Tax Management International Journal

Transcription

1 Tax Management International Journal Reproduced with permission from Tax Management International Journal, 42 TMIJ 339, 06/14/2013. Copyright 2013 by The Bureau of National Affairs, Inc. ( ) Fixing FIRPTA? (Design Flaws Worsen with Age) by Peter A. Glicklich, Esq., and Megan J. Grandinetti, Esq. Davies Ward Phillips & Vineberg LLP New York, New York There exists everywhere a medium in things, determined by equilibrium. Dmitri Mendeleev, Creator of the Periodic Table of the Elements 1 U.S. Congressional Research Service, Foreign Direct Investment in the United States: An Economic Analysis, James K. Jackson (Oct. 26, 2012). INTRODUCTION According to data from the U.S. Department of Commerce, foreigners invested approximately $234 billion in U.S. businesses in 2011; of that, approximately $48.4 billion was invested in U.S. real estate. 1 Foreigners have various incentives to invest in U.S. real estate, including, on a macroeconomic level, a relatively stable currency, a relatively strong economy, a reliable infrastructure, and legal certainty. From 2007, commercial and residential real estate prices in the United States declined; however, prices have firmed recently, and lenders have been more willing to lend to real estate investors at historically low interest rates. Depreciation and interest deductions typically shelter much of the net operating income of a U.S. real estate investment, so tax is commonly deferred. In this way, U.S. real estate investments attract foreign investors with their potential for U.S. dollar-dominated returns, generally on a tax deferred basis. 2 Since its enactment, the Foreign Investment in Real Property Tax Act of 1980 (as amended, FIRPTA ) 3 has played a large role in the lives of tax advisors and a somewhat smaller role in the lives of their clients. In its initial proposed form, FIRPTA was designed to close certain U.S. tax loopholes and ensure that foreign investors would be taxable on dispositions of U.S. farmland. 4 As enacted (and subsequently amended), FIRPTA s objective grew to ensure that foreign investors in U.S. real property would pay at least one tax on gain from the disposition of any interest in U.S. real estate (and U.S. resource property). 5 Since its enactment, and particularly since addition of 2 Foreign investors may nevertheless be subject to estate tax on the U.S. real estate investment unless such investment is exempt (e.g., because the real estate is held through a foreign corporation). See Unless indicated otherwise, all section or references in this article are to the Internal Revenue Code of 1986, as amended (the Code ), or to the Treasury regulations promulgated thereunder. References to the IRS are to the Internal Revenue Service, and references to Treasury are to the U.S. Department of the Treasury. 3 Section 897 was enacted by the Omnibus Reconciliation Act of 1980, P.L , 1122(a) (1980). 4 See Joint Comm. on Tax n, Description of S. 192 and S. 208, Relating to Tax Treatment of Foreign Investment in the United States, at 3 (1979). 5 Amendments were made to 897 in 1981 to make clear the intent of Congress to tax dispositions of USRPIs by foreign inves Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 1

2 the FIRPTA-withholding regime to enforce it, 6 FIRPTA has indeed ensured collection of U.S. income tax upon direct, taxable dispositions of U.S. real estate by foreign corporations, nonresident alien individuals, foreign trusts, and foreign estates. FIRPTA has also served as a model for taxation of real estate held by foreign investors in other countries. 7 As enacted and amended over the years, however, FIRPTA has suffered from a major design flaw: FIRPTA has never effectively functioned to ensure that either: (1) only a single level of U.S. tax would be paid by foreign investors; or (2) every foreign investor would bear at least one level of tax on disposition of an indirectly held interest in U.S. real estate. The reason for this flaw is that FIRPTA does not, in all circumstances, properly take into account U.S. real estate investments held indirectly by foreign investors through entities, whether corporations or partnerships (as determined for U.S. tax purposes). Indeed, U.S. real estate is commonly held by foreign investors through one or more domestic or foreign blocker corporations to limit reporting, exposure to estate taxes, and similar tax and other non-tax concerns. The choice by foreigners to hold U.S. real estate through a blocker should be expected to continue as individual U.S. tax rates increase and a plethora of deductions remain available to offset taxable income at the blocker level. 8 This article considers whether from a micro level foreign investors, who commonly hold U.S. real estate through one or more corporations, ordinarily bear U.S. income tax upon their disposition of interests in a corporation or partnership that holds U.S. real estate among its assets. This article then considers how changes to FIRPTA might reach such structures better, either by ensuring one level of tax on indirect investments, or by taxing such indirect investments more consistently, regardless of whether the investment is held through a domestic or foreign blocker or domestic or foreign partnership. 9 Some of the proposed changes represent minor tweaks to the tors. Joint Comm. on Tax n, General Explanation of the Economic Recovery Tax Act of 1981, at 369 (1981). 6 Section 1445 was enacted as part of the Tax Reform Act of 1984, P.L , 129(a)(1) (1984), and was effective for dispositions after Jan. 1, This article does not generally include reference to the FIRPTA withholding rules, which commonly add to work of the transactional attorneys and annoy clients. 7 This is reflected in the Real Estate and/or Gain articles of U.S. income tax treaties, as well as in many other countries own internal laws. See, e.g., 116 of the Canadian Income Tax Act, discussed in note 28, below. 8 But see discussions of the personal holding company and accumulated earnings taxes, discussed at notes below. 9 It may be appropriate to provide exemption, in certain circumstances, under U.S. income tax treaties for example, exemption FIRPTA rules, some would require new legislation, and others would reflect major departures from the present legislation. BACKGROUND What Does FIRPTA Cover? FIRPTA generally taxes foreign investors on the disposition of directly held interests (other than an interest held solely as a creditor) in U.S. real property (USRPIs), including an interest in a U.S. real property holding corporation (USRHPC). 10 The definition of a USRPI is actually very broad, because it includes not only interests in real property located in the United States (or the Virgin Islands), but also contracts providing for the holder sharing in gross or net income from or appreciation in the value of U.S. real estate or natural resources in place, 11 as well as certain interests in pass-through entities, to the extent of real property held by such entities. 12 The definition of a USR- PHC is somewhat narrower than the general definition of a USRPI. In addition, the taxation of gain on a disposition of a USRPHC is not accomplished based upon a look-through (i.e., proportionate) rule; instead, it is an all-or-nothing rule based on whether the majority (by value) of its relevant assets are interests in U.S. real property. 13 The definition of a USRPHC is thus, by design, both over-inclusive (by taxing foreign investors on the appreciation inherent in some non- U.S. real estate assets) and under-inclusive (by permitting some appreciation in U.S. real estate to go untaxed at the stockholder level); presumably both shortcomings are due simply to administrative concerns. 14 Under FIRPTA, gain from the disposition of a US- RPI by a nonresident alien or a foreign corporation is could be appropriate for foreign entities that would be exempt from FIRPTA if they had been incorporated in the United States. 10 Technically, an interest in a USRPHC already falls within the definition of a USRPI, so the USRPHC definition narrows taxation of shares. Without such a narrowing, FIRPTA would tax dispositions of shares of any corporation, and could capture both domestic and foreign corporations owning U.S. real property, which, as explained further below, was not intended by Congress. 11 Regs (d)(2)(i) (g); Regs T; Notice 88-72, C.B (c)(2). A domestic corporation is considered a USRPHC if the fair market value of the USRPIs held by the corporation equals or exceeds 50% of the sum of the fair market value of its: (1) USRPIs; (2) interests in real property located outside the United States; and (3) assets (other than USRPIs and foreign real property) that are used or held for use in the corporation s trade or business. 14 This article later considers certain alternatives, which admittedly involve greater complexity Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.

3 taxable as income that is considered effectively connected with a U.S. trade or business (ECI), which the holder is deemed to carry on. 15 FIRPTA does not tax the disposition by foreign investors of interests in foreign corporations, or interests in U.S. corporations that do not fall within the USRPHC definition. 16 Interests in a former USRPHC, however, typically maintain their taint for five years after the corporation no longer satisfies the USRPHC test. 17 More About FIRPTA The Treasury regulations expanded the definition of a USRPI dramatically to include any direct or indirect right to share in the appreciation in the value, or in the gross or net proceeds or profits generated by, the real property. 18 This definition includes options and contracts to acquire real property, installment obligations related to the disposition of a USRPI, and many derivatives. 19 A domestic corporation is also generally considered a USRPHC (and thus non-creditor interests therein would constitute a USRPI) if the fair market value of the USRPIs held by the corporation equals or exceeds 50% of the sum of the fair market value of its: (1) US- RPIs; (2) interests in real property located outside the United States; and (3) assets (other than USRPIs and foreign real property) that are used or held for use in the corporation s trade or business. 20 Generally, passive assets are ignored for these purposes, assets held in partnerships are considered owned proportionately by partners (based on liquidation values), and assets held by controlled subsidiaries, whether domestic or foreign, are included (rather than including stock or 15 FIRPTA losses are also considered effectively connected. 16 Prior to the enactment of FIRPTA, capital gains on the disposition of USRPIs by foreign investors were generally not subject to U.S. federal income tax unless either: (1) the gains were effectively connected with a U.S. trade or business (ECI); or (2) the foreign investor was a resident of the United States for 183 days or more. See Joint Comm. on Tax n, Description of S. 1915, Relating to Tax Treatment of Foreign Investment in Real Property, at 8 (1984). 17 The reason for adopting a five-year (as opposed to a shorter or longer) period is not clear from the legislative history. Section 1248, applicable to former 10% U.S. shareholders of a controlled foreign corporation, also incorporates a five-year period (or taint ). 18 Excluding interests solely as a creditor under this definition, participating debt is included as a USRPI, but the payment of such debt at its maturity is not considered the disposition of a USRPI. Regs (d)(2)(i). 19 Regs (d)(2)(ii); but cf. Rev. Rul , C.B (ruling that a total return swap, the return of which is calculated by reference to a broadly based real estate index, does not give rise to a U.S. real property interest (USRPI) for purposes of 897) (c). securities issued by that controlled entity). 21 For these purposes, fair market value means the gross value of the property, less any outstanding debt secured by the property. 22 Section 897(g) provides that, [u]nder regulations prescribed by the Secretary, amounts of money and the fair market value of property received in exchange for all or part of an interest in a partnership are treated as amounts received from the sale or exchange of a USRPI to the extent attributable to the USRPI. To date, the Service has only issued temporary regulations under 897(g) as it applies to certain partnerships, the gross value of which are composed: (1) 50% of USRPIs; and (2) 90% of USRPIs plus any cash or cash equivalents. 23 From a policy perspective, the rule might be viewed as a (generous) de minimis rule. The Service takes the view that 897(g) is effective even absent the issuance of regulations, 24 however, which means that, but for application of the rule in the temporary regulations, an interest in a partnership is treated as a USRPI for purposes of 21 In determining the relevant assets held by a domestic corporation, the Treasury regulations apply a look-through rule for controlled subsidiaries (i.e., subsidiaries owned 50% or more by the domestic corporation, applying a modified 318 attribution rule). Assets held by controlled subsidiaries are deemed held proportionately by the domestic corporation, assets held for use in a subsidiary s trade or business are treated as though held by the domestic corporation in its own trade or business, and interests (debt or equity) issued by the subsidiary are excluded. Assets held by investment companies are excluded from this look-through rule, which means that an investment company essentially becomes a blocker (of its own assets) in determining USRPHC status of any of its shareholders. Regs (e)(2). Corporations are considered investment companies if 90% or more of its total assets consist of cash, stock, securities, and other investment assets. Regs (f)(3)(ii). Additionally, noncontrolling interests held in foreign corporations are presumed to be USRPIs for calculating whether the domestic corporation is a USRPHC. Regs (e)(1). In practice, however, paying attention to detail will avoid this result. There is also a look-through rule for pass-through interests held by the domestic corporation: domestic corporations are treated as holding a proportionate share of the assets held by the pass-through entity (based on relative liquidation values), except to the extent that the entity is considered an investment entity. 22 Regs (o)(2)(i). Under the regulations, debts secured by property are debts secured by a mortgage or other security interest that is valid and enforceable under the jurisdiction in which the property is located, and either: (1) incurred to acquire the property; or (2) otherwise incurred in direct connection with the property, such as property tax liens upon real property or debts incurred to maintain or improve property. Regs (o)(2)(iii). It also includes refinancing debt, to the extent the refinanced debt is less than or equal to the original debt and incurred for a valid business purpose, but excludes related-party debt. Below we consider changing this offset rule. 23 Regs T(a). 24 See Notice Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 3

4 897(a) to the extent the value thereof is attributable to USRPIs held by the entity. 25 An early proposed version of FIRPTA would have taxed gain on the disposition of certain foreign corporations ( real property holding organizations, or RPHOs ) and taxed them the same as similar domestic corporations. 26 Ultimately, however, FIRPTA as enacted excluded from tax gain on the disposition of stock in a foreign corporation. 27 Instead, the legislative history indicates that a foreign corporation was merely to be taxed on direct disposition and certain distributions (whether or not in liquidation) of appreciated U.S. real property interests to its shareholders. 28 The determination of whether a company is a US- RPHC must be made on several dates, primarily on: (1) the last day of the corporation s taxable year; (2) the date upon which the corporation acquires a US- RPI; (3) the date upon which the corporation disposes of a foreign real property interest, or a trade or business asset; and (4) the date upon which a controlled subsidiary acquires a USRPI or disposes of foreign real property interests/trade or business assets. Notwithstanding the required determination dates, however, corporations may test their USRPHC status at any time. FIRPTA also includes a slow purging rule that, in essence, removes taint from a specific interest in a former USRPHC after five years of losing USRPHC (or USRPI) status. The slow purging rule applies five years after the fair market value of a domestic corporation s USRPIs no longer equals or exceeds 50% of the fair market value of all of its includible assets, and 25 Many questions remain unanswered as to the application of 897(g), and the interaction of FIRPTA rules with partnerships, including whether FIRPTA gain is limited to the lesser of inside (FIRPTA) and outside (partnership) gain. The partnership rules provide mechanisms to assure that a single level of tax is ultimately imposed on appreciated assets, but no tax system is foolproof. See generally 704(c), H.R. Rep. No , at 187 (1980). 27 Presumably, this decision was made either for administrative convenience, or to prevent overreaching by the U.S. government on the taxation of foreigners, or both. But cf. 116 of the Canadian Income Tax Act (under the Canadian FIRPTA, nonresidents of Canada are taxed on the disposition of shares of a non-resident, privately owned corporation that are not listed on a prescribed stock exchange if, at any time during the last 60 months: (1) more than 50% of the fair market value of all the property of the non-resident corporation consisted of Canadian taxable property and other similar assets; and (2) more than 50% of the fair market value of the shares was derived directly or indirectly from real property situated in Canada and other similar assets). 28 H.R. Rep. No , at 187 (1980). remains so. 29 This slow purging rule also applies to a change in the status of an interest that was subject to FIRPTA before an IPO or upon the change in status of a corporation into a DC REIT (defined below). 30 Furthermore, under a quick purging rule, interests in a USRPHC will immediately cease to be considered USRPIs as of the date that: (1) the corporation no longer holds any USRPIs; and (2) all of the USR- PIs directly or indirectly held by the corporation during the last five years were either disposed of in transactions in which the full amount of gain (if any) was recognized by the company or ceased to be USRPIs based on serial application of this quick purging rule. 31 FIRPTA AND U.S. TAX TREATIES After FIRPTA was enacted, but prior to December 31, 1984, investors could continue to rely on U.S. income tax treaties for exemption from U.S. income tax on gain related to the disposition of U.S. real property. 32 Under the 1942 U.S.-Canada Income Tax Treaty, for example, exemption remained for capital gains recognized by a Canadian resident for capital assets (including real property) held in the United States, provided such resident did not have a permanent establishment in the United States. 33 Subsequently, all U.S. tax treaties were amended to conform to FIRPTA and include a FIRPTA-type standard in the Gain article. 34 Limited treaty relief was also available under certain post-firpta treaties, including the U.S.-Canada Income Tax Treaty. Under Article XIII(9) of that new treaty, a Canadian resident owning U.S. real property as of September 26, 1980 (or real property that it acquired in a nonrecognition transaction if such property was not acquired in a taxable transaction on or after September 26, 1980), was given a fresh start under the treaty, effectively allowing pro-rata (c)(1)(B). Addition of a de minimis exception to the US- RPHC definition is suggested below. 30 An exception seems to apply in the event of an IPO where the holder has held less than 5% for the past five years (or the holder s entire shorter holding period); it is not clear whether a similar (taxpayer-favorable) result applies when a C corporation becomes a domestically controlled REIT (and the statute seems to look to the period of existence of the REIT). 31 Id. 32 Joint Comm. on Tax n, General Explanation of the Economic Recovery Tax Act of 1981, at 369 (1981) U.S.-Canada Income Tax Treaty, Art. VIII. As described further below, a transitional rule under the 1980 convention also permitted a deemed step up, allocated proportionately to the property holding periods before 1980 and phased-out exemptions after See U.S. Model Income Tax Convention of Nov. 15, 2006, Art Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.

5 exclusion of gain deemed to have occurred on or before December 31, 1984, provided the resident met certain other requirements. In addition, 897(i) was enacted to address claims by foreign corporations that FIRPTA applied to them was discriminatory, in violation of treaties. 35 Section 897(i) allows a foreign corporation holding USRPIs to elect to be treated as a domestic corporation for purposes of FIRPTA taxation, withholding taxes on the transfer of USRPIs, and reporting requirements with respect to such transfers. 36 The foreign corporation may make the election only if it is entitled to nondiscriminatory treatment under a treaty and, under the regulations, only if the corporation will be a USRPHC once the election takes effect. 37 FIRPTA EXCEPTIONS Despite the apparent breadth of FIRPTA s reach, foreign investors may rely on a number of nonrecognition rules and other exceptions to defer or avoid triggering FIRPTA and thereby avoid payment of U.S. tax on gain attributable to appreciation in U.S. real properties. A few of the more commonly used exceptions are described below, and they are referred to later as a tool by which gain in U.S. real estate may eventually escape taxation. 38 Publicly Traded Corporations 5% Threshold Section 897(c)(3) provides that stock in a corporation that otherwise would be considered a USRPHC is not treated as a USRPI on its disposition by a foreign shareholder if: (1) the corporation is regularly traded on an established securities market; and (2) the shareholder disposing of the stock did not own 5% of the total fair market value of that class of stock at any time during the five-year period prior to disposition (the 5% Threshold ). 39 The 5% Threshold applies the constructive ownership rules of 318(a) to determine whether the shareholder owns more than 5%. 40 The 5% Threshold specifically provides that stock of a publicly traded USRPHC will only be considered 35 S. Rep. No. 176, (1981) (i)(1). 37 Regs (c)(2). 38 As the saying goes: A tax deferred is a tax denied. 39 In the case of non-traded stock of a publicly traded corporation, stock of that class will not be considered a USRPI to the extent that the amount held is less than 5% of the fair market value of the publicly traded class of stock. See Regs T(b)(1). As discussed in more detail below, where publicly traded shares are held in a pass-through entity, there is an unresolved issue whether the 5% exemption applies at the partnership level (c)(6)(C). a USRPI in the case of a person who [during the testing period of up to five years]... held more than 5 percent of such class of stock. 41 Under 7701(a)(1), the term person includes an individual, a trust, estate, partnership, association, company, or corporation. Yet, because neither the statute nor the regulations specify whether the 5% Threshold should be tested at the level of the partnership or the partners, there is ambiguity as to how the 5% Threshold should be applied in the context of an entity that is treated as a partnership for U.S. tax purposes. Under Regs (c)(2)(iii), the 5% Threshold is exceeded in the case of regularly traded stock that is owned by a person who beneficially owned more than 5 percent. The Treasury regulations on the 5% Threshold thus would support looking through a partnership to its partners because partnerships are treated as pass-through entities for U.S. tax purposes, and partners are thus generally treated as beneficial owners, but this result is not free from doubt. 42 Publicly Traded Partnerships 5% Threshold The Treasury Regulations under 897 treat publicly traded partnerships (whether foreign or domestic) 43 in the same manner: an interest in a publicly traded partnership is not treated as a partnership interest under FIRPTA; rather, the interest is subject to the 5% Threshold described above, and the determination of whether a greater than 5% interest in the partnership would be considered a USRPI hinges on whether the fair market value of its USRPIs equals or exceeds 50% of the sum of the fair market value of its USR- PIs, its interests in real property located outside the United States, and any other of its assets which are (c)(3). (Emphasis added.) 42 See, e.g., 318(a)(2)(A) (providing that stock owned by a partnership is treated as owned proportionately by its partners); Regs (c)(6) (defining beneficial owner for withholding tax purposes as the person who is the owner of the income for tax purposes and is required under U.S. tax principles to include the amount paid in gross income ). Similarly, for securities law purposes, the term beneficial owner includes any person who, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise has or shares: (1) voting power which includes the power to vote, or to direct the voting of, such security; and/or, (2) investment power which includes the power to dispose, or to direct the disposition of, such security. See 17 CFR d-3(a). See also Regs (g)(3) (testing ownership of portfolio interest at the partner level for purposes of the 871(h) exemption for a similar, less than 10% owner, test). 43 U.S. tax law confused the definition of a U.S. or foreign partnership; here the authors mean a partnership created or organized under the laws of the U.S. or a non-u.s. jurisdiction, respectively Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 5

6 held for use in its trade or business. 44 In other words, if the majority of the value of the publicly traded partnership is attributable to non-u.s. real estate, then the gain on the sale is not taxable under FIRPTA, even for partners with a greater than 5% interest. 45 REITs An interest in a domestically controlled real estate investment trust 46 (DC REIT) is not considered a US- PRI at all under 897(h)(2), and so its disposition is not subject to FIRPTA. A REIT can qualify as a DC REIT if, at all times during the testing period (the shorter of five years or the period the REIT was in existence), it is less than 50% owned by foreign persons. For purposes of determining whether a REIT is domestically controlled, the actual owners of stock must be taken into account. Regs (b) provides that the actual owner of stock of a REIT is the person who is required to include in gross income in his return the dividends received on the stock. Under this rule, a pass-through entity such as a partnership would not be treated as the actual owner of REIT shares, but a taxable corporate entity would be. 47 FIRPTA treats certain distributions from a REIT as gain from the disposition of a USRPI, but exempts certain 5% or less shareholders from such treatment. 48 Where the entity holding the USRPIs was previously a C corporation prior to conversion to a REIT whether or not domestically controlled the 44 Regs (c)(2)(iv); 897(c)(2). This rule for publicly traded partnerships assumes that 7704, which treats certain publicly traded partnerships as corporations for U.S. tax purposes, is not applicable. If 7704 applied before application of the FIRPTA rules, the applicable threshold would be the 5% Threshold for corporations, so the FIRPTA rule treating publicly traded partnership interests the same as corporations arguably would not be necessary. 45 Section 7704 rules have a lighter touch on treatment of potentially publicly traded partnerships as corporations if they do not meet the 90% qualified-income test. Presumably, FIRPTA would apply (only) its own USRPHC rules to any such deemed corporation. 46 REITs are complex, however, and require meeting and maintaining certain ownership, income, asset, and distribution requirements, and require avoidance of certain activities, such as operating businesses or engaging in gambling activities. Thus, for example, a REIT may not be closely held and must have at least 100 shareholders. Conversion of a C corporation into a REIT also requires distribution of any accumulated earnings and profits. 47 See PLR (entity, which was owned 100% by two domestic subchapter C corporations, was considered domestically controlled, even though one of the domestic corporations was indirectly owned by foreign persons). 48 The testing period for 5% shareholdings here is limited to 12 months, and no attribution rules apply. See 897(h)(1), as amended in REIT is subject to the built-in gain tax rules of That rule requires payment of corporate taxes if, during the 10-year period that begins when the REIT election is made, a REIT sells any of its assets for an amount in excess of the asset s basis at the beginning of the 10-year period, it will be liable to pay a U.S. federal income tax at regular corporate rates (currently 35%) on the amount by which the fair market value of the asset when the REIT election was made exceeds its basis when the REIT election was made. A liquidation of the REIT within the 10-year period also would be taxable under Noncontrolled USRPHCs Governmental Entity Exemption Investors in U.S. real property that are exempt from tax under 892 (e.g., certain foreign-governmental pension plans and sovereign wealth funds, and their 100% controlled entities) are partially exempt from FIRPTA. 51 The exemption applies only to dispositions of interests in non-controlled USRPHCs. That is, to the extent that the 892 investor owns less than 50% of the stock in a USRPHC (on a vote/value and an effective practical control basis), 892 allows the investor to sell the stock without triggering FIRPTA. However, gain from the disposition of other USRPIs generally is not exempt under 892, including certain distributions from REITs that are attributable to US- RPI gain. 52 Under current law, the 892 exemption is also denied to a controlled entity ( Deemed CCE ) that would be considered USRPHC if it were a U.S. corporation. 53 In a trap for the unwary, the Deemed CCE Rule thus treats a foreign controlled entity that holds predominantly USRPIs (including stock in USR- PHCs) as a controlled commercial entity and not exempt under 892 if USRPIs constitute more than 50% of the entity s FIRPTA-relevant assets. 54 Moreover, temporary regulations under 892 provide that a partnership interest is not an exempt security for purposes of 892, which has caused the IRS in the past to conclude that the disposition of a part- 49 Regs (d)-7(b)(1)(i). 50 Note that the amount of gain that can be triggered is limited by the valuation of the property on the REIT s commencement date and whether the tax is triggered ( all or nothing ) depends upon failing to defer a recognition event. 51 See Regs T(a), (b). 52 Regs T(a)(1)(i), (b) Ex. 1; 897(h)(i); Notice , C.B Regs T(b)(1) (c)(2). In a recent report, the New York State Bar Association recommended that Treasury eliminate this rule, and the same change is suggested below. New York State Bar Assoc., Proposed Regulations Under Section 892 (2012) Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.

7 nership interest is not exempt under In the context of FIRPTA, this could give rise to the absurd result that a foreign governmental investor that holds a noncontrolling interest in a USRPHC directly would not be subject to tax, whereas a foreign governmental investor that holds a noncontrolling interest in a US- RPHC through a partnership would be subject to tax Regs T(a)(2); PLR (ruling, without analysis or discussion, that [t]he disposition of an interest in [a partnership] by an integral part or controlled entity of a foreign government will not qualify for the exemption under section 892. ). 56 See Blanchard, FIRPTA in the 21st Century, Installment Six: FIRPTA Withholding Where a 892 Investor Is a Partner, 38 Tax Mgmt. Int l J. 5 (May 2009) (noting that the temporary regulations arguably do not provide an exemption in the case of a partnership holding only shares in a non-controlled USRPHC and such regulations need to be rewritten from the ground up to deal comprehensively, and in an internally consistent way, with partnerships ). 57 Regs T(a)(1). (This regulation narrows the approach of the statute by requiring an exchange of a USRPI for another USRPI.) 58 In connection with the transfer to a partnership, it is commonly assumed that even if the partnership interest is not itself subject to FIRPTA under 897(g) and the applicable regulations the application of 704(c) principles (tracking unrealized gain to the transferor on disposition of the interest) is adequate to avoid immediate gain recognition. The IRS has not expressed its view in such cases, however. Nonrecognition Transactions Section 897(e) permits application of the Code s nonrecognition rules if: (1) the transferor receives another USRPI in exchange for the transferred USRPI; (2) the new USRPI would be subject to U.S. taxation on its disposition immediately after the transaction; and (3) the transferor of the USRPI complies with certain filing requirements. 57 Generally, these rules permit transfer of a USRPI to a partnership 58 or to a domestic corporation that is a USRPHC, and allow domestic reorganizations of USRPHC, without recognition of FIRPTA gain. Restructuring of a former USRPHC may trigger gain under this rule, however. Under the 1988 Temporary Regulations, a foreign person may contribute a USRPI to a foreign corporation, and certain foreign-to-foreign reorganizations are also permitted. For example, the regulations expressly allow for certain foreign-to-foreign transactions, including a D or F reorganization: (1) in which a subsequent disposition of the USRPI by the transferee would be taxable under 897(a); (2) that meets certain conditions described in Temp. Regs T(b)(2); (3) for which the transferee obtains a notice of nonrecognition; and (4) for which certain filing requirements are satisfied. 59 Under Notice , a transaction that otherwise meets the requirements set forth above is no longer required to satisfy the additional conditions of Temp. Regs T(b)(2). 60 USE OF BLOCKERS As noted above, foreign investors commonly hold their USRPIs through a blocker corporation. With patience and proper planning, it should be possible for a foreign investor to defer and sometimes, ultimately, avoid bearing any U.S. income tax on such investments. Therefore, whether a foreign seller of an interest in a USRPHC should bear a haircut on value for the embedded tax can be purely a matter of negotiation. 61 It makes sense, however, to consider the generally applicable tax rules in more detail before assuming that no U.S. tax needs to be borne by a foreign investor. A domestic corporation is subject to U.S. corporate income tax on its worldwide income so, as a starting notion, U.S. real estate held by or through a U.S. blocker will always bear at least one level of U.S. income tax. Moreover, foreign shareholders are ordinarily subject to U.S. withholding tax on any dividends paid by such a U.S. corporation, so double taxation of such investment income by the United States is very possible. Foreign shareholders may choose instead to invest in U.S. real estate through a foreign blocker. From the perspective of a foreign investor, the use of a foreign blocker may be viewed as preferable in any event because: (1) shares in the foreign blocker are not considered USRPIs, so disposition of shares in the foreign blocker generally should not give rise to FIRPTA consequences; and (2) a foreign blocker will avoid imposition of U.S. estate tax otherwise applicable to individual investors. 62 Nevertheless, certain other considerations (such as branch profits tax, the availability of U.S. tax treaty benefits, etc.) may come into play in choosing whether to use a foreign blocker. 59 Regs T(b)(1). A and C reorganizations are also permitted where the transferring shareholders control the transferee corporation after the transaction. Notice , C.B Notice , C.B See also Notice 89-85, which was amplified by Notice Given the deferral and nonrecognition rules noted above, it appears that a foreign investor may largely avoid FIRPTA consequences by holding its USRPIs through a domestic or foreign blocker. But see notes 24 26, and accompanying discussion, regarding the look-through rule for USRPIs held through partnerships. 62 The definition of USRPHC includes any corporation, but the definition of USRPI includes only a domestic corporation, if it cannot be proven that the corporation is not a USR- PHC. See 897(c)(1) (c)(2) Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 7

8 A blocker may be able to offset much of its operating income through the use of depreciation and interest deductions, and may be able to employ corporatelevel, tax-deferral techniques. There are some distinct differences, however, which are described below. Real estate improvements are generally subject to depreciation deductions, which shelter some of the operating income from the underlying property. 63 In addition, interest paid or accrued on debt incurred within the blocker will be deductible, within certain limits, 64 and will effectively and permanently reduce taxable income. Such debt is commonly incurred by a blocker in order to fund acquisition, improvement, or carrying of the real estate. Unrelated lenders typically will lend at a level of least 50% of the fair market value of subject property, and often more, where repayment is fundamentally ensured by the expected rentals on current and future leases. Deduction of interest paid to a related foreign investor, where the investor pays less than a 30% U.S. withholding tax on the interest, is subject to limitation under 163(j) (the earnings stripping limitation ). 65 The earnings stripping limitation also applies to loans from unrelated lenders if a related foreign person guarantees the debt. 66 A guarantee for this purpose is very broadly defined, including, under the legislative history, even a nonbinding comfort letter from a related foreign person. 67 Other rules may limit the timing 68 or the amount 69 of deductible interest in applicable cases, and care must be taken to the extent those rules apply. Additionally, there is always a risk that debt can be recharacterized by the IRS as equity, particularly when the debt is issued between related parties and, 70 quite often, reform proposals include further restrictions on related-party deductions and 168. Depreciation, however, reduces U.S. tax basis and so gives rise largely to timing differences (a). 65 Section 163(j) limits the deductibility of certain interest otherwise deductible under the Code if the payor has a debt-to-equity ratio exceeding 1.5-to-1. This limitation applies only to disqualified interest, which includes interest paid to a related person or interest paid to an unrelated person if there is a disqualified guarantee of a loan. 163(j)(3). 66 A disqualified guarantee is a guarantee by a related person that is a foreign person. 163(j)(6)(D). The limitation applies, however, only to the extent that the interest deductions exceed 50% of the payor s adjusted taxable income plus any excess limitation carryforward. See 163(j)(4), 267(b), 707(b)(1). 67 Technically, for a closely held corporation, an issue arises whether a bad boy guarantee could invoke the earnings stripping limitation described herein, to the extent the bad boys hold more than 50% of the stock of the blocker corporation. 68 See, e.g., 267(a)(3), 163(e)(5). 69 See, e.g., 163(e)(5), 163(l), and See, e.g., Laidlaw Transp., Inc. v. Comr., 75 T.C.M. 2598, Because of the availability of deductions for interest payments and the lack of deduction for dividends paid to shareholders in the context of a C corporation, along with the fact that shareholders of C corporations are subject to double taxation by virtue of holding equity, the general trend is for corporations to use as much leverage as is supportable (i.e., from a debtequity, earnings stripping, and cash flow perspective) both for the capitalization of new corporations and for providing liquidity to existing corporations in need of funding. Due to this tax bias, an advisory panel for President George W. Bush recommended lessening or eliminating these distinctions between the tax treatment of debt and equity to encourage firms to rely less on leverage and more on equity. 72 Like a domestic blocker, a foreign blocker may be able to leverage its investment and use interest deduction to shelter some of its U.S. taxable income. The availability of interest deductions may be restricted by the applicable interest allocation rules, however, which initially require a foreign corporation to calculate its interest expense allocable to effectively connected income based on its worldwide asset ratio. 73 The level of U.S. tax paid by the foreign blocker on the operating income from its USRPIs could be increased under the branch profits tax (BPT). 74 The BPT is imposed on foreign corporations that engage in a trade or business in the United States either directly, through a branch, or through a flow-through entity such as a partnership or a wholly owned disregarded entity. The BPT applies at a 30% rate (subject to reduction under any applicable treaty) to the dividend equivalent amount for the taxable year. Generally, the dividend equivalent amount is the amount of the current and retained earnings of the branch that are withdrawn or deemed to have been withdrawn from the branch during the year. 75 The BPT is intended to put a foreign corporation doing business in the United States through a branch 2617 (1998) (additional scrutiny necessary when debt arises from transactions not at arm s length). 71 See, e.g., U.S. Dep t of Treasury, General Explanations of the Administration s Fiscal Year 2013 Revenue Proposals, at (Feb. 2013). The most recent proposal would revise 163(j) to strengthen the limitation on the deductibility of interest paid by an expatriated entity to related persons, by eliminating the current law debt-to-equity safe harbor, lowering the 50% adjusted taxable income threshold to 25%, and limiting the carryforward available for disallowed interest to 10 years. 72 Rep t of the President s Advisory Panel on Tax Reform, Simple, Fair and Pro-Growth: Proposals to Fix America s Tax System, at (2005). 73 Regs (a). The earnings stripping rules, describe above, also apply to foreign corporations (a). As noted above, it may be possible to avoid distributing profits from a U.S. blocker by lending to an affiliate at a low rate of return, or reinvesting excess cash within the blocker. 75 The dividend equivalent amount is equal to (1) to the amount Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.

9 in a similar position to a foreign corporation operating through a U.S. corporate subsidiary, by treating reductions in the net equity invested in the U.S. business as having been withdrawn from the U.S. business and by taxing such amounts as if they were dividends subject to U.S. withholding tax. Finally, a foreign blocker may also be subject to the branch-level interest tax under 884(f), which would tax the foreign corporation at a 30% rate on certain interest deducted by the corporation. This provision includes two components. The first component is a source rule that treats interest paid by the branch as U.S.-source income. The second component is an additional 30% tax (before application of a treaty) imposed on any interest paid by the foreign corporation on debt that is allocable to the branch, but that was not actually paid by the branch. 76 As suggested above, the BPT and branch-level interest tax may be reduced or eliminated under a U.S. tax treaty, so foreign investors looking to use foreign blockers should structure their investments to receive such a reduction. The amount of BPT under a treaty is determined either by the branch profits tax amount specified in the treaty or by the dividend rate specified in the treaty. Typically these treaty provisions reduce the branch profits rate to 5% or 15%, though in some cases to zero. 77 The branch-level interest tax is determined based on the interest rate specified in the applicable treaty; in many cases, interest is taxed at 0%. Character of Distributions from a Blocker Distributions to foreign shareholders by a domestic corporation are treated as dividends, and are subject to U.S. withholding tax, to the extent of the current or of earnings and profits for the year that are effectively connected to the U.S. trade or business, decreased by (2) the amount of any increase in the corporation s U.S. net equity, and increased by (3) the amount of any decrease in the U.S. net equity. 884(b). The U.S. net equity is equal to the excess of the corporation s assets connected with the U.S. trade or business over the liabilities connected with such business. 884(c). 76 Such interest is treated as if it had been paid to the foreign corporation by a wholly owned domestic subsidiary and is therefore not eligible for the portfolio interest exemption. The BPT is often said to be a proxy for the dividend withholding tax levied on wholly owned U.S. subsidiaries of a foreign parent corporation. As a practical matter, however, it may be more difficult to control or anticipate triggering BPT, as compared to triggering dividend withholding taxes from a controlled subsidiary. 77 Under the U.S.-Canada Tax Treaty, there is a $500,000 exemption allowing Canadian corporations to accrue $500,000 of dividend equivalent, under the branch profits tax, and NOLs can be used to reduce the dividend equivalent amount. accumulated earnings and profits (E&P) of the corporation. 78 During years that depreciation deductions are available, E&P is typically less than the blocker s cash flow, and the excess cash can be distributed by the blocker as a return of capital. 79 If the blocker entity is not a USRPHC, of course, a return of capital does not give rise to any FIRPTA consequences, nor will it give rise to U.S. withholding tax. If the blocker is a USRPHC, FIRPTA withholding on a return of capital can be avoided by applying for and obtaining a withholding certificate from the IRS. U.S.-source dividends are generally subject to a 30% gross withholding tax, 80 unless reduced by a U.S. tax treaty. Under some U.S. tax treaties, dividends can be taxed as low as 0%. 81 The blocker has the ability to defer distributions by lending excess cash to an affiliate at low rates 82 or by investing the cash in other investments (e.g., stocks, securities, other USRPIs, etc.). However, the ability to defer distributions is limited by the potential application of the personal holding company rules, in the case of a blocker that is closely held. The personal holding company tax, or PHC tax, is imposed at a rate of 20% of a corporation s undistributed personal holding company income, which is generally its taxable income for the year (with certain adjustments), minus the dividends paid deduction. 83 The ability to defer distributions may also be limited by the accumulated earnings tax, which is levied on accumulated taxable income, also at a rate of 20% (c)(1), (c)(2). But cf. 1445(e)(3) (absent a withholding certificate, distributions representing a return of capital are subject to 10% withholding) (a). 81 See, e.g., the U.S.-Belgium Income Tax Treaty (0% rate applies if a corporate shareholder owns 80% or more of the voting stock of the U.S. corporation for the 12-month period ending on the date on which entitlement to the dividend is determined, and qualifies under certain provisions of the limitation on benefits article of the treaty). 82 But see Regs (a) (requiring arm s-length rate of interest between related parties) , 545. A personal holding company is generally defined as a corporation if it is closely held and at least 60% of its adjusted ordinary gross income for the taxable year is dividends, interest, royalties, and other passive income. 542, 543(a). 84 The accumulated earnings tax, or AET, is imposed on every corporation formed or availed of for the purpose of avoiding the income tax with respect to its shareholders... by permitting earnings and profits to accumulate instead of being divided or distributed unless the corporation is a personal holding company, foreign personal holding company, tax-exempt corporation, or passive foreign investment company A corporation s accumulated taxable income is its taxable income for the year (with certain adjustments), minus the sum of: (1) a deduction for 2013 Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 9