, although a mechanism exists to alleviate that problem (as discussed below). The transferee also is required to report the transfer to the IRS on the various versions of Form 8288, and to remit the amount withheld within 20 days of the date of the transfer. 74 Failure to comply with the withholding obligation will result in the transferee s being liable for the withholding tax, including interest and penalties. 75 If the tax eventually is paid by the transferor, the transferee is still liable for interest on the amount not timely withheld. 76 The withholding obligation does not absolve the foreign transferor from having to file a return with the IRS and to report any additional taxes. The amount withheld is counted as a credit against the transferor s tax liability. 77 If the amount withheld exceeds the transferor s actual tax liability, a return should be filed to obtain a refund. The transferee is not required to withhold if an exemption from withholding exists. Proof of exemption generally is required to be submitted to the transferee in the form of an affidavit or other statement made under penalties of perjury; the statement is required to be reported to the IRS as well. The transferee generally may rely on such a certificate unless there is actual knowledge or the transferee receives a notice that it is false. 78 The major reasons for exemption are: (1) The transferor is not a foreign person 79 and certifies so under penalties of perjury 80 (this exemption includes a foreign corporation that made a Section 897(i) election to be treated as a domestic corporation 81 ). (2) The interest transferred is not a USRPI. 82 (3) The interest is stock in a U.S. corporation and the corporation is either not a USRPHC 83 in the required testing period or its stock is publicly traded and less than 5% of its stock is acquired in the transfer. 84 (4) The transaction is for a purchase of a personal residence for $300,000 or less. 85 (5) The transfer is a nonrecognition transfer and the transferor provides notice of such nonrecognition transfer to the transferee and the IRS. 86 (6) The transfer involves an acquisition by a U.S. governmental body

15 (7) The amount realized is zero. 88 (8) A withholding certificate is issued by the Service which either reduces or eliminates the withholding obligation, as discussed further below. 89 Effect of application. The 10% withholding obligation on the gross proceeds of the sale is, in many instances, much higher than the actual tax liability imposed on the gain realized on the sale. The problem becomes greater if the real estate is sold at a loss as the withholding obligation looks to the amount received, not to any gain or loss realized on the sale. One major administrative tool that assists investors in eliminating overwithholding is an application for a withholding certificate. As noted above, the purchaser of a USRPI normally must withhold 10% of the amount realized on the transfer and remit and report it within 20 days of the date of transfer. One of the main advantages of a good-faith withholding certificate application is that it postpones the transferee s obligation to remit and report the amount withheld from 20 days after the date of transfer to 20 days after the date the Service mails either a copy of the withholding certificate or notice of denial to the transferee. 90 The postponement of the withholding obligation is available only if the application is submitted by the date of transfer that may give rise to withholding, and on the date of transfer the application is still pending with the Service. 91 The transferee can put the withheld amount in escrow and allow it to earn interest until either the withholding certificate is issued or the correct amount to be withheld is determined by the Service. IRS procedures. The Service recently updated its procedures for obtaining withholding certificates and the basis on which they will be granted. Rev. Proc , CB 211, provides guidance with respect to applications for withholding certificates. It supersedes Rev. Proc , CB 787, and is effective for all applications submitted after 9/27/00. Pursuant to the updated rules, a withholding certificate generally may be issued when the application is based on one of three grounds: (1) Reduced withholding is appropriate, either because the normal FIRPTA withholding amount exceeds the tax liability on the transaction or withholding at a reduced rate would not otherwise jeopardize the collection of tax. (2) The gain realized by the transferor is exempt from U.S. tax. (3) The transferor or the transferee enters into an agreement providing for payment of the tax, providing security for the tax liability. 92 The IRS generally will act on an application within 90 days after receiving all of the information necessary to a determination, unless the application is based on unusual circumstances or is unusually complicated. In those circumstances, the Service will notify the applicant within 45 days of its receipt of all of the information necessary to a determination that additional processing time will be needed, and will provide a target

16 date for final action (contingent on timely submission by the applicant of any other necessary information). PARTNERSHIP vs. REIT INVESTMENTS Foreign persons investing in a limited partnership or LLC that owns U.S. real estate generally will be required to file annual U.S. tax returns and pay tax each year on their allocable share of the taxable income of the entity. 93 State and local tax filings also may have to be made and corresponding additional tax liability may result. In addition, the partnership itself is subject to an additional U.S. withholding tax regime designed to make sure that the federal income tax associated with that foreign investor s allocable share of the partnership s effectively connected taxable income is withheld by the partnership and remitted to the IRS. Withholding is generally required regardless of whether any current distributions are made to the partners. 94 This partnership withholding regime can be especially difficult on both the partnership and the foreign partner where the partnership may have phantom income. One example is a workout situation where cancellation of indebtedness income may be generated under Section 108 and no exception from income recognition is available; the lack of available cash to meet the withholding obligation is no excuse not to withhold. 95 Apart from the foregoing, as noted earlier, the sale of an interest in a partnership that principally holds real estate generally will attract tax under FIRPTA. In certain circumstances, foreign investors may find a real estate investment trust (REIT) is preferable to investing in a partnership or LLC holding U.S. real estate. A REIT is a corporation or trust whose predominant assets comprise equity and debt investments in real estate, and which satisfies certain highly technical requirements found in Section 856. The special REIT requirements add large compliance costs, in both time and money, and also can restrict what the REIT can do (potentially undercut the entity s usefulness). Nonetheless, a principal advantage of REIT status is the elimination of any entity-level tax, assuming the REIT timely distributes all its earnings to its shareholders as dividends and complies with certain other rules. Dividends paid by the REIT to its shareholders are either ordinary dividends that reflect a distribution of profits from operations or capital gain dividends that reflect distributions of capital gains realized from a sale of underlying REIT investments. The investors then pay tax on the REIT s earnings, with U.S. individual investors getting the benefit of being able to pay tax on the capital gains dividends at favorable capital gains rate. The REIT is also advantageous to its investors because it affords limited liability protection as well as potentially far greater liquidity than that afforded by a limited partnership or LLC. A significant advantage of the REIT for foreign investors is that investment in a REIT does not cause the foreign investor to be engaged in a U.S. trade or business with respect to the entity s operating income, unlike an investment in a partnership or LLC. The investor thus avoids the necessity of having to file annual income tax returns. In addition,

17 although a REIT generally would be considered a USRPHC due to the nature of its required real estate investments, no FIRPTA tax is imposed on a sale of REIT shares if the REIT is publicly traded and the investor holds less than a 5% interest in the REIT. More important, even if the REIT stock is not eligible for that exclusion, a special FIRPTA exception exists for a domestically controlled REIT. This is a REIT in which, at all times during the testing period, less than 50% in value of the stock was held directly or indirectly by foreign persons. 96 Thus, unlike a similarly situated partnership, it may be possible to sell REIT shares without the FIRPTA tax taint. While the REIT therefore may appear to be a more advantageous investment vehicle than a partnership, the treatment of REIT capital gains dividends and ordinary dividends must be further explored before any conclusions can be drawn. The REIT dividend issue. Under Section 897(h), capital gain dividends paid by a REIT to a foreign investor that are attributable to gain from sales or exchanges of USRPIs held by the REIT are treated as gain recognized by the foreign investor from the sale or exchange of a USRPI. As a result, such gain is fully taxable to the investor. Moreover, Reg (c)(2)(i) provides that these capital gain dividends will be subject to withholding at a 35% rate. 97 The Regulation adds that the amount treated as a capital gain dividend will be the highest amount that could be so designated regardless of the amount actually designated. If the tax withheld exceeds the investor s actual tax liability, the investor could file a tax return to take advantage of lower tax rates that will apply. This would negate some of the benefits of investing in a REIT, however. Thus, the treatment of capital gains dividends does not afford an advantage to the use of the REIT as compared with a partnership. REITs are allowed to retain capital gains received during the year, but at the cost of having to pay income tax on those gains. 98 If a REIT makes this election, the REIT shareholders must include in their income as long-term capital gains their proportionate share of the undistributed long-term capital gains as designated by the REIT. Each shareholder would be deemed to have paid the shareholder s share of the tax paid by the REIT, which would be credited or refunded to the shareholder when the shareholder files its return. The shareholder s basis in his shares would be increased by the long-term capital gains less the tax paid by the REIT included in the shareholder s income. As a result, shareholders should not be subject to a second-level withholding tax when those amounts are actually distributed. The withholding Regulations under Section 1445 have not yet been amended to confirm this conclusion. The REIT is required to withhold a 30% tax on any ordinary dividends paid to foreign investors. U.S. tax treaties typically reduce the withholding tax imposed on dividends paid by U.S. corporations to foreign investors. For example, Article 10(2) of the U.S.- Netherlands Income Tax Treaty reduces the withholding tax paid on most portfolio stock investments to 15%. If a treaty rate could be applied, the investor may be in a lower tax situation for ordinary dividends than otherwise would exist if the investor invested in a partnership and was subject to regular tax rates that can go as high as 39.6% for an individual

18 Prior to 1997, the U.S. had generally adopted a policy in its tax treaties that ordinary income distributions from a REIT were not eligible for the lower treaty rate on dividends but, rather, were subject to the full 30% withholding rate. As a result of concerns expressed by the REIT industry, in 1997 the U.S. formally announced a change in treaty policy with respect to REITs. 99 Under the revised policy, REIT dividends paid to a resident of a treaty country will be eligible for the reduced rate of withholding tax applicable to portfolio dividends (generally 15%) in two situations: (1) The lower withholding rate will apply if the treaty country resident beneficially holds an interest of 5% or less in each class of the REIT s stock and such dividends are paid with respect to a class of stock that is publicly traded. (2) The lower withholding rate will apply if the treaty country resident beneficially holds an interest of 10% or less in the REIT and the REIT is diversified, regardless of whether the stock of the REIT is publicly traded. 100 Certain recently negotiated treaties reflect this policy change but provide that the lower (15%) rate applies to dividends paid by a REIT only if the recipient is the beneficial owner of less than a 10% interest in the REIT. 101 Overall benefit? The REIT clearly offers some advantages to a foreign investor in potentially reducing the U.S. tax burden and U.S. reporting obligations. A careful review of the overall tax situation is needed, however, so as to determine whether investing in an entity that itself is subject to special and complicated tax requirements of its own is truly beneficial. While not typically done by a REIT, a special rule applies to distributions of USRPIs by domestically controlled REITs. Such distributions are treated as if the USRPI was distributed by a foreign corporation, requiring the domestically controlled REIT to recognize gain on the distribution of the USRPI as if the USRPI were sold by a foreign corporation, to the extent of the foreign ownership percentage of any gain. 102 Foreign ownership percentage means that percentage of the stock of the REIT which was held, directly or indirectly, by foreign persons at any time during the applicable test period during which the direct and indirect ownership of stock by foreign persons was the greatest. 103 The testing period is the shorter of (1) the five-year period ending on the date of the disposition or the distribution, or (2) the period during which the REIT was in existence. 104 The result is somewhat harsh although the domestically controlled REIT will be taxed only on the foreign ownership percentage of the gain, the burden of such taxation is borne by all shareholders, not only the foreign shareholders

19 POSSIBLE INVESTMENT STRUCTURES The foreign investor choosing to acquire, for example, a vacation home, incomeproducing property, or raw land as an investment has several options to choose from. For purposes of simplification, these options are discussed below in the context of an individual investor. Individual Direct Investment An individual could simply choose to own the U.S. real estate investment in her own name. Alternatively, the individual could own such property through a single-member LLC so as to attain liability insulation while maintaining direct ownership for tax purposes (absent any elections to the contrary). 105 This structure does not come burdened with the many different entities that potentially accompany the other approaches discussed below. As a result, foreign investors who would prefer a simple structure may view this approach most favorably. This approach also is helpful on a disposition of the real estate; only one level of tax will be imposed. Furthermore, the investor can take advantage of favorable individual capital gains tax rates that can further lower her inevitable U.S. tax bill. The direct holding structure has several disadvantages, however. First, the investor will have U.S. estate and gift tax exposure, which can lead to a very significant tax bill at death or on making a gift. Second, the investor s presence in the U.S. will be known; that investor will not have the cloak of anonymity that many foreign investors prefer. Third, the investor will have to file annual income tax returns with respect to income-producing property. Even if the property does not produce income, an ultimate sale of the property will necessitate the need to file a tax return. This factor may discourage many foreign investors due to the complexity of the filing, the fear of possible added tax burdens, and the concern that U.S. tax authorities may be too invasive in their inquiries into private matters and too communicative. U.S. Corporation A U.S. corporation owned by a nonresident alien individual would give that person a liability shield, the reason some investors may choose to operate in such manner. 106 In addition, the corporation becomes a separate taxpayer, which eliminates the need for the individual to file annual U.S. federal as well as state and local tax returns. This structure has its own disadvantages that may undercut the usefulness of this structure: (1) The investor still will have U.S. federal estate tax liability 107 (no U.S. federal gift tax liability should result from a lifetime gift of the stock in the U.S. company, however)

20 (2) Two levels of tax may be imposed on the corporation s income (assuming it will be repatriated back to the individual). A corporate-level tax will be imposed, as will a 30% withholding tax on dividends paid to the investor. This withholding rate could be reduced to as low as 5%, however, by a tax treaty between the country in which the investor is a resident and the U.S. 108 Moreover, many times dividends from operations are not even anticipated if available cash flow is used in whole or substantial part for debt service; if the real estate is then sold in a fully taxable transaction, all debt is paid down with a portion of the sales proceeds and the company then adopts a plan of liquidation and distributes the remaining proceeds as a liquidating distribution, which can be paid free of any U.S. withholding tax. (3) The shield of anonymity that the investor may desire is not total. The U.S. tax return filed by the corporation requires the corporation to disclose the name, address, and taxpayer identification number of any person who owns 50% or more of the company s stock. 109 Foreign Corporation As with the use of a U.S. corporation to hold the real estate, the use of a foreign corporation to hold the real estate gives the nonresident alien investor the shield of limited liability. Moreover, the investor also does not have to file a U.S. tax return; the corporation will do so if it is engaged in a U.S. trade or business or sells the realty. Nevertheless, it is necessary to examine whether this structure is better than using a U.S. corporation to hold the real estate. First, neither U.S. gift nor estate tax will apply to a lifetime gift or testamentary transfer of the stock in the foreign corporation. Second, there is no U.S. withholding tax imposed on dividends paid by a foreign corporation to its shareholder even where the corporation s only activities are in the U.S. In its place, however, is imposed the 30% BPT on the foreign corporation s dividend equivalent amount, as discussed above. 110 While the BPT was designed to be a surrogate for the 30% passive income tax that applies to dividends paid by U.S. corporations to foreign shareholders, the BPT sometimes can be more onerous. 111 Thus, its impact can make the use of a foreign corporation both more complicated and more costly. Third, the shield of anonymity that the investor may desire is not total. As with a U.S. corporate taxpayer, the U.S. tax return filed by the foreign corporation also requires the foreign corporation to disclose the name, address, and taxpayer identification number of any person who owns more than 50% of the corporation s stock. 112 Fourth, if the property were to be refinanced, a distribution of the refinancing proceeds to the shareholder would not attract either a dividend withholding tax or the BPT. This may

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