Increased Foreign Investment In United States Requires Review of the FIRPTA Provisions
Under 26 USC §897, which was adopted into law as part of the Foreign Investment in Real Property Tax Act (“FIRPTA”) in 1980, gain realized by a foreign person with respect to the disposition of an interest in US real property (“USRPI”) is characterized as income effectively connected with the conduct of a U.S. trade or business and subjects the foreign person to U.S. income tax on the net income derived from such gain at normal U.S. income tax rates. In general, under §1445 a purchaser of a USRPI from a foreign person is required to withhold a tax equal to 10% of the amount realized (generally gross purchase price). §1445(c); Treas. Reg. §1.1445-1(a). See also §6039C.
The person in control of the payment, usually the buyer, or the closing agent, is required to deduct and withhold such portion of the payment and pay it over to the IRS. The required withholding must be remitted to the IRS within 20 days. The foreign transferor must report the gain, e.g., for a non-resident by filing a U.S. income tax return on Form 1040NR, on which withheld amounts are credited against the liability. The law also permits individuals to reduce or eliminate the required withholding by obtaining prior to closing an exemption certificate from the IRS or submit a U.S. resident certificate (under penalty of perjury) containing the seller’s identification number and that the transferor is not a foreign person to the buyer or closing agent. If the transferee or other person required to withhold the §1445 tax fails to withhold or pay over the amount withheld, that person is liable for the tax required to be withheld, plus interest and potential penalties (to the extent that the transferor's tax liability on the transfer is not otherwise paid). §1461; Treas. Reg. §1.1445-1(e)(1).
A USRPI is an interest in real property located in the U.S. or the U.S. Virgin Islands and any interest (other than solely as a creditor) in a domestic corporation that is a U.S. real property holding corporation (USRPHC). §897(c)(1)(A). For this purpose “real property” includes land and unservered natural products of land such as minerals, oil and gas deposits, unharvested crops and uncut timber, buildings and permanent structures. Also included within the term “real property” is personal property associated with the use of such real property such as equipment used in farming, construction, forestry or mining, property used in lodging places or rented office space.
Under §897(c)(2), a USRPI also includes any the stock of any corporation if the FMV of its USRPIs equals or is greater than 50% of the FMV of its USRPIs, its interests in real property situated outside of the US and including any other of its assets used in a trade or business.
A USRPHC, i.e., US real property holding corporation, does not include any class of stock of a corporation which is regularly traded on an established securities market unless a foreign person who during the preceding 5 year period held more than 5% of such class of stock. Stocks in U.S. corporation are presumed to be USRPI unless it can be established otherwise. Taxpayers seeking to rebut this presumption must affirmatively certify that the stock is not USRPI no later than the date of the disposition.
Under §897(c)(4) in determining whether a USRPHC exists, a foreign corporation holding USRPIs is treated as a a domestic corporation (§897(c)(4)(A)) and under regulations assets held by a partnership, trust or estate are treated as held proportionately by its partners or beneficiaries. See §897(c)(4)(B). Under §897(c)(5)(A), under regulations, if any corporation holds 50% or more of the FMV of all classes of stock of a second corporation, then for purposes of determining whether the corporation is a USRPHC, the first corporation is treated as owning a portion of each asset of the controlled corporation equal to the percentage of the second corporation represented by the stock held by the first corporation.
Under §897(d)(1) a foreign corporation may be required to recognize gain on the distribution of a USRPI subject to an exception provided under §897(d)(2). Furthermore, §897(j) requires that a nonresident alien individual or a foreign corporation recognize gain on the contribution of a USRPI to a foreign corporation. The treatment of transfers of USRPIs and stock of a USRPHC in what otherwise would be treated as a nonrecognition transaction is set forth in §897(e). Section 897(e)(1) for starters explains that it overrides all the nonrecognition provisions set forth in the Code, at least in the absence of a specific exception. Therefore §897(e)(1) applies to an exchange of a USRPI for an interest the sale of which would be subject to tax. Under §897(d)(2) a foreign corporation may avoid gain recognition with respect to the distribution of a USRPI in certain instances such as under §337. Where §§897(e) and 897(d) are in conflict or overlap, §897(e)(1) requires that §897(d) control. In general, §897 will override any contrary treaty provision. But see Temp. Regs. §§1.897-5T(d)(2), 1.897-6T(a)(9).
As an illustration of the potential reach of §897 is with respect to transactions that would otherwise be entitled to nonrecognition treatment. See §§897(d), 897(e). Suppose FC, a foreign corporation sells shares of stock in a U.S. corporation which is not a USRPC. Nevertheless, the purchaser of the share would be required to withhold and remit to the IRS 10% of the gross sales price within 20 day of the closing. Then FC would be required to file a U.S. income tax return for the year of sale, report the gain, and pay the tax due, if any, with a credit for the amount withheld or apply for a refund. See §881(a). Alternatively, withholding could be avoided if prior to the date of sale the US corporation provided a certificate of non-USRPHC (based on the lack of USRPIs) to the seller and a copy is provided to the purchaser. Then after the closing, the U.S. corporation is required to provide the IRS with a notice of non-USRPI status and a copy of the statement of non-USRPI status within 30 days of providing the statement of non-USRPI status to the seller.
To avoid the withholding, the seller could request a statement of non-USRPI status from U.S. Corp. no later than the date of the sale. Before that date, U.S. Corp. must provide the statement of non-U.S.RPI status to the seller and a copy must be provided to the buyer. Subsequently, U.S. Corp. must provide the IRS with a notice of non-USRPI status (i.e. a cover letter explaining non-USRPI status) and a copy of the statement of non-USRPI status within 30 days of providing the statement of non-USRPI to the seller.
Another illustration is also involves a U.S. corporation (USCorp1) which has no USRPIs. USCorp1 is owned 100% by FC which transfers its stock in USCorp1 to another wholly owned U.S. subsidiary USCorp2 as part of a non-taxable §351 transaction. In this case §351 will be overridden by the FIRPTA and USCorp2 would be required to withhold and remit to the IRS 10% of the FMV of USCorp1 on a timely basis unless the necessary exemption certificates were obtained and provided to USCorp2 prior to the transfer. See Treas. Reg. §1.897-6T(a)(3).
The regulations provide for an exception. In this regard, Treas. Reg. §1.897-6T(a)(1) provides that any nonrecognition provision , i.e., §351, shall apply to a transfer by a foreign person of a USRPI on which gain is realized only to the extent that the transferred property would be subject to U.S. taxation upon its disposition and the transferor complies with certain filing requirements. Treas. Reg. §1.897-5T. This exception is referred to as the “USRPI for USRPI” rule. The rationale for the exception is that the transferor would be subject to US income tax on the interest it receives back in the exchange, i.e., the US corporation is a USRPHC. See Treas. Regs. §§1.1445-2(d)(2)(iii); Temp. Reg. §1.897-5T(d)(1)(iii).
This is a short summary of the FIRPTA provisions which are quite detailed and complex. In certain instances, transactions which may look as falling outside of FIRPTA are clearly subject to its application. The up-swing in foreign investment in USRPI should spark renewed interest by the IRS in auditing taxpayers subject to these rules.
