Executive Summary:
Treasury and the IRS recently issued proposed regulations under section 897 (The Foreign Investment in Real Property Tax Act or FIRPTA), and section 892 (the exemption from U.S. tax for foreign governments and sovereign wealth funds) (the Proposed Regulations) regarding the determination of whether a qualified investment entity (QIE) is domestically controlled under section 897(h)(4), and treatment of qualified foreign pension funds (QFPFs) under section 892. Broadly, the Proposed Regulations adopt a limited look-though approach to determine if a QIE is domestically controlled. Under this approach, the payor looks through partnerships and foreign owned domestic corporations to determine if the QIE is domestically controlled applying the proportionate ownership interest for indirect ownership interest. The Proposed Regulations also align the exception for QFPFs under FIRPTA to exclude these pension funds under the foreign government exception. Below is a summary of some of the key provisions from the New Proposed Regulations.
On the same date, Treasury and the IRS also issued final regulations under Code section 897(l) (the Final Regulations) addressing general QFPF qualification issues. Refer to our alert for a summary of the Final Regulations.
Background
Under the Internal Revenue Code, a nonresident alien’s or foreign corporation’s gain or loss on the disposal of a U.S. Real Property Interest (USRPI) is taxed as if they are engaged in a U.S. trade or business and such gain or loss on the disposition is effectively connected with that trade or business. Such disposal is taxable, and under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), is subject to withholding by the U.S. payor. If there is required a FIRPTA withholding, then the U.S. payor is required to withhold and remit 15% of the amount realized on the disposition.
The Internal Revenue Code generally defines a USRPI to be an interest in real property, as well as any interest in a domestic corporation that is a U.S. Real Property Holding Corporation (USRPHC) during the shorter of when the foreign person held such interest in the corporation or the five-year period ending on the date of the disposition of such interest. In general, a USRPHC means any corporation whose fair market value of its USRPI is 50% or greater than the total of the corporations URPI, real property interests outside the U.S. and all other assets of the corporation used or held for use in a trade or business.
The Code provides special rules with respect to distributions from Qualified Investment Entities (QIE) and domestically controlled qualified investment entities (DC-QIE) to nonresident aliens and foreign corporations. The distributions from these entities are subject to U.S. tax and FIRPTA withholding to the extent the distribution is attributable to gains from sales or exchanges by a QIE of a U.S. real property interest. However, the regulations provide that an interest in a domestically controlled REIT is not a U.S. real property interest. For the purposes of determining whether a REIT is a domestically controlled REIT, the actual owner of the stock is used to determine ownership. The actual owner of a stock in a REIT is the person who is required to include in gross income in their return the dividends received from the REIT.
A QIE includes a real estate investment trust (REIT), and a regulated investment company (RIC) that is a US real property holding corporation. A domestically controlled qualified investment entity is a REIT or RIC that was held directly or indirectly by less than 50% of foreign persons during the testing period. The testing period is the shorter of the five years period ending on the date of disposition or the period during which the QIE exists.
For the purposes of determining foreign ownership percentage of a DC-QIE, if a party owns less than 5% of a DC-QIE that is a publicly traded security, then the party is deemed to be a U.S. person unless the QIE has actual knowledge that such person is foreign. Additionally, any stock of a QIE held by another QIE that is publicly traded, or is a RIC that uses redeemable securities, is treated as a foreign person unless that QIE is domestically controlled.
The current regulatory framework led to a situation where a foreign party could have an indirect interest in a REIT through a domestic blocker corporation, and thus avoid FIRPTA tax and withholding. This position was affirmed in PLR 200923001.
An additional nuance to FIRPTA taxation and withholding is with respect to Qualified Foreign Pension funds (QFPF). Under FIRPTA, these QFPFs are treated as not nonresident aliens nor a foreign corporation (but explicitly not a U.S. person), and thus not subject to FIRPTA withholding and taxation. However, under Internal Revenue Code’s foreign government exemption of section 892 and a temporary regulation dealing with commercial activities of foreign governments, these QFPFs were treated as “controlled commercial entities” subject to U.S. taxation and withholding (on U.S. sourced income). This resulted in QFPF being exempt from FIRPTA yet still subject to tax since it did not qualify under the foreign government exemption. In order to satisfy both code sections, QFPFs may reduce their investments in U.S. real property interest, an unintended negative consequences to this misalignment between code sections. This temporary regulation included a U.S. real property holding company as a controlled commercial entity if it satisfied the requirements of such status. Without the temporary regulation a passive foreign controlled entity that would otherwise qualify as a USRPHC would not necessarily be deemed so.
Proposed Regulation
On Dec. 29, 2022, Treasury and the IRS released the Proposed Regulations (REG–100442-22), to address these issues.
The Proposed Regulation provide guidance with respect to QIE stock held directly or indirectly by foreign persons and how that affects the determination of whether a QIE is domestically controlled. The Proposed Regulations use a “limited ‘look-through’ approach.” As noted above, under the current regulations, a QIE would be deemed domestically controlled if it is controlled by a domestic corporation. There is no consideration of whether that domestic corporation is foreign controlled.
Under the limited look through approach, only a “non-look-through person” is treated as holding directly or indirectly stock of a Qualified Investment Entity. Stock of a QIE held by or though one or more intermediary “look-through persons” is treated as held proportionately by the look-through owners’ ultimate owners, who are non-look-through persons. Thus, ownership is determined by finding all of a QIE’s non-look-through persons and based on their identity determining whether the QIE is domestically controlled.
A “look-through person” is defined as any person that is not a “non-look-through person,” specifically g a REIT, RIC, S corporation, a non-publicly traded partnership (foreign or domestic), trusts (foreign or domestic) and most importantly a foreign-owned domestic corporation. A “foreign-owned domestic corporation” is any non-public domestic corporation in which foreign persons hold directly or indirectly at least 25% of the fair market value of the corporation’s outstanding stock.
A “non-look-through person” includes individuals, “domestic C corporations” (which is a domestic corporation other than an S corporation, REIT, or RIC), foreign corporations, international organizations (as defined under IRC 7701(18), Qualified Foreign Pension Funds (and entities wholly owned by one or more QFPFs) and “nontaxable holders.” Nontaxable holders are defined to include tax exempt entities under section 501(a), the U.S. government, a U.S. state or a subdivision thereof.
The proposed regulation applies the special ownership rules with respect to special investment entities, so that when a person owns less than 5% of a publicly traded QIE, they are deemed to be U.S. persons, absent actual knowledge to the contrary. By default, a public QIE itself is treated as a foreign person that is a non-look-through person, unless the publicly traded QIE is a domestically controlled QIE, in which case it is treated as a U.S. person that is a non-look-through person.
A QFPF that owns less than 5% of a U.S. publicly traded QIE stock at all times during the testing period (and absent actual knowledge that the person is not a United States person), is treated as a United States person that is a non-look through person with respect to that stock even though the QFPF would otherwise be treated as a foreign person under the Proposed Regulations.
These Proposed Regulations explicitly reverse PLR 200923001 and expand the scope of FIRPTA to foreign persons that own US real property interests via domestic corporations.
The Proposed Regulations also coordinate between the Internal Revenue Code’s foreign government exception and FIRPTA with respect to Qualified Foreign Pension funds. The proposed regulation amended the temporary regulation for the foreign governments’ exception to exclude Qualified Foreign Pension Funds from the “controlled commercial entity” classification. The concern was that a QFPF that was exempt under FIRPTA was being dragged back into US taxation under the foreign government exemption. This alignment ensures QFPF is not encouraged to dispose of U.S. real property interests to avoid taxation.
