IRS says FIRPTA publicly traded stock exemption applies at partnership level

In Advice Memorandum (AM)2023-003 the IRS Office of Chief Counsel International concluded that a partner is ineligible for the publicly traded exception in section 897(c)(3) if the partnership’s percentage of ownership in the U.S. corporation exceeds 5%, even if the partner’s direct and indirect ownership in the U.S. corporation is 5% or less.  

On May 19, 2023, the IRS Office of Chief Counsel International issued a Generic Legal Advice Memorandum (“GLAM”) regarding the application of the publicly traded exception in section 897(c)(3) to the disposition of shares in a U.S. real property holding company (“USRPHC”) when shares are held through partnerships. Under the GLAM, if a partnership (U.S. or foreign) owns more than 5% of a class of regularly traded stock in a USRPHC, foreign partners will generally be required to treat the gain from the disposition of that stock as income that is effectively connected to a U.S. trade or business (“ECI”) and cannot apply the publicly traded exception to avoid the U.S. tax or a U.S. filing obligation. This issue is particularly important for nonresidents who invest in the U.S. through investment funds which often invest in U.S. companies through partnership structures.

Background on the Publicly Traded Exception

Section 897, enacted in 1980 as part of the Foreign Investment in Real Property Tax Act (“FIRPTA”), provides that gain (or loss) recognized by a nonresident alien or foreign corporation from the disposition of a U.S. real property interest (“USRPI”) is classified as ECI. The ECI is normally collected through withholding at 15% of the amount realized on the disposition pursuant to section 1445. However, a foreign owner is required to file a U.S. income tax return to report the transaction even if the full amount of the ECI was collected through withholding.

The definition of a USRPI includes shares in a USRPHC. A USRPHC is essentially a U.S. corporation which had over 50% of its trade or business and real property assets invested in USRPI at any time during the five-year period preceding the disposition. However, section 897(c)(3) provides that if a class of shares in the U.S. corporation are regularly traded on an established securities market, any shares of that class of stock will not be treated as a USRPI with respect to a “person” who held 5% or less of that class of stock during the five years prior to the disposition. In the case of a publicly traded U.S. corporation that is taxable as a real estate investment trust (“REIT”), the ownership threshold is increased to 10%.¹ The publicly traded exception in section 897(c)(3) generally allows a foreign person to dispose of stock in a publicly traded U.S. corporation without testing for USRPHC status, and without filing a U.S. tax return, provided the foreign person owns 5% or less (10% in the case of a REIT) of the U.S. corporation’s shares.

These rules apply regardless of whether the partnership disposes of stock in a USRPHC (and the gain is included in a partner’s distributive share of partnership income) or the partner recognizes gain on the disposition of an interest in a partnership that holds stock in a USRPHC. Pursuant to section 897(g), a partner that disposes of its interest in a partnership is generally treated as having disposed of an interest in U.S. real property to the extent the partnership holds U.S. real property.

In determining whether a nonresident alien or foreign corporation holds 5% or less of a class of stock in a U.S. corporation, the constructive ownership rules in section 318(a)(2)(A) and (3)(A) apply. Section 318(a)(2)(A) provides that stock owned directly or indirectly by a partnership is considered owned proportionately by its partners. Proportionate ownership is the percentage of stock held by the partnership multiplied by the partner’s percentage of ownership in the partnership.² Thus, if the 5% threshold is tested at the partner level, nonresident investors in widely held funds ordinarily would be eligible for the publicly traded exception even if the partnership held more than 5% in the U.S. corporation.

Prior to the issuance of AM 2023-003 there was no specific guidance with respect to whether the 5% threshold should be tested at the partner or partnership level. In the absence of specific guidance, some practitioners may have taken the position that a partnership should be “looked through” (treating the partnership as an aggregate) such that the 5% threshold would be applied at the partner level based on the partner’s proportionate share of the stock held by the partnership. This position was supported by language in Reg. 1.897-1(c)(2)(iii)(A) which provides that an interest in a publicly traded U.S. corporation will be treated as a USRPI only if the interest is “owned by a person who beneficially owned more than 5 percent.” A “person” is not defined in section 897 or the regulations but is defined in section 7701(a)(1) as including a partnership. Thus, both the partnership and a partner could be considered a “person” for purposes of applying the publicly traded exception. However, under U.S. tax principles, only a partner would normally be viewed as the beneficial owner of income earned through the partnership.

Under U.S. tax principles, the beneficial owner of income is essentially the person that would be required to include the income (including income generated by an asset) in gross income for U.S. tax purposes (determined without regard to an exclusion or exemption and taking into account common law doctrines such as agency, conduit, and economic substance). Because partners, not the partnership, are required to pay tax on income earned through the partnership, including the section 897 ECI gain on the disposition of a USRPI, the partners could be viewed as the beneficial owners for purposes of applying the publicly traded exception.³

Practitioners may also have drawn comfort from the treatment of partnerships in the context of the portfolio interest exception in sections 871(h) and 881(c) which applies only to nonresidents who own less than 10% of the equity in the debtor. Reg. section 1.871-14(g)(3) expressly provides that the 10% test is applied only at the partner level (by multiplying the partnership’s percentage of ownership in the debtor by the partner’s percentage of ownership of the partnership). Both the portfolio interest exception in sections 871(h) and 881(c) and the publicly traded exception in section 897(c) appear to have been designed to encourage foreign investment in U.S. capital markets by portfolio investors.

The 2023 GLAM

In AM 2023-003 the IRS took the opposite approach, concluding that the 5% threshold should be tested at the partnership level by treating the partnership as an entity rather than an aggregate of its investors. Under the entity approach taken by the IRS⁴, if a partnership holds more than 5% of the shares in a U.S. corporation, no partner in the partnership will qualify for the publicly traded exception, even if the partner is treated as owning less than 5% in the U.S. corporation through an application of the constructive ownership rules.

The IRS justified its conclusion by stating that whether the 5% threshold should be applied at the partnership or partner level depends on whether the partner’s share of partnership income has nexus with the U.S. sufficient to allow a foreign partner’s income to be subject to U.S. tax. In support of its conclusion, the IRS cited sections 875(1) and Unger v. Comm’r., 936 F.2d 1316 (D.C. Cir. 1991). Section 875(1) and Unger essentially provide that a U.S. trade or business conducted by a partnership is attributed to its partners for purposes of determining whether a partner’s distributive share of partnership income is classified as ECI.⁵ Under this authority, if a partnership conducts a U.S. trade or business, income earned by the partner (including but not limited to a partner’s distributive share of partnership income) from that business activity may be classified as ECI even if the partner is not directly engaged in any U.S. business activity. The IRS’ reference to section 875(1) and Unger is appropriate, but not for the conclusion that an entity approach should be applied in this context. Section 875(1) and Unger are essentially applying the principal of attribution of business activity similar to the attribution of U.S. business activity that occurs under ECI case law from an agent to its principal. It is that attribution of business activity to the partner that gives the U.S. the nexus to tax a foreign partner on its income that is derived from the partnership’s business activity.

The IRS’ position, and the application of section 875(1) and Unger in support of an entity approach to partnerships in the context of the publicly traded exception, fails to appreciate that the statutory framework of section 897, and the Congressional justification for asserting nexus in the case of U.S. real property, is based on ownership of U.S. real property and treating partnerships as an aggregate to characterize a partner’s income derived through a partnership as if the partner held the USRPI directly. This is particularly true when section 897 is applied to a partner’s disposition of an interest in a partnership that holds USRPI. Section 897(g) treats the partners as having owned a proportionate share of the USRPI held by the partnership for purposes of taxing gain on the partnership interest as the disposition of a USRPI. However, even when the gain on the disposition of a USRPI occurs at the partnership level, the ability to tax the gain on the USRPI in the hands of a foreign partner requires that the partner be treated as having disposed of an interest in USRPI as the plain language of section 897 expressly applies only to gain or loss taken into account by a nonresident alien or foreign corporation. It does not apply directly to the partnership. Thus, similar to section 875(1) and Unger which attributes U.S. business activity to foreign partners for purposes of classifying a partner’s income from that business activity as ECI, the partnership’s USRPI is more properly viewed as having been attributed to its foreign partners under section 897 for purposes of classifying the foreign partner’s income from that USRPI as ECI. This attribution approach is consistent with treating a partnership as an aggregate and testing the 5% threshold at the level of the partners.

Additionally, a partnership essentially functions as an agent on behalf of its partners and should not be treated as the beneficial owner of property or income held or received by the partnership on behalf of its partners. Thus, a court could conclude that under Reg. section 1.897-14(g)(3), the partner is the relevant “person” for purposes of applying the 5% threshold of the publicly traded exception because only a partner could be considered the beneficial owner of the gain on the disposition of the USRPI for purposes of applying section 897.

_{¹ The exception for U.S. REITs is normally only relevant where the REIT is not owned at least 50% by U.S. persons such that it does not qualify for the section 897(h)(2) exemption for domestically controlled qualified investment entities.}

_{²  Although section 318(a)(3)(A) provides that stock owned by partners is attributed down to the partnership, stock owned by a partner that is attributed to a partnership is not reattributed out to other partners. Thus, for purposes of determining what percentage of stock a nonresident alien or foreign corporation holds in a U.S. corporation, shares held (directly or indirectly) by the partnership and shares held by the nonresident alien or foreign corporation partner may be combined. However, shares held by one partner normally would not be included in another partner’s percentage of ownership. Nevertheless, for nonresidents investing in a fund structure, the relevant ownership interest in the U.S. corporation will be the shares held directly or indirectly by the partnership because fund investors typically do not also own stock in the U.S. corporation directly.}

_{³ See e.g., Reg. section 1.1441-1(c)(6)(ii)(B) (addressing withholding on FDAP payments made to foreign persons and expressly providing that it is a partner and not the foreign partnership that is the beneficial owner of income paid to the partnership).}

_{⁴ Under an aggregate approach to partnerships, the partners, and not the partnership, are treated as owning the partnership’s assets and conducting the partnership’s operations. In contrast, under an entity approach to partnerships, the partnership is respected as a separate entity distinct from its partners and is treated as owning the partnership’s assets and conducting the partnership’s operations.}

_{⁵ The IRS also cited section 512(c)(1) which, in the context of an exempt organization, attributes an unrelated business conducted by a partnership to a partner for purposes of classifying the partner’s distributive share of partnership income as unrelated business taxable income (“UBTI”).}