The IRS issued proposed regulations (Reg.-109826-17 or the “proposed regulations”) designed to clarify and modify the rules that apply to foreign pensions investing in U.S. real property. The 1980 Foreign Investment in Real Property Tax Act (FIRPTA) imposes tax and withholding obligations on dispositions of U.S. real property interests (USRPIs) by foreign corporations and nonresident alien individuals. The proposed regulations address section 897(l), which provides that a qualified pension fund (or a qualified controlled entity) is not treated as a nonresident alien individual or foreign corporation for purposes of FIRPTA. Under the proposed regulations, a qualified pension fund that has a gain or loss from the disposition of USRPIs, would be exempt from taxation.
Requirements applicable to a Qualified Foreign Pension Fund
The regulations take a broad approach in determining what entities can be a Qualified Foreign Pension Fund (QFPF) and define a QFPF for purposes of FIRPTA as any trust, corporation, or other organization or arrangement that was organized under the laws of a country outside of the U.S. The regulations did not generally broaden the class of individuals who may be beneficiaries of the QFPF. The fund must be established to provide retirement or pension benefits to participants or beneficiaries that are current and former employees (including self-employed individuals), and thus the regulations do not permit de minimis ownership interests by managers or directors. The regulations did not change the requirement that the fund cannot have a single participant or beneficiary with a right to more than 5% of its assets or income (the 5% limitation).
Additionally, to be a QFPF for purposes of section 897, the laws of the country in which the eligible fund is established or operates must provide that either (i) the contributions to such eligible fund are deducted/excluded from the gross income of the eligible fund or taxed at a reduced rate as per the applicable local laws or (ii) taxation of any investment income of the eligible fund is deferred or excluded from the gross income of the eligible fund or taxed at a reduced rate. Treasury Department and the IRS have determined that an eligible fund is treated as satisfying this requirement if the fund is established and operates in a foreign country that has no income tax.
A qualifying fund must be subject to government regulation and the annual information regarding its beneficiaries must be provided, or be otherwise available, to the relevant tax authorities in the country in which the fund operates or is established. Additionally, all of the benefits that an eligible fund provides must be qualified benefits to qualified recipients, and at least 85% of the present value of the qualified benefits that the eligible fund reasonably expects to provide in the future must be retirement or pension benefits. Thus, a qualifying fund may provide de minimis “ancillary” benefits in addition to the retirement or pension benefits that are the main purpose of the fund. This may relieve some concerns about funds providing limited disability payments, for example.
Withholding under sections 1445 and 1446
The proposed regulations also address the documentation rules that apply to exemptions from withholding taxes otherwise required by sections 1445 and 1446. A transferee of U.S. real property would not be required to withhold under section 1445(a) if the transferor is not a foreign person. As such, a qualifying foreign pension fund should provide certification to a transferee or partnership to claim an exemption under section 897(l). In order to do so, the IRS intends to revise Form W-8EXP to permit qualified holders to certify their status under section 897(l).
Similarly, section 1446 generally requires that a partnership must withhold tax on effectively connected taxable income (ECTI) allocable under section 704 to a foreign partner. The proposed regulations generally provide that any gain from the disposition of a USRPI, or distribution received from a qualified investment entity, that is not otherwise treated as effectively connected with a U.S. trade or business will not be treated as ECTI subject to section 1446 withholding to the extent allocable to a qualified holder. The proposed regulations would permit a partnership to rely on Form W-8EXP to determine a partner’s foreign status and, as appropriate, exclude any gain from the disposition of USRPI.
Foreign pensions investing in USRPIs should take note of the proposed regulations and discuss with their advisers how they can best structure their fund to allow for preferential U.S. tax treatment. Withholding agents should also review the proposed regulations so that they understand the documentation requirements for qualifying foreign pension plans going forward. The need for proposed regulations arose from the perception that certain foreign pension funds were refraining from investment in U.S. real property due to ambiguities over their qualification for the foreign pension fund exemption. While the proposed regulations do not specifically aim to increase/decrease foreign pension fund investment in the U.S., they aim to provide guidance such that investment can be made on an efficient basis consistent with the intent and purposes of the statute. Treasury has requested public comments and public hearing requests by Sept. 5, 2019.