How Foreign Pension Funds Avoid FIRPTA Tax and Withholding Rules

When U.S. real estate became a popular investment with foreigners 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 tried to equate 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 disposition of a U.S. 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 estate interests are taxed at the regular graduated rates, whereas losses are deductible from effectively contracted income. To ensure the collection of the FIRPTA tax, any transferred acquiring a U.S. real property interest generally must deduct and withhold a tax equal to 15% of the amount realized on the disposition. Foreign investors may use Qualified Foreign Pension Funds (“QFPFs) and Qualified Controlled Entities (“QCEs”) to completely exempt U.S. real estate gains from FIRPTA tax and withholding rules. This article discusses the potential advantages QFPFs offer foreign investors in U.S. real estate.

U.S. Taxation of Foreign Investors Generally

The way in which foreign persons are taxed in the United States depends generally on whether income derives from U.S. sources and whether the income that is taxed derives from the conduct of a U.S. trade or business or from passive investment arrangements. As a general rule, a nonresident alien or foreign corporation that conducts a U.S. trade or business will be subject to the usual (individual or corporate) U.S. tax rates on net income “effectively connected with the conduct of a trade or business within the United States. Tax treaties generally provide, however such income will not be taxed unless attributable to a “permanent establishment” maintained by the foreign person in the United States.

Most of the forms of U.S.-source income received by foreign persons that are not effectively connected with a U.S. trade or business will be subject to a flat tax of 30 percent on the gross amount of the income received. Sections 871(a) (for nonresident aliens) and 881(a) (for foreign corporations) of the Internal Revenue Code impose the 30 percent tax on interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income.” This type of income is often referred to as “FDAP income.” As in the case of U.S. trade or business income, tax treaties may reduce or eliminate FDAP withholding tax.

U.S. Taxation of the Foreign Real Estate Investor

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.

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. Purpose 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 exceed 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.

A foreign corporation may be a U.S. real property holding corporation. However, stock in a foreign corporation will not be classified as a U.S. real property interest unless it elects to be treated as a U.S. corporation. Ordinarily, the sale or other disposition of shares in a foreign corporation that owns a U.S. real property interest is not subject to U.S. taxation. Instead, the 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 redemption of stock.

Partnerships, Trusts, and Estates

U.S. partnerships, trusts, and estates are required to withhold tax in respect of the share of gain attributable to a foreign partner or foreign beneficiary of any amount realized by the entity a disposition of a U.S. real property interest. The withholding will generally be 37 percent. However, the withholding rate may be reduced to reflect the lower applicable long-term capital gains rates.

Withholding Requirements

To ensure collection of FIRPTA, any transferred acquiring a U.S. real property interest must deduct and withhold a tax on the amount realized on the disposition. A transferee is any person, foreign or domestic, that acquires a U.S. real property interest by purchase, exchange, gift, or any other type of transfer. See Treas. Reg. Section 1.1445-1(g)(4). The amount subject to withholding is the sum of cash paid, the market value of the property transferred, or the amount of liabilities to which the transferred property is subject. See Treas. Reg. Section 1.1445-1(g)(5). The withholding rate is generally 15 percent of the sales price of the real property.

If the real property being sold or transferred is commercial property, the foreign seller or transferor is subject to a 15 percent withholding tax. If the real property being sold or transferred is residential real estate is $300,000 or less, then the withholding tax is not required. If the sales price is equal to or greater than $300,001, but equal to or less than $1 million then the seller may qualify for a reduced withholding in the amount of 10 percent. If the sales price for the residential real estate is greater than $1 million, then the withholding rate is 15 percent. To qualify under the personal residence exemption, the transferee or certain members of the transferred’s family (lineal descendants) must intend to reside at the real property at issue for more than 50 percent of the number of days that the property is used by any person for residential purposes during each of the two years following the purchase. See Treas. Reg. Section 1.1445-2(d)(1).

If the sales price of U.S. real estate is equal to or greater than $300,001, but equal to or less than $1 million then the seller would qualify for reduced withholding in the amount of 10 percent (instead of 15 percent). If the sales price is greater than $1 million, then no exception applies, and the buyer is responsible for withholding 15 percent of the amount realized by the seller.

Foreign Pension Funds Investing in U.S. Real Estate

Foreign pension funds have increased investments in U.S. real estate over the past few years because of favorable U.S. tax treatment. Under the Tax Hike Act of 2015, QFPFs are completely exempted from FIRPTA taxation. In final regulations, the Department of Treasury and the Internal Revenue Service (“IRS”) addressed the qualifications for the exemption from taxation under Internal Revenue Code Section 897(l) for gain or loss attributable to the disposition of U.S. real property interests held by QFPFs and their wholly owned subsidiaries. The final regulations also address gain from distributions described in Internal Revenue Code Section 897(h), as well as related withholding requirements under Sections 1445 and 1446 of the Internal Revenue Code.

Section 897 treats gain recognized by a foreign person from the disposition of a U.S. real property interest as income that is effectively connected with a trade or business, and therefore, is subject to net basis tax at the graduated, regular U.S. federal income tax rates. In 2015, Congress amended Section 897 to create a new exemption under Section 897(l) for U.S. real property interest held by QFPFs or an entity wholly owned by a QFPF (qualified controlled entity or QCE). Section 897(l) provides that a QFPF is not treated as a nonresident alien individual or foreign corporation for purposes of Section 897 and that an entity, all the interests of which are held by a QFPF, will be treated as such a fund. As a result, QFPF’s (and their wholly owned subsidiaries are trusts) are exempt from tax on certain dispositions of, and distributions with respect to, United States Real Property Interest or (“USRPI”). The final regulations limit the exemption under Section 897(l) to gain or loss that is attributable to one or more qualified segregated accounts (“QSA”) that the qualified holder maintains. A QSA as an identifiable pool of assets maintained for the “sole purpose” of funding “qualified benefits benefits” (generally retirement, pension and ancillary benefits) to “qualified recipients” (generally, plan participants, and beneficiaries).

The final regulations enacted on December 29, 2022 provides the following requirements:

1. The direct owner of a USRPI must hold the USRPI in a “qualified segregated account,” i.e., an identified pool of assets maintained for the sole purpose of funding and providing “qualified benefits” to “qualified recipients” and not inuring to anyone else.

2. The direct owner must be a QFPF or “QCE, i.e. a foreign corporation or foreign-law trust all the “interests” of which are held by one or more QFPFs directly or indirectly through one or more QCEs (looking through partnerships).

i) The owner’s status as a QFPF/QCE is determined by restricting focus only to its qualified segregated accounts.

ii) Thus, a segregated pool of assets used exclusively to fund pension liabilities may qualify even though it is a “separate entity” for U.S. purposes. See Section 301.7701-1(a).

3. The direct owner of the USRPI is a “qualified holder,” i.e. satisfies a broad anti-abuse rule meant to ensure that any gain on the USRPI remains fully taxable under FIRPTA if it arose, or may have arisen, while a non-QFPF had an interest in the USRPI at any time in the prior 10 years.

To qualify as a QFPF, Section 897(l) requires the entity to be a trust, corporation, or other organization or arrangement (i.e., an eligible fund”) that satisfies five requirements. The fund must:

1) Be created or organized under the law of a country other than the United States;

2) Be established by either: i) The foreign jurisdiction or one or more of its political subdivisions to provide retirement or pension benefits to participants or beneficiaries who are current or former employees or persons designated by these employees (including self-employed workers) or these employees (government-established fund) or
ii) One or more employees to provide retirement or pension benefits to participants or beneficiaries that are current or former employees (including self-employed workers) or persons designated by those employees in consideration for services rendered by the employees to the employers (employer fund);

3) Have no single participant or beneficiary with a right to more than 5 percent of the fund’s assets or income;

4) Be subject to government regulation and provide annual information about the amount of qualified benefits (or this information must otherwise be available) to the relevant tax authorities in the country in which it is established or operates;

5) Be eligible for certain tax treatment under the laws of the country in which the fund is established or operates (e.g., contributions to the eligible fund that would otherwise be subject to tax under the foreign law are deductible or excluded from gross income of the eligible fund or taxed at a reduced tax rate. Privately organized funds established by government mandate may qualify as QFPFs such as Mexican SIEFORs and other Latin American national retirement schemes.

6) Under an “established to provide retirement and pension benefits” requirement, the plan must provide 100 percent “qualified benefits,” at least 85 percent “retirement and pension benefits,” at most 15 percent “ancillary benefits,” and at most 5% “non-ancillary benefits.”

i) “Retirement and pension benefits” include most types of benefits payable on reaching retirement age or permanently disability, and “ancillary benefits” many types of health and unemployment benefits.

ii) “Non-ancillary benefits” provides a de minimis rule for other miscellaneous benefits (housing, education, etc).

iii) These tests must be determined annually based on the present value of all benefits to be provided over the life of the plan. If the plan fails the annual test, it may fall back on a 4-year rolling average.

iv) If a plan provides other types of benefits, the assets used to fund those benefits must be held in a separate qualified segregated account rather than commingled with assets used to provide qualified benefits.

U.S. Taxation of QFPFs

Although a QFPF avoids FIRPTA withholding tax, QFPFs are generally taxed on direct operation of real estate. However, an investor claiming a QPPR exemption from FIRPTA withholding tax, must provide an affidavit that it is a “qualified holder.” Qualified holder requirement is satisfied if: 1) the QFPF or QCE owned no USRPI as of the earliest date during the uninterrupted period ending on the date of sale in which it qualified as a QFPF or QCE; 2) the QFPF or QCE has qualified as such continuously for the 10-year “testing period” ending on the date of the sale of the USRPI.

QFPFs typically invest in U.S. real estate through a United States Real Property Holding Corporation (“USRPHC”), including private Real Estate Investment Trusts (“REITs) for which no attribution of effectively connected income arises under Sections 875 or 897(h)(1). However, any dividends paid by a QFPF is taxable in the U.S. at a 30% rate unless reduced or eliminated by an applicable treaty.

Conclusion

This article is intended to provide the reader with a basic understanding of the rules governing QFPFs holding U.S. real estate and FIRPTA. It should be evident from this article that this is a relatively complex subject. In addition, it is important to note that this area is constantly subject to new developments and changes.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony has advised various Fortune 500 companies and large privately held businesses in their cross-border tax planning. Anthony is a frequent author and speaker on international tax topics.

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.