Under FIRPTA, a non-U.S. person’s gain from the sale of U.S. real property interests is treated as income that is effectively connected with a U.S. trade or business (“ECI”), and therefore, is subject to U.S. federal income tax and tax return filing obligations, regardless of whether the non-U.S. investor in fact is engaged in a U.S. trade or business. Distributions by REITs to non-U.S. investors that are attributable to gains from the sale of U.S. real property interests generally are taxed in the same manner, as are gains from the sale of stock of a U.S. corporation if at least 50% of its assets consist of U.S. real estate. Prior to the modifications made by the PATH Act, a non-U.S. investor could avoid FIRPTA taxes under certain limited exceptions for: (i) distributions by a publicly traded REIT or sales of stock of a publicly traded REIT or other corporation, if the non-U.S. shareholder did not own more than 5% of the stock of the REIT or other corporation (the “Publicly Traded Exception”), although distributions from a publicly traded REIT generally are still subject to the 30% U.S. withholding tax (subject to possible reduction under an applicable tax treaty), and (ii) sales of stock of a domestically controlled REIT (the “Domestically Controlled REIT Exception”). In addition, foreign government investors that qualify for the “Section 892” sovereign tax exemption are exempt from FIRPTA on the sale of stock in a REIT (regardless of whether domestically controlled) or other corporation, as long as the foreign government does not control the REIT or other corporation.
Exemption for Certain Non-U.S. Pension Funds
The new law exempts “qualified foreign pension funds” from FIRPTA, meaning that such investors are not subject to U.S. federal income tax on U.S. real property gains unless the gains arise from the actual conduct of a U.S. trade or business by the investor. While ownership of U.S. real estate through tax transparent entities such as a partnership often will rise to the level of a U.S. trade or business for this purpose, ownership of U.S. real estate through REITs does not. The new exemption from FIRPTA allows qualifying foreign pension funds to invest in U.S. real estate through a private or public REIT and not pay U.S. tax under FIRPTA or any U.S. withholding taxes on either capital gain from the sale of the underlying real property or a sale of the stock in the REIT, regardless of whether the REIT is domestically controlled or the percentage of the REIT stock owned by the foreign pension fund. Further, there is no analogy to the pension-held REIT rules or debt-financed UBTI rules that apply to U.S. pension plans investing in REITs that would restrict the level of ownership of a REIT by one or more foreign pension plans or the manner in which the foreign pension plan finances its REIT investment. That being said, a foreign plan may desire to limit its ownership of the REIT in order to qualify for a reduction of, or exemption from, U.S. withholding tax on REIT dividends of ordinary income under an income tax treaty. Qualified pensions also would be exempt from FIRPTA tax on sales of stock in domestic corporations that own real estate.
Undercutting the positive impact of this change is that the definition of qualified foreign pension fund is very specific and imposes numerous requirements that may exclude certain foreign pension plans from the exception, potentially for completely arbitrary reasons.[1] For example, many foreign government-run pension funds may not meet the technical requirements to qualify. In addition, the new exemption needs to be coordinated with the U.S. rules regarding withholding on FIRPTA and ECI in order to eliminate any potential liability for U.S. withholding agents in the event that an investor that claims to be a qualified foreign pension plan does not, in fact, qualify.
Effect on Private Joint Venture and Fund Structures
Under the new rules, qualified foreign pension funds in most circumstances should prefer that joint ventures use a single REIT blocker for all their real estate investments, with asset sales as the preferred exit strategy. Qualified foreign pension funds presumably will no longer push for domestically controlled baby REIT structures with an exit through a sale of baby REIT stock, and may even resist the use of that structure in commingled funds or multi-party joint ventures where other non-U.S. investors continue to favor this strategy.
Effect on Investments in Publicly Traded REITs
The PATH Act facilitates investments in publicly traded REITs by increasing, from 5% to 10%, the percentage of publicly traded REIT shares that a non-U.S. person can hold and qualify for the Publicly Traded Exception. In addition, in determining whether a publicly traded REIT is domestically controlled, the REIT may treat any shareholder owning less than 5% of a publicly traded class of stock during the preceding five years as a U.S. person unless the REIT has actual knowledge to the contrary. As a result, it should be easier for a publicly traded REIT to determine whether or not it is domestically controlled.
Domestically Controlled Look-Through Rules
The new law provides special rules for a REIT (an “upper-tier REIT”) that holds stock in another REIT (a “lower-tier REIT”) in testing the domestically controlled status of the lower-tier REIT. Prior law provided no guidance as to whether the determination of whether the lower-tier REIT was domestically controlled required a look-through to the ultimate shareholders of the upper-tier REIT. The PATH Act requires the lower-tier REIT to look through to the shareholders of the upper-tier REIT unless the upper-tier REIT is publicly traded. If the upper-tier REIT is publicly traded, it is treated as a U.S. person if it is domestically controlled and as a non-U.S. person if it is not. This is potentially very helpful for public REITs that wish to enter into joint ventures with non-U.S. partners that require a domestically controlled REIT structure, as it could permit the subsidiary REIT to be treated as domestically controlled notwithstanding some foreign ownership in the upper-tier REIT, but only if the public REIT is comfortable it can establish and maintain its status as domestically controlled. For private REITs, the look-through rule may limit or eliminate their ability to undertake joint ventures with these types of non-U.S. partners.
New Qualified Shareholder Exemption
Under the Act, REIT stock held by a “qualified shareholder” is not subject to FIRPTA and any capital gain distribution from a REIT to such qualified shareholder is not subject to FIRPTA, unless a non-U.S. investor owns more than 10% of the REIT directly or indirectly, including through such qualified shareholder. Unlike the exemption for qualified foreign pension funds, however, capital gain dividends paid to a qualified shareholder from a publicly traded REIT are generally still subject to the 30% U.S. withholding tax unless a lower treaty rate applies. The definition of qualified shareholder is highly complex, and appears specifically designed for a very limited category of non-U.S. publicly traded investment vehicles such as certain non-U.S. publicly traded partnerships and investment vehicles from certain tax treaty jurisdictions, including Australia and the Netherlands.[2] Nonetheless, for those that can work within its parameters, this exemption could provide a highly tax-efficient structure for aggregating non-U.S. investors to invest into U.S. public or private REITs.
[1] A “qualified foreign pension fund” means any trust, corporation, or other organization or arrangement (i) which is created or organized under the law of a foreign country, (ii) which 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, (iii) which does not have a single participant or beneficiary with a right to more than 5% of its assets or income, (iv) which 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 (v) with respect to which, under the laws of the country in which it is established or operates, either (A) contributions to such organization or arrangement that would otherwise be subject to tax under such laws are deductible or excluded from the gross income of such entity or taxed at a reduced rate, or (B) taxation of any investment income of such organization or arrangement is deferred or such income is taxed at a reduced rate.
[2] A qualified shareholder is a non-U.S. person that (i) is eligible for the benefits of a comprehensive income tax treaty which includes an exchange of information program and whose principal class of interests is listed and regularly traded on one or more recognized stock exchanges (as defined in such comprehensive income tax treaty), (ii) maintains records on the identity of each person who, at any time during the foreign person’s taxable year, is the direct owner of 5% or more of the class of interests or units (as applicable) described in (i), above, and (iii) is a qualified collective investment vehicle (“QCIV”). A QCIV is a foreign person that: (A) would be eligible for a reduced rate of withholding under a comprehensive income tax treaty described above with respect to ordinary dividends paid by a REIT, even if such entity holds more than 10% of the stock of such REIT, (B) is a publicly traded partnership that qualifies for the passive income exception, is a withholding foreign partnership, or is a foreign partnership that would be a U.S. real property holding corporation, or (C) is designated as such by the Secretary of the Treasury and is either fiscally transparent for U.S. federal income tax purposes or is required to include dividends in its gross income but gets a deduction for dividends paid to its equity holders.
Contacts
- /en/people/g/glazer-edward
Edward L. Glazer
Of Counsel - /en/people/l/lemaster-kelsey
Kelsey Lemaster
Partner - /en/people/p/patton-david
David M. Patton
Partner - /en/people/s/sandford-h-neal
H. Neal Sandford
Partner - /en/people/t/turk-karen
Karen F. Turk
Partner