In view of the frenzy in the profession over compliance with the new FATCA rules, it seems appropriate to take an overview of how FATCA applies to a major source of inbound investment by foreign individuals – “FIRPTA” investments in U.S. real property. This commentary considers the extent to which FATCA might apply to the most common structures that are used. What is most striking, however, is that the FATCA rules provide for explicit exceptions for a substantial portion of FIRPTA – related income.
It is assumed in this commentary that the investment in U.S. real property is made by an individual who is a nonresident alien (NRA) for U.S. income tax purposes, and a “nonresident not a citizen of the United States” (i.e., a non-U.S.-domiciled alien) for U.S. estate and gift tax purposes. The following structures are examined in this commentary: (1) direct investment in U.S. real property by the NRA; (2) investment through a directly owned “United States real property holding corporation” (RPHC); (3) investment through a directly owned foreign corporation (FC) that owns the U.S. real property in its own name through a U.S. “branch”; (4) investment through an FC that in turn owns a U.S. subsidiary (an RPHC) which holds the U.S. property; (5) direct or indirect investment in U.S. real property by a nongrantor foreign trust that was created in the past by an NRA; and (6) direct investment by a foreign partnership.1
In examining how the FATCA rules apply to FIRPTA investments, three special FATCA rules must be kept in mind. First, the FATCA rules do not apply to income realized directly by individuals (in this case, NRAs), but only to income realized by foreign entities such as foreign corporations, foreign partnerships, and foreign nongrantor trusts.2 Second, there is an exception from the definition of “withholdable payment” for U.S.-source rents, whether from the rent of U.S.-situs real property or from the rent (lease) of U.S.-situs tangible personal property (for example, of furniture and fixtures that are rented out as part of the rental of the real property in which they are located), and this exception also applies after 2016 (when the FATCA rules on withholding on gross proceeds take effect) to gross proceeds from the sale of property that does not generate U.S.-source interest or dividends but only rental income (either actual or hypothetical). Finally, there is a broad exception for transactions that are subject to the §1445 FIRPTA withholding tax rules (although the regulations are still much too scanty on this point), an exception that will also be important after 2016.
In the discussion below, it is assumed that the U.S. real property may or may not be rented out (thus, it might be used as a personal residence by the ultimate NRA investor and never rented out); that it might be subject to a mortgage extended by a foreign lender; and that the property is eventually sold either directly by the NRA investor, by an entity that the NRA controls directly or indirectly, or (in the case of a nongrantor foreign trust) by an entity that was at one time created by an NRA. The reader should always be cognizant of the possible overlap between the “chapter 3” withholding rules in §1441/§1442 and the “chapter 4” FATCA withholding rules.
1. Direct Investment by the Foreign Individual3
Because FATCA only applies to foreign entities, no FATCA compliance is required from the individual with respect to either rents that he/she may receive from the property, or gross proceeds from the sale of the property. However, the rents are subject to gross 30% withholding under §1441 (subject to possible treaty reduction) unless the NRA owner provides Form W-8ECI to the lessee in order to establish that the rental income is taxed on a net basis as effectively connected income (ECI). When the property is sold, the withholding provisions of §1445 must be complied with; thus, up to 10% withholding tax may be imposed on the gross proceeds from the sale.
If the individual borrows funds from a foreign lender and if the property generates rental income that is ECI, the related interest expense will usually be deductible under §873. However, where the borrower is an NRA, interest paid by the NRA nevertheless is still classified as foreign-source income under §861(a)(1), and thus no withholding is imposed under either chapter 3 or chapter 4.4 Thus, it will usually not be necessary for the parties to try to structure the loan as “portfolio debt” for purposes of §871(h) or §881(c).
2. Direct Investment in an RPHC5
If the U.S. property is owned by an RPHC that is directly owned by the NRA and if the U.S. property is rented out by the RPHC, FATCA will not apply because the lessor is a domestic entity and not a foreign entity. Similarly, if the RPHC pays dividends to the foreign individual, FATCA will not apply because the shareholder is an individual and not an entity, although the NRA would need to give the RPHC Form W-8BEN in order to comply with §1441. Finally, FATCA will not apply when the property is eventually sold, whether that occurs by having the RPHC sell the property and then liquidate, or the NRA sells the RPHC stock. Although the FIRPTA withholding provisions of §1445 (if applicable) would need to be complied with, FATCA would not apply because the foreign shareholder who owns the RPHC is an individual and not an entity.
If, however, the RPHC borrows funds from a foreign lender that is an entity, the interest expense will usually be classified as U.S.-source “fixed or determinable annual or periodical” income (FDAP), and thus potentially subject to withholding under §1441/§1442. If the foreign lender is an individual, no FATCA compliance will be required, although the chapter 3 withholding rules must still be satisfied. However, if the foreign lender is an entity, FATCA compliance may be required — even if the interest is exempt from chapter 3 withholding as “portfolio interest” — unless the interest happens to be paid on a pre-July 1, 2014 “grandfathered obligation.”6Repayment of the principal could also be subject to 30% gross FATCA withholding after 2016 unless the foreign lender has provided the RPHC borrower with proper FATCA documentation.
3. Investment Through a Foreign Corporation (FC) with a U.S. Branch
Because FC is an entity and not an individual, it is potentially subject to FATCA on income that would clearly be exempt from FATCA if realized directly by its NRA shareholder. However, if the property is rented out, the rental income is exempt from FATCA because rents (whether from real property, or from tangible personal property such as furniture and fixtures) are not “withholdable payments” for FATCA purposes. FC should nevertheless comply with the chapter 3 (§1442) rules, usually by making a §882(d) “net election” in order to ensure that the rental income is taxed on a net basis as ECI and by providing the lessee with Form W-8ECI.7
If FC has borrowed from a foreign lender and if the related interest expense is deductible in calculating ECI, the interest is usually classified as U.S.-source FDAP that is not ECI and is subject to the chapter 3 withholding rules. However, FATCA compliance is only necessary if the foreign lender is an entity and not an individual. As noted above, failure to comply with the FATCA rules could result in a 30% tax under chapter 4 even if the interest is exempt from chapter 3 withholding as “portfolio interest,” and after 2016 the repayment of the loan could be subject to 30% FATCA tax on the amount of the gross repayment.
If FC becomes subject to the U.S. “branch tax” under §884, no chapter 3 or chapter 4 withholding rules will come into play on the deemed dividends, because the tax is self-assessed.
When FC eventually sells the U.S. property, it will be subject to the FIRPTA withholding rules of §1445. However, because FATCA withholding on gross proceeds (after 2016) applies only to assets that generate dividends or interest7 (and not rents), FATCA compliance should not be required.
4. Investment Through an FC with an RPHC Subsidiary
If the investment is made through a “two-tier” structure – through a foreign corporation (FC) which is owned by the NRA, and which in turn owns a U.S. RPHC subsidiary (DS), additional FATCA rules can come into play.
Although any rents that are paid to DS are not subject to potential withholding under chapter 3 or 4 (because DS is a U.S. corporation), if DS pays dividends to FC, FATCA compliance is required. However, if FC is located in a “tax haven,” as is frequently the case, the failure to comply with FATCA will result in the same 30% dividend withholding tax under chapter 4 that applies under chapter 3.8 If FC is located in a country whose tax treaty with the United States results in a lower U.S. withholding rate on U.S.-source dividends, compliance with FATCA will usually be advisable in order to obtain the lower treaty rate. As noted above, if DS pays interest to a foreign lender that is an entity and not an individual, FATCA compliance would be required.
When FC eventually sells or liquidates DS, the transaction will be potentially subject to the §1445 FIRPTA withholding rules. In this case, the FATCA exception for the sale of U.S. real property (mentioned above) will not apply, because the asset that is sold is stock that can produce U.S.-source dividends.9 Thus, after 2016 the gross proceeds from the disposition of the RPHC stock are potentially subject to 30% FATCA withholding. However, the FATCA regulations provide for an exception for amounts that are “subject to withholding under section 1445.”10 Unfortunately, the FATCA regulations on this point are extremely scanty. Presumably, however, if the FIRPTA “cleansing” rule of §897(c)(1)(B) applies so that DS ceases to be an RPHC immediately after selling all of its U.S. real property, §1445 will not apply to the disposition of the DS stock. Thus, after 2016 the sale or liquidation of DS could be potentially subject to 30% FATCA withholding if there is no FATCA compliance on the part of FC.
5. Investment by a Nongrantor Foreign Trust
If the U.S. property is directly owned by a nongrantor foreign trust,11 the FATCA results are similar to those that apply to direct investment by an NRA (see 1, above). Thus, rental income is exempt from FATCA (although subject to potential §1441 withholding). If the trust pays interest to a foreign lender that is deductible under §873 in calculating tax on ECI from the rental income, the interest is foreign-source and thus exempt from withholding under both chapters 3 and 4, because the trust is not a U.S. “resident.” Finally, if the property is eventually sold at a gain, the sale is exempt from FATCA because the asset that is being sold does not generate U.S.-source dividends or interest12 (see 3, above).
If instead the foreign trust owns the U.S. property through a directly owned RPHC, through a directly owned FC with a U.S. branch, or through a two-tier structure (i.e., through a directly owned FC with an RPHC subsidiary) – rules similar to those described above for an NRA who uses one of these structures would apply, but with a few differences in the case of a directly owned RPHC. Where the foreign trust directly owns RPHC stock, any dividends that the RPHC pays to the trust are subject to FATCA (as well as chapter 3), because the trust is an entity and not an individual. Similarly, the eventual sale of the RPHC stock by the trust is subject to FATCA after 2016, although the exception for transactions that are “subject to withholding under section 1445” may apply. In both situations, the trust may need to comply with the more extensive compliance rules that apply to “foreign financial institutions” (FFIs) under §1471, if the trust is “managed” by a trustee or advisor that is itself an FFI.
6. Investment by a Foreign Partnership
This structure assumes that the NRA invests in U.S. property through a foreign partnership, but in order to protect the partnership interest from potential U.S. estate tax, the property is never rented out and the foreign partnership is not otherwise engaged in a U.S. trade or business.13 If the partnership pays interest to a foreign lender, the interest is usually not U.S.-source because the partnership is not “resident” in the United States (because it is not engaged in a U.S. trade or business). Thus, it is generally exempt from withholding under both chapters 3 and 4.
If the partnership itself sells the U.S. property, the fact that the property is not an asset that could generate interest or dividends would protect it from FATCA withholding after 2016. However, the partnership would need to comply with the §1445 withholding rules. If instead the NRA sells the partnership interest, FATCA would not apply because the seller is an individual and not an entity, although in this case as well the NRA would need to comply with §1445.
This commentary also will appear in the October 2014 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Caballero, Feese, and Plowgian, 912 T.M., U.S. Taxation of Foreign Investment in U.S. Real Estate, Tello, 915 T.M., Payments Directed Outside the United States — Withholding and Reporting Provisions Under Chapters 3 and 4, Nauheim, Cousin, Ewell, Limerick, Lakritz, and Lee, 6565 T.M., FATCA — Information Reporting and Withholding Under Chapter 4, and in Tax Practice Series, see ¶7140, Foreign Persons — FIRPTA, and ¶7170, U.S. International Withholding and Reporting Requirements and FATCA.
Copyright©2014 by The Bureau of National Affairs, Inc.
1 For a discussion of all of these structures, see Bissell, 903 T.M., Tax Planning for Foreign Investment into the United States by Foreign Individuals, at X. See also Caballero, Feese, and Plowgian, 912 T.M., U.S. Taxation of Foreign Investment in U.S. Real Estate.
2 It should be cautioned, however, that if an individual owns securities or other assets that are held in nominee form through a “foreign financial institution” (FFI) or through a “non-financial foreign entity” (NFFE), the FATCA rules apply even though the beneficial owner of the underlying asset and the income that it generates is an individual.
3 Although a direct investment in U.S. real property is potentially subject to U.S. federal estate tax if the value of the property at death exceeds $60,000, the U.S. property may be partially or completely exempt from U.S. estate tax if the alien is resident in a country whose estate tax treaty with the United States has an enhanced unified credit with a worldwide exemption of up to $5,340,000 (2014 amount). See the Canada-U.S. Income Tax Treaty, and the U.S. estate tax treaties with Australia, Finland, Greece, Ireland, Italy, Japan, Norway, South Africa, and Switzerland.
4 The reason is because interest paid by an individual is U.S.-source income under §861(a)(1) only if it is paid by a “resident” of the United States. Thus, even though an NRA is engaged in a trade or business within the United States and incurs interest expense that is fully deductible under §873, the interest income remains foreign-source income in the hands of the lender, whether the lender is a U.S. or a foreign person. See Blessing and Lubkin, 905 T.M., Source of Income, at II.D.1. See also Reg. §1.861-2(a)(2).
5 Although the RPHC stock is potentially subject to U.S. federal estate tax if the value of the stock at death exceeds $60,000, the estate tax may be reduced or eliminated as a result of the enhanced unified credit under the estate tax treaties cited in n. 3, above. In addition, the U.S. estate and gift tax treaties with Austria, Denmark, France, Germany, the Netherlands, and the United Kingdom provide for a broad U.S. estate tax exemption for U.S.-situs intangible property (such as stock in a U.S. corporation, whether or not it is an RPHC), regardless of the value of the company at death. See Bissell, 903 T.M., Tax Planning for Portfolio Investment into the United States by Foreign Individuals, at II.E.4.a.
6See Bissell, Foreign `Blocker’ Corporations with No FATCA Documentation: What Happens Now?” 43 Tax Mgmt. Int’l J. 488 (Aug. 2014).
7 Because a §882(d) net election only applies to rents from “real property,” the election technically would not apply to income from the lease of tangible personal property (such as furniture and fixtures). Thus, rental income from tangible personal property is only taxed on a net basis under §882 if on the basis of the actual facts the income is ECI.
8See Bissell, Foreign `Blocker’ Corporations with No FATCA Documentation: What Happens Now? 43 Tax Mgm. Int’l J. 488 (Aug. 2014).
10 Reg. §1.1445-6(c)(1). The question remains whether a FATCA exemption applies where the foreign person disposing of the RPHC stock obtains a “withholding certificate” that exempts the disposition from any §1445 withholding tax, or where the disposition is otherwise exempt from §1445. It is also not clear whether this exception applies if the disposition is “subject to withholding under §1445” but if the parties fail to comply with the §1445 rules.
11 This structure has become more common in recent years, because the maximum 20% long-term capital gains rate from the sale of the property is lower than the regular corporate income tax rates of up to 35% that are imposed if the property is owned by a U.S. or foreign corporation and is sold at a gain. At the same time, if properly structured and operated, the trust usually protects the NRA grantor from potential U.S. estate tax with respect to the underlying U.S. property.
13See Bissell, 903 T.M., Tax Planning for Foreign Investment into the United States by Foreign Individuals, at X. See also Caballero, Feese, and Plowgian, 912 T.M., U.S. Taxation of Foreign Investment in U.S. Real Estate.