How Foreign Corporations Can be Used to Avoid FIRPTA

U.S. real estate has become a popular investment with foreigners. However, few foreign investors fail to consider the U.S. tax implications of holding U.S. real property. There are significant income, gift and estate tax consequences that may result when U.S. real property is sold or transferred. This article discusses the withholding requirements of the Foreign Investment in Real Property Tax Act of 1980 (or “FIRPTA”) and how certain foreign investors can hold U.S. real estate in foreign corporations to avoid the FIRPTA withholding tax.

Introduction

Under FIRPTA, gains or losses realized by foreign corporations or nonresident alien individuals from any sale, exchange, or other dispositions 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 interest includes interests in any of the following types of property located within the United States:

1. Land;
2. Buildings, including a personal residence;
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 the 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-sharing interest, a life estate, remainer, or reversion interest, and any other direct or indirect right to share in the appreciation in value or proceeds from the sale of real property. A U.S. property interest also includes 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 nonresident held the interest. This prevents foreign persons from avoiding the FIRPTA tax by incorporating their U.S. real estate investment and then realizing the resulting gains through stock sales which may be exempt from U.S. tax.

Enforcement Mechanisms

Section 1445 requires that, when a foreign person disposes of a U.S. real property interest, the “transferee” must withhold 15 percent of the amount realized by the transferor on the disposition and pay it to the Internal Revenue Service (“IRS”). A transferee includes “any person, foreign or domestic, that acquires a U.S. real property interest by purchase, exchange, gift, or any other transfer.” See Treas. Reg. Section 1.1445-1(g)(4). Since it applies to the proceeds of the disposition and not to the income realized on the disposition, Section 1445 provides another example of the imposition of a withholding obligation for an amount not necessarily equal to the income tax liability. In fact, the withholding obligation is imposed on gross receipts rather than gross income. Any tax imposed on a foreign person under Section 897 in excess of amounts withheld remains the liability of the foreign investor. The foreign person is entitled to recover any portion of the tax withheld that exceeds the actual tax liability, but must file a refund claim with the IRS.

The amount to be withheld on the sale by a foreign investor of a U.S. real property interest generally is the lesser of 15 percent of the “amount realized” or the transferor’s “maximum tax liability.” The amount realized equals the cash and fair market value of other property received any liability assumed by the transferee or which the property was subject. Thus, the withholding obligation may exceed the cash paid by the transferee.

Exception to Withholding Requirements

The purpose of the withholding requirement is obviously to assure compliance by the taxpayer. There are, therefore, a series of exceptions designed to deal with circumstances in which the tax is not payable or collection of the applicable tax liability seems assured. Withholding is not required:

1. By the transferee of property if the transferor of property furnishes an affidavit that the transferor is not a foreign person and setting forth the transferor’s identification number. See IRC Section 1445(b)(2).

2. On the disposition of an interest in a U.S. corporation if the corporation furnishes an affidavit stating that it is not and has not been a U.S. real property holding corporation during the five-year or shorter base period specified in Internal Revenue Code Sections 897(c)(1)(A)(ii) and 1445(b)(3).

3. If the transferee receives a “qualified statement” from the IRS that the transferor is exempt from tax or that adequate arrangements to secure payment of the tax or acceptable arrangements to payment the tax have been made. See IRS Section 1445(b)(4).

4. If the transferee is going to use the property as a residence and the amount realized by the transferor on disposition does not exceed $300,000. See 1445(b)(5).

5. On a disposition of shares of a class of stock regularly traded on an established securities market. See IRC Section 1445(b)(6). This exemption has been expanded to cover certain dispositions of classes of stock and other interests that are not traded on established markets if the issuing corporation has at least one class of stock that is so traded. See Treas. Reg. Section 1.1445-2(c)(2).

Who is a U.S. Person for Purposes of FIRPTA that is Not Subject to Withholding

An individual is deemed a U.S. person” for purposes of FIRPTA if he or she is either a U.S. citizen or a resident of the U.S. In other words, a U.S. citizen or U.S. resident seller of U.S. real property is not subject to FIRPTA withholding. Under Internal Revenue Code Section 7701(b), an alien may be classified as a U.S. resident under either the “green card” or “substantial presence” tests. Under the green card test, a lawful permanent resident (green card holder) for any part of the calendar year for U.S. immigration purposes is a U.S. resident until the green card is administratively or judicially rescinded or has been abandoned. Under the substantial presence test of Internal Revenue Code Section 7701(b)(3), an alien is a U.S. person for purposes of FIRPTA if he or she is present in the United States for 183 days or more in a single year, including partial days, in the U.S. for that year. This is known as the substantial presence test. The test can be met if an alien is present within the United States during the tax year on at least 31 days and was present within the United States for 183 days during the tax year and two preceding years, as determined under the following formula:

Current year……………………………………………one day is one day
First preceding year……………………………………one day is ⅓ of a day
Second preceding year……………………………….one day is ⅙ of a day

Becoming a U.S. Person for FIRPTA Purposes by Making a “First-Year Election”

Another way for an alien to be treated as a resident of the United States is for the alien to make a so-called first-year election to be treated as a resident of the United States. An alien may make this election if the five requirements are satisfied:

(1) The alien individual is not a resident of the United States under either the green card test or for the calendar year immediately after the election year; See IRC Section 7701(b)(4)(A)(iii).

(2) The alien individual was not a resident of the United States under the green card test, the substantial presence test or the first-year election provision for the calendar year immediately before the election year; See IRC Section 7701(b)(4)(A)(ii).

(3) The alien individual is a resident of the United States under the substantial presence test for the calendar year immediately after the election year; See IRC Section 7701(b)(4)(A)(iii).

(4) The alien individual is present in the United States for a period of at least 31 consecutive days in the election year; See IRC Section 7701(b)(4)(A)(iv)(I).

(5) The alien individual is present in the United States for at least 75 percent of the number of days in the “testing period.” The testing period starts with the first day of the 31-day period and ends with the last day of the election year. See IRC Section 7701(b)(4)(A)(iv)(II).

Corporations

The definition of a “U.S. person” includes a domestic corporation. The definition of a “U.S. corporation,” is defined by Section 7701(a)(4) to be corporations organized under the laws of the United States, any state or the District of Columbia. Any corporation not organized under the laws of the United States, any state or the District of Columbia is a “foreign corporation” under current law, regardless of the location of its head office or place of management. U.S. real property interest is defined to include any interest (other than an interest solely as a creditor) in a U.S. corporation unless the foreign person holding such interest establishes that that U.S. corporation was at no time during the five years ending on that date of disposition a U.S. real property holding corporation. See IRC Section 897(c)(A)(ii). A “U.S. real property holding corporation” is defined to include any corporation, the fair market value of whose U.S. real property interests equal or exceeds 50 percent of the sum of the fair market value of (1) its real property interests, (2) its interests in real property located outside the United States and (3) any other of its assets that are used or held for use in a trade or business. Since the test depends on comparative asset values, note that a corporation could become a U.S. real property holding corporation, even though it did not modify its asset holdings, simply as a result of fluctuating property values.

Gains realized from the disposition of an interest in a U.S. corporation that constitutes a U.S. real property holding corporation are generally taxed at the same rate and under the same rules as the disposition of direct holdings in U.S. real property. The entire amount of gain realized from the sale of stock in a domestic U.S. real property holding corporation is subject to tax, regardless of the portion attributable to the U.S. real property interest that it holds. However, Section 897 will not apply to the sale or other disposition of the stock if the corporation holds no U.S. real property interest at the time of the disposition and if all U.S. real property interests held by the corporation during the five years prior to the disposition (which made the corporation itself a U.S. real property holding corporation) have been transferred by the corporation in transactions in which the full amount of gain has been recognized.

Disposition of Interests in Foreign Corporations and Distributions by Foreign Corporations

A foreign corporation must recognize gain and pay U.S. tax when it distributes a U.S. real property interest to any of its shareholders, whether by way of dividend, liquidation or redeemption of stock. The foreign corporation is generally obligated to pay tax on the amount equal to the excess of the fair market value of the U.S. real property interest at the time it is distributed over its adjusted basis. See IRC Section 897(d)(1). Such a gain will be taxed as if it were effectively connected with the conduct of a U.S. trade or business.

Election by Foreign Corporation to be Treated as U.S. Corporation

Many tax treaties between the United States and other countries have nondiscrimination clauses that prohibit the United States from treating a permanent establishment of a foreign corporation in the United States less favorably than domestic corporations carrying on the same activities. Section 897(i) of the Internal Revenue Code permits a foreign corporation having a permanent establishment in the United States that is protected by a nondiscrimination clause in a tax treaty to elect to be treated as a U.S. corporation for purposes of Sections 897, 1445 (withholding requirements) and 6039C (reporting requirements). Thus, gains realized from the disposition of an interest in a foreign corporation treated as a U.S. corporation that constitutes a U.S. real property holding corporation are generally taxed at the same rate and under the same rules as the disposition of direct holdings in a U.S. real property. Consequently, the entire amount of gain realized from the sale of stock in the holding corporation will be subject to tax, regardless of the portion attributable to the U.S. real property interest it holds. However, Section 897 will not apply to the sale or disposition of the stock if the corporation holds no U.S. real property interest at the time of the disposition (which made the corporation a real estate holding corporation) and if all U.S. real estate interests held by the corporation during the five years prior to the disposition have been transferred by the corporation in transactions in which the full amount of gain was recognized. See IRC Section 897(c)(1)(B).

As discussed above, a corporation is considered to be a U.S. real estate holding company if the fair market value of its assets is 50 percent or more of the sum of the fair market values of its U.S. real estate interest holdings. (A corporation is considered to be a U.S. real estate holding company if the fair market value of its U.S. real property interests is 50 percent or more of the sum of the fair market value of all its assets taking into consideration financial assets, intangibles, tangibles, and inventories). A foreign investor is not subject to FIRPTA on the disposition of its interest in a U.S. corporation (or foreign corporation treated as a U.S. corporation) that was not a U.S. real estate holding company on any of the specific dates during the relevant testing period (i.e., the shorter of the foreign investor’s holding period or the five-year period ending on the date of the corporation is presumed to hold a U.S. real property interest unless it is established that such corporation was at no time a U.S. real estate holding company during the previous five years).

Thus, if the corporation was not a U.S. real estate holding corporation (as defined above), during the five year testing period, the sale of the shares of the foreign investor may be able to avoid not only FIRPTA withholding tax but also U.S. tax on the sale of the foreign investor’s corporate shares. If a foreign corporation is entitled to make an election to be treated as a U.S. corporation for FIRPTA purposes, the election could be an extremely useful tool to eliminate the impact of FIRPTA and U.S. tax..

Conclusion

This article is intended to provide the reader with a basic understanding as to how a foreign corporation can be utilized to mitigate or eliminate the impacts of FIRPTA. It should be evident from this article that this is a relatively complex subject. It is also important to note that this area of tax law is constantly subject to new developments and changes. As a result, it is crucial that foreign multinational corporations and foreign corporations doing business in the United States consult with a qualified International attorney.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & 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 adiosdi@sftaxcounsel.com.

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.