By Anthony Diosdi
Foreign investors actively invest in U.S. real estate by speculating on land and developing homes, condominiums, shopping centers, and commercial buildings. Many foreign investors own recreational property in popular U.S. beach and ski destinations. Any foreign investor in U.S. real estate should consider the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”). FIRPTA is designed to ensure that a foreign investor is taxed on the disposition of a U.S. real property interest, which includes an interest in U.S. reality and an interest in a U.S. corporation that was a U.S. real property holding corporation (“RPHC”) at any time during the five-year period before the disposition. A corporation is deemed an RPHC if the value of its U.S. real property interests equals or exceeds the value of all its real property interests plus its business assets. Similarly, the disposition of an interest in a partnership that holds U.S. real property is treated as a disposition of a U.S. real property interest to the extent that is attributable to the underlying U.S. real property interests.
The FIRPTA rules do not apply if the transferor is not a foreign person, if the disposition involves a sale of publicly traded stock in a U.S. corporation in which the foreign investor owns 5 percent or less, or if the disposition relates to the sale of shares in a U.S. company that has not been an RPHC during the last five years or that has disposed of all of its U.S. real property interests and recognized all the gain therefrom.
The purchaser of a U.S. real property interest from a foreign investor is, in general, required to withhold 15 percent of the purchase price, which can be claimed by the foreign investor as a credit against U.S. federal taxes. If there is an installment sale, the withholding amount is still based on 15 percent of the total price and not the amount of installments.
In some circumstances foreign investors can apply to the Internal Revenue Service (“IRS”) for a certificate authorizing a reduced amount of withholding tax (for example, if the 15 percent withholding tax exceeds the maximum amount of tax payable on disposition). Also, no withholding is required on the disposition of a partnership interest, unless 50 percent or more of the partnership’s gross assets are U.S. real property interests and 90 percent or more of its gross assets are U.S. real property interests, cash, or cash equivalents. Under Internal Revenue Code nonrecognition provisions, there are some FIRPTA exceptions for transactions involving an exchange of property interests. See Canadian Investing in U.S. Real Property, Jack Bernstein (2016).
A distribution of a U.S. real property interest by a foreign corporation, a foreign partner of a U.S. partnership, or U.S. trust with a foreign beneficiary are taxed under FIRPTA. The FIRPTA withholding may be greater than 15 percent in certain cases.
This article advocates a holistic approach to FIRPTA planning: foreign investors should consider not only the FIRPTA withholding on the sale of U.S. real property, but also the potential U.S. estate tax consequences associated with acquiring U.S. real property and the U.S. branch profits tax that may be triggered when placing U.S. real property in a corporate structure. This article addresses planning available to avoid FIRPTA withholding. It also describes common planning options for ameliorating the 30 percent branch profits tax. The article then explores the potential estate tax consequences of such planning options.
Investing in the U.S. Real Estate Through a “Foreign Blocker Corporation”
Probably the most common FIRPTA planning option foreign investors use to invest in U.S. real estate is through so-called foreign “blocker” corporations. Foreign blocker corporations offer protection from the U.S. estate tax. However, foreign blocker corporations are efficient structures from a U.S. income tax standpoint. Foreign corporations are subject to the same two federal income taxes as domestic corporations. However, if the foreign corporation receives U.S. source rental income, a different taxing regime usually applies that may result in the imposition of a flat tax of 30 percent (or lesser treaty rate) on the rental income. Foreign corporations also are taxed on gains from the sale of real estate situated in the U.S. under FIRPTA. In addition, Internal Revenue Code Section 884 imposes a 30 percent “branch profits tax” on any earnings received from a U.S. trade or business carried on by the foreign corporation or through a U.S. branch of the foreign corporation. The branch profits tax can apply to the gains received from the sale of U.S. real estate.
The branch profits tax can potentially be avoided if the foreign corporation liquidates its U.S. property holdings prior to transferring proceeds offshore. See Treas. Reg. Section 1.884-2T(a)(1), (2). In certain cases, the branch profits tax may be avoided if the foreign blocker corporation is established in certain countries that have entered into bilateral income tax treaties with the U.S. For example, the branch profits tax may be avoided if a foreign blocker corporation is established in certain countries whose tax treaties with the U.S. was established before the enactment of the branch profits tax. This includes China, Korea, Norway, Cyprus, Egypt, Greece, Hungary, and Poland, among others. The branch profits tax may also potentially be avoided if the foreign blocker corporation is formed in France, United Kingdom, Netherlands, Australia, Japan, and Mexico. See Daily Tax Report, 215 DTR J-1, 11/07/2016.
Investing in U.S. Real Estate Through a “Multi-Tiered Blocker Structure”
Instead of utilizing a “foreign blocker corporation” to invest in U.S. real estate, some foreign investors elect to use a “multi-tiered blocker structure.” A “multi-tiered blocker structure typically uses a foreign parent corporation or foreign corporations with a U.S. corporate subsidiary. Typically, a U.S. corporation will be treated as a RPHC and upon the sale of U.S. real estate, its foreign owners would be subject to FIRPTA withholding. However, if the U.S. subsidiary elects to sell all of its U.S. real estate in a taxable sale, it may be liquidated without triggering a second layer of tax, the branch profits tax, or FIRPTA. In some cases, if a lower-tier subsidiary holding U.S. property is a foreign corporation, that corporation may be liquidated through a sale without triggering a FIRPTA tax consequence.
There are some risks that the IRS could attempt to claim the use of such a multi-tiered structure triggers an inversion and the anti-inversion rules are triggered. The IRS and the Department of Treasury have 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. These rules must be considered by anyone utilizing multi-tiered blocker structures when investing in U.S. real estate.
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. See Taxation of International Transactions, Thomson West, Charles H. Gustafson, Robert J. Peroni, Richard Drwford Pugh (2006).
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 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 foreign investor of the stock in a RPHC 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 RPHC 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 RPHC 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 foreign investor’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, utilizing a multi-tiered blocker structure can be a very effective way to avoid FIRPTA withholding and reduce U.S. tax consequences associated with the sale of U.S. real estate, however, a multi-tiered blocker structure may not be an effective tool for estate tax planning purposes.
Finally, a multi-tiered blocker structure may not be an efficient planning option if the foreign investor has U.S. heirs who may inherit a “cursed gift” that is subject to the passive foreign investment company (“PFIC”) or the tax regime for controlled foreign corporations (“CFC”). A multi-tiered blocker structure may be more viable for the foreign investor if his or her children or heirs are not U.S. citizens or residents.
The foregoing discussion is intended to provide a basic understanding utilizing multi-tiered structures to avoid FIRPTA. It should be evident from this article, however, that this is a very complex subject. As a result, it is crucial that a foreign investor in U.S. real estate review his or her circumstances with a qualified international tax attorney.
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.