Tax alert

Final regs issued on sale of US real property by foreign pension funds

Feb 22, 2023
Real estate funds International tax
Business tax REITs Private equity Real estate

Treasury and the IRS provide guidance for foreign pension funds that dispose of an interest in U.S. real property

Treasury and the IRS have issued new guidance on the application of the rules relating to the ownership and disposition of interests in U.S. real property by foreign persons (The Foreign Investment in Real Property Tax Act or FIRPTA). That guidance includes both Final Regulations that apply to qualified foreign pension funds (QFPFs) (the Final Regulations) and proposed regulations that apply to real estate investment trusts (REITs), regulated investment companies (RICs) and foreign governments eligible for section 892 (the Proposed Regulations). Below is a summary of the Final Regulations. Refer to our alert for a summary of the Proposed Regulations. 

Final Regulations

The Final Regulations adopt most of the framework set out in the proposed regulations (REG-109826-17) released June 6, 2019, but also include some taxpayer favorable changes and provide additional definitional rules for greater clarity.

The Final Regulations generally apply to dispositions of an interest in U.S. real property on or after Dec. 29, 2022.  However, certain rules regarding qualified controlled entities are retroactive to June 6, 2019, the date the proposed regulations were released. A fund may also choose to apply the Final Regulations going back to Dec. 18, 2015, the date section 897(l) was enacted, provided the eligible fund and all related parties consistently apply the Final Regulations for all relevant years. 


Section 897(a) deems gain or loss realized by a nonresident alien or foreign corporation on a disposition of an interest in U.S. real property to be effectively connected income (ECI), regardless of whether the property was used in a U.S. trade or business. Section 897(l) provides that a qualified pension fund, or an entity all the interests in which are held by a qualified foreign pension fund, is not treated as a nonresident alien or foreign corporation for purposes of section 897, thus excluding the gain or loss from the scope of section 897(a).  

Section 897(l) generally defines a qualified foreign pension fund as a trust, corporation or other organization or arrangement which is established by a foreign country or employer to provide retirement or pension benefits to participants that are current or former employees as a result of services rendered by such employees to their employers. The statute also requires that no single participant have a right to more than 5% of the assets or income of the fund, and that foreign law either allow a deduction or exclusion for contributions to the fund, or exempt the income earned in the fund or tax it at a reduced rate.

Definition of qualified foreign pension fund

The Final Regulations adopt a series of objective tests that a pension fund must satisfy to qualify for the section 897(l) exemption. Under Reg. section1.897(l)-1(c), a pension fund is not a QFPF unless 100% of the benefits that a pension fund provides are “qualified benefits” provided to “qualified recipients,” and 85% or more of the present value of the “qualified benefits” that the fund expects to provide in the future are retirement and pension benefits.  

“Qualified benefits” include retirement and pension benefits, ancillary benefits and non-ancillary benefits. The Final Regulations define retirement and pension benefits as benefits payable to qualified recipients after reaching retirement age or after an event in which the fund recognizes that a qualified recipient is permanently unable to work, including distributions to surviving beneficiaries of the qualified recipient. The regulations do not require that the retirement and pension benefits be paid in a particular manner such that both an annuity and a lump-sum payment can qualify. 

In addition to retirement and pension benefits, a fund may provide an unlimited amount of ancillary benefits to qualified recipients. The Final Regulations contain a list of benefits that qualify as ancillary, including benefits payable upon the diagnosis of a terminal illness, medical benefits, unemployment benefits, incidental death benefits, short-term disability benefits, life insurance benefits, shutdown, or layoff benefits and other similar health-related or unemployment benefits.  

In response to comments regarding the cliff effect caused by the use of the 100% and 85% thresholds to determine whether a fund qualifies, and concerns that some plans are required to provide a minor amount of other benefits, the Final Regulations allow a fund to provide a limited amount of non-ancillary benefits to qualified beneficiaries. Non-ancillary benefits are essentially any benefit other than an ancillary benefit or a retirement and pension benefit that the fund is permitted or required to provide under foreign law. Non-ancillary benefits are limited to 5% of the present value of qualified benefits the fund expects to provide during the fund’s existence. 

The Final Regulations also clarify that certain withdrawals made from a retirement plan and loans made by the fund to qualified beneficiaries are not taken into account in calculating the 100% and 85% thresholds and the limitation on non-ancillary benefits. Specifically, the Final Regulations exclude the following distributions from these calculations: (i) a loan to a qualified recipient, (ii) a distribution made to a designee that is a qualified holder or to another arrangement subject to similar rules under the laws of the foreign jurisdiction (i.e., a ‘rollover’), and (iii) a withdrawal before the participant or beneficiary reaches retirement age to satisfy a financial need under rules similar to the hardship rules in Reg. section 1.401(k)-1(d)(3), provided the distribution is subject to tax and penalties in the foreign jurisdiction. 

A “qualified recipient” is defined differently depending on whether the fund is established by a foreign government or an employer. A qualified recipient of a government sponsored plan includes any person who is eligible to be treated as a beneficiary of the fund, and any person designated by such beneficiary to receive benefits. A qualified recipient of a pension plan established by an employer is defined as current or former employees, a spouse of a current or former employee and any person designated by such beneficiary to receive benefits. In response to comments that the proposed regulations were too restrictive with respect to employer sponsored plans and did not allow any participation by individuals who were neither current nor former employees, the Final Regulations allow up to 5% of the beneficiaries in an employer’s plan to be persons other than current or former employees, or a spouse of a current or former employee. 

The Final Regulations also clarify that a plan established by self-employed individuals may qualify (provided no one individual is entitled to more than 5% of the fund’s income or assets) by defining a self-employed individual as both an employer and an employee for purposes of applying section 897(l). A fund established by a trade union, professional association or similar group may also qualify under the Final Regulations which define these organizations as an employer with respect to providing benefits for its members. 

The regulations relax the statutory requirement that the tax laws of the foreign jurisdiction in which the fund is established or operated provide favorable tax treatment for the contributions to the fund or the income earned in the fund, by requiring that only a minimum of 85% of the contributions or 85% of the income earned in the fund qualify for the favorable tax treatment under foreign law. The regulations also provide that a foreign jurisdiction which exempts the fund from tax or has no income tax will satisfy this requirement. 

Ownership in controlled entities 

The section 897(l) exception applies to gain or loss recognized by a QFPF or an entity that is wholly owned by a QFPF, referred to as a qualified controlled entity (QCE). Generally, a QCE must be wholly owned by one or more QFPFs. Treasury and the IRS rejected commentators’ requests to allow some de minimis ownership in a QCE by non-qualified investors.1  However, the regulations treat partnerships (U.S. or foreign) as aggregates and allow non-qualified investors to invest in a partnership alongside a QFPF without disqualifying the QFPF for the exemption with respect to its distributive share of gain from the partnership’s disposition of a U.S. real property interest (which may include shares in a U.S. blocker corporation that is classified as a real property holding corporation). Consequently, a QFPF may invest in U.S. real property with non-qualified investors through a partnership. A QFPF may also invest in U.S. real property through a foreign blocker corporation (independently or collectively with other QFPFs) and allow the foreign corporation to claim the exemption as a QCE.2  However, if non-qualified investors and QFPFs jointly invest in a foreign corporation that holds an interest in U.S. real property, the foreign corporation would not be entitled to claim the exemption as a QCE.  

Segregated accounts 

The Final Regulations provide that the exemption only applies to gain or loss from U.S. real property interests held in a qualified segregated account maintained by a QFPF or QCE. A qualified segregated account is an identifiable pool of assets maintained for the sole purpose of funding and providing qualified benefits to qualified recipients. Although the regulations generally require that all the income earned from the assets in the account be used to fund qualified benefits to qualified recipients, income earned in the account may also be used to satisfy necessary expenses of the fund, including a reasonable fixed fee paid to a fund manager.3  However, the fund will be disqualified if, upon liquidation of the account, the assets would be transferred to a person other than a qualified recipient. 

Lookback period for testing qualified status

The regulations impose a lookback period for determining whether a fund is a QFPF or a QCE. If at any time during the “testing period” a fund or entity fails to satisfy the definitional requirements in the regulations, the fund or entity will be ineligible for the section 897(l) exception. The testing period is the shortest of the following: (1) Dec. 18, 2015 through the date of disposition, (2) the date the entity was created through the date of disposition or (3) the 10-year period preceding the disposition. However, the regulations include a transition rule that deems a pension fund to satisfy the requirements of the regulations for the period from Dec. 18, 2015 through Dec. 29, 2022 (the effective date of the regulations) provided the fund or qualified controlled entity satisfies the requirements of section 897(l) based on a reasonable interpretation of the statutory requirements. 

Next steps

Foreign pension funds and their tax advisors should closely review the Final Regulations and reassess whether they meet the QFPF requirements.

1 The Final Regulations permit a 5% de minims ownership in the QCE to be held by service providers to the fund (e.g., fund managers) through Feb. 27, 2023. This limited time for the de minimis ownership may have been inserted to allow fund managers time to redeem their shares in the entity to prevent the QCE from becoming ineligible for the exemption.  

2 If a QFPF invests in a foreign blocker corporation jointly with other QFPFs, the loss of QFPF status by one of the investors will disqualify the foreign blocker corporation from claiming the exemption, effectively causing the remaining QFPFs to lose their exemption. 

3 See Reg. section 1.897(l)-1(f), Example 6.

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