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.
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.
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. 11
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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.
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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.
1.884-2T(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
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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.
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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.
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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. 1.897-1(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. 1.897-1(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. 1.897-1(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. 1.897-1(d)(3)(i)(A)).
(2) A partnership interest (Reg. 1.897-1(d)(3)(i)(B)).
(3) A beneficiary’s interest in a trust or another ownership interest in a trust (Reg.
1.897-1(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
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(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. 1.897-2(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
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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. 1.897-2(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. 57
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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
351 58 are partially overridden by FIRPTA’s own special nonrecognition rule in Section
897(e). As fleshed out in Temp. Reg. 1.897-6T, 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
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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. 1.897-1(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.
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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 12/16/99. 65 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
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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. 87
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(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. 2000-35, 2000-2 CB
211, provides guidance with respect to applications for withholding certificates. It
supersedes Rev. Proc. 88-23, 1988-1 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
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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,
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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. 1.1445-8(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.
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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.
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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).
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(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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be an advantage over a U.S. corporation, which likely would have to withhold a 30%
passive income tax from a similar distribution to its shareholder (to the extent that the
company has accumulated or current E&P).
Notwithstanding the latter benefit, these factors overall may also undercut the usefulness
of this structure. 113
Foreign Corporation Owning a U.S. Corporation
A foreign investor could set up a foreign corporation whose sole asset is all the stock of a
U.S. corporation. The U.S. corporation, in turn, acquires the U.S. real estate project. This
structure again gives the investor a liability shield while also eliminating the need for the
investor to file a U.S. tax return. While this two-tiered structure is more intricate than the
other approaches discussed above, this option does have many benefits that make its
usefulness worthwhile notwithstanding the added complexity and cost to administer.
First, both U.S. federal estate and gift tax will not apply if stock in the foreign
corporation is the subject of a gift or is transferred at death.
Second, the complex and somewhat overbroad BPT will not be applicable since the
operating asset and the income generated therefrom reside in a U.S. corporation.
Third, while the U.S. corporation must disclose the identity of its 100% shareholder by
name, that will identify only the foreign corporation. The foreign corporation is under no
such obligation since it is not engaged in a U.S. trade or business. Thus, a better shield of
anonymity is preserved for the foreign investor.
Fourth, assuming no operating income is to be distributed out of the U.S., once the
property is sold in a fully taxable transaction and one level of U.S. tax has been paid on
the resulting gain, the U.S. company can be liquidated, with the cash coming out to the
foreign corporation free of any U.S. withholding tax. The foreign corporation is then free
to distribute the cash to the ultimate shareholder, at any time, with no U.S. tax impact.
As a consequence, the complexity of this structure may be a fair price to pay for the
resulting benefits. 114
Multiple Properties
Where more than one property is to be acquired, consideration should be given to having
each property owned by a separate entity, to limit liability exposure. A separate
corporation or a series of single-member LLCs could be used. In this situation, the
primary issue may be whether to use a common holding company and, if so, where to
locate it (namely, in or outside the U.S.).
Where a separate U.S. corporation is to be used for each property, the use of a foreign
holding company to hold all the stock of each real estate holding company may give the
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benefits noted above (namely, elimination of estate and gift tax liability as well as
preserving anonymity). A negative factor, however, is that the losses of one project
cannot be used to offset the income of another. One positive factor is what happens on a
sale of an underlying project—if the goal is to repatriate the sale proceeds to the investor,
this structure is very helpful if a plan of liquidation is adopted for the specific company
whose property will be sold, with any remaining sales proceeds (after servicing debt and
paying transaction costs) then being paid out to the holding company as a nontaxable
liquidating distribution. 115
If a U.S. corporation (rather than a foreign holding company) is used as the common
parent, a consolidated tax return can be filed for the U.S. corporations. This generally
allows the use of one project’s losses to offset the income of another. If a certain project
is sold, the consolidated group will stay in existence. In that instance, if the ultimate
shareholder wishes to repatriate the sale proceeds, a dividend paid by the U.S. operating
company to the U.S. holding company parent generally can be paid free of U.S. tax, but
any dividend then paid by the U.S. corporate parent out of the U.S. will attract a 30%
withholding passive income tax (subject to tax treaty reduction). In addition, if the
foreign investor owns the U.S. holding company directly, then U.S. estate tax exposure
still exists. To eliminate this latter exposure, a foreign holding company may have to be
inserted between the ultimate shareholder and the U.S. corporate holding company.
CONCLUSION
Notwithstanding FIRPTA, planning opportunities still exist for foreign investors seeking
to invest in U.S. real estate. Prudent use of secured debt as an alternative investment
vehicle can potentially eliminate all U.S. tax exposure. For those seeking equity
positions, care in structuring the investment can limit the tax exposure to one level of tax
on sale or possibly no tax. The key for any investor is to do the planning before acquiring
the U.S. real estate. Once the asset has been acquired, there is far less flexibility to
restructure the investment without potentially triggering a tax liability.
Practice Notes
Planning to minimize the impact of FIRPTA, its associated withholding regime, or U.S.
federal gift and estate taxes, can be much more effective before a foreign investor takes
the plunge into U.S. real estate. The different approaches available come with their own
tax and non-tax advantages and disadvantages, as summarized below.
•
Debt-type investments, such as mortgages, may be the best choice. FIRPTA will
not apply on a disposition; the interest income generally should qualify for the
portfolio interest exemption from the 30% passive income tax; and, if it does, the
underlying debt obligation will not be included in an individual investor’s estate
for U.S. estate tax purposes.
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•
Debt instruments with equity kickers that are classified as USRPIs will trigger
FIRPTA only if the instrument is sold; fixed interest income should qualify for
the portfolio interest exemption, and a treaty might reduce or eliminate the 30%
withholding on any contingent interest.
•
Direct investment or the use of a disregarded entity, such as a single-member
LLC, is the simplest approach in terms of both filing requirements and triggering
only one level of tax. It will, however, entail exposure to both potential non-tax
liability and federal estate and gift taxes, and is not the vehicle for a foreign
investor seeking to preserve anonymity in the U.S.
•
A U.S. corporation would give a nonresident alien individual a liability shield,
and becomes a separate taxpayer, eliminating the need for the individual to file
annual returns. But: the investor still will have federal estate (but not gift) tax
liability; two levels of tax may be imposed on the corporation’s income (assuming
it will be repatriated back to the individual); and the investor might not obtain the
desired level of anonymity.
•
The use of a foreign corporation to hold the real estate gives the nonresident alien
investor the shield of limited liability; eliminates the need for the investor to file a
U.S. tax return; eliminates U.S. estate and gift tax exposure; and eliminates U.S.
withholding tax on dividends paid by the foreign corporation (but in its place is
the often onerous 30% BPT on the foreign corporation’s “dividend equivalent
amount).” Here, too, the anonymity that the investor may desire is not total.
•
A foreign corporation whose sole asset is all the stock of a U.S. corporation that
acquires the U.S. real estate project will give the investor a liability shield while
also eliminating the need for the investor to file a U.S. tax return; will eliminate
exposure to both federal estate and gift taxes; will avoid the BPT; will cloak the
investor with anonymity; and can provide a mechanism for ensuring liquidating
distributions are subject to only one level of U.S. tax. The price is a great deal of
complexity and extra costs of administration, and whatever the tax costs are of
doing business as a corporation at home.
•
Investment in a publicly traded or domestically controlled REIT can provide
limited liability and may avoid not only FIRPTA but also the annual filings that
are required in connection with investments made through a partnership or LLC.
REIT capital gain dividends may be subject to a 35% withholding rate, however,
which may wipe out any other perceived advantages of this form.
1
Issues related to state and local income tax and state estate tax consequences of foreign investment in U.S.
real estate are beyond the scope of this article.
2
The withholding regime created along with FIRPTA, found in Section 1445 and discussed in more detail
below, ensures that taxation is extended to any foreign investor, which also includes foreign partnerships,
foreign estates, and foreign trusts.
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3
Reg. 1.1-1(b). Nevertheless, tax treaties between the U.S. and foreign countries sometimes may ameliorate
the adverse impact of being a U.S. resident alien if the affected person also is a resident of the treaty partner
country. Any applicable tax treaty should be reviewed carefully to determine what benefits, if any, might be
available.
4
Section 7701(b)(1)(A)(i).
5
Sections 7701(b)(1)(A)(ii) and 7701(b)(3). Certain individuals who satisfy neither of the previous tests but
who will satisfy the substantial presence test in the following tax year as well as a complex set of other
rules may elect to be treated as residents. Sections 7701(b)(1)(A)(iii) and 7701(b)(4).
6
In particular, an individual will be presumed to be a U.S. resident if the aggregate number of days spent in
the U.S. in a three-year span is 183 days or more. For this purpose, each day in the current year is counted
but only one-third of the days in the first preceding year and one-sixth of the days in the second preceding
year. Take, for example, a person that spends 122 days annually in the U.S. in 2001, 2000, and 1999. Under
this test, the person is treated as spending 122 days in the U.S. in 2001, 41 days in 2000, and 21 days in
1999, or an aggregate of 184 days. Thus, the person will be presumed to be a resident for 2001. The
presumption can be rebutted, however, by a showing that the person has both a “tax home” and a “closer
connection” to a foreign country than to the U.S., provided that in no event did he or she spend more than
183 days in the U.S. in the year in question. Section 7701(b)(3)(B).
7
Sections 871(b) and 882(a).
8
Sections 871(a)(1) and 881(a). This class of passive income includes dividends, interest, rents, royalties,
other specified types of income, and a general catch-all basket of income called FDAP (“fixed or
determinable annual or periodical gains, profits and income”).
9
Sections 1441 and 1442. See generally Lederman and Hirsh, “Final Regs. Revamp Withholding on
Foreign Persons—Will the New Burdens Backfire?,” 88 JTAX 112 (February 1998).
10
The 1996 U.S. Model Income Tax Treaty provides for reductions in the withholding rates for interest (to
zero), royalties (again, to zero), and dividends (to 5% when the beneficial owner of the distributing U.S.
corporation is a contracting-state company that owns directly at least 10% of its voting stock; otherwise, to
15%). The reduction generally is not available when such passive payments are attributable to the activities
or a permanent establishment of the recipient in the U.S. or to the performances of personal services
through a fixed base. The rates agreed on in negotiated treaties, however, may vary from the Model’s
figures. Currently, the treaty withholding rate in U.S. tax treaties ranges from zero to 30% for interest, zero
to 15% for royalties, and 10%-30% for non-intercorporate dividends.
11
Consistent with the view that a partnership is a pass-through entity for tax purposes, a foreign investor that
is a partner in a partnership (or a beneficiary of an estate or trust) which is engaged in a U.S. trade or
business is itself deemed to be engaged in such trade or business. Section 875; Reg. 1.875-1. While this is
helpful for the investor seeking to avoid the adverse impact of the passive income tax, it poses problems for
the investor who wishes to avoid being engaged in a trade or a business in the U.S., as will be discussed in
the text.
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12
Sections 871(b) and 882(a). In general, the deductions also are required to be related to the effectively
connected income, with the exception of certain charitable contributions and (for individuals) certain
personal exemptions. Sections 873 and 882(c).
13
Sections 871(a)(1) and 881(a)(1). Tax treaties can reduce or eliminate this passive income tax, but treaties
generally do not reduce the passive income tax imposed on rental income.
14
For example, consider a foreign investor holding a single parcel of U.S. real estate that is triple net leased
out to a single tenant. The tenant pays the lessor $1 million in rent and another $1 million for expenses
related to the property (such as real estate taxes, insurance, etc.). The 30% tax would be imposed on the
“grossed up” rent of $2 million; the withholding tax would be $600,000; the foreign investor would be left
with only a net $400,000 after taxes. By contrast, a U.S. lessor would start with $1 million of net income
(that is, $2 million of gross income less $1 million of operating expenses), reduced by further deductions
for depreciation, interest, and other allocable expenses. Clearly, the foreign investor’s tax bill could be
much greater than that of a U.S. lessor under the same circumstances.
15
Neill, 46 BTA 197 ; GCM 18835, 1937-2 CB 141.
16
Sections 871(d) and 882(d). The election can be made only in a year in which the investor has income
from U.S. real estate, and applies to all properties (it cannot be made on a property-by-property basis).
Once made, the election is effective for all subsequent years and can be revoked only with IRS consent.
17
Sections 871(h) and 881(c).
18
Sections 871(h)(3) and (h)(4) and 881(c)(3) and (c)(4).
19
For example, the tax treaties with the U.K. and Holland both provide for an exclusion from the passive
income tax on interest. See U.S.-Netherlands Treaty, Article 12(a);, U.S.-U.K. Treaty, Article 11(1). Other
treaties mitigate the tax bite, such as that with Japan, which reduces the withholding rate down to 10%. See
U.S.-Japan Treaty, Article 13(4).
20
Section 163(j) applies if (1) the corporation has either (a) interest expense paid or accrued to a related
person for which a tax treaty reduces the applicable withholding tax or (b) interest owed to an unrelated
person but for which there is a guarantee by a related person, and such guarantor is eligible for treaty relief
if interest were paid to it directly; (2) the corporation has “excess interest”; and (3) the corporation’s debtto-equity ratio exceeds 1.5 to 1. Excess interest is in turn defined to be the excess of (1) the corporation’s
net interest expense over (2) the sum of the corporation’s “adjusted taxable income” plus any excess
interest carryforward from preceding years. Adjusted taxable income is in turn defined to be taxable
income with certain adjustments (such as an add back for depreciation taken).
21
This issue does not typically arise for debt instruments with fixed interest except where the loan comes
from a related party and there is, for example, an excessive debt-to-equity ratio for the project. The issue
can be more of a concern for debt instruments having contingent interest features, sometimes called “equity
kicker” loans, where the interest paid bears a relationship to income or profits from the project.
Nonetheless, even here planning techniques (such as the introduction of limits on the aggregate amount of
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interest that can be paid on the instrument) can minimize the risk of a successful challenge to the status of
the underlying instrument as debt for tax purposes.
22
This passive income tax on dividends may be reduced by a tax treaty. In addition, liquidating distributions
paid by that corporation are generally not subject to tax except where FIRPTA, as discussed below,
overrides the general rule. See note 24, infra.
23
Sections 884(b) and (d); Regs. 1.884-1(b) and -1(f).
24
Reg. 1.1441-3(b)(1)(ii) (effective through 12/31/00) and Reg. 1.1441-3(c)(2)(b) (effective after 12/31/00).
Such a distribution also is not subject to FIRPTA withholding unless the corporation is a U.S. real property
holding company (discussed later in this article). Reg. 1.1445-5(e)(2).
25
See, for example, Reg. 1.884-1(g)(3) for a partial list (although the applicable treaty should be reviewed
before reliance on this Regulation, to ensure that the applicable exemption still is in effect).
26
Section 884(e); Reg. 1.884-5. No foreign corporation that is a resident of a tax treaty jurisdiction can
obtain a BPT exemption under a limitations on benefits provision of such treaty unless (1) the foreign
corporation is a qualified resident of that foreign country or (2) the limitation on benefits provision came
into force after 1986. Reg. 1.884-1(g)(1). A foreign corporation is a qualified resident if (1) it meets the
stock ownership and base erosion requirements, intended to make sure that the company is not primarily
owned (that is, not more than 50% owned) by non-treaty residents or its income is not being primarily
diverted to non-treaty persons through debt service (i.e., no more than 50% of its income can be used to
meet liabilities owed to persons who are not treaty residents); (2) it is publicly traded; (3) it meets the test
of being an active trade or business; or (4) a ruling is obtained from the IRS. Reg. 1.884-5(a). The foreign
corporation also must be “liable to tax” in that foreign country. See Article 4 of the 1996 U.S. Model Tax
Convention; Rev. Rul. 2000-59, 2000-2 CB 593.
27
See, generally, Section 894.
28
Section 884(f)(1); Reg. 1.884-4(a)(1).
29
Section 884(f)(1). See generally H. Rep’t No. 104-586, 104th Cong. 2d Sess. 173 (1996).
30
The interest allocable to the U.S. branch is determined under a complex formula in Reg. 1.882-5.
31
Reg. 1.884-4(a)(1). This exemption does not apply, however, to “excess interest.”
32
Sections 2001(a) and 2031(a).
33
Regs. 20.0-1(b), 25.2501-1(b), and 26.2663-2(a). See also Farmers’ Loan & Trust Co., 11 AFTR 794, 60
F2d 618 ; Rodiek v. Helvering, 33 BTA 1020 , aff’d 18 AFTR 770, 87 F2d 328, 37-1 USTC ¶9032 .
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34
Sections 2103 and 2104.
35
Section 2001(c)(1).
36
Sections 2056(d) and 2056A. Another aggravating factor for nonresidents is that the Section 2010 annual
exclusion from estate tax ($650,000 for decedents dying in 2000) applies only to U.S. residents. The estates
of nonresidents get a very limited $13,000 estate tax credit, which translates into an exclusion of only
$60,000 of assets passing at death free of U.S. estate tax. Section 2102(c)(1). See generally Siegler and
Plaine, “Despite Some Easing in Final Regs., QDOT Rules Remain Intensely Complicated,” 83 JTAX 368
(December 1995).
37
Section 2104(a); Regs. 20.2104-1(a)(1) and (5).
38
Sections 2104(c) and 2105(b).
39
Rev. Rul. 55-701, 1955-2 CB 836. See also Sanchez v. Bowers, 13 AFTR 1074, 70 F2d 715 . The IRS
generally refuses to rule on whether partnership interests are intangible assets, unless unique or compelling
circumstances exist. Rev. Proc. 2000-7, 2000-1 CB 227.
40
Regs. 25.2511-1(a) and (b). While not free from doubt, the treatment of the gift of an interest in a
cooperative apartment as subject to the gift tax generally should depend on whether local law will view it
as an interest in real estate or an intangible interest. A co-op is a combination of (1) an intangible interest in
a domestic cooperative corporation and (2) a long-term lease, which is a real estate asset. Assuming local
law would allow the co-op interest to be treated as an intangible, and thus escape gift tax exposure, a
foreign person who may want to take advantage of the potential tax benefits must be aware of the nontax
complications that burden co-ops, such as the need to get board of directors approval for a sale (which can
be frustrating), limitations by some co-ops on who can be an owner (such as a prohibition on corporate
ownership), and other factors that can undercut any tax advantage.
41
Section 897(c)(1)(A)(i); Reg. 1.897-1(b)(2). These deposits, however, cease to be real property once they
are severed or extracted from the land.
42
Reg. 1.897-1(d)(2)(ii)(B). Compare the similar definition in Reg. 1.897-1(d)(3)(i)(E) of options to acquire
an interest in entities that hold USRPIs, discussed in the text, below.
43
Section 897(c)(1)(A)(ii). The Regulations provide separate rules for determining noncreditor interests in
USRPIs (in Reg. 1.897-1(d)(2)) and in entities that hold USRPIs (in Reg. 1.897-1(d)(3)), even though the
principles are similar.
44
In the grantor trust setting, a grantor may be treated as the owner of a portion of a trust under Section 671.
Persons other than the grantor also may be treated as the holder of ownership interests (see, e.g., Section
678), and they too are considered holders of an interest other than solely as a creditor in the trust.
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45
Reg. 1.897-1(d)(3)(ii)(B).
46
Reg. 1.897-1(d)(3)(i)(E).
47
Section 897(c)(2); Reg. 1.897-2(b). Rules as to how FMV is determined generally look to an asset’s net
(rather than gross) market value. Reg. 1.897-1(o)(2)(i).
48
While foreign corporations are generally not USRPHCs, in determining whether a U.S. corporation is a
USRPHC, the Code “looks through” foreign corporations to determine whether a U.S. corporate holder of
stock in the foreign corporation is a USRPHC. If the foreign corporation would be a USRPHC had it been a
U.S. corporation, the interest in the foreign corporation will be a USRPI for purposes of determining
whether the U.S. corporate holder of the interest may be a USRPHC. Section 897(c)(4).
49
The book value is determined by the value at which an item is carried on the financial accounting records
of the corporation, if such value is determined in accordance with generally accepted accounting principles
applied in the U.S. Reg. 1.897-2(b)(2)(ii).
50
Section 897(c)(1)(A)(ii). The procedure for establishing that the corporation is not and was not a
USRPHC in the testing period is normally accomplished by obtaining a statement from the corporation;
Reg. 1.897-2(g)(1)(i)(A). Such statement generally may be used to obtain exemption from withholding
under Section 1445; Reg. 1.897-2(g)(1)(ii)(B). The corporation must comply with certain notice
requirements in Reg. 1.897-2(g)(1)(ii)(A) for such statement to be valid. What happens, however, if the
corporation fails to file such a notice with the IRS? While the corporation that believes it is not a USRPHC
also may believe that it can then establish that it was not a USRPHC on audit or in litigation, the
Regulations do not offer any such clear path. Furthermore, if the corporation’s non-USRPHC certification
is later found to be false, the shareholder is excused from penalties and interest, but the shareholder is not
excused from liability for the tax. Reg. 1.897-2(g)(1)(ii)(A). While some taxpayers may feel such risk is
warranted given the likely inability of the IRS to be able to follow the shareholder back to his home country
to seek collection of the tax, it would nonetheless appear prudent to still have the corporation file the notice
with the IRS, especially given the cursory amount of information required to be filed.
51
Reg. 1.897-2(f)(1).
52
In fact, it may notify the Service when it has ceased to be a USRPHC. See Regs. 1.897-2(f)(1) and 1.8972(h).
53
While a leasehold interest in real estate is generally a USRPI, the value of a FMV lease for purpose of
determining whether the corporation is a USRPHC will be close to zero. See Reg. 1.897-1(o)(3). In that
instance, the leasehold interest’s nominal value should be less than the value of the non-USRPIs held by the
corporation. As a result, the corporation should not then be a USRPHC.
54
Section 897(c)(3); Reg. 1.897-1(c)(2)(iii).
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55
Reg. 1.897-2(f)(2). The corporation may continue to hold a leasehold interest that has an FMV of zero,
even if there is a renewal option (so long as the renewal is at FMV), and interests in corporations that
ceased to be USRPHCs. Reg. 1.897-2(f)(2).
56
Section 865(a)(2). See also Section 864(c)(2). Similar provisions exist in applicable tax treaties. See, e.g.,
the U.S. 1996 Model Tax Treaty, Article 13(5).
57
Section 897(c)(1)(B).
58
As well as other nonrecognition provisions, such as Sections 332, 354, 355, 361, 721, 731, 1031, 1033,
and 1036. See Temp. Reg. 1.897-6T(a)(2).
59
The transfer also would be exempt from withholding if the parties comply with notice requirements; see
the discussion in the text, below. These rules do not, however, negate the nonrecognition available under
Section 897(d) for certain distributions made by foreign corporations, which generally follow a similar
principle requiring taxation on subsequent disposition and no change in the adjusted basis in the USRPI
distributed (except for increases for any gain recognized).
60
Section 897(g); Temp. Reg. 1.897-7T(a).
61
Reg. 1.897-7(a); Temp. Reg. 1.1445-11T(d).
62
Reg. 1.897-1(c)(2)(iv).
63
Unlike partnerships, the Code and the Regulations do not provide special rules defining interests in trusts
and estates as USRPIs.
64
Reg. 1.897-1(d)(1). Whether an interest is not solely as a creditor is important for two reasons: not only
whether the disposition of the interest itself is subject to FIRPTA taxation but also whether the interest will
be taken into account in determining whether a corporate holder of that interest is a USRPHC.
65
P.L. 106-170, 12/17/99, adding Section 453(a)(2). See Lipton, “Installment Rule Change Creates a
Multitude of Problems for Many Taxpayers,” 92 JTAX 134 (March 2000). See also Rev. Proc. 2000-22,
2000-1 CB 1008, as modified by Rev. Proc. 2001-10, 2001-1 CB 272 (providing for an exclusion for
“small” taxpayers but excepting tax shelters), and Seago, “A New Revenue Procedure Makes the Cash
Method More Available, but Does It Go Far Enough?,” 93 JTAX 12 (July 2000); Notice 2000-26, 2000-1
CB 954 (offering guidance by the IRS in interpreting the repeal of the installment sale technique).
Generally also see Testimony of Joseph Mikrut, Treasury Tax Legislative Counsel, before the House
Committee on Small Businesses, 4/5/00 (Tax Analysts Doc. 2000-10201, 2000 TNT 68-22).
66
H.R. 3594, 106th Cong., 2d Sess. (2/8/00).
- 28 -
67
Reg. 1.897-1(d)(2)(ii)(A).
68
An anti-abuse rule maintains the character of the obligation as a USRPI in the hands of the transferee if it
is disposed of with a principal purpose to avoid FIRPTA. Id. Also, certain payments received after 6/18/80
are exempt if the disposition took place before 6/19/80, as are certain payments received after 1984 if the
disposition took place before 1985 and is exempt under a U.S. tax treaty. Id.
69
Id.
70
Reg. 1.1445-2(d)(4).
71
Rev. Proc. 2000-35, 2000-2 CB 211, section 7.
72
U.S. possessions are not included for this purpose; Section 7701(a)(9). Thus, a U.S. Virgin Islands
partnership will be considered a foreign partnership even though U.S. Virgin Islands real property is
generally a USRPI.
73
TRA ‘97 amended Section 7701(a)(4) to authorize Regulations that would determine the residency of
partnerships by taking into account factors such as the residency of the partners, whether the partnership
does business in the U.S., etc. See H. Rep’t No. 105-220, 105th Cong., 1st Sess. 630 (1997). These
Regulations have not yet been proposed.
74
Reg. 1.1445-1(c)(1).
75
Section 1461; Reg. 1.1445-1(e).
76
Reg. 1.1445-1(e)(3)(ii).
77
Reg. 1.1445-1(f).
78
Regs. 1.1445-2(b)(4)(ii) and (iii), 1.1445-2(c)(3)(ii), and 1.1445-2(d)(2)(ii).
79
Reg. 1.1445-2(b)(1).
80
Reg. 1.1445-2(b)(2).
81
Reg. 1.1445-7(a).
82
Reg. 1.1445-2(c).
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83
A certificate of non-USRPHC status should be obtained. Regs. 1.1445-2(c)(3) and 1.897-2(h).
84
Regs. 1.1445-2(c)(2) and 1.897-1(c)(2)(iii)(A).
85
Reg. 1.1445-2(d)(1).
86
Reg. 1.1445-2(d)(2). See also Temp. Regs. 1.1445-9T and -10T.
87
Reg. 1.1445-2(d)(5).
88
Reg. 1.1445-2(d)(8).
89
Reg. 1.1445-2(d)(7). Special rules exist for certain installment payments. See Reg. 1.1445-2(d)(4) and the
text accompanying notes 70 and 71, supra.
90
Reg. 1.1445-1(c)(2)(i)(A).
91
Also available is a special application for a “blanket withholding certificate” when a series of transfers is
anticipated and the transferor or the transferee wish to avoid submitting multiple applications. Such an
application must be submitted by the date of the first transfer that may give rise to withholding. Rev. Proc.
2000-35, supra note 71, section 9.
92
Id., section 3.
93
Unless the entity is not engaged in a trade or business in the U.S. Section 875(1); Reg. 1.875-1.
94
Section 1446. In particular, the partnership must withhold at the highest tax rate on the foreign partner’s
allocable share of its effectively connected taxable income for the tax year, which generally means income
that may be effectively connected with a U.S. trade or business, with certain adjustments.
95
For a comprehensive discussion of this issue, see Appel and Hirschfeld, “Withholding Tax on Phantom
Gain,” 11 Practical Tax Lawyer 43 (No. 2, Winter 1997).
96
Section 897(h)(4)(B). The testing period is defined in Section 897(h)(4)(D) as the shortest of (1) the
period beginning on 6/19/80 and ending on the date of the disposition or distribution, (2) the five-year
period ending on the date of the disposition or distribution, or (3) the period during which the REIT was in
existence.
97
See also Section 1445(e)(1).
- 30 -
98
Section 857(b)(3)(D).
99
See Prepared Testimony of Kenneth J. Kies on Behalf of the Staff of the Joint Committee on Taxation
before the Senate Committee on Foreign Relations, JCX-53-97 (10/7/97), Tax Analysts Doc. 97-28025, 97
TNI 197-21. See also Testimony of Joseph H. Guttentag, Treasury International Tax Counsel, before the
Senate Foreign Relations Committee, RR-1981 (10/7/97), Tax Analysts Doc. 97-28027, 97 TNI 197-24.
100
A REIT will be diversified if the value of no single interest in real property held by the REIT exceeds
10% of the value of the REIT’s total interests in real property. An interest in real property will not include
foreclosure property or mortgages unless the mortgage has substantial equity components. Thus, a REIT
that holds mortgages will be considered to be diversified. Where a REIT holds interests in real property
through a partnership, the diversification rule will be applied by looking through the partnership interest to
the underlying interests in real property held by the partnership.
101
See, e.g., U.S.-Austria Treaty, Article 10(2); U.S.-South Africa Treaty, Article 10(2); U.S.-Denmark
Treaty, Article 10(3); U.S.-Italy Treaty, Article 10(9).
102
Sections 897(h)(3) and 897(d)(1).
103
Section 897(h)(4)(C).
104
Section 897(h)(4)(D).
105
Regs. 301.7701-3(b)(1)(ii) and -3(b)(2)(i)(c).
106
The use of a single-member LLC, however, also can accomplish limited liability while not creating a
separate taxpayer.
107
Although U.S. estate tax treaties can, if applicable, eliminate such tax liability (the U.S.-Netherlands
Estate Tax Treaty, for example, would eliminate such tax on intangible property for a Dutch domiciliary).
108
To achieve a 5% withholding rate, the foreign investor must generally first form a foreign corporation in a
tax treaty jurisdiction that will hold all the stock of the U.S. corporation (to qualify for reduced treaty
withholding rates on dividends) and then ensure that the reduced withholding rate is not denied because of
a treaty “limitation on benefits” clause. This clause generally will not be breached if the foreign corporation
is incorporated or formed under the laws of the same country as the place of residence of the foreign
individual. The individual should then further ensure that the interposition of the foreign corporation does
not result in a second level of foreign tax.
109
IRS Form 1120, Schedule K, Question 5.
110
Section 884(a). Tax treaties also can reduce or eliminate the BPT; Section 884(e).
- 31 -
111
For example, the 30% passive income tax does not generally apply to a liquidating distribution paid by a
U.S. corporation to a foreign shareholder. Temp. Reg. 1.884-2T(a) provides a similar rule for the BPT, but
requires satisfaction of four conditions that can sometimes be hard to meet (e.g., none of the assets can be
used in a U.S. trade or business until lapse of a three-year period that starts at the end of the year of
termination).
112
IRS Form 1120F, Section I, Item (U).
113
A foreign investor, however, still may prefer this structure if (1) such person resides in a treaty country,
(2) the investment entity will be formed in the treaty country so that it gets treaty benefits, (3) the treaty
provides for an exemption from the BPT, and (4) anonymity is not a primary concern for the investor.
114
The advantages discussed in the text consider merely the U.S. tax considerations. The structure may
become disadvantageous if the use of the foreign corporation creates another level of tax to the foreign
individual investor in her own country.
115
In certain situations, foreign investors may wish to use multiple foreign corporations, one for each U.S.
corporation. This structure is helpful, for example, if the investor wishes to transfer properties separately by
gift or bequest.
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