By Anthony Diosdi
Foreign investors generally have the same goals of minimizing their income tax liabilities from their U.S. real estate as do their U.S. counterparts, although their objective is complicated by the very fact that they are not U.S. persons. That is, non-U.S. investors must be concerned not only with income taxes in the United States, but also income taxes in their home country. U.S. tax law contains the following two-pronged territorial system for taxing the U.S.-source income of nonresident individuals and foreign corporations:
1) U.S. trade or business profits– If a nonresident alien individual or foreign corporation is engaged in a trade or business within the United States, the net amount of income effectively connected with the conduct of that U.S. trade or business is taxed at the same graduated rates that would apply to a U.S. person [i.e., at a current maximum of 37 percent].
2) U.S.-source investment-type income- If a nonresident alien individual or foreign corporation derives investment-type income from sources within the United States, the gross amount of that income is taxed at a flat rate of 30 percent. The person controlling the payment of the income must deduct and withhold U.S. tax at the 30 percent rate.
There is a major exception to the general rules for taxing foreign persons. Income tax treaties usually reduce the withholding tax rate on U.S.-source interest income from the statutory rate of 30 percent to 15 percent or less. In addition, the United States generally exempts from U.S. taxation capital gains, except for gains on the sale of U.S. real property interests, which are taxed in the same manner as income effectively connected with the conduct of a U.S. trade or business. Since the typical income-producing real estate property will constitute a U.S. trade or business, a foreign person’s investment in such property normally will be taxed if the foreign person invests individually or at 21 percent if the foreign person invests through a corporate vehicle. This article discusses how nonresidents investing U.S. real estate may utilize shared appreciation loans and tax treaties to potentially significantly reduce their exposure to U.S. capital gains taxes.
A Closer Look at Shared Appreciation Loans
As discussed above, foreign persons typically are not subject to U.S. source capital gains unless those gains are effectively connected to a U.S. trade or business. Internal Revenue Code Section 897 treats any gains recognized by a foreign person on the disposition of U.S. real property interest (“USRPI”) as if it were effectively connected to a U.S. trade or business. A USRPI is broadly defined as: 1) a direct interest in real property located in the United States; 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 (i.e., a corporation whose USRPI make up at least 50 percent of the total value of the corporation’s real property interest and business assets).
The Income Tax Regulations under Internal Revenue Code Section 897 elaborate 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.” See Treas. Reg. Section 1.897-1(d)(2)(i). The regulations go 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 appreciation in value of, or in the gross or net proceeds or profits generated by, an interest in real property of the debtor is, in its entirety, an interest in real property other than solely as a creditor.”
This principle is illustrated by an example in Income Tax Regulation Section 1.897-1(d)(2)(i) as follows: A non-U.S. taxpayer lends to a U.S. resident to use in purchasing a condominium. The nonresident lender is entitled to receive 13 percent annual interest for the first ten years of the loan and 35 percent of any appreciation in the fair market value of the condominium at the end of the ten-year period. The example concludes that, because the lender has a right to share in the appreciation of the value of the condominium, he has an interest other than solely as a creditor in the condominium (i.e., a USRPI). Accordingly, a debt instrument with contingent interest that is tied to U.S. real estate (otherwise known as a shared appreciation mortgage) is a USRPI for purposes of Internal Revenue Code Section 897.
Income Tax Regulation Section 1.897-1(h) Example 2 illustrates a significant planning opportunity for non-U.S. investors investing in U.S. real estate. In the example, Forign corporation Y makes a loan of $1 million to domestic individual Z, secured by a mortgage on residential real property purchased with the loan proceeds. The loan agreement provides that Y is entitled to receive fixed monthly payments from Z, constituting repayment of principal plus interest at a fixed rate. In addition, the agreement provides that Y is entitled to receive a percentage of the appreciation value of the real property as of the time that the loan is retired. The obligation in its entirety is considered debt for federal income tax purposes. However, because of Y’s right to share in the appreciation in the value of the real property, the debt obligation gives an interest in the real property other than solely as a creditor. Nevertheless, as principal and interest payments do not constitute gain under Section 1001 and paragraph (h) of this section, and both the monthly and final payments received by Y are considered to consist solely of principal and interest for federal income tax purposes, Section 897 shall not apply to Y’s receipt of such payments.
The above example provides that, because of the foreign lender’s right to share in the appreciation in the value of the real property, the debt obligation given the foreign lender is an interest in the real property “other than solely as a creditor.” With that said, the example concludes that Section 897 will not apply to a foreign lender on 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. Thus, by classifying a contingent payment on the debt instrument as interest (and not gain from the distribution of the USRPI) for income tax purposes, regulations promulgated under Internal Revenue Code Section 897 potentially allow foreign investors to avoid U.S. income tax on gains arising from the sale of U.S. real estate. Consequently, a shared appreciation loan offers foreign investors the opportunity to avoid U.S. capital gains taxes on at least a portion of real estate gains. With that said, a shared appreciation loan is still subject to a 30 percent U.S. withholding tax. Planning opportunities using tax treaties is discussed in the next subsection of this article.
Planning for the 30 Percent Withholding Tax
As discussed above, it is possible to avoid the tax on U.S. real property interests by utilizing shared appreciation mortgages and other hybrid debt instruments to obtain debt characterization for what are, in substance, equity investments in U.S. real property. The problem shared appreciation mortgages will generate interest income for U.S. purposes.
Like the United States, most foreign countries impose flat withholding taxes on interest derived by offshore investors from sources within the country’s borders. The U.S. statutory withholding tax rate is 30 percent for nonresident alien individuals and foreign corporations. However, most tax treaties provide for reduced withholding tax rates, as long as the interest is not attributable to a permanent establishment of the taxpayer that is located within the United States. Tax treaties usually reduce the withholding tax rate on interest to 15 percent or less. The U.S. treaties with France, Germany, and the United Kingdom provide a 0% withholding tax rate for interest paid. If a foreign investor is a resident of a country that has a bilateral income tax treaty with the United States, the foreign investor can reduce or even eliminate the withholding on the interest income generated from the shared appreciation mortgage instrument.
Because tax treaties provide lower withholding rates on interest income, foreign investors sometimes establish a company in a third foreign country that has a tax treaty with the United States in order to take advantage of the treaty. This practice is known as “treaty shopping.”
Below, please see Illustration 1. Which demonstrates a typical “treaty shopping” example.
Let’s assume that Paul is a citizen of country A. Country A does not have an income tax treaty with the United States. Therefore, the U.S. withholding tax rate on any interest received by Paul from U.S. sources is 30 percent. In contrast, the withholding tax rate on interest in Country B under the treaty between the United States and Country B is 0%. Paul may believe that he can establish a company in Country B to reduce the withholding tax rate on interest received from U.S. sources. Unfortunately for Paul, most (but not all) current tax treaties between the United States and other countries contain an anti-treaty shopping provision that restricts the ability of foreign investors to engage in treaty shopping.
Anti-treaty shopping provisions also known as limitation on benefits or (“LOB”) provisions. The principal target of a LOB provision is a corporation that is organized in a treaty country by a resident of a non-treaty country merely to obtain the benefits of that country’s income tax treaty. A limitation on benefits provision denies such corporations the benefits of the treaty. Therefore, even if a corporation qualifies as a resident of the treaty country, that corporation is not entitled to treaty benefits unless it also satisfies the requirements of the treaty’s LOB provision. For example, under the limitation on benefits provision found in Article 22 of the U.S. Model Treaty, a corporation that is a resident of a treaty country generally is entitled to treaty benefits only if the corporation meets one of the following additional 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 is owned by residents who are entitled to treaty benefits), and a base erosion test (less than 50 percent of corporation’s gross income is used to make deductible payments to persons who are not residents of either treaty country.
Below, please see Illustration 2. which demonstrates how a LOB provision works.
FORco, a foreign company incorporated in foreign country F is owned 45 percent by Paul, a citizen and resident of foreign country F, and 55 percent by Karen, a Hong Kong individual. The United States has a treaty with foreign country F similar to the U.S. Model Treaty, but does not have a tax treaty with Hong Kong. Let’s assume that FORco receives an interest payment from a source within the United States. The interest payment is not entitled to the benefits of the treaty and withholding must occur at the 30 percent statutory rate. More specifically, FORco fails to satisfy the LOB article because only 50 percent of the FORco shares are owned by a resident of country F.
It is important to note that not all tax treaties contain a LOB provision. For example, in its current form, the United States- Hungary Income Tax Treaty does not contain a LOB. In certain cases, planning opportunities exist even if a foreign investor is not a resident of a foreign country which has a bilateral tax treaty with the United States. For example, foreign investors can lend money from a company formed in a jurisdiction which has a favorable treaty (such as Hungary) with the United States and that completely exempts contingent interest from U.S. income tax and has the interest on that loan tied to gain on the sale of U.S. real estate. So long as the debt instrument is not disposed of prior to the maturity, any interest that is tied to the gain on the sale of such real property will be completely exempt from U.S. income tax under the applicable tax treaty.
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.