Tax Issues - The consequences of indirect investment in US real estate
A non-US investor considering acquiring exposure to US real estate through a financial instrument should be aware of the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA). FIRPTA subjects a non-US investor to US tax on gain on the disposition of a "US real property interest" (USRPI) by creating the fiction that the non-US investor is engaged in a US trade or business and by treating the gain or loss from the disposition as effectively connected to such business. Under the statute, a USRPI includes "an interest in real property (including an interest in a mine, well, or other natural deposit) located in the US." USRPIs also include options or contracts to acquire land or land improvements and leaseholds of land or land improvements. Under FIRPTA, then, a non-US investor is generally subject to tax at regular rates on any gain realised on the sale of real estate. The regular US income tax rate is 35%, although individuals may qualify for a rate as low as 15% on capital gain, if certain holding period requirements are satisfied.
Congress also realised that non-US investors could invest in real estate through various types of business entities, such as corporations, master limited partnerships, and real estate investment trusts. In addition, an investor may enter into options, convertible debt and other derivative contracts that provide exposures to USRPIs. US income and withholding tax rules apply to a non-US investor who seeks exposure to US real estate through an investment in an entity that itself holds such real estate.
US real property holding corporations
Applicability of FIRPTA rules
Generally, interests held in a US corporation, other than those held solely as a creditor, are treated as USRPIs, unless the taxpayer can establish that the corporation was not a US real property holding corporation (USRPHC)) during the shorter of the period during which the taxpayer held such interest and the five-year period ending on the date of the disposition of such interest (the applicable period). A US corporation is a USRPHC if the fair market of its USRPIs is 50% or more of the sum of the fair market value of its USRPIs, its interests in real property outside the US and other assets used or held for use in a trade or business (the USRPHC test). As part of this calculation, if a corporation owns a controlling interest (that is, 50% or more of the stock) in another corporation, the controlling corporation is treated as owning a portion of each asset equal to the percentage of the controlled corporation's stock held by the controlling corporation.
Income tax consequences
If the corporation is a USRPHC, the non-US investor's gain from the disposition of the stock (including gain realised from certain transactions that would normally not require the recognition of gain) is taxed as if the non-US investor were engaged in a trade or business and as if that gain were effectively connected with that trade or business. This generally results in an income tax liability at regular US tax rates. Dividends paid by a USRPHC are not subject to tax under FIRPTA, but are subject to the generally applicable 30% tax imposed under the Internal Revenue Code (IRC) on dividends (potentially subject to reduction if an income tax treaty applies).
Withholding tax regime
Upon the disposition of stock of a USRPHC by a non-US investor, the transferee generally is required to deduct and pay the Internal Revenue Service (IRS) a withholding tax equal to 10% of the amount realised on the disposition. The amount realised is the sum of the cash paid or to be paid, the fair market value of other property transferred or to be transferred and the outstanding amount of any liability assumed by the transferee or to which the property is subject to immediately before and after the transfer. Withholding is not required when the transferor's gain is not recognised under an applicable provision of the IRC, as long as the non-US investor complies with applicable procedural requirements.
5% publicly-traded exception
Shares of a class of stock of a corporation that is regularly traded on an established securities market are not a USRPI unless the shareholder beneficially owned more than 5% of the total fair market value of that class at any time during the applicable period. These rules (the corporate five percent exception) effectively eliminate income and withholding tax liability under FIRPTA for many small shareholders of publicly traded US real estate corporations. As a precautionary note, in determining whether a non-US investor meets the corporate five percent exception, constructive ownership rules apply to treat the non-US investor as the owner of stock owned by certain family members, partnership and trusts, in the partner's proportionate share, and corporations, in the shareholder's proportionate share if the non-US investor owns more than 5% of the value of the stock in such corporation.
Notwithstanding the general definition of a USRPHC, an interest in a US corporation is not treated as a USRPI if two conditions are satisfied. First, as of the date of disposition of such interest, the corporation must not hold any USRPIs. Second, all of the USRPIs held by such corporation at any time during the applicable period must have been disposed of in transactions in which the full amount of gain (if any) was recognised or must have ceased to be such by reason of the application of the application of this exception to one or more other corporations.
Applicability of FIRPTA rules
Interests in a master limited partnership (MLP) that is treated as a partnership for US federal income tax purposes will be USRPIs to the extent that the MLP owns USRPIs. A non-US investor who owns an interest in an MLP is generally treated as owning his proportionate share of partnership assets and conducting the partnership's trade or business, if any. An MLP frequently will be engaged in a sufficiently high level of activity that it will be treated as engaged in a trade or business in the US. Accordingly, the provisions of the Code that impose liability on a non-US partner of a partnership that is engaged in a trade or business in the US, rather than FIRPTA, frequently will apply to impose income and withholding tax on the PTP.
Income and withholding tax consequences
A disposition of a USRPI by an MLP (for example, an oil well) generally will produce gain that is taxable at regular US rates. The MLP will be required to withhold tax under section 1446 on effectively connected income (including gains treated as effectively connected income under FIRPTA) allocable to non-US partners. Subject to the discussion below, on the disposition of an MLP interest, the non-US investor generally owes income tax at the regular rates under FIRPTA only to the extent that the gain on the transfer is attributable to USRPIs held by the MLP, and not to the extent it is attributable to cash, cash equivalents or other property.
Full inclusion rule
If 50% or more of the value of the gross assets in the MLP consists of USRPIs and 90% or more of the value of the gross assets consists of USRPIs, cash and cash equivalents, there is a withholding tax at the rate of 35% on the entire amount of a distribution and at the rate of 10% on a disposition.
Five percent publicly-traded exception
If any class of interests, not just the class a particular investor holds, in an MLP is regularly traded on an established securities market, the MLP interest is not treated as an interest in a partnership. Instead, the interest is subject to the rules applicable to interests in publicly traded corporations. To apply this test, the MLP must determine whether it would be a USRPHC if it were a corporation. If it would be a USRPHC, then any non-US person who would meet the corporate 5% exception with respect to such USRPHC is not subject to income or withholding tax under FIRPTA with respect to any sales of its interest in the MLP. If the MLP would not be a USRPHC under this test, then any non-US person, even one who would not meet the corporate 5% exception, is not subject to income or withholding tax under FIRPTA on any sales of its interest in the MLP. However, this exception for public trading affects only the non-US investor's liability for income and withholding tax on a disposition of its interest in the MLP; the exception has no effect on the investor's liability for income and withholding tax on distributions made by the MLP. Thus, an MLP would still be required to withhold tax at regular rates on its non-US partners' distributive share of its effectively connected income.
Real estate investment trusts
Applicability of the FIRPTA rules
A real estate investment trust (REIT) is a US corporation that invests more than 75% of its assets in real estate assets, cash, cash items and government securities, derives at least 75% of its income from its real estate related investments (which can include mortgages secured by real property), and meets various other requirements. Because of the asset requirement, REITs are frequently USRPHCs. If a REIT is a USRPHC, the rules for the disposition of stock in a USRPHC generally also apply to the REIT, including the corporate 5% exception. However, the common stock is not a USRPI, and therefore not subject to tax under FIRPTA, if at all times during the testing period, less than 50% of the value of the common stock is held directly or indirectly by non-US investors. If the FIRPTA rules do apply to the sale of the common stock in a REIT, the non-US investor is subject to the same treatment as a US stockholder with respect to the gain.
Withholding and income tax regimes
A REIT generally avoids corporate level taxation by, among other things, distributing all of its income (including that resulting from recognised capital gains) to its shareholders each year. The FIRPTA rules provide that REIT distributions to non-US investors are treated as gain from the sale or exchange of a USRPI to the extent the REIT gain is attributable to gain from sales or exchanges of USRPIs. Accordingly, the distribution is treated as income that is effectively connected with a US trade or business and is subject to income tax and withholding tax at regular US rates. Distributions from a REIT that are not attributable to gain from sales or exchanges of USRPIs are generally subject to a 30% withholding tax to the extent made out of the earnings and profits of the REIT, subject to reduction pursuant to an applicable tax treaty.
5% publicly-traded exceptions
In the REIT context two similar, but slightly different, 5% exceptions limit the imposition of tax under FIRPTA: one applies to dispositions and the other to distributions. First, a REIT is a corporation, and so the corporate 5% exception potentially applies to any gain realized on the disposition of an interest in a REIT. Second, if a REIT makes a distribution with respect to any class of stock that is regularly traded on an established securities market in the US and a non-US holder of such stock did not own more than 5% of such class of stock at any time during the one-year period ending on the date of such distribution, such distribution generally is not treated as a gain from the sale or exchange of a USRPI. Accordingly, any such distribution would generally be subject to the 30% tax that applies to payments of dividends, to the extent paid out of the earnings and profits of the REIT, subject to reduction pursuant to an applicable tax treaty.
FIRPTA application to certain other types of investments
Options to purchase stock
In addition to applying to a gain from the disposition of stock in a USRPHC, the FIRPTA rules also apply to other interests in a corporation, other than interests solely as a creditor. Thus, they clearly apply to an option issued by a USRPHC with respect to its stock and, as a general rule, any gain recognised on the sale of an option would therefore be subject to tax at regular US rates.
An option or other interest in a corporation, however, may qualify for the 5% exception. If any class of a corporation's stock is regularly traded on an established securities market, an interest in such corporation is a USRPI only in the case of:
a regularly traded interest owned by a person who beneficially owned more than 5% of the total fair market value of that class of interests at any time during the applicable period; or
any other interest in the corporation (other than an interest solely as a creditor), if such interest had, on the date it was acquired by the non-US investor, a fair market value greater than the fair market value on that date of 5% of the regularly traded class of the corporation's stock with the lowest fair market value.
However, if a non-regularly traded class of interests in the corporation is convertible into a regularly traded class of interests in the corporation (for example, preferred stock or convertible debt issued in a Rule 144A offering that is convertible into the company's publicly-traded common stock), an interest in such non-regularly traded class is treated as a USRPI if on the date it was acquired by its present holder it had a fair market value greater than the fair market value on that date of 5% of the regularly traded class of the corporation's interests into which it is convertible.
Assuming the option is not regularly traded on an established market, but is convertible into stock that is so traded, the key criterion in determining whether gain on the sale of the option would be subject to tax under FIRPTA is whether the fair market value of the option is more than the fair market value of the class of stock into which the option is exercisable, with both of such fair market values being determined as of the date of acquisition of the option. Note that this rule does not require the relative fair market values to be redetermined on the date a gain is realised.
This absence of retesting may produce some surprising results. Consider an option issued by a corporation with respect to its single class of equity. The option, when issued, allowed its holder to obtain an amount of stock considerably more than 5% of the number of outstanding shares. However, the strike price was relatively high at the time the taxpayer acquired the option, so its fair market value was less than 5% of the fair market value of the corporation's outstanding equity. Since the taxpayer acquired the option, the price of the underlying equity has increased considerably and the value of the option has thus increased as well to the point where its value is more than the value of 5% of the corporation's equity. However, because no revaluation of the option is required before the sale of the option, the 5% safe harbour is satisfied and the taxpayer has no liability for tax under FIRPTA upon the sale of the option.
Convertible debt instruments
The same rule for valuing convertible non-traded interests in USRPHCs, which was apparently too lenient in the option context described before, can also be too harsh. Consider a USRPHC that issues a debt instrument that is convertible into less than 5% of the corporation's outstanding publicly-traded common stock (assume the common stock is the only class outstanding). Furthermore, on the acquisition date, the value of the entire debt instrument (not just the value attributable to the conversion feature) is greater than 5% of the value of the corporation's common stock (for example, because the corporation is highly leveraged). Note that even where a convertible instrument is being evaluated, the regulation looks to the relative fair market values of the non-stock interest, on the one hand, and the traded equity on the other hand. By contrast, the regulation does not look to the number of shares into which the interest is convertible relative to the total number of shares of that class (whether traded or otherwise). Under these circumstances, even though the great majority of the value of the debt instrument represents an interest "solely as a creditor", any gain on the sale of the debt instrument is subject to tax under FIRPTA. In this instance, then, the FIRPTA rules, by failing to account separately for the debt-value inherent in the convertible debt instrument, appear overly harsh.
The authors would like to thank Jeff Maddrey of PricewaterhouseCoopers for his observations on the topic discussed in this section
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Matthew Stevens, a partner in the international tax group of Alston & Bird, advises clients on a wide range of tax-related issues. He handles planning and controversy matters regarding the US federal income tax consequences of transactions, specialising in the design, structuring and implementation of domestic and international financial transactions, including structures involving preferred stock financing transactions, swaps, options, all types of debt instruments (including hybrid debt and bond-hedge transactions), forward contracts and Tier One capital financing transactions. He also has substantial experience in international tax issues involving foreign tax credits, subpart F and PFICs, withholding taxes, dual consolidated losses, hybrid and reverse hybrid entities and tax treaties.
From 2002 to 2004, Stevens served as special counsel to the chief counsel for the Internal Revenue Service. He advised the chief counsel regarding published guidance, including regulations, revenue rulings and notices involving contingent convertible debt instruments, prepaid forward contracts, debt-forward contract units, partnership options and notional principal contracts.
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Brian Harvel is an associate in the federal income tax group with a practice focus on complex tax structuring and planning for a wide range of domestic and international business entities. He also has experience in federal tax controversy in regard to refund and assessment claims with the Internal Revenue Service.
Harvel received his JD from the Emory University School of Law in 2007 with honours. He served as the marketing editor on the Emory Law Journal and is a member of the Order of the Coif. At Emory, He earned the American Institute of Bankruptcy Award, the Georgia Tax Bar Section Most Outstanding Student Award, the Sutherland, Asbill and Brennan Tax Award, and a 2006-2007 Emory Service Award. He received his BS in economics from Clemson University, summa cum laude, in 2004 with general and departmental honours for a thesis entitled "Is Economic Growth Affected by the Establishment of a Central Bank?".