By Anthony Diosdi
Two different U.S. federal tax methods apply to foreign investors. First, foreign investors engaged in a trade or business in the United States are taxed on income that is effectively connected with a trade or business. Such income is taxed at applicable graduated U.S. federal individual income tax rates. Foreign investors are subject to a different set of rules for income that is not effectively connected with a trade or business in the U.S. Under this method, a flat 30 percent tax is imposed on U.S. source fixed or determinable annual or periodic income such as (interest, dividend, rents, annuities, and other types of “fixed or determinable annual or periodic income,” which is also known as “FDAP.”). Under FDAP, tax is imposed on gross income and no deductions are permitted to reduce the tax. This tax is collected by withholding. However, the 30 percent withholding tax may be reduced or eliminated by a tax treaty.
Modern vs. Older Tax Treaties
Even though the statutory rate of withholding on U.S. source payments of FDAP income to a foreign person is 30 percent, for the most part, income tax treaties will reduce and in some cases eliminate the U.S. withholding on FDAP income. For a foreign investor to be eligible for the benefits of a tax treaty, as a general rule, the investor should be a “resident” of a particular treaty country and must satisfy a so-called “limitation on benefits” (“LOB”) provision contained in the treaty. Under the vast majority of bilateral tax treaties, a foreign person will be considered a resident of the treaty country if such person is “liable to tax therein by reason of its domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of similar nature.”
Under most income tax treaties recently entered into by the United States, a resident of a treaty country will satisfy the LOB provision if that resident is an individual, or a corporation that is at least 50 percent owned by citizens or residents of the U.S. or by residents of the jurisdiction where the corporation is formed and not more than 50 percent of the gross income of the foreign corporation is paid or accrued, in the form of deductible payments, to persons who are neither citizens not residents of the U.S. or residents of the jurisdiction where the corporation is formed. There are no such residency requirements under older income tax treaties. As will be discussed in more detail below, this may result in interesting tax planning opportunities.
U.S. Tax Planning Opportunities Utilizing Older Tax Treaties
All modern bilateral tax treaties negotiated by the U.S. contain LOB provisions. With that said, certain older income tax treaties do not contain LOB provisions. As of the 2021, approximately ten effective tax treaties with foreign countries do not contain a LOB provision. Most of these treaties reduce FDAP withholding rates. For example, the U.S. treaties with Hungary, and Poland reduce the withholding rate on payments of U.S. source dividends to as low as five percent for federal income tax purposes.
As discussed above, payments of U.S. source dividends to a foreign corporations are generally subject to a 30 percent federal withholding tax. While many treaties reduce or eliminate this withholding rate, not all foreign investors are residents of a treaty country. Thus, they may qualify for reduced treaty rates. In such a situation, the foreign investor may consider establishing an entity in a country that has a treaty with the U.S. that does not contain a LOB provision.
For example, let’s assume that Tom is a resident of Singapore. Tom would like to invest in the United States. However, the United States has not entered into a bilateral tax treaty with Singapore. Instead of investing directly into a U.S. corporate structure, Tom may consider investing in the U.S. through a Hungarian corporation. The U.S.-Hungary tax treaty reduces the U.S. withholdings on dividends to five percent. By establishing a Hungarian corporation, Tom can potentially reduce the U.S. federal tax on dividends from 30 percent to 5 percent.
Whenever a tax treaty is utilized, we must consider the treaty partner’s country’s local tax. When Hungarian residents receive a dividend payment, they usually have to pay 15% income tax on the whole dividend amount and 15.5% social contribution tax up to a yearly limit. However, all dividends received by a Hungarian corporation are exempt from corporate tax unless the paying corporation is a “controlled foreign corporation,” (“CFC”) as that term is defined for Hungarian tax purposes. A CFC is defined in Hungary as a foreign corporation that is subject to an effective tax rate below 10 percent (which is ⅔ of the 15 percent Hungarian tax rate), unless that foreign corporation has a real economic presence in Hungary.
Tom’s Hungarian corporation will not be classified as a CFC for Hungarian tax purposes because it does not have a real economic presence in Hungary. By investing to the U.S. through a Hungarian corporation, a dividend paid from the U.S. to Tom would only be subject to a five percent U.S. federal withholding and the dividend received in Hungary would be completely exempt from Hungarian corporate income tax as a result of its favorable participation exemption. In addition, a dividend paid out of Hungary could be completely exempt from Hungarian withholding tax. The exemption from withholding tax on dividends from Hungary applies if the recipient is a corporation. In this case, Tom can own shares of the Hungarian corporation through a low or no-tax jurisdiction such as the British Virgin Islands.
Since U.S.- Hungary tax treaty still contains no LOB provisions, it is possible for anyone residing in a jurisdiction that does not have a bilateral tax treaty with the U.S. to take advantage of a Hungarian structure.
Foreign investors may also consider utilizing a Hungarian structure to limit their exposure to gains realized from the disposition of U.S. real property. Foreign investors are typically not subject to U.S. income tax on U.S. source capital gains unless the gains are effectively connected to a U.S. trade or business. See IRC Section 871(a)(2). However, the Internal Revenue Code treats any gain realized by a foreign person on the disposition of a U.S. real property interest (“USRPI”) as if it were effectively connected to a U.S. trade or business. A USRPI is classified by the Internal Revenue Code as: 1) a direct interest in real property located in the U.S. and 2) an interest (other than an interest solely as a creditor) in any U.S. corporation that constitutes a U.S. real property holding corporation (a corporation whose USRPIs makeup at least 50 percent of the total value of the corporation’s real property interests and business assets). See IRC Section 871(c)(2).
Internal Revenue Code Section 1445 requires that a transferee of a USRPI from a foreign person must withhold fifteen percent of the total amount realized by the foreign seller, unless an exemption or limitation applies. This withholding is known as the Real Property Tax Act of 1980 (“FIRPTA”).
The regulations promulgated under Internal Revenue Code Section 897 provide an exception to the USRPI rules as follows: “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 corporation 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.” See Treas. Reg. Section 1.897-1(h). This example states 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. income tax purposes. The example also concludes that 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 and the amount is considered to be interest instead of gain.
By characterizing a contingent payment on a debt instrument as interest for U.S. income tax purposes, the Income Tax Regulations promulgated under Internal Revenue Code Section 897 may permit non-U.S. taxpayers to avoid U.S. income tax on gain arising from the sale of U.S. real estate. This means, foreign investors can potentially lend money from a company established in a country that has a treaty with the United states with no LOB provision can have that interest on the loan tied to gain on the sale of the property. The interest that is tied to the gain of the sale of the real property may be completely exempt from U.S. income tax.
Let’s assume that Tom entered into an agreement to share in the appreciation in the value in U.S. real estate similar to the example discussed in Treasury Regulation Section 1.897-1(h). The result would be that the amount realized is considered to be interest rather than gain under Internal Revenue Code Section 1001. If the distribution of the U.S. real estate proceeds to his Hungarian corporation would be classified as interest, Tom would likely be subject to a 15 percent Hungarian corporate tax. The Hungarian corporate tax could be reduced through tax treaties Hungary has with Switzerland or Luxembourg. At one time, both these jurisdictions had a very favorable branch taxing regime. Thus, Tom may consider utilizing the U.S.-Hungarian tax treaty to minimize his Hungarian tax by registering a branch in either Switzerland or Luxembourg. A finance branch registered in either of these two jurisdictions may reduce the overall effective tax rate on interest income to as low as two percent. By having Tom’s Hungarian corporation own a finance branch in either Switzerland or Luxembourg and by allocating loans and interest to such a financial branch, rather than to the Hungarian company directly, the foreign income tax imposed on the receipt of the interest income may be significantly reduced.
It should be noted that the U.S.-Hungarian tax treaty contains an “anti-triangular” provision in the tax treaty. Typically, an “anti-triangular” provision prevents a non-U.S. taxpayer from utilizing treaty benefits if the income benefit received is attributable to an establishment located in a third jurisdiction and the combined tax rate of both jurisdictions is lower than the U.S. tax rate. In this case, the use of a Swiss or Luxembourg would likely be lower than the U.S. tax rate. Thus, the “anti-triangular” provision of the U.S.-Hungary treaty would prevent Tom from reducing his global tax burden associated with the sale of U.S. real estate.
This does not mean that Tom does not have other options. The current U.S.-Polish tax treaty provides similar benefits to foreign investors as the U.S.-Hungarian bilateral tax treaty. For example, suppose a foreign investor realizes a gain on a debt instrument on real property classified as interest under Section 897 of the Internal Revenue Code. Like the previous example, under the U.S.-Polish tax treaty, a foreign investor can lend money to a Polish company and have the gain of the real property completely exempt from U.S. income tax.
Under the U.S.-Polish tax treaty, Tom can establish a Polish corporation to lend money to a U.S. individual holding the real property. The Polish corporation could secure a mortgage on the U.S. property. Under the loan agreement, the Polish corporate lender would receive fixed monthly payments from the domestic borrower, constituting repayment of the principal plus interest, and a percentage of any appreciation in the value of the real property at the expiration of the loan. The Income Tax Regulations of Section 897 potentially allows Tom to lend money from a company formed in Poland and completely exclude the gain on the real property from U.S. income tax.
If the transaction is properly arranged, Tom could avoid Polish corporate income tax which is currently 19 percent (As of January, 2019, a lower 9% rate for ‘small taxpayers’ has been introduced. Companies with revenues of up to 1.2 million euros (EUR) in any given year may qualify for the reduced rate). In order to mitigate Polish corporate tax, a “finance branch” may be established in a low-tax third party jurisdiction. Poland has bilateral tax treaties with Switzerland, Luxembourg, and the United Arab Emirates. These countries have very favorable branch tax regimes. Consequently, a “finance branch” could be registered in one of these countries to reduce the effective tax rate on the gains from U.S. real estate activities to a marginal tax rate of potentially less than two percent. See Article 23(1) of the Poland-Switzerland Income Tax Treaty; Article 24(2)(a) of the Poland-Luxembourg Income Tax Treaty; and Article 24(1)(a) of the Poland-UAE Income Tax Treaty.
Under such planning, any income derived by the “finance branch” could potentially be exempt from Polish corporate tax under the respective tax treaty. Unlike many bilateral income tax treaties with other jurisdictions (including the U.S.-Hungary tax treaty), the bilateral U.S. treaty with Poland has no “anti-triangular” provision.
Foreign investors may utilize tax treaties to significantly reduce their exposure to FDAP and FIRPTA. In some limited cases, foreign investors can utilize “triangular” tax treaty positions to reduce their exposure to FDAP and FIRPTA. However, the use of “triangular” tax treaty positions is incredibly complicated and full of land mines. If you are not a resident of the U.S. and are considering investing in the U.S., you should seek advice from an international tax attorney who has a solid understanding of global tax treaties before investing in the United States.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: 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.