By Anthony Diosdi
For some time, many non-residents (who are not domiciled in the U.S.) held U.S. real property through U.S. corporations which were wholly owned by foreign corporations. The purpose of these multi-tiered structures was to avoid the U.S. estate and gift tax. At one time, if implemented properly, this type of structure protected the non-U.S. individual from U.S. federal estate and gift tax, and also allowed the non-resident to control the timing of shareholder-level tax on dividend distributions.
All this was possible because prior to the 2004 calendar year, a U.S. corporation may reincorporate in a foreign jurisdiction and thereby replace the U.S. parent corporation with a foreign parent corporation. These transactions are commonly referred to as asset inversion transactions. In asset inversions, a U.S. corporation generally recognized gain (but not loss) under Section 367(a) of the Internal Revenue Code as though it had sold all of its assets, but the shareholders generally did not recognize gain or loss, assuming the transaction met the requirements of a reorganization under Section 368. To remove the incentive to engage in corporate inversion transactions, Congress included several provisions in the 2004 JOBS At aimed at corporate inversions. One of these provisions was Section 7874 to the Internal Revenue Code.
After Section 7874 was enacted, holding U.S. real property through a U.S. corporation that is wholly owned by a foreign corporation can result in an “inversion.” If this were to take place, a foreign corporation that holds a U.S. corporation could be treated as a U.S. corporation for U.S. tax purposes. This means that an estate plan that holds U.S. property through a U.S. corporation which is wholly owned by a foreign corporation may not protect non-residents from the U.S. federal estate tax. Since non-residents only have a $60,000 exemption on the value of their U.S. situs assets excluded from their gross estate for U.S. gift and estate tax purposes, a structure such as the one described above may have disastrous U.S. federal estate tax consequences to the non-U.S.resident and his or her family on death.
This article will discuss one variation of the “inversion” transaction, which involves the transfer of shares by non-U.S. individuals of a U.S. corporation owning U.S. real estate to a foreign corporation in exchange for shares of the foreign corporation. It then describes the effect of such a share inversion and associated anti-inversion rules on the recipient foreign corporation and its non-U.S. individual owners.
Summary of U.S. Federal Income Tax Law
To fully appreciate the inversion rules’ impact on estate planning utilizing multi-tier corporate structure, we will begin with a discussion of U.S. federal income, estate, and gift taxes that apply to individuals.
Under Internal Revenue Code Section 7701(a)(30)(A), an individual is a U.S. person if he or she is either a citizen or a resident of the United States. Under Section 7701(b), an individual who is not a U.S. citizen (i.e., a non-resident) may be a U.S. resident for U.S. income tax purposes (i.e., a “resident alien”) under either the “permanent residence” test or “substantial presence” test.
Under the “permanent residence” or “green card test,” an alien is treated as a resident alien if he or she is a “lawful permanent resident of the United States” at any time during the calendar year. Under Section 7701(b)(6), an alien is a lawful permanent resident of the United States at any time if: 1) the individual has been lawfully accorded the privilege of residing in the United States as an immigrant in accordance with the immigation laws (i.e., the individual holds a green card); and 2) such status has not been revoked.
Under the substantial presence test of Section 7701(b)(3), an alien is treated as a resident alien if he or she is physically present in the United States during the 3-year period that includes the current year and the previous 2 calendar years. In calculating an individual’s total day count for the relevant 3-year period, the number of days present in the United States in the current calendar year is multiplied by 1, the number of days present in the United States in the immediate preceding calendar year multiplied by ⅓, and the number of days present in the 2nd preceding calendar year is multiplied by ⅙. As a general rule, an alien present in the United States 183 days or more in a taxable year, including partial days, is a U.S. resident for that year for tax purposes.
If an individual is not a citizen or resident of the United States or does not satisfy the “permanent residence test” or “substantial presence” test, he or she will be classified as a non-resident for U.S. purposes. U.S. tax law contains a two-pronged system for taxing the U.S. -source income of foreign persons, including nonresident aliens, and foreign corporations. The United States taxes foreign persons at graduated rates on the net amount of income effectively connected with the conduct of a trade or business with the United States. The United States also taxes the gross amount of a foreign person’s U.S.- source investment-type income at a flat rate of 30%. The U.S. person controlling the payment of the U.S.-source investment income must withhold the 30% tax. Income tax treaties usually reduce the withholding tax rate on interest, dividend, and royalty income to 15% or less. Capital gains from sales of stocks or bonds are generally exempt from U.S. taxation.
Special rules apply to gains from the sale of U.S. real property. Under Internal Revenue Code Section 897,gains or losses realized by foreign persons from 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. A U.S. real property interest stock of a domestic corporation which is a U.S. holding corporation if the market value of its U.S. real property interest equals 50% or more of the net fair market value of the sum of its total real property interest. To ensure collection, any purchaser of a U.S. real property interest must withhold a tax equal to 15% of the amount realized by the foreign person on the sale.
Unlike the U.S. federal income tax, the U.S. federal estate and gift taxes are applied based on an individual’s “residency.” The term “residency” means “domicile.” Although the U.S. income tax concept of residency relates only to physical presence in a place for more than a transitory period of time, domicile relates to a permanent place of abode. For U.S. estate and gift tax purposes a person can have (and must have) only one place of domicile, while for U.S. income tax purposes a person may have more than one place of residence, or none. Although an alien may be classified as a resident alien for U.S. income tax purposes, such classification is not determinative of the alien’s domicile for U.S. estate and gift tax purposes.
The concept of domicile is subjective, focusing on the intentions of the alien as manifested through certain lifestyle-related facts. See Treas. Reg. Sections 20.0-1(b)(1) and 25-2501-1(b) offer only limited guidance, stating: “A person acquires a domicile in a place by living there, for even a brief period of time, with no definite present intention of later removing therefrom. Residence without the requisite intention to remain indefinitely will not suffice to constitute domicile. Nor will the intention to change domicile effect such a change unless accompanied by actual removal.” Accordingly, to be domiciled in the United States physical presence must be coupled with the requisite intent to remain indefinitely.
U.S. citizens and U.S. domiciliaries are subject to the U.S. federal estate and gift tax on the fair market value of their worldwide assets that they transfer during life or at death. On the other hand, individuals who are neither citizens of the United States nor considered domiciled in the United States are subject to U.S. federal estate or gift tax only on the fair market value of their ownership interest in certain U.S.assets are situated in one of the U.S. states or District of Columbia at the time of death. A nonresident’s (an individual not domiciled in the U.S.) gross is composed like a U.S. person’s gross estate in that transfers within three years of death are includible in the gross estate but only if the subject property had U.S. situs at either the time of transfer or the time of death. Situs is determined by the physical location of the asset. Thus, U.S. real property has a U.S. situs. Stock of a U.S. corporation is U.S. situs and the stock of a foreign corporation is foreign situs, regardless of the place of management or the location of the stock certificates.
U.S. citizens and U.S. domiciliaries are currently entitled to a $11,700,000 lifetime exemption (adjusted for inflation) from the estate and gift tax. On the other hand nonresident aliens (who are not domiciled in the U.S.) are only permitted to exclude $60,000 of U.S.-situs property from the calculation of his U.S. federal estate tax. The current top estate tax rate is 40%.
Given the extremely low exclusion rate, for many foreign individual investors, the most important U.S. tax consideration when considering an investment in the United States is how to avoid the U.S. federal estate and gift taxes. Many nonresident foreign investors have utilized strategies of holding U.S.-situs assets, such as U.S. real estate through a foreign corporation, as shares in a foreign corporation are explicitly excluded from the definition of U.S. -situs assets. Further, foreign individuals often prefer to have the same U.S.-situs assets held directly by domestic entities, such as U.S. corporations. This is because domestic entities typically have an easier time conducting business in the United States and there are a number of income tax benefits to holding U.S.-situs assets in a domestic corporation compared to a foreign corporation.
Overview of FIRPTA
At one time, nonresidents could avoid paying taxes on U.S. real estate gains. FIRPTA addressed closed this loophole by subjecting gains from dispositions of U.S. real property interests (“USRPI(s)”) derived by nonresidents or foreign corporations to U.S. federal tax under Sections 871(b) or 882(a) of the Internal Revenue Code as if effectively connected with a U.S. trade or business. The Tax Reform Act of 1984 added Section 1445 to the Internal Revenue Code to utilize a withholding tax as the enforcement mechanism for the tax. See IRC Section 897.
To trigger the application of Internal Revenue Code Section 897, there must be a disposition of a USRPI by a nonresident individual or foreign corporation. A USRPI is defined as an interest, other than an interest solely as a creditor, in real property located in the United States or the U.S. Virgin Islands. The term “real property” includes land and unsevered natural products of the land, improvements, and personal property associated with the use of real property. Also constituting a USRPI is an interest in a domestic corporation that is classified as a “United States Real Property Holding Corporation” (“USRPHC”) because its assets consist predominantly of USRPIs, or an interest in a partnership that meets certain USRPI ownership tests. The stock of a foreign corporation is not a USRPI and thus can be sold without FIRPTA tax applying, but the purchaser inherits any built-in tax liability.
The Temporary Regulations under Section Section 897(e) provide an exception that allows for nonrecognition treatment in certain foreign-to-foreign exchanges of USRPIs. Specifically, this exception provides for nonrecognition treatment if a foreign person exchanges stock in a USRPHC in three types of transactions:
1) A Type D or Type F reorganization exchange between foreign corporations (and their foreign shareholders).
2) A Type C reorganization between foreign corporations if the transferor’s shareholders also own more than 50% of the transferred.
3) A Section 351 transfer (or a Type B reorganization exchange) of USRPHC stock to a foreign corporation and immediately after the exchange all of the outstanding stock of the transferee corporation is owned by the same nonresident alien individuals and foreign corporations that immediately before the exchange owned the stock of the USRPHC.
Taking into consideration estate and gift taxes and FIRTPA, for many years, the optimal structure for nonresident investors was to have a U.S. corporation own an interest in real estate located in the United States. The domestic corporation would be classified as a USRPHC. A foreign corporation was formed to hold the USRPHC stock because stock in a foreign corporation is not included in the nonresident’s U.S. gross estate and is not subject to U.S. estate or gift tax. This type of planning is permitted to avoid the FIRPTA withholding rules. However, as a result of Section 7874, such a strategy may result in potentially disastrous U.S. estate and gift tax exposure, as discussed below.
Overview of Internal Revenue Code Section 7874 and the Anti-Inversion Rules
The U.S. government has recognized that inversions provide tax savings in two significant ways. First, an inversion may reduce U.S. tax on foreign-source income by effectively shifting income away from a U.S. corporation to its related foreign corporation (“income shifting”). In turn, this potentially achieves pure territorial tax treatment for the group, rather than worldwide income treatment. Second, an inversion may reduce U.S. tax through earnings stripping with foreign related-party debt, where a U.S. subsidiary pays interest to its foreign parent and the interest may then be deductible for U.S. federal tax purposes. In light of these abuses, the U.S. government has issued numerous anti-inversion rules over the past 20 years to prevent U.S. multinational corporations from relocating their domicile to foreign jurisdictions.
Prior to March of 2003, a U.S. corporation could reincorporate in a foreign jurisdiction and thereby replace the U.S. parent corporation of a multinational corporate group with a foreign parent corporation. These transactions were commonly referred to as inversion transactions. Inversion transactions could take many different forms, including stok inversions, asset inversions, and various combinations of and variations on the two. In a stock inversion, a U.S. corporation forms a foreign corporation, which in turn forms a domestic merger subsidiary. The domestic merger subsidiary would then merge into the U.S. corporation, with the U.S. corporation surviving as a subsidiary of the new foreign corporation. The U.S. corporation’s shareholders would receive shares of the doreign corporation and would be treated as having exchanged their U.S. corporate shares for the foreign corporation shares. An asset inversion would reach a similar result, but through a direct merger of the top-tier U.S. corporation into a new foreign corporation.
Inversions were done to remove income from foreign operations from the U.S. taxing jurisdiction. In addition to removing foreign operations from the U.S. taxing jurisdiction, a corporate group was typically able to derive further advantages from an inverted structure by reducing U.S. tax on U.S. source income through various earnings stripping or other transactions.
In 2004, corporate inversion transactions became a prime focus of Congress as a result of several well-publicized inversion transactions during the prior decade (e.g., the inversion transactions involving Tyco Corporation and Cooper Industries). To remove the incentive to engage in corporate inversion transactions, Congress included several provisions in the 2004 JOBS Act aimed at this perceived problem. In particular, Congress enacted Section 7874 of the Internal Revenue Code. Section 7874 defines two different types of corporate inversion transactions and provides a different set of tax consequences to reach each type of inversion transaction.
Internal Revenue Code Section 7874
The anti-inversion rules are designed to prevent corporate inversions by providing different methods of taxation depending on whether the former U.S. shareholders own at least 80 percent of the new foreign corporation or at least 60 percent (but less than 80 percent) of the shares of a new foreign corporation.
The anti-inversion rules apply if pursuant to a plan or series of related transactions: 1) a U.S. corporation becomes a subsidiary of a foreign-incorporated entity or otherwise transfers substantially all of its properties to such an entity in a translation; 2) the former shareholders of the U.S. corporation hold (by reason of holding stock in the U.S. corporation) 80 percent or more (by vote or value) of the stock of the foreign-incorprated entity after the transaction; and 3) the foreign-incorporated entity, considered together with all companies connected to it by a chain of greater than 50 percent ownership (ie., the “expanded affiliated group), does not have substantial business activities in the entity’s country of incorporation, compared to the total worldwide business activities of the expanded affiliated group. The provision denies the intended tax benefits of this type of inversion by deeming the top-tier foreign corporation to be a domestic corporation for all purposes of the Internal Revenue Code.
In determining whether a transaction meets the definition of an inversion, stock by members of the expanded affiliated group that includes the foreign incorporated entity is disregarded. For example, if the former top-tier U.S. corporation receives stock of the foreign incorporated entity (e.g., so-called “hook” stock), the stock would not be considered in determining whether the transaction meets the definition. Similarly, if a U.S. parent corporation converts an existing wholly owned U.S. subsidiary into a new wholly owned controlled foreign corporation, the stock of the new foreign corporation would be disregarded. Stock in a public offering related to the transaction also is disregarded for these purposes.
In addition, the Internal Revenue Service (“IRS”) is granted authority to prevent the avoidance of the purpose of the proposal through the use of related persons, pass-through or other noncorporate entities, or other intermediaries, and through transactions designed to qualify or disqualify a person as a related person or a member of an expanded affiliated group. In this type of inversion transaction, the anti-inversion rules deny the intended tax benefits by deeming the top-tier foreign corporation to be a U.S. corporation for all U.S. tax purposes.
If U.S. shareholders own at least 60 percent (but less than 80 percent), by vote or value, of the foreign corporation, a different anti-inversion rule applies. Under these rules, the inversion transaction is respected (i.e., the foreign corporation is treated as foreign), but any applicable corporate-level “toll charges” for establishing the inverted structure are not offset by tax attributes such as net operating losses or foreign tax credits. Specifically, any applicable corporate-level income or gain required to be recognized under Internal Revenue Code Sections 304, 211(b), 367, 1001, 1248, or any other provision with respect to the transfer of controlled foreign corporation stock or the transfer of other assets by a U.S. corporation stock or the transfer or license of other assets by a U.S. corporation as part of the inversion transaction or other such transaction to a related foreign person is taxable, without offset by any tax attributes (e.g., net operating losses or foreign tax credits). These measures generally apply a 10-year period following the inversion transaction.
The anti-inversion rules do not apply where: 1) the transferee is a foreign partnership; 2) less than substantially all of the assets are transferred; or 3) substantial activities are conducted in the country where the new holding copy is located. The Income Tax Regulations provide that the substantial activities test is met only if the following tests are met:
1. Group employees.
A. The number of group employees based in the relevant foreign country is at least 25 percent of the total number of group employees on the applicable date.
B. The employee compensation incurred with respect to group employees based in the relevant foreign country is at least 25 percent of the total employee compensation incurred with respect to all group employees during a testing period.
2. Group Assets
A. The value of the group assets located in the relevant foreign country is at least 25 percent of the total value of all group assets on the applicable date.
B. The group income derived in the relevant foreign country is at least 25 percent of the total group income during a testing period.
Although there are many variations of inversions, a domestic corporation holding U.S. real estate that merges into a foreign corporation to avoid U.S. estate and gift taxes can be classified as inversion. This is because the U.S. corporation holding the real estate becomes a subsidiary of a foreign corporation and the former shareholders of the U.S. corporation will ultimately hold at least 80% (by vote or value) of a foreign corporation by reason of holding stock in the U.S. corporation. Although this type of planning will not likely trigger the recognition of the inversion gain, it will deny the intended tax benefit by treating the foreign corporation as a domestic corporation for all purposes of the Internal Revenue Code.
The Effects of Section 7874 on Multi-Tiered Structures Holding U.S. Real Estate for Estate and Gift Taxes
As discussed above, holding U.S. in a multi-tiered corporate structure involves a transfer by a nonresident of the stock in a USRPHC to a foreign corporation in exchange for stock in a foreign corporation. If structured and implemented properly, this type of planning qualifies for nonrecognition under Internal Revenue Code Section 351. In addition, the Income Tax Regulations under Internal Revenue Code Section 897 permit the nonrecognition of a Section 351 transaction. Consequently, the merger of a USRPHC into a foreign corporation is not likely a taxable event under Section 351 and FIRPTA.
However, Section 7874 of the Internal Revenue Code may result in adverse estate and gift tax consequences because the merger of a USRPHC into a foreign corporation satisfies three requirements discussed above. More specifically, the foreign corporation indirectly acquires all of the properties held by the U.S. corporation; the nonresident who directly owned the shares in the U.S. corporation now owns all of the shares of the foreign corporation, which holds the stock of the U.S. corporation; and, finally, neither the foreign corporation nor any of its affiliated members satisfy the substantial business activities exception because they do not meet the “Group Assets” test discussed above.
This is because the majority of domestic and ultimately the foreign corporation’s assets consist of U.S. real property interests. Because this type of planning triggers the inversion rules, the foreign corporation holding U.S. real estate will be treated as a U.S. corporation for all U.S. federal tax purposes. This means, on the date of the nonresident’s death, he or she will be treated as owning stock in a U.S. corporation (a U.S.-situs asset) rather than stock in a foreign corporation (a foreign-situs asset).
Consequently, unless the goal is to avoid FIRPTA withholding or plan for a Section 351 transaction, the above discussed transaction is practically useless.
Although it does not appear that a multi-tiered corporate structure will provide protection from the U.S. estate and gift tax, there are several other possible ways to mitigate the U.S. estate tax risk without using a foreign holding company holding structure. For example, a properly structured, a foreign or domestic irrevocable trust will protect the nonresident grantor from U.S. federal estate tax. Placing U.S. property into a partnership or limited liability company may provide protection from U.S. estate and gift tax. Finally, a foreign investor may consider acquiring U.S. real property through a split-interest purchase. In a split-interest ownership plan, the foreign investor purchases from an unrelated owner a “life estate” (generally for his or her lifetime or for a stated term of years), while the investor’s children purchase a “remainder interest” in the same property, each paying their respective actuarial values of the interests purchased based upon the actuarial tables in Treasury Regulation Section 20.2031-7(f). Because the life tenant’s interest ends upon his or her death, there is no transfer of a property interest subject to U.S. federal or estate tax. This is an incredibly complicated area of tax law. If you are a foreign investor who owns U.S. real estate or are considering acquiring U.S. real estate, you should consult with a tax attorney well versed in this area of the law.
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.