The Foreign Investment in Real Property Tax Act (FIRPTA) Made Simple AFIRE News September/October 1996 Andrea Comeau-Shirley and Charles Harrison
The Foreign Investment in Real Property Tax Act (FIRPTA) Made Simple AFIRE News September/October 1996 Andrea Comeau-Shirley and Charles Harrison This article describes the general principles of FIRPTA and is intended for use by foreign persons, corporations, and individuals who are considering investing in US real estate. The title implies that the subject matter can be simplified. However, in doing so, general statements will be made without disclosure of all the related traps. The US tax law is extremely complex and most of the general principles have numerous exceptions that are, in turn, interpreted by a jungle of regulations, judicial discussions, and rulings by the tax authorities. This article should not be relied upon as tax advice. Analysis for a specific investment should be done in concert with a tax advisor If, however, the article broadens your tax vocabulary so that the conversation with your advisor is less painful, then the title is justified. Foreign investment in the United States is on the rise after a decline in the early 1990s. As part of analyzing projected returns on investment in US real estate, owners/investors need to examine how the United States will tax that investment. Generally, the United States taxes its citizens, residents and domestic entities on all income regardless of where it is earned. Foreign entities (including corporations, trusts, estates and partnerships) and international investors are subject to US tax on only their US-source income and on their income that is effectively connected with a US trade or business. Rental income and gain from the sale of real estate located in the United States is US-source income. On the other hand, income from the sale of stock is generally sourced to the country of residence of the seller. As such, if foreign investors structure their US real estate investment through corporations, the investors could avoid US income taxes and improve the return on their investment simply by choosing to sell stock rather than assets. Congress felt this created an unfair advantage. The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) denies this exclusion for gains from dispositions of US real property interests (USRPI) in an attempt to create equity of tax treatment between international and US investors. The law broadly defines USRPIs to include all direct and indirect rights to appreciation in real estate. The US taxation of international investors is governed by either the Internal Revenue Code (the Code) or income tax treaties that the United States has signed with other nations. FIRPTA changed the Code and expressly overrides the treaty negotiated right to tax gains from the sale of stock solely in the country of residence of the stockholder. The law, in essence, makes the gains effectively connected to a US trade or business and, therefore, taxes the gain netted with effectively connected expenses or losses at the regular US tax rates (28 percent to 39.6 percent for individuals and 35 percent for corporations). When determining whether FIRPTA will impose US taxation on your investment, you should be familiar with several key terms: US Real Property Interest, US Real Property Holding Corporation, base period and determination date. US Real Property Interests A USRPI includes any interest in real property located in the United States or the US Virgin Islands. Real property includes the obvious items: land, buildings, timber and mineral interests (such as mines and wells). It also includes movable walls, furnishings, mining equipment, drilling rigs and certain other property associated with the use of real property. For example, farm tractors connected with the farming operation in the United States are considered USRPIs. In addition to these direct interests, the term USRPI includes the stock of a domestic (US) corporation that is or has been a US real property holding corporation (USRPHC) during the
period that the foreign investor held the stock or the period five years preceding the sale, whichever is shorter (the base period). A USRPHC is a corporation whose assets consist primarily of USRPIs. Thus, it is no longer possible to avoid US tax on the sale of US real property by holding the property indirectly through a US corporation and disposing of the corporation's stock. If a foreign person disposes of stock of a domestic company, such stock is presumed to be a USRPI unless it is established that on specific dates during the base period that the fair market value of its USRPIs is less than 50 percent of the fair market value of all its USRPIs, foreign real property and any other assets used or held for use in the business (the 50 percent test). Conversely, a corporation is presumed not to be a USRPI if the book value of USRPIs held on specific determination dates during the base period is 25 percent or less of the total book value of the company's assets on those dates. In performing these tests, if the company owns an interest in a partnership or trust, it is treated as owning its pro-rata share of the assets of such entity. In addition, if the company owns more than 50 percent of the stock of a second company, it is treated as owning its pro-rata share of the assets of the second company. If the company owns less than 50 percent of the second company, those shares are treated as a USRPI if that company is itself a USRPHC on any determination date during the base period. Determination Dates An investor will be subject to FIRPTA tax on the stock sale only if the 50 percent test is met on certain determination dates. These dates are the last day of its taxable year, the date on which it acquires a USRPI, the date it disposes of foreign real property or other trade or business assets, and on the dates such acquisitions and dispositions are made by entities whose assets the corporation is treated as holding. These determination dates are waived for the first 120 days after incorporation/acquisition and the last 12 months of a formal liquidation period (to avoid inadvertently becoming a USRPHC). If the company is a USRPHC on any of the determination dates in the base period, the stock is a USRPI. FIRPTA Exceptions A foreign entity or international investor is not subject to US tax on the disposition of stock that is not a USRPI. A USRPT does not include a 5 percent or less interest in a publicly traded corporation, an interest in a domestically controlled real estate investment trust (REIT), or an interest in a US company that has disposed of all its USRPIs in a taxable sale. To meet this last exception, the US company cannot, on the date of the disposition, own any USRPIs and must have recognized all gains on USRPIs held during the base period. An interest in real property that is solely a creditor's interest is also not subject to FIRPTA. Thus, a mortgage interest or other security interest in US real property, even if the interest rate is indexed, is not a USRPI (and therefore not subject to FIRPTA). If the interest extends beyond that of a creditor, however, FIRPTA may come into play. Thus, an ownership, co-ownership or leasehold interest in or option to buy real property is an interest other than solely as a creditor and is, therefore, considered an interest in real property. In addition, any right to share in the appreciation in value of the real property or in the gross or net proceeds or profits generated by real property is also a USRPI. Thus, a loan with an equity kicker is treated as a USRPI, and an international investor disposing of this interest is subject to US tax. The collection of principal and interest is not considered a disposition. Therefore, the normal collection of interest and principal, including the final equity kicker payment, is not subject to the FIRPTA tax. Significance of USRPHC Status It is important for international investors owning shares in a US company to know whether the corporation is or was a USRPHC on the applicable determination dates. If the US company meets this test, the international investor is subject to tax when the shares are sold or
transferred and must file a US tax return reporting the gain. In addition, any person acquiring stock of a domestic company from a foreign person is responsible for collecting a withholding tax, unless the buyer determines that the stock is not a USRPI. Since it is presumed that all shares of a domestic company held by a foreign person are USRPIs, the rules taxing dispositions of USRPIs by foreign investors must be considered every time a foreign investor transfers shares of a US company in a taxable sale or non-taxable transfer. These rules can override the normal non-recognition rules and cause an otherwise nontaxable transfer of shares of a domestic corporation to be taxable. As previously mentioned, FIRPTA expressly overrides the provisions of most tax treaties that would otherwise have exempted the gain from US tax. US tax treaties with Canada and the Netherlands provide some relief to certain qualified residents of those countries. For example, a Canadian resident selling a USRPI may be eligible to take advantage of a provision that exempts gain attributable to appreciation occurring prior to December 31, 1984. The Dutch treaty provides similar benefits that are limited to sales of corporate stock held continuously since June 18, 1980. The definition of USRPHC includes only domestic corporations. The shares of foreign corporations are not subject to US tax under FIRPTA even if the foreign corporation owns primarily USRPls. Thus, a foreign person desiring to avoid US tax on the gain from the sale of US real estate can have the property held by a foreign corporation and then sell the stock of a foreign corporation. Sounds incredibly simple. However, FIRPTA impacts the foreign corporation's actions - even if it can't reach its owners - and this imbedded tax will, in turn, have an impact on the market value of the foreign corporation's shares. Any person who purchases the shares of the foreign corporation and plans to liquidate that corporation will generally trigger tax on the appreciation in the USRPIs. If the foreign corporation sells the USRPIs, that corporation is subject to US tax on the sale. Alternatively, if the foreign corporation transfers the USRPI to another entity in a transaction that would generally be nontaxable under the Code, the foreign corporation is taxable under FIRPTA unless the asset the corporation receives in the transfer is also a USRPI. These built-in taxes will be reflected in the price an informed purchaser would be willing to pay for the stock of the foreign holding company. Other Indirect Ownership US tax laws have made other forms of ownership - partnerships, trusts & REITs - advantageous to investors. While interests in partnerships, trusts and estates that hold US real property is not defined to be a USRPI, FIRPTA taxes an international investor that sells or exchanges such an interest at a gain. The amount that is taxable is only that portion of the gain that is related to the USRPI. If the partnership, trust or estate sells the USRPI, each foreign partner or beneficiary is deemed to have sold his/her pro-rata share of the USRPI. REIT income earned by foreign investors is subject to FIRPTA to the extent attributable to gains from sales or exchanges of USRPIs. As previously mentioned, gains on the sale of REIT shares are not subject to tax under FIRPTA, unless the majority of the shares are held by foreign persons. In light of these rules, foreign persons can avoid FIRPTA by selling qualifying shares prior to receiving the distribution from the REIT. Obviously, this tactic should only be used when the investor believes the REIT investment is at maximum value. FIRPTA Withholding You may be impacted by FIRPTA whether you are the buyer or seller of US real estate. FIRPTA requires any person acquiring stock of a domestic company from a foreign person to collect a withholding tax, unless the buyer determines that the stock is not a USRPI. This tax is 10 percent of the gross sales price (or 10 percent of the fair market value of the property exchanged) unless certain exemptions apply. Additionally, if the seller determines that the actual US tax owed is less than this amount, the parties can submit a request to the IRS that
only this lesser amount be withheld. Without IRS permission, the 10 percent must be withheld regardless of the actual US tax due or the amount of cash received. FIRPTA withholding also applies to property and cash received in redemption of USRPHC stock (10 percent withholding on the gross value), distributions of USRPIs from foreign corporations (35 percent withholding on the net gain), and gains realized by partnerships, trusts, estates and REITs on the sale of USRPI (35 percent withholding on the net gain). These amounts must be paid over to the IRS within 20 days of the transfer unless a withholding certificate application to reduce or eliminate the withholding has been submitted to the IRS. The application suspends the obligation to pay over the amount withheld until 20 days after the IRS completes its determination. Unlike other withholding taxes, FIRPTA withholding does not eliminate the seller's obligation to file a US tax return reporting its gain. The withholding agent must report the details of the transaction on Forms 8288 and 8288A. The seller includes the Form 8288, which has been stamped by the IRS, in its return in order to claim credit for the withheld taxes. Planning With FIRPTA Although FIRPTA was drafted broadly to capture most real estate investments, savvy investors still look for ways to avoid characterization as a USRPI. Rather than direct investment, foreign investors can structure their participation in the property to meet the "solely as a creditor" exception. If the investor wants additional upside potential, indexed interest rates as well as equity kickers may avoid a FIRPTA tax. Additionally, royalties and other fees can be imposed which can allow a portion of the income to be returned to the foreign investor without FIRPTA tax. Each investor should review the alternatives to ensure that non-traditional notes and other instruments are considered to take advantage of all allowable FIRPTA exceptions or carve outs. These options may also be available to long term investors on their existing portfolios if appropriate restructuring is done.As you begin or expand investment in US real estate, remember that FIRPTA is only one of the US tax costs which must be considered. Your after-tax return on such investment can also be impaired by other US tax laws such as Branch Profits Tax, Earnings Stripping, Partnership Withholding and Estate Taxation.