Locke Lord LLP INVESTORS IN U.S. REAL ESTATE FUNDS FEDERAL INCOME TAX ISSUES FOR FOREIGN

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1 FEDERAL INCOME TAX ISSUES FOR FOREIGN INVESTORS IN U.S. REAL ESTATE FUNDS Locke Lord LLP Andrew Betaque Partner-Tax November 14, 2013 CIRCULAR 230 DISCLAIMER. ANY DISCUSSION OF U.S. FEDERAL TAX ISSUES SET FORTH HEREIN WAS NOT INTENDED OR WRITTEN TO BE USED, AND IT CANNOT BE USED, BY ANY PERSON FOR THE PURPOSE OF AVOIDING ANY U.S. FEDERAL TAX PENALTIES THAT MAY BE IMPOSED ON SUCH PERSON.

2 Objectives of Foreign Investors Foreign Investors have two principal objectives: - Minimize U.S./Global Tax Liability - Avoid U.S. Tax Reporting -2-

3 Base Case. Direct Investment in Fund Assume for all Scenarios that Fund income is ECl. U.S. Foreign Investors Investor Tax Liability: - 35% for corporations (EC!) Withholding: - Fund must withhold based on the maximum applicable rate, even if there are no distributions. Tax Return Filing: - Foreign Investor must file a U.S. federal income tax return. Comment: - Most countries permit a foreign tax credit for taxes paid in other countries. Thus, if a Foreign Investor is subject to tax in its own country at a rate greater than the U.S. rate, U.S. taxes may be fully creditable. As a result, a direct investment in the Fund would potentially be an efficient structure for the Foreign Investor -3-

4 Key Tax Concepts Effectively Connected Income ("ECl") Fixed or Determinable Annual or Periodic Income ("FDAP") Portfolio Interest Branch Profits Tax Foreign Investment in Real Property Tax Act ("FIRPTA") Income Tax Treaties REITs FATCA

5 ECl Applies to income effectively connected with a U.S. "trade or business". Ownership of one triple net leased real property generally would not constitute a trade or business. Most other real estate activities would constitute a trade or business. If a Fund is engaged in a U.S. trade or business, its partners will be treated as engaged in a U.S. trade or business. Taxed on a net basis at the regular rates applicable to U.S. persons - 35% for corporations - Graduated rates up to 39.6% for individuals (20% for capital gains) A Fund must withhold at the highest tax rate on a foreign partner's share of the Fund's ECl for the year (even if no distributions are made). Foreign Investors must file U.S. federal income tax returns.

6 FDAP Applies to U.S. source interest, dividends and other fixed or determinable annual or periodic income. Does not apply to the above items if they are effectively connected with a U.S. trade or business. Does not apply to capital gain (but see FIRPTA discussion). Taxed on a gross basis. - 30% flat rate. - Subject to reduction by treaty. May result in a higher tax liability than ECl because deductions are not taken into account. Generally subject to withholding at a 30% rate (subject to reduction by treaty). Foreign Investors not required to file U.S. income tax returns.

7 Portfolio Interest Interest that qualifies as ''portfolio interest'' is not subject to tax (unless it is ECl) Requirements: - lender not a bank - lender owns no more than 10% of the U.S. borrower - debt must be in registered form or in a bearer form that precludes ownership by U.S. holders -7-

8 Branch Profits Tax Generally applies only to foreign corporations engaged in a U.S. trade or business or holding a U.S. real property interest. 30% tax on "dividend equivalent amount" (subject to reduction by treaty). Prevents utilization of a foreign corporation to avoid the 30% tax on dividends that would apply if the business were held through a U.S. corporation. Generally does not apply in the year in which the foreign corporation completely terminates all of its U.S. trade or business. -8-

9 FIRPTA Gain recognized by a foreign investor on the sale of a ''U.S. real property interest" (a "USRPr') is treated as ECl (even if the investor is not engaged in a U.S. trade or business). Therefore, the gain is subject to U.S. federal inconne tax as ECl. A partnership interest constitutes a USRPI if: - 50% or more of the value of the partnership's gross assets are USRPIs; and - 90% or more of the value of the partnership's gross assets consists of USRPIs plus cash or cash equivalents. Applies to a sale of real property by the partnership or to a sale of the partnership interest by the Foreign Investor. Withholding: - If the gain on the sale of real property by a Fund is non-effectively connected income, the Fund must withhold an amount equal to 35% of the gain to the extent such gain is allocable to a foreign investor. (If the gain is ECl, the Fund must withhold on net income at the highest applicable rate). - On a sale of an interest in the Fund by a foreign Investor, the purchaser must withhold an amount equal to 10% of the amount realized by the Investor in the sale. Foreign Investors are generally required to file U.S. federal income tax returns under FIRPTA.

10 Income Tax Treaties Dividends -- rates generally vary from 0% -15% (rather than the 30% non-treaty rate) - often limited or no treaty benefit for dividends paid by REITs Branch Profit Tax - treaty rates generally correlate with the treaty rates for dividends Interest - rates are usually reduced or eliminated Business Profits - taxable only to the extent the profits are attributable to a permanent establishment located in the U.S. Income From Real Property - generally taxable - 30% withholding on rental income, unless a net basis election has been m to tax the rental income at a 35% rate -10-

11 REITS Deduction for dividends paid, with the result that REITs generally pay little or no federal income tax. Asset Tests - 75% of the REITs assets must be real estate assets - various other asset tests Income Tests - 75% of the REIT's income must be rents from real property and/or other real estate related income - 95% of the REIT's income must be income that qualifies for the 75% test plus dividends and interest. Withholding on dividends - 30% in general - 35% on dividends attributable to the REIT's disposition of U.S. real estate - Treaties typically provide less of a rate reduction on REIT dividends (compared to the rate reduction for dividends paid by ordinary corporations) Key Advantage: If the REIT is "domestically controlled" (at least 50% U.S. shareholders), the sale of stock in the REIT is not subject to withholding under FIRPTA. Sovereign Wealth Funds - Generally not subject to tax on dividends (other than capital gains dividends) - Not subject to tax on the sale of stock of a domestically controlled REIT - Therefore, often can avoid all U.S. tax as longer as real estate is not sold while the SWF is a shareholder of the REIT -11-

12 FATCA Goal is to reduce tax evasion by U.S. individuals with respect to assets held out of the U.S. 30% withholding on: - US source FDAP; and - Gross proceeds from the sale or disposition of any property that can produce U.S. source interest or dividends. Applies even to payments otherwise excluded from general FDAP yvithholding, such as portfolio interest. Withholding not reduced or eliminated by treaty. Applies to payments to foreign funds and other ''foreign financial institutions'' ("FFr'). FFI can avoid withholding by entering into an FFI agreement with the IRS or satisfying one of several narrow exemptions. Intergovernmental Agreements may ease withholding and administrative burdens. U.S. funds in which a foreign fund or any other FFI is an investor could be subject to substantial withholding obligations and administrative burden. -12-

13 Structural Alternative 1: Investment Through a Leveraged U.S. Blocker Corporation. Loan Foreign Investor Tax Liability: - 35% tax on income of US Corporation - reduce taxable income by interest expense (subject to limitations) - 30% tax on dividends by US Corporation (subject to reduction by treaty) - 30% tax on interest (subject to reduction by treaty), unless the portfolio interest exception applies. - No tax on liquidating distributions by US Corporation Withholding: - No withholding by Fund - 30% withholding by US Corporation on dividends (subject to reduction by treaty). - 30% withholding on interest (subject to reduction by treaty), unless the portfolio interest exception applies. Tax Return Filing: - US Corporation must file a U.S. federal income tax return. - Foreign Investor is not required to file a U.S. federal income tax return.

14 structural Alternative 2: Investment Through Foreign Blocker Corporation U.S. Investors Foreign Investor Tax Liability: - 35% tax on Foreign Corporation (ECl) - 30% branch profits tax (subject to reduction by treaty). (Exempt in year of termination). Withholding: - Fund must withhold based on the maximum applicable rate, even if there are no distributions. - Dividends paid by the Foreign Corporation are not subject to withholding. Tax Return Filing: - The Foreign Corporation must file a U.S. federal income tax return. - The Foreign Investor is not required to file a U.S. federal income tax return. -14-

15 1 structural Alternative 3: Investment Through Domestically Controlled REIT U.S. Investors Foreign U.S. (tax exempt) Investors Tax Liability: Tax liability of the REIT can generally be reduced to zero. 30% tax on dividends other than real estate dividends (subject to reduction by treaty). 35% tax on dividends attributable to the REIT's disposition of US real estate. No tax on sale of stock of REIT. Withholding: No withholding on payments to REIT Withholding on dividends paid by REIT at the above rates. Tax Return Filing: The REIT must file a U.S. federal income tax return. The Foreign Investors are not required to file U.S. federal income tax returns. more REITs could be formed below the Fund. -15-

16 Summary of Scenarios No Scenario avoids U.S. tax completely. Often, investment through a domestically controlled REIT will be the most tax-efficient structure (because (1) the REIT can generally avoid federal income tax, and (2) the Foreign investors are not subject to tax on the sale of stock of the REIT). However, the most efficient structure will depend on the facts and circumstances applicable to the Fund and Foreign investor, including the tax laws of the Foreign investor's country, the terms of the tax treaty (if there is one), the type of income expected to be earned by the Fund, the frequency of distributions, etc. -16-