By Anthony Diosdi
When U.S. real estate became a popular investment with foreign investors in the 1970s, the favorable tax treatment accorded foreign investors in U.S. real property became a domestic political issue. Congress responded in 1980 by enacting the Foreign Investment in Real Property Tax Act of 1980 (or “FIRPTA”), which attempted to equalize the tax treatment of real property gains realized by domestic and foreign investors. Prior to FIRPTA, foreign persons generally were not taxed on gains from the disposition of a U.S. real property interest. Under FIRPTA, gains or losses realized by foreign corporations or nonresident alien individuals from any sale, exchange, or other disposition of a U.S. real property interest are taxed in the same manner as income effectively connected with the conduct of a U.S. trade or business. This means that gains from dispositions of U.S. real property interests are taxed at the regular graduated rates, whereas losses are deductible from effectively connected income.
A U.S. real property includes interests in any of the following types of property located within the United States or the U.S. Virgin Islands:
3) Inherently permanent structures other than buildings;
4) Mines, wells, and other natural deposits;
5) Growing crops and timber; and
6) Personal property associated with the use of real property.
For this purpose, an “interest” in real property means any interest (other than an interest solely as a creditor), including fee ownership, co-ownership, a leasehold, an option to purchase or lease property, a time-share interest, a life estate, remainder, or reversionary interest, and any other direct or indirect right to share in the appreciation in value or proceeds from the sale of real property. See IRC Section 897(c)(1)(A)(i) and Treas. Reg. Section 1.897-1(b).
A U.S. real property interest also includes any interest (other than an interest solely as a creditor) in a domestic corporation that was a U.S. real property holding corporation at any time during the five-year period ending on the date of the disposition of such interest or, if shorter, the period the investor held the interest. This provision prevents foreign persons from avoiding the FIRPTA tax by incorporating their U.S. real estate investments and then realizing the resulting gains through stock sales, which ordinarily are exempt from U.S. taxation. A domestic corporation is a U.S. real property holding corporation if the fair market value of its U.S. real property interest equals 50 percent or more of the net fair market value of the sum of the corporation’s following interests:
1) U.S. real property interests;
2) Interests in foreign real property; and
3) Any other property of the corporation which is used or held for use in a trade or business.
To ensure collection of the FIRPTA tax, any transferee acquiring a U.S. real property interest must deduct and withhold a tax equal to 15 percent (21 percent in the case of corporations) realized on the disposition (A transferee must file Forms 8288 and 8288-A to report and deposit any tax withheld within 20 days of withholding). The amount realized is the sum of the cash paid or to be paid (excluding interest), the market value of other property transferred or to be transferred, the amount of liabilities assumed by the transferee, and the amount of liabilities to which the transferred property was subject. Withholding requirements also apply to distributions made by a domestic or foreign corporation, partnership, estate, or trust, to the extent the distribution involves a U.S. real property interest, as well as to dispositions of interests in a partnership, trust, or estate that has a U.S. real property interest.
Introduction to Shared Appreciation Mortgages
From a U.S. federal income tax perspective, the primary obstacle facing foreign persons who invest in U.S. real estate is FIRPTA, more specifically Internal Revenue Code Section 897. Internal Revenue Code Section 897 treats any gain recognized by a foreign person on the disposition of a USRPI as if it were effectively connected to a U.S. trade or business. A potential strategy to avoid FIRPTA is the use of a shared appreciation mortgage. A typical shared appreciation mortgage is a loan secured by a lien upon real property in which the currently payable interest rate is fixed below the prevailing market rate for a standard fixed-rate mortgage. In exchange, the lender receives, as “contingent deferred” interest, a predetermined share of the property’s appreciation between the time the loan is made and the time the property is sold or the loan otherwise is paid. See Friend, Shared Appreciation Mortgages, 34 Hastings L.J. 331 (November 1982).
The appreciation portion of the interest is “contingent” because it is payable only to the extent the property appreciates in value. It is “deferred” because it is not payable until the maturity date of the loan or the sale of the property. There are a number of ways a shared appreciation mortgage can be structured. For instance, many shared appreciation mortgages are 30-year loans with the lender receiving payment of principal and deferred contingent interest upon the sale of the secured property or maturity of the note.
Effects of Internal Revenue Code Section 897
Internal Revenue Code Section 897 was designed to counteract the use of various techniques that had been developed to avoid income tax on the disposition of U.S. real estate. Section 897 provides that gain or loss realized by nonresident aliens or foreign corporations on the disposition of U.S. real property interests will generally be treated as if such gain or loss were effectively connected with a U.S. trade or business. Section 897 imposes a tax on gain realized upon the disposition of a “U.S. real property interest.” A U.S. real property interest does not include an “interest solely as a creditor *** in real property.” See Treas. Reg. Section 1.897-1(d)(1). However, a loan in which the lender has a direct or indirect right to share in the increase in value or the proceeds of the disposition of property will not be regarded as an interest solely as a creditor. See Treas. Reg. Section 1.897-1(d)(2).
Treasury Regulation Section 1.897-1(d)(2)(i) elaborates on the phrase “an interest other than an interest solely as a creditor” by stating it includes “any direct or indirect right to share in the appreciation in the value, or in the gross or net proceeds or profits generated by, the real property.” The Income Tax Regulation goes on to state that a “loan to an individual or entity under the terms of which a holder of the indebtedness has any direct or indirect right to share in the appreciation in value of, or the gross or net proceeds or profits generated by, an interest in real property of the debtor or of a related person is, in its entirety, an interest in real property other than solely as a creditor.” Accordingly, a shared appreciation mortgage that is tied to U.S. real estate is a United States real property interest (“USRPI”) for purposes of Internal Revenue Code Section 897.
Holding a USRPI will not trigger a U.S. tax obligation. However, when the foreign investor liquidates the USRPI, the foreign investor will be subject to U.S. tax under that Section 897 to the extent that the USRPI is disposed of.” Treasury Regulation Section 1.897-1(g) provides that disposition “means any transfer that would constitute a disposition by the transferor for any purpose of the Internal Revenue Code and regulations thereunder.” In regards to shared mortgage sharing agreements, Treasury Regulation 1.897-1(h), Example 2, outlines a tax planning opportunity for foreign investors investing in U.S. real estate. In Example 2, a foreign corporation lends $1 million to a domestic individual, secured by a mortgage on residential real property purchased with the loan proceeds. Under the loan agreement, the foreign corporate lender will receive fixed monthly payments from the domestic borrower, constituting repayment of principal plus interest at a fixed rate, and a percentage of the appreciation in the value of the real property at the time the loan is retired.
The example states that, because of the foreign lender’s right to share in the appreciation in the value of the real property, the debt obligation gives the foreign lender an interest in the real property “other than solely as a creditor.” Nevertheless, the example concludes that Internal Revenue Code Section 897 will not apply to the foreign lender on the receipt of either the monthly or the final payments, because these payments are considered to consist solely of principal and interest for U.S. federal income tax purposes. Example 2 concludes that the receipt of the final appreciation payment that is tied to the gain from the sale of the U.S. real property does not result in a disposition of a USRPI for purposes of Section 897, because the amount is considered to be interest rather than gain under Internal Revenue Code Section 1001. The example does note, however, that a sale of the debt obligation by the foreign corporate lender will result in gain that is taxable under Internal Revenue Code Section 897. See Using Shared Appreciation Mortgages to Avoid FIRPTA, Florida Bar Journal, Volum. 80, No. 3 March 2006, Pg 40 Jeffrey L. Rubinger.
Consequently, foreign investors may attempt to use debt instruments with contingent interest features to avoid Internal Revenue Code Section 897. This does not mean that using a shared appreciation mortgage avoids U.S. tax. Instead, a shared appreciation mortgage requires the lender to treat the receipt of contingent deferred interest as interest rather than capital gain. In Dorzback v. Collison, 195 F.2d 69 (3rd Cir. 1952), a debtor/creditor relationship was amended to provide that, in lieu of interest at the rate of 5 percent per annum, the creditor would receive 25 percent of the net profits of the debtor’s business. The court quoted the United States Supreme Court in defining interest as being “the amount which one has contracted to pay for the use of borrowed money.” The court also noted that payments made in lieu of interest were in fact to be treated as interest, and that it was not a requirement that the interest be computed at a stated or fixed rate, but only that it be an ascertainable amount. In Kena, Inc. v. Commissioner, 44 B.T.A. 217, 219-20 (1941), the borrower and lender entered into an agreement in which the borrower received a sum of money as a “loan;” the borrower agreed to repay the principal and to pay a further sum “in lieu of interest” equal to 80 percent of the net profits of the borrower’s business. The court held that the agreement was one creating a relationship of creditor and debtor, and that the amount paid for the use of the borrowed money was interest.
In order the contingent interest of a shared appreciation mortgage to be recognized by the Internal Revenue Service (“IRS”), at a minimum, the debt instrument must contain the following terms: 1) the terms of the loan should contain a definite maturity date as well as a cap on interest participation; 2) the loan should not be convertible into an equity interest for the borrower; 3) the lender should not have effective control over the borrower or the borrower’s assets exceeding that which a lender ordinarily would have; 4) there should be sufficient security for the debt; 5) the loan should be recourse under in nature, rather than nonrecourse; 6) there should not be a provision in the loan under which the purported lender is obligated to subordinate to some or all the borrower’s gross receipts rather than on its net income.
Although interest received by a foreign investor is not subject to Section 897 and the FIRPTA provisions of the Internal Revenue Code, Sections 871(a) (for nonresidents aliens and 881(a) (for foreign corporations) impose a 30 percent withholding tax on “interest.” In other words, the contingent interest received by the foreign investor through a shared appreciation mortgage is generally subject to 30 percent withholding tax. However, the withholding tax is often eliminated or reduced by treaty. However, tax treaties generally provide for a reduction or elimination of withholding tax on interest income. Treaty benefits will typically depend upon the residence of the foreign investor.
Currently, there are a significant number of countries that have income tax treaties with the United States that contain articles which entirely eliminate withholding tax on interest paid from the U.S. Some of these countries include the United Kingdom, France, Germany, Czech Republic, Finland, Germany, Hungary, Iceland, Norway, Poland, the Russian Federation, the Slovak Republic, Sweden, and Ukraine. A number of other treaties reduce withholding to only 5 percent. This means that residents of a country that has entered into a bilateral income tax treaty with the United States that eliminates or significantly reduces the withholding on interest income can potentially utilize a shared appreciation mortgage to avoid the harsh consequences of FIRPTA.
In certain cases, even foreign investors that are not residents of a country that the United States has entered into a tax treaty with can still completely exempt the U.S. withholding tax on contingent interest received from a shared appreciation mortgage. In order for a foreign investor who is not a resident of a treaty jurisdiction listed above to obtain a complete exemption from U.S. withholding tax on contingent interest payments, the investor must rely on a treaty that has no limitation on benefits (“LOB”) provision.
Because tax treaties provide lower withholding tax rates on interest income, individuals and foreign corporations like to establish residency in a country that has a favorable tax treaty with the United States. This practice is known as “treaty shopping.” Anti-treaty shopping provisions known as LOB provisions restrict an individual’s or corporate structure’s ability to engage in treaty shopping. Under most U.S. tax treaties that contain a LOB provision, a foreign person will be considered a resident for treaty purposes and permitted to benefit from the treaty if such person is liable to tax therein by reason of its domicile, residence, or citizenship. LOB provisions contained in many modern U.S. treaties also deny corporations the benefits of a treaty. Under most LOB provisions, even if a corporation qualifies as a resident of a treaty country, that corporation is not entitled to treaty benefits unless the corporation is a resident of the treaty country if the corporation meets one of the following requirements: 1) more than 50 percent of the corporation’s stock is regularly traded on a recognized stock exchange (i.e., the corporation is a publicly traded company) and the corporation’s primary place of management is in its country of incorporation; 2) the corporation is a 50 percent or more owned by 5 or fewer companies entitled to treaty benefits, or 3) the corporation meets both a stock ownership test (at least 50 percent of the corporation’s stock stock is owned by residents who are entitled to treaty benefits), and a base erosion test (less than 50 percent of the corporation’s gross income is used to make deductible payments to persons who are not residents of either treaty county.
It is important to note that not all U.S. tax treaties contain LOB provisions. There are four treaty countries that provide an exemption from withholding on payments of U.S. source interest, including contingent interest, and do not have LOB provisions. These countries are Hungary, Iceland, Norway, and Poland. In certain cases, a foreign investor that is not a resident of a country that has entered into a tax treaty with the U.S. or the treaty does have a favorable provision regarding interest income can still obtain a complete exemption from withholding on contingent interest by a finance corporation in one of the four countries discussed above.
Using Foreign Entities Located in Favorable Tax Treaty Jurisdictions
When organizing a corporation outside the United States, local income taxes need to be considered. Of the four treaty countries discussed above that do not have a LOB, Hungary does not impose withholding tax on interest paid to nonresidents. Thus, by lending money to a corporation formed in Hungary and then re-lending those funds to the United States pursuant to a shared appreciation mortgage, it may be possible to avoid U.S. federal and foreign income tax on shared appreciation mortgage payments. Please see Illustration 1 which demonstrates how a foreign investor can fund a shared appreciation mortgage through a Hungarian company.
A resident of Taiwan wishes to participate in the appreciation of a real estate development project in the United States. Taiwan does not have a tax treaty with the United States. Therefore, the investor establishes a Hungarian company that owns 100 percent of the units of a U.S. limited liability company (“LLC”) that elects to be treated as a disregarded entity under the “check-the-box” rules. With this chosen structure and under the U.S.-Hungary Income Tax Treaty, no U.S. withholding tax would be imposed on the shared appreciation mortgage payments.
Potential IRS Challenges to Using a Foreign Finance Branch
The IRS has sought to defend against treaty-shopping abuse in some cases by arguing that a financing corporation interposed between a “true” borrower and the lender should be disregarded because it is without substance. The IRS has, however, been uniformly unsuccessful in such attempts. The failure of the IRS argument is largely attributable to the test originated by the United States Supreme Court in Moline Properties, Inc. v. Commissioner, 319 U.S. 436, 438-39 (1943), under which the taxpayer need only establish that the corporation was formed for a business purpose or carried on business activity in order to be respected as a separate entity for tax purposes. In Bass v. Commissioner, 50 T.C. 595 (1968), the United States Tax Court rejected the use of the IRS argument to deny benefits to a Swiss corporation under the United States- Switzerland Tax Treaty. The Tax Court held that the question of whether a corporation has been organized for a business purpose or carries on sufficient business activity to require its recognition as a separate entity for tax purposes are questions of fact. In this case the Tax Court concluded that the documentary evidence and testimony assembled by the taxpayer “demonstrated that the corporation was managed as a viable concern, and not as simply a lifeless facade.”
The IRS has enjoyed somewhat greater success with its alternative argument in Aiken Industries, Inc. v. Commissioner, 56 T.C. 925 (1971) that the foreign corporation interposed in the treaty country should be treated as a mere conduit not entitled to the benefits of the treaty. In Aiken, the IRS successfully denied treaty benefits that the taxpayer attempted to obtain through the use of a back-to-back loan arrangement. In addition, Internal Revenue Code Section 7701(I) gies the IRS the authority to disregard the existence of an intermediary or conduit entity with respect to treaty shopping that results in the avoidance of U.S. taxes. A multi-party financing arrangement is subject to recharacterization if a related intermediate entity participates in a back-to-back loan arrangement as part of a plan to avoid U.S. withholding taxes.
The weakness in applying the rationale of Aiken or the conduit financing regulations is that the entity making the first loan (i.e., the hybrid entity) is disregarded for U.S. income tax purposes and is treated as a branch of the Hungarian company. As a result, there are no-back-to-back interest payments for U.S. federal income tax purposes. Thus, the IRS would have a difficult time contending that the Hungarian company is acting as a mere conduit for payments between the U.S. and the hybrid entity. See Using Shared Appreciation Mortgages to Avoid FIRPTA, Florida Bar Journal, Volum. 80, No. 3 March 2006, Pg 40 Jeffrey L. Rubinger.
This article attempts to briefly summarize how shared appreciation loans can be used by a foreign investor for U.S. federal income tax planning. No portion of this article should be taken as a comprehensive or exhaustive treatment of the subject matter. Foreign investors should consult with a qualified international tax attorney regarding planning opportunities to mitigate their exposure to U.S. income, estate and gift tax associated with U.S. real estate ownership.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.