US IRS and Treasury amend FIRPTA regulations to reflect PATH Act

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1 23 February 2016 International Tax Alert US IRS and Treasury amend FIRPTA regulations to reflect PATH Act EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Executive summary On 17 February 2016, the US Internal Revenue Service (IRS) and the US Department of the Treasury issued final and temporary regulations (T.D. 9751) on the taxation and withholding to which foreign persons are subject on certain dispositions of, and distributions with respect to, US real property interests (USRPIs) under Sections 897 and 1445 (the New FIRPTA Regulations). These regulations largely reflect modifications to Sections 897 and 1445 made by the Protecting Americans from Tax Hikes Act (the PATH Act). See US enacts legislation with implications for certain foreign pension funds and FIRPTA. In particular, the New FIRPTA Regulations include the following changes: The withholding tax rules under Treas. Reg. Section (b) are amended to not require withholding under Section 1445(a) on qualified foreign pension funds as defined by new Section 897(l) or entities wholly owned by such funds. The withholding tax rates contained in the regulations addressing Section 1445(a) and (e) are updated to reflect general increases in such rates from 10% to 15%. The IRS s mailing address for certain notices, certificates, statements and elections is updated to conform to current IRS administrative practice. The US real property holding company (USRPHC) cleansing exception described in the existing regulations is modified to reflect that certain former real estate investment trusts (REITs) or regulated investment companies (RICs) are no longer eligible for the exception.

2 2 International Tax Alert Detailed discussion A. Background and the PATH Act The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) enacted Section 897, which generally characterizes gain a nonresident alien individual or foreign corporation derives from the sale of a USRPI as US-source income effectively connected with a trade or business in the United States that is taxable to a nonresident alien individual under Section 871(b)(1) and to a foreign corporation under Section 882(a)(1). The PATH Act (P.L ), signed by President Obama on 18 December 2015, made changes to FIRPTA designed to increase foreign capital investment in USRPIs by, among other things, creating a new exception to Section 897 for USRPIs held by qualified foreign pension funds. Specifically, new Section 897(l) exempts from Section 897 a USRPI held directly (or indirectly through one or more partnerships) by a qualified foreign pension fund or an entity all of whose interests are held by a qualified foreign pension fund. Section 897 also provides that a USRPI includes an interest (other than an interest solely as a creditor) in a domestic corporation that is treated as a USRPHC. Historically, a domestic corporation could cleanse itself of the USRPHC taint by disposing of all of the USRPIs that it held during the testing period described under Section 897(c)(1)(A)(ii) in fully taxable transactions. The PATH Act, however, amends this cleansing exception by providing that the exception will not apply to a corporation if it or its predecessor was a REIT or RIC during the testing period. Section 1445 complements Section 897 by generally imposing a withholding tax in transactions related to the disposition of USRPIs by foreign persons. Section 323(b) of the PATH Act also amended Section 1445 by changing the definition of foreign person in Section 1445(f)(3) to exclude from such definition (unless otherwise provided by the Treasury) qualified foreign pension funds or entities wholly owned by such funds. In addition, Section 324(a) of the PATH Act generally increased the withholding tax rate imposed by Section 1445(a) on dispositions of USRPIs by foreign persons from 10% to 15%. Similarly, it increased the withholding tax rate imposed by Section 1445(e) from 10% to 15% on: (a) certain distributions from USRPHCs to foreign persons; (b) certain distributions by partnerships, trusts, or estates of USRPIs to foreign person; and (c) certain dispositions of interests in partnership, trusts, or estates. B. Withholding exception for qualified foreign pension funds Treas. Reg. Section outlines situations in which withholding is not required under Section 1445(a). One such exception applies when the transferor of the applicable USRPI is not a foreign person. Under this exception, withholding tax may be avoided if the transferor of a USRPI provides a certificate to the transferee stating that the transferor is not a foreign person. The New FIRPTA Regulations clarify that, for purposes of Section 1445 and consistent with the PATH Act amendments to Section 1445(f)(3), a foreign person does not include a qualified foreign pension fund or an entity all of whose interests are held by such a fund. Thus, the New FIRPTA Regulations clarify that a qualified foreign pension fund or an entity wholly owned by such a fund may avoid withholding tax under Section 1445(a) by providing a certificate that such fund or entity is not a foreign person. C. Section 1445 withholding rate changes As noted previously, the PATH Act increased the withholding tax rates under Section 1445(a), (e)(3), (e)(4), and (e)(5) from 10% to 15%. The New FIRPTA Regulations amend the existing regulations to reflect this rate change throughout each of the relevant regulatory provisions. 1 The New FIRPTA Regulations also reflect the PATH Act s retention of the 10% withholding tax rate for a disposition of property that is acquired by the transferee for his or her use as a residence for which the amount realized is between $300,000 and $1 million. D. Address change Prior to the New FIRPTA Regulations, the existing regulations generally stated that taxpayers were to send the various notices, certificates, statements and elections related to Sections 897 and 1445 to the IRS Philadelphia Service Center. Since issuing the existing regulations, the IRS had changed its administrative practice to have these items sent to the Ogden Service Center. To reflect this change, the New FIRPTA Regulations amend the existing regulations by updating the mailing address used for these items to the address listed in the Where to File instructions for Form 8288, US Withholding Tax Return for Dispositions by Foreign Persons of US Real Property Interests. 2 The mailing address listed in the instructions to that form is currently: Ogden Service Center P.O. Box Ogden, UT 84409

3 International Tax Alert 3 E. USRPHC cleansing exception modification Section 325 of the PATH Act states that the cleansing exception will not apply if the corporation or its predecessor was a REIT or a RIC during the testing period described under Section 897(c)(1)(A)(ii). The New FIRPTA Regulations adopt this change in the regulatory description of the cleansing exception contained in Treas. Reg. Section (f)(2). F. Effective dates The following effective dates apply to the provisions in the New FIRPTA Regulations: The new definition of a foreign person under Treas. Reg. Section (b), which excludes qualified foreign pension funds or entities wholly owned by such funds, applies to dispositions and distributions occurring after 18 December The changes to the withholding tax rates from 10% to 15% to reflect the changes in such rates under Section 1445(a) and (e) apply to dispositions after 16 February The updates to the applicable mailing address, although already used in practice, formally apply beginning 20 February 2016, but the IRS will not assert penalties for the failure to use this mailing address before 21 June The change excluding certain REITs and RICs from the cleansing exception for USRPHCs applies to dispositions of USRPIs occurring on or after 18 December Implications The modifications contained in the New FIRPTA Regulations generally reflect certain changes to Sections 897 and 1445 made by the PATH Act. Although most of the provisions in the New FIRPTA Regulations merely conform the existing regulations to the PATH Act, these regulations contain an important change to the definition of a foreign person under Treas. Reg. Section (b). In particular, this revised definition clarifies that qualified foreign pension funds or entities wholly owned by such funds may avoid withholding under Section 1445(a) because they are not foreign persons. With publication of the New FIRPTA Regulations, the IRS and Treasury have taken care of the immediate administrative tasks relating to the PATH Act. They now have to consider substantive guidance for the new law, and did ask for comments on what regulations, if any, should be issued under Section 897(l)(3) (regulations as may be necessary or appropriate to carry out the exception for interests held by foreign pension funds). Endnotes 1. The updated withholding tax rates are reflect in the following: Treas. Reg. Sections (a), (b)(4)(iii), (c)(2)(i)(a), (c)(2)(i)(b); (b)(4)(iv), (c)(3)(iii), (d)(3)(i)(a), (d)(3)(i)(b); (c)(1); (c)(3)(iv), (e)(1). 2. The updated Service Center address is reflect in the following: Treas. Reg. Sections (h)(2)(v), (h)(4)(ii); (c); (d)(1), (f)(1); (d)(2)(i)(B); (b)(1), (f)(1), (f)(2)(iii), (g); (c)(2); (b)(2)(ii), (c)(3) (v); (f)(2)(iii); (f)(1), (f)(2)(iii), (g).

4 4 International Tax Alert For additional information with respect to this Alert, please contact the following: Ernst & Young LLP, International Tax Services, Washington, DC Lilo Hester Heather Gorman Ernst & Young LLP, International Tax Services, New York Harry Shannon Ernst & Young LLP, International Tax Services, Chicago Gunnar Haugen International Tax Services Global ITS, Alex Postma, Tokyo ITS Director, Americas, Jeffrey Michalak, Detroit Ernst & Young LLP, National Director of ITS Technical Services, Jose Murillo, Washington Member firm contacts, Ernst & Young LLP (US) Northeast Johnny Lindroos, McLean, VA Financial Services Chris J Housman, New York Central Mark Mukhtar, Detroit Southeast Scott Shell, Charlotte, NC Southwest Amy Ritchie, Austin West Beth Carr, San Jose, CA Canada Ernst & Young LLP (Canada) Albert Anelli, Montreal Israel Kost Forer Gabbay & Kasierer (Israel) Sharon Shulman, Tel Aviv Mexico Mancera, S.C. (Mexico) Koen Van t Hek, Mexico City Central America Ernst & Young, S.A. Juan C Chavarria Pozuelo, San José South America Ernst & Young Serviços Tributários S.S. Gil F. Mendes, São Paulo

5 EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. About Ernst & Young s International Tax Services practices Our dedicated international tax professionals assist our clients with their cross-border tax structuring, planning, reporting and risk management. We work with you to build proactive and truly integrated global tax strategies that address the tax risks of today s businesses and achieve sustainable growth. It s how Ernst & Young makes a difference. International Tax Services 2016 EYGM Limited. All Rights Reserved. EYG no. CM NY ED None This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. ey.com