New Modifications to FIRPTA Tax Insights from International Tax Services

Tax Insights
from International Tax Services
New Modifications to FIRPTA
December 23, 2015
In brief
On December 18, 2015, President Obama signed into law legislation (H.R. 2029, herein ’the PATH Act’))
that, in part, modifies the application of the Foreign Investment in Real Property Tax Act (commonly
referred to as FIRPTA). The PATH Act: (i) exempts certain foreign retirement funds from the application
of FIRPTA, (ii) increases the general rate of withholding on dispositions of US Real Property Interests
from 10% to 15%, (iii) increases the amount of stock a foreign person may own in a publicly traded real
estate investment trust (REIT) from 5% to 10%, (iv) adds a new exception for qualified shareholders in
REITs, and (v) modifies the ‘cleansing rule’ and the definition of a ’domestically controlled’ qualified
investment entity.
In detail
Modifications to rules
applicable to investments in
REITs and RICs
In general, gain or loss from the
disposition of a US real property
interest (USRPI) by a foreign
person is treated as if the gain or
loss were effectively connected
with the conduct of a US trade
or business and, accordingly, is
subject to US net income
taxation. Additionally, Section
1445 provides rules for
determining the withholding tax
applicable to dispositions of a
USRPI. Specifically, in the case
of a disposition of a USRPI by a
foreign person, the transferee is
required to deduct and withhold
a tax equal to 10% of the
amount realized on the
disposition.
Pursuant to Section 897(h)(2), a
disposition of an interest in a
REIT is not subject to US
federal income tax if the REIT is
considered domestically
controlled. A similar rule
applied to regulated investment
companies (RICs) for taxable
years ended December 31, 2014.
According to the Joint
Committee on Taxation
Explanation, Section 133 of the
PATH Act is intended to
permanently extend this rule to
RICs (the legislation contains a
typo). This provision is effective
on January 1, 2015. Unless
otherwise noted, REITs and
RICs are referred to collectively
as qualified investment entities
(QIEs). In order for a QIE to be
considered domestically
controlled, less than 50% of the
value of the QIE must be held
directly or indirectly by foreign
persons during the testing
period (the ’Domestically
Controlled Exception’). That is,
an interest in a domestically
controlled QIE is not considered
a USRPI. However, any
distributions from a
domestically controlled QIE
may still be subject to US
federal income tax under
Section 897(d).
Additionally, special rules apply
to the extent that a QIE makes a
distribution to its foreign
shareholder and the distribution
is attributable to gain from the
sale or exchange of a USRPI.
The foreign shareholder is
treated as though it sold the
USRPI directly unless the
distribution is from a publicly
traded QIE and the foreign
shareholder did not own more
than 5% during the one-year
period ending on the date of the
distribution (the ‘Publicly
Traded QIE Exception’).
Further, an interest in a publicly
traded USRPHC is not a USRPI
if the foreign person did not
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Tax Insights
own more than 5% (directly or
indirectly) during the shorter of the
ownership period or the five-year
period ending on the date of
disposition (the ’Publicly Traded
USRPHC Exception’).
which it is established or
operates,
i.
contributions to such
organization or arrangement
that would otherwise be
subject to tax under such laws
are deductible or excluded
from the gross income of such
entity or taxed at a reduced
rate, or
ii.
taxation of any investment
income of such organization
or arrangement is deferred or
such income is taxed at a
reduced rate.
Description of legislation
New exception for foreign pension
funds and retirement plans
In general, FIRPTA (i.e., Sections 897
and 1445) will not apply to any USRPI
held directly or indirectly through one
or more partnerships, or to any
distribution received from a REIT, by
a qualified foreign pension fund or
any entity all of the interests of which
are held by a qualified foreign pension
fund. A qualified foreign pension
fund is defined as any trust,
corporation, or other organization or
arrangement:
a) which is created or organized
under the law of a country
other than the United States,
b) which is established to provide
retirement or pension benefits
to participants or beneficiaries
that are current or former
employees (or persons
designated by such employees)
of one or more employers in
consideration for services
rendered,
c) which does not have a single
participant or beneficiary with
a right to more than five
percent of its assets or income,
d) which is subject to government
regulation and provides annual
information reporting about its
beneficiaries to the relevant
tax authorities in the country
in which it is established or
operates, and
e) with respect to which, under
the laws of the country in
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The Secretary is authorized to
prescribe regulations as may be
necessary to carry out the purposes of
this section. Although this new
exception is viewed by many as a
mechanism to increase foreign
investment in the United States, due
to the various requirements, foreign
pension funds will need to carefully
consider whether they are eligible for
this new exception. Additionally,
although the Path Act indicates that
withholding is not required, the
statute does not create a mechanism
for the withholding agent to know that
it does not have a withholding
obligation.
Notably, the President’s FY 2016
Budget included a similar exception.
However, the President’s budget only
required that the pension fund be
generally exempt from income tax in
the jurisdiction in which it is created
or organized and that substantially all
of the activity is administering or
providing pension or retirement
benefits. Further, the new law only
indicates that Sections 897 and 1445
will not apply to USRPIs held by the
qualified foreign pension funds. That
is, foreign pension funds will still need
to consider other applicable
provisions (i.e., Sections 892, 864,
etc.).
Increased withholding tax
Generally, any disposition of a USRPI
is subject to a withholding tax equal to
10% of the amount realized. The
PATH Act increases the withholding
tax to 15%. The increase would not
apply to the sale of personal
residences with respect to which the
purchase price does not exceed $1
million. The increased withholding
tax applies to dispositions 60 days
after the date of enactment.
Publicly traded REITs
The PATH Act increases the amount
of stock a foreign person may own
under the Publicly Traded USRPHC
Exception from 5% to 10% solely for
publicly traded REITs (i.e., the
proposal does not increase the
percentage for publicly traded nonREITs that are USRPHCs). As noted
above, the Publicly Traded USRPHC
Exception applies to the sale of stock.
Additionally, the foreign ownership
percentage is increased from 5% to
10% with respect to the Publicly
Traded QIE Exception solely for
publicly traded REITs (not RICs). The
Publicly Traded QIE Exception
applies to distributions from a QIE
(i.e., not a sale of the REIT). In
addition, any distribution from a
publicly traded REIT to a less than
10% foreign shareholder would be
treated as a dividend rather than
effectively connected income (ECI)
and would be subject to US federal
income tax under Sections 871 or 881,
which can be reduced under a US
income tax treaty to the extent the
foreign shareholder is eligible for the
benefits of such treaty. Importantly,
most US income tax treaties have
additional requirements in order to
receive a reduced rate of tax with
respect to dividends from REITs.
The increased ownership percentages
are effective for dispositions on or
after the date of enactment.
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New exception for qualified
shareholders
The legislation adds a new USRPI
exception for stock held in a REIT by
‘qualified shareholders’ (defined
immediately below). Stock of a REIT
that is held by a qualified shareholder
is not a USRPI unless there is an
investor in the qualified shareholder
(other than an investor that is a
qualified shareholder) who holds
directly or indirectly (by applying the
attribution rules of Section
897(c)(6)(C)) more than 10% of the
stock of such REIT (referred to as an
‘applicable investor’). Distributions to
a qualified shareholder by a REIT are
not treated as gain from the sale or
exchange of a USRPI and
distributions by a REIT to a qualified
shareholder that are treated as a sale
or exchange of the REIT stock by
reason of Sections 301(c)(3), 302, or
331 are treated as dividends under
section 857(b)(3)(F). However, to the
extent there is an applicable investor
in the qualified shareholder, a
percentage of the REIT stock is
treated as a USRPI. Thus,
distributions from the REIT that are
attributable to the sale or exchange of
a USRPI are treated as ECI in the
hands of the qualified shareholder.
Similarly, distributions under Sections
301(c)(3), 302, or 331 are also treated
as the sale or exchange of a USRPI.
The amount treated as ECI is based on
the applicable investor’s percentage
ownership in the qualified
shareholder multiplied by the
disposition proceeds and REIT
distribution proceeds attributable to
the underlying USRPI gain.
A qualified shareholder is defined as
an entity that is:
i.
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eligible for the benefits of a
comprehensive income tax
treaty which includes an
exchange of information
program and the principal
class of interests is listed and
regularly traded on one or
more recognized stock
exchanges (as defined in such
comprehensive income tax
treaty), or
a foreign partnership that is
organized under foreign law
as a limited partnership in a
jurisdiction that has an
agreement for the exchange of
information with respect to
taxes with the United States
and has a class of limited
partnership units which is
regularly traded on the NYSE
or the Nasdaq and the class of
limited partnership units
value is greater than 50% of
the value of all partnership
units,
ii.
is a qualified investment
vehicle, and
iii.
maintains records on the
identity of each person who,
at any time during the
qualified shareholder’s
taxable year, is the direct
owner of more than 5% of the
class of interests described
above.
A qualified investment vehicle is a
foreign person:
i.
which would be eligible for a
reduced rate of withholding
under the comprehensive
income tax treaty even if such
entity holds more than 10% of
the stock of such REIT,
ii.
is a publicly traded
partnership as defined under
Section 7704(b), is a
withholding foreign
partnership for purposes of
chapters 3 (i.e., Section 1441
withholding), 4 (i.e., FATCA),
and 61, and if such foreign
partnership were a US
corporation would be treated
as a USRPHC at any time
during the five-year period
ending on the date of
disposition of, or distribution
to, such partnership’s interest
in a REIT, or
iii.
is designated as such by the
Secretary of the Treasury and
is either fiscally transparent
within the meaning of Section
894, or required to include
dividends in its gross income,
but is entitled to a deduction
for distributions to its
investors.
Accordingly, in order for this new
exception to apply to foreign
corporations, the REIT stock must be
held by a foreign entity that: (i) is
eligible for a reduced rate of
withholding tax even if it holds more
than a 10% interest in the REIT, (ii)
and is eligible for the benefits of a US
income tax treaty under the publicly
traded rule of the limitation on
benefits article, and (iii) there is no
owner in the foreign entity that owns
more than 10% of the REIT either
directly or indirectly, and (iv) the
foreign entity maintains ownership
records.
Notably, in order to receive a reduced
withholding rate on dividends paid by
a REIT, most US income tax treaties
require that the entity receiving the
dividend hold less than 10% in the
REIT. In order to receive the new
USRPI exception, the qualified
shareholder must be entitled to a
reduced rate of tax even if the entity
holds more than 10% of the REIT. For
example, Article 10(d) of the USAustralia Treaty provides that the 10%
ownership threshold does not apply to
listed Australian property trusts
(LAPTs). Thus, the LAPTs’ interest in
the REIT would not be a USRPI as
long as the investors in the LAPT held
less than 10% of the REIT directly and
indirectly. (If an investor owns 5% or
more in the LAPT then such owner is
treated as owning the REIT directly
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under the treaty). The USNetherlands Treaty provides a similar
exception if the beneficial owner is a
Dutch ‘beleggingsinstelling’ (the
Dutch equivalent of a REIT). As most
US income tax treaties require the
beneficial owner of the dividend to
hold less than 10% in the REIT, this
new exception would appear to be
quite limited in its application.
Alternatively, a foreign publicly traded
partnership may be treated as a
qualified shareholder if: (i) it has
entered into an agreement with the
IRS to be treated as a withholding
foreign partnership, (ii) it is organized
as a foreign partnership (i.e., an entity
cannot make an election to be treated
as a partnership for US federal tax
purposes) and treated as a
partnership for purposes of section
7704; (iii) it has a class of limited
partnership units that are regularly on
either the NYSE or the NASDAQ and
the value of such units is greater than
the value of all other partnership
units; and (iv) it would be treated as a
USRPHC if it was a US corporation.
Notably, the exception for publicly
traded partnerships does not require
that the partnership be organized in a
jurisdiction with which the United
States has an income tax treaty. The
exception only requires that the
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foreign partnership be organized in a
jurisdiction that has entered into an
exchange of information agreement
with the United States. Thus, this
may create opportunities for publicly
traded partnerships that hold a
significant amount of US real estate
that are organized in non-treaty
jurisdictions.
the lower-tier QIE will be treated as
held by a foreign person unless the
upper-tier QIE is domestically
controlled.
However, the PATH Act adds a layer
of complexity with respect to
partnership allocations for applicable
investors. It would appear that these
allocation rules were intended to
ensure that partners who are
applicable investors in a publicly
traded partnership that is a qualified
shareholder pick up their fair share of
USRPI gain.
If a USRPHC disposes of all of its
USRPIs in taxable transactions within
a five-year period preceding the date
of disposition, the stock interest
ceases to be a USRPI. The law
modifies the cleansing rule by
specifying that it does not apply to any
corporation that was a RIC or a REIT
at any time during the shorter of the
ownership period or the five-year
period ending on the date of
disposition of the stock. This revision
is effective on date of enactment.
The qualified shareholder exception is
effective on the date of enactment and
applies to any disposition on or after
the date of enactment.
Revisions to domestically controlled
exception
The law allows a publicly traded QIE
to presume that stock held by less
than 5% shareholders is held by a US
person (during the prescribed testing
period) unless the QIE has actual
knowledge to the contrary.
Additionally, if stock in a QIE is held
by a publicly traded QIE, the stock in
The determination for domestic
control is effective on the date of
enactment.
Cleansing rule modifications
The takeaway
Foreign investors should be aware of
the new qualified shareholder
exception, the increase from 5% to
10% for interests in publicly traded
REITs, the increased rate of
withholding on dispositions and the
new exception for qualified foreign
pension funds.
See also House approves major tax
extender package
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Let’s talk
For a deeper discussion of how this might affect your business, please contact:
International Tax Services
Bernard Moens
(202) 414-4302
[email protected]
Oren Penn
(202) 414-4393
[email protected]
Steve Nauheim
(202) 414-1524
[email protected]
Alexandra Helou
(202) 346-5169
[email protected]
Eileen Scott
(202) 414-1017
[email protected]
Susan Conklin
(202) 312-7787
[email protected]
Ilene Fine
(202) 346-5187
[email protected]
Nita Asher
202-312-7513
[email protected]
Nils Cousin
(202) 414-1874
[email protected]
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