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New PATH Act Modifies Tax Rules Applicable to Foreign Investment in U.S. Real Estate and Introduces a New Exemption for Certain Foreign Pension Plans

December 21, 2015

 

On December 18, 2015, as part of the “Protecting Americans from Tax Hikes of 2015” (the “PATH Act”), President Obama signed into law provisions that make significant changes to the so-called FIRPTA rules that govern the U.S. federal income tax consequences to foreign investors of investing in U.S. real property. The changes include:

  • an increase in the FIRPTA withholding tax rate from 10% to 15%;
  • a new exemption from FIRPTA for certain foreign retirement or pension funds;
  • an expansion of existing FIRPTA exceptions for disposition of stock of publicly-traded REITs;
  • new FIRPTA exceptions benefiting “qualified shareholders” of REITs;
  • new rules, generally taxpayer friendly, for determining whether a REIT or other qualified investment entity (such as certain RICs) is domestically controlled, a disposition of the stock of which is not subject to tax under FIRPTA; and
  • an exclusion of the stock of REITs and RICs from the so-called “cleansing exemption” under FIRPTA

The new rules in the PATH Act remove some of the barriers to foreign investment in U.S. real estate erected by FIRPTA and are therefore expected to lead to increased interest by foreign investors in the U.S. real estate market.

FIRPTA Withholding Rate

Effective for dispositions and distributions subject to FIRPTA on or after February 17, 2016, the FIRPTA withholding rate will increase from 10% to 15%. The new rate will apply to gross proceeds from:

  • dispositions of United States real property interests (“USRPI”), including dispositions of the stock of a domestic corporation that is or is presumed to be a United States real property holding corporation (“USRPHC”);
  • certain redemption distributions by current (and certain former) USRPHCs;
  • distributions of USRPIs by partnership, trusts and estates to their foreign partners or beneficiaries; and
  • dispositions by foreign partners of interests in partnerships, 50% or more of the value of the gross assets of which consists of USRPIs and 90% or more of the value of the assets of which consists of USRPIs, cash and cash equivalents.1

Complete FIRPTA Exemption for Certain Foreign Pension Funds

The PATH Act exempts from the FIRPTA rules all USRPIs held, directly or indirectly through one or more partnerships by, and all distributions received from a REIT by, any “qualified foreign pension plan” and any entity, all of the interests of which are held by a qualified foreign pension plan. Any trust, corporation, or other organization or arrangement will constitute a “qualified foreign pension plan” and benefit from this exemption if:

  • it is created or organized under the law of a country other than the United States;
  • it is established to provide retirement or pension benefits to participants or beneficiaries that are current or former employees (or persons designated by such employees) of one or more employers in consideration for services rendered;
  • it does not have a single participant or beneficiary with a right to more than 5% of its assets or income;
  • it is subject to government regulation and provides annual information reporting about its beneficiaries to the relevant tax authorities in the country in which it is established or operates; and
  • under the laws of the country in which it is established or operates either (i) contributions to it which would otherwise be subject to tax under such laws are deductible, excluded from gross income or taxed at a reduced rate or (ii) taxation of any of its investment income is deferred or taxed at a reduced rate.

While details of this exemption will need to be provided in forthcoming Treasury Department guidance, it is likely to have a significant impact on the U.S. real estate market.

Higher Ownership Thresholds for Regularly Traded REIT Exceptions

FIRPTA generally applies to a foreign person’s disposition of stock of a USRPHC. An exception exists for dispositions of shares of a regularly traded class of stock of a USRPHC if the foreign person does not (and did not at any time during the shorter of her holding period for the shares or the 5-year period that ends on the disposition date) hold more than 5% of such class of stock, taking into account certain ownership attribution rules. The PATH Act increases the ownership percentage from 5% to 10% if the USRPHC is a REIT.

FIRPTA also generally applies to a distribution by a REIT or other qualified investment entity (such as certain RICs) (“QIE”) to a foreign person, to the extent the distribution is attributable to gain from sales or exchanges of USRPIs by the REIT or other QIE. An exception exists for distributions of USRPIs that are with respect to any regularly traded class of stock if the foreign person did not actually own more than 5% of such class of stock at any time during the one year period ending on the distribution date. The PATH Act also increases the ownership percentage from 5% to 10%, but only for distributions by REITs, not by other QIEs.

Exception for Qualified Shareholders of REITs

The PATH Act treats stock of a REIT as not constituting a USRPI if it is held, directly or indirectly through one or more partnerships, by a foreign person that is a “qualified shareholder” of the REIT. This treatment results in two new exceptions to the FIRPTA withholding tax: (i) for dispositions of REIT stock by qualified shareholders and (ii) for a REIT distribution attributable to gain from sales or exchanges of USRPIs by the REIT if the distribution is to a qualified shareholder.

Two types of foreign shareholders of a REIT constitute “qualified shareholders” that will benefit from these new exceptions:

  • A foreign person that is eligible for the benefits of a U.S. tax treaty that includes an agreement for the exchange of information if that person’s principal class of interests is listed and regularly traded on one or more recognized stock exchanges; and
  • a foreign partnership created or organized under foreign law as a limited partnership in a jurisdiction that has an information exchange agreement with the United States, if that foreign partnership:
    • has a class of limited partnership units regularly traded on the NYSE or Nasdaq, maintains records on the identity of 5% or greater owners of such class of partnership units, and
    • constitutes a “qualified collective investment vehicle” by virtue of being:
      • entitled to tax treaty benefits with respect to ordinary dividend distributions paid by a REIT,
      • a publicly traded partnership that functions as a withholding foreign partnership and would be a USRPHC if it were a domestic corporation, or
      • designated as a qualified collective investment vehicle in future Treasury Department guidance.

This qualified shareholder exception is itself subject to a partial exception if a qualified shareholder holding stock in a REIT has any “applicable investor,” namely a person (other than another qualified shareholder) that holds an interest (other than solely as a creditor) in the qualified shareholder and holds, or is deemed to hold after application of ownership attribution rules, more than 10% of the stock of the REIT. In such a case, the qualified shareholder exception will be turned off and FIRPTA will apply with respect to a percentage of the proceeds from dispositions of REIT stock by the qualified shareholder (and REIT distributions to the qualified shareholder) generally equal to the percentage ownership (by value) held by applicable investors in the qualified shareholder.2

Domestically Controlled REITs and Other Qualified Investment Entities

A widely used exception to the FIRPTA withholding tax applies with respect to dispositions of stock of domestically controlled REITs or other QIEs. For this purpose, domestic control requires that foreign persons in the aggregate hold, directly or indirectly, less than 50% of the REIT or other qualified investment entity by value at all relevant times. Taxpayers and practitioners alike have long been concerned about how to make this ownership determination in the case of a publicly-traded REIT or other QIE. The PATH Act alleviates this concern by providing that:

  • in the case of any class of stock regularly traded on an established securities market in the United States, a person holding less than 5% at all relevant times is treated as a U.S. person unless the REIT or other QIE has actual knowledge that such person is not a U.S. person;
  • any stock held by another REIT or other QIE that either has a class of stock that is regularly traded on an established securities market or is a RIC is treated as held by:
    • a foreign person if the other REIT or other QIE is not domestically controlled (determined after application of these new rules), but
    • a U.S. person if the REIT or other QIE is domestically controlled (also determined after application of these new rules); and
  • any stock held by any other REIT or other QIE is treated as held by a U.S. person in proportion to the stock of such other REIT or other QIE held by U.S. persons.

Modification of the “Cleansing Exception” for USRPHCs

As mentioned above, a disposition by a foreign person of the stock of a USRPHC is generally subject to the FIRPTA withholding tax. A significant exception to this general rule, sometimes referred to as the “cleansing exception,” applies to dispositions of stock of USRPHCs that disposed of all of their USRPIs in fully taxable transactions. To date, this exception could be applied to dispositions of stock of any corporation. The PATH Act narrows its scope by turning it off with respect to dispositions of stock of REITs and RICs.


[1] The FIRPTA statute contemplates the possibility that dispositions by foreign beneficiaries of certain interests in trusts and estates may be subject to the FIRPTA withholding tax, but no regulation has been promulgated to date that would lead to that result. If any such regulation were enacted, the withholding rate would be 15% under the PATH Act.


[2] Another rule in the PATH Act appears to provide, albeit in language that lacks clarity (but is somewhat elucidated in the related Joint Committee on Taxation), that a REIT distribution treated as a sale or exchange of stock under Sections 301(c)(3), 302 or 331 of the Internal Revenue Code with respect to a qualified shareholder is to constitute a capital gain subject to the FIRPTA withholding tax if attributable to an applicable investor and, but a regular dividend if attributable to any other person.



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