Hot Topics: Foreign versus Domestic Trusts, US Trusts for Foreign

Families, Migration of Trusts, FATCA Requirements, Investment in US

Real Estate, and FIRPTA

ABA RPTE 2016 Spring Symposia Boston, MA

Presenters Brian Tsu Henderson, Caverly, Pum & Charney LLP San Diego, CA Phone: 858-755-3000 X130 Email: btsu@hcesq.com Web: www.hcesq.com Jeff Billings Godfrey & Kahn Milwaukee, WI Phone: 414-287-9615 Email: jbillings@gklaw.com Web: www.gklaw.com

Mary Akkerman Lindquist and Vennum LLP Sioux Falls, SD Phone: 605-978-5204 Email: makkerman@lindquist.com Web: www.lindquist.com

PART I – FOREIGN VERSUS DOMESTIC TRUSTS

Nonresident Aliens (NRAs)

• Not a US resident • Not a US citizen • Must fail to meet both the

– Substantial Presence Test; and – Lawful Permanent Residence/Green Card test

• Discussed in more detail, below

Substantial Presence Test • The "substantial presence" test

– Physical presence in the US for 31 days in the current year; and

– Physical presence in the US for a weighted average of no less than 183 days in the current year and the two prior years, calculated by including

• All days in the current year • 1/3 of the days in the prior year • 1/6 of the days in the year before the prior year

– IRC §7701(b)(3) – Subject to certain exemptions for employees of foreign governments,

teachers or trainees with J visas, students with F and J visas, and professional athletes competing in charitable competitions during the actual event (IRC §7701(b)(5)(A)-(D));

Lawful Permanent Residence Test

• Or the "lawful permanent residence/green card" test – Considered a resident alien from the date admitted to

the US as a lawful permanent resident (i.e., date green card is obtained)

– Continues until green card is revoked or abandoned – Continues even while living outside the US

• IRC §7701(b)(6)

NRAs • Normally taxed only on "US source" income

– Income "effectively connected" to a US trade or business

• Salary or compensation

– US investment income • Generally taxed at 30% flat rate • May be reduced by applicable tax treaty

• Non-domiciliaries are only subject to US transfer taxes on US-situs assets

NRAs

• Green card issues – Could cause a foreign national to be domiciled in

the US for estate and gift tax purposes – Could subject foreign national to US exit taxes

under IRC §877A expatriation rules • If a "long-term" green card holder (i.e., 8 of the last 15

years)

Resident Aliens

• Definition: a foreign national who either falls under the substantial presence test or the lawful permanent residence test/green card test, discussed above

• Consider effect of green card on resident aliens continuing to hold green card while living abroad – Status continues, as discussed above

Exceptions to Residency Period • Exempt individuals, discussed above • Commuters from Mexico or Canada who work in the US

– IRC §7701(b)(7)(B) • Physical presence in the US during transit for no more than 24

hours – IRC §7701(b)(7)(C)

• Trapped in the US for medical emergencies – IRC §7701(b)(3)(B)(ii)

• Closer connection to another country – In US for less than 183 days – Can show a tax home in another country with closer connection

• Treas. Reg. §301.7701(b)-2

Taxation of Resident Aliens • US taxes resident aliens on their worldwide income

derived from any source – US employment income – Foreign employment income – US passive income – Foreign passive income – US capital gains

• May be able to defer through like-kind exchanges, corporate reorganizations, or take advantage of exclusions for personal residence

– Foreign capital gains – Some income from controlled foreign corporations

• Graduated tax rates • Income determined as with a US citizen

Taxation of NRAs • Generally subject to tax on income from US

sources • Gains on sale of US real property are taxable

– Typically unable to defer through like-kind exchanges or corporate reorganization

– May be allowed exclusion for $250,000 of gain on personal residence ($500,000 for married couple)

• US investment income generally taxed at 30% rate – Tax treaty may apply

US Transfer Taxes (Estate and Gift) • Different tax trigger for US transfer taxes than for

US income taxes – Domicile triggers imposition of US transfer taxes

• US domiciliary is subject to US transfer taxes on all assets worldwide

• Non-domiciliary is only subject to US transfer taxes on US-situs assets

– Domicile factors the IRS considers • Time spent in US; location of business interests and social

contacts; location of family and friends; green card status; declarations in wills, visas, deeds, gift instruments, or trusts

US Tax Planning • Residency considerations

– Whether to become a resident or not • Consider effect of green card status

– Visa may be preferable

• Income tax recognition – Client may be able to time recognition event to

avoid US taxation • Accelerate gains before being subject to US income taxes and

defer losses until after being subject to US income taxes

• Achieve step up in basis prior to immigration • Examine foreign business interests

Foreign Trusts • Foreign national is grantor

– If he or she has made gifts to the trust – Trust is considered a grantor trust upon move to

US if • Gifts made within 5 years prior; or • Grantor has retained an interest to trigger US grantor

trust rules • This status would subject grantor to US taxation on

trust income

Foreign Trusts • Income tax payable by US beneficiaries if

foreign trust is not a grantor trust • Foreign trust remains a grantor trust to NRA

grantor if – Trust is revocable by grantor or on consent of

unrelated person with no interest in the trust – Distributions only to grantor or spouse during

grantor's lifetime – Grandfathered grantor trust created prior to

9/19/95

Foreign Trusts • If non-grantor trust

– Distributions taxable to US beneficiary • Character of distributions from current year income

and gains flow through to beneficiary • Distributions of accumulated income and gains are

taxed as ordinary income, plus there is an interest charge for accumulations of offshore income

– Loans to beneficiaries are treated as distributions unless "qualified obligations"

• 5 year maximum term, in writing, with certain reporting requirements for the beneficiary

– IRC §643(i)

PART II – DOMESTIC TRUST PLANNING FOR INTERNATIONAL FAMILIES

Domestic Trust Planning • Evaluate whether a non-grantor foreign trust's

ownership of foreign investment companies will be subject to foreign personal holding company, controlled foreign corporation or passive foreign investment company rules.

• If the foreign trust is expected to accumulate income, the trustee should consider possibly converting the foreign trust to a US domestic trust.

Domestic Trust Planning • Considerations on whether to convert a

foreign trust to a US domestic trust: – if the trust has or will acquire US beneficiaries; – how long the existing or potential US beneficiaries

will remain US income tax resident; and – the trust's investment and distribution strategy

both at the time of conversion and in the future • Changes in US tax law should also be

considered

Perpetual US Trusts • NRA Dynasty Trust

– strategy for foreign citizens with US citizen and/or green card children, grandchildren, and great grandchildren (whether born or unborn)

• Benefits include: – NRA parent/grandparent can transfer an unlimited amount of assets on-shore into

the trust without gift, death, or generation-skipping taxes – Assets are not subject to state income tax with trustee in tax favored US

jurisdiction – The life insurance investment option (traditional or PPLI) is frequently chosen for

the trust, thereby also avoiding federal income taxes within the trust – The life insurance option may also provide for federal and state income-tax-free

withdrawals for the US beneficiaries – The Dynasty Trust can continue forever for the benefit of US beneficiaries and

provide creditor protection

Self-Settled Trusts – For NRAs who anticipate immigrating to the US – Prior to immigration an NRA may generally make

unlimited transfers to a Self-Settled Trust in certain US jurisdictions with the NRA as a permissible beneficiary without incurring any US transfer tax

– After immigration, if the Grantor as a permissible beneficiary needs assets, he or she can generally be distributed by an Independent Trustee

– If properly structured, the assets may be excluded from one’s estate and protected from creditors and lawsuits

Foreign Grantor Trusts Administered in the US • Established as a “foreign” trust for US tax purposes and

therefore is treated the same as an offshore trust • Benefits include the following:

– Typically, the trust assets are all in off-shore entities and the trust is not generally subject to US income tax (except for any US-source income)

– The trust is typically revocable and distributions are only to the grantor or grantor’s spouse

– Upon the grantor’s death, the trust can be transformed to a US Dynasty Trust to avoid US income tax on distributions of accumulated income

– The trust may be funded with other off-shore corporate entities, such as private investment companies, to avoid US estate taxes

– The trust may reduce exposure to sovereign risks – Forced heirship protection – US is generally a transparent, non-blacklisted jurisdiction

Standby US Dynasty Trusts • A strategy for foreign citizens with US

beneficiaries who have established foreign trusts in off-shore jurisdictions

• Upon the grantor’s death, the foreign trust pours the trust assets over to an existing (nominally funded) Standby US Dynasty Trust

• Can avoid income tax filing requirements of US beneficiaries and negative US income tax rules on distributions of accumulated income

• Avoids US transfer taxes

PART III – MIGRATING TRUST ONSHORE

Why Migrate a Foreign Trusts to the US?

• Trust law and administration considerations – The settlor may wish to take advantage of a highly-

developed body of trust law and infrastructure available in the United States

– Easier access to US capital markets – Administrative costs of an offshore trust are typically

higher than a US situs trust – Trustees in US jurisdictions may offer US settlors and

beneficiaries greater personal contact – Availability of asset protection trusts under the laws of

certain states – Trusts administered in US jurisdictions may avoid

application of forced heirship for foreign settlors

Why Migrate a Foreign Trusts to the US? (cont’d)

• Tax considerations – The US settlor or US beneficiaries of a foreign trust (as

defined under IRC §7701(a)(30)(E)) may wish to avoid additional tax compliance required in conjunction with foreign trusts

– Migrating a foreign trust to a US jurisdiction may • Avoid application of IRC §684 (e.g. upon death of US settlor of a

foreign grantor trust that is not included in estate of settlor) • Avoid accruing undistributed net income (though migrating to a US

jurisdiction does not expunge undistributed net income that has already accrued)

– Trusts created by foreign settlors and beneficiaries can achieve favorable tax results by migrating to a US jurisdiction (particularly one with no state and local tax)

Migration of Foreign Trusts to the US: Methods

• Basic methods for accomplishing a migration include – Resignation/removal of foreign trustee ad

substitution with a trustee in a US jurisdiction – Distribution/decanting to a trust located in a US

jurisdiction – Trust consolidation with a trust located in a US

jurisdiction

Migration of Foreign Trusts to the US: Tax Considerations

• Generally, speaking there is no current US income tax consequence to a migration of a foreign trust to a US jurisdiction – Grantor trust to non-grantor trust is treated as a transfer

(and a potentially taxable event) for income tax purpose (Treas. Reg. §1.1001-2(c), Ex. 5)

– Non-grantor trust to grantor trust, generally a non-taxable event for income tax purposes

• Should not trigger any reporting obligation • Will not prevent application of throwback tax to

accumulation distributions of undistributed net income

Throwback Tax - Introduction

• Concerned with the deferral of income tax on US trust beneficiaries, the throwback tax seeks to tax distributions deemed to contain accumulated income (“undistributed net income”) as if the beneficiary received distribution of such income in the year it was earned

• The Taxpayer Relief Act of 1997 has eliminated the throwback tax for beneficiaries of most domestic trusts

• Although the throwback tax has largely been repealed for domestic trusts, it still applies to the US beneficiaries of foreign (as defined under IRC §7701(a)(30)(E)) non-grantor trusts

Accumulation Distributions

• The throwback tax applies to accumulation distributions (to the extent of undistributed net income) made to US beneficiaries by a foreign non-grantor trust

• If a foreign trust distributes amounts in excess of its distributable net income to a US beneficiary, the excess is treated as an accumulation distribution (IRC §665(b))

• However, distributions of the foreign trust’s current distributable net income (which includes capital gain) are not subject to the throwback tax

• Note that specific gifts (as defined under IRC §663(a)(1)) can not be accumulation distributions (Treas. Reg. §1.665(b)-1A(c)(1))

Undistributed Net Income

• If a foreign non-grantor trust does not distribute all of its distributable net income (“DNI”) in the current year, the after-tax portion of DNI will become undistributed net income (“UNI”) (IRC §665(a))

• Accumulation distributions of UNI are taxed as ordinary income, regardless of its original character

Throwback Tax – Allocation and Interest Charge

• In order to tax the US beneficiary as if the beneficiary received a distribution of UNI in the year it was earned, the accumulation distribution is allocated across the span of preceding years of the trust for which there is any UNI and taxed at the tax rate for that year – See IRC §§666 and 667

• In addition to the throwback tax, there is an interest surcharge on the tax that is intended to capture the time value of money on the deferred payment of tax

• The interest charge on the accumulation distribution is the compound interest that applies to underpayment of tax

What to Do?

• Difficult to cleanse or expunge foreign trust of UNI, instead – Limit accrual of UNI – Draft or structure distributions to US beneficiaries to

avoid characterization as accumulation distributions • Investment strategies

– Buy and hold – Life insurance

• Specific gifts • Distributions to charity if permitted under trust

instrument

What to Do? (cont’d)

• Loans to US beneficiaries – Must be a “qualified obligation” (See Notice 97-34) – A qualified obligation must be:

• Reduced to writing by an express written agreement • Limited to a term of not more than 5 years and must actually

be repaid within that term • Yield to maturity is not less than 100%, but cannot exceed

130% of the applicable federal rate for the day that the obligation is issued

• US beneficiary must generally agree to 3-year statute extension and report payments on principal and income on Form 3520

What to Do? (cont’d)

• Take caution – Distributions from a foreign trust to non-settlor,

foreign intermediaries who subsequently “gift” the distribution to US beneficiaries are deemed distributions to US beneficiaries (IRC §643(h))

– The use of a foreign trust property by a US beneficiary, without compensation, is a deemed a distribution

PART IV – FATCA REQUIREMENTS

Foreign Account Tax Compliance Act (FATCA)

• Enacted March 18, 2010 • Effective January 1, 2013 (although withholding and

other requirements deferred until July 1, 2014) • The goal was to address perceived tax abuse by US

persons through the use of offshore accounts and to raise money to create US jobs coming out of the recession

• US Congress Joint Committee on taxation estimated that FATCA would produce $8.7 billion in revenue over an 11 year period ($792 million per year)

• Actual projections on revenue raised to date are significantly less

Who is Affected? • Individuals must file Form 8938 – Statement of Specified Foreign

Financial Assets if you are: (1) a “Specified Individual” (2) you have an interest in “Specified Foreign Financial Assets” required to be reported, and (3) The aggregate value of your specified foreign financial assets is more than the reporting threshold

• Foreign Financial Institutions (“FFIs”) register and report certain information to IRS on US persons invested in accounts outside the US

• Certain non-US entities must provide information about US owners • US Financial Institutions and other US Withholding agents must

withhold 30% on certain payments to foreign entities that do not document their FATCA status and report information about certain non-financial foreign entities to IRS

Form 8938 Reporting A “Specified Individual” is: • A US citizen • A resident alien of the United States for any

part of the tax year • A nonresident alien who makes an election

to be treated as resident alien for purposes of filing a joint income tax return

• A nonresident alien who is a bona fide resident of American Samoa or Puerto Rico

Form 8938 Reporting “Specified Foreign Financial Assets” include: • Financial (deposit and custodial) accounts at FFIs • Foreign stock or securities not held in a financial account • Foreign partnership interests, hedge funds and private

equity funds • Foreign mutual funds • Foreign accounts and foreign non-account investment

assets held by foreign or domestic grantor trust for which you are the grantor

• Foreign-issued life insurance or annuity contract with a cash-value

• A foreign entity holding foreign real estate (the entity counts and its value includes the value of the real estate)

Form 8938 Reporting Thresholds • Taxpayers living in the US: The total value of your

specified foreign financial assets is more than $50,000 on the last day of the tax year or more than $75,000 at any time during the tax year (individual or married filing separately) or $100,000 and $150,000 (married)

• Taxpayers living abroad: If you are a taxpayer living abroad (US citizen living abroad the entire tax year or US citizen or resident living abroad for at least 330 days in the year) you must file if: – You are filing a return other than a joint return and the total

value of your specified foreign assets is more than $200,000 on the last day of the tax year or more than $300,000 at any time during the year; or

– You are filing a joint return and the value of your specified foreign asset is more than $400,000 on the last day of the tax year or more than $600,000 at any time during the year.

Foreign Financial Institutions (FFI) • To avoid being withheld upon, FFIs have the

option of registering and agreeing to report certain information about their US accounts to IRS

• Since enactment over 77,000 financial institutions have registered under FATCA. In addition, more than 100 jurisdictions have or are negotiating a Model 1 agreement with the US FFIs located in those signing jurisdictions are not required to sign an FFI agreement

Penalties • Non-Compliance with Form 8938 Reporting

– $10,000 failure to file penalty – Additional penalty of up to $50,000 for continued failure to

file after IRS notification – 40% penalty on understatement of tax for non-disclosed

assets • Failure to Register as FFI

• US Financial Institutions and other US withholding agents must withhold 30% on withholdable payments to FFIs

• FFIs must withhold 30% on any pass through payments made to other FFIs or to recalcitrant account holders

Other Important Items to Note • A “double taxation” or an “exchange of information treaty” with the US

does not exempt individuals or entities located in that jurisdiction from having to comply with the FATCA provisions

• Does not replace the FinCEN Form 114 – Report of Foreign Bank and Financial Accounts (FBAR). It just adds to the reporting requirements

• FATCA provisions apply to all “withholdable payments” – these include any payment of interest, dividends, rents, royalties, salaries, wages, annuities, and licensing fees sourced in the US It also includes gross proceeds from the sale of US property that can produce interest or dividends and foreign pass through payments attributable to US source income

• The IRS expects to issue regulations requiring a domestic entity to file Form 8938 if the entity is formed or used to hold specified foreign financial assets in excess of the appropriate reporting threshold. Until the IRS issues such regulations, only individuals must file Form 8938. For more information about domestic entity filing, see Notice 2013-10

The Worst Law Nobody has Heard of • Some of the roughly 7 million Americans living abroad

criticize FATCA for making it difficult for them to establish and maintain foreign accounts

• FATCA has resulted in an increase in US citizenship renunciations

• Foreign firms are less likely to hire American workers given reporting and compliance

• US taxpayers living in the US with sophisticated foreign investments are affected

• Foreign Trusts must understand FATCA even if neither the trust's beneficiaries nor the trust's assets have any US connection

• Other countries are following the lead of the US

PART V – INVESTING IN US REAL ESTATE AND FIRPTA

Income Taxation of NRAs Generally

• NRAs generally subject to tax on income from US sources (IRC §871)

• Income that is effectively connected with a US trade or business is taxable at generally applicable graduated rates of tax on a net basis (IRC §864(c))

Income Taxation of NRAs Generally (cont’d)

• Gains are generally excluded from taxation • However, gains on sale of US real property are

taxable (IRC §897) (see below) • US investment income (“FDAP”), including rental

income, and similar income not effectively connected with a US trade or business is generally taxed at 30% rate on a gross basis (IRC §871(a)(1)) – Tax treaty may apply to reduce rate

Estate Taxation of Foreign Persons - Domicile

• US citizens and “residents” are subject to US wealth transfer taxation on gratuitous transfers of property, wherever situated

• Nonresident non-citizens or non-domiciled aliens (“NDAs”), on the other hand, are only taxed on certain US situs property.

• “Residency” for US wealth transfer taxation looks to the donor’s domicile. To be a US domiciliary an individual must: – Live in the US, and – Have a present intent to remain indefinitely (facts and circumstances).

• Possession of immigrant status (e.g., a “green card”) is not definitive proof or domicile but it is strong presumptive evidence of an intention to remain indefinitely

• Treaties may affect domicile analysis

Estate Taxation of NDAs Generally

• NDA is subject to estate tax on testamentary transfers of US situs tangible and intangible property

• $60,000 exclusion only – no inflation adjustment • Marital and charitable deductions available

– Marital deduction subject to QDOT requirement for amounts passing to a non-citizen spouse

– Amount of marital deduction limited to property situated in US

• Administrative expenses and debts are deductible in proportion to that US estate bears to worldwide estate

• Portability unavailable for NDA

Estate Taxation of NDAs: Property Situs

• Select US Situs Property – Cash – US tangible personal property and real property – Debt of a US person – Stock in US corporation – Transfers of US situs property subject to IRC §§2035-2038

• Select Non-US Situs Property – Cash deposits in US banks – Life insurance proceeds on the NDA’s life – US Treasury obligations and other portfolio debt excepted from the

withholding rules • Note that this exception does not apply if NDA is a resident for income tax

purposes – Shares in a foreign corporation

Gift Taxation of NDAs Generally

• NDA is subject to gift tax on inter vivos transfers of US situs real and tangible personal only (IRC §§2501(a)(2), 2511(a))

• Transfers of intangibles (non-taxable) versus tangibles (taxable) – Bank deposits versus cash – Corporations versus partnerships and limited liability companies

• The applicable exclusion is unavailable to NDAs • Gift tax exclusions and deductions available to NDAs

– Annual exclusion – Educational/medical expense exclusion – Charitable deduction – Marital deduction (gifts to US citizen)

Converting US Situs Real Property Into non-US Situs Property

• Direct interests in real property are US situs property and are subject to US estate taxation

• To avoid US estate taxation, a NDA may convert US situs real property into non-US situs property

• For example, a NDA may choose to acquire US real property through a foreign corporation

• Accordingly ownership of US real property is a critical

US Real Property Structuring Alternatives for NDA/NRA

• Possible structures for NDA/NRA – Direct ownership – Foreign corporation – Domestic corporation owned by NDA/NRA, foreign corporation, or

trust – Other entities or arrangements

• Single-member disregarded entity (“DRE”) • Partnership or entity classified as a partnership • Trusts

• Note, there is significant tension between estate and income tax considerations with respect to real property structuring

US Real Property Structuring Alternatives – Direct Ownership

• Advantages – Simple and cost-efficient – Single level of income taxation – Preferential rates of taxation on long-term capital gains – Eliminates imputed rent issues – Step-up in basis for transfers at death – IRC § 121 exclusion may apply if home was principal residence

• Disadvantages – Exposure to US estate tax at death – Lack of privacy

US Real Property Structuring Alternatives – Foreign Corporation

• Advantages – No US estate taxation – Anonymity – Limited liability for shareholders

• Disadvantages – Taxed at rates of up to 35% at corporate level – Loss of preferential rates for long-term capital gains – Loss of stepped up basis on real property – Potential double income taxation/branch profits tax

• 30% branch profits tax exposure (effective tax rate of 54%) • May be reduced/eliminated by treaty

– Potential risk of imputed dividend income on personal use – If US beneficiaries inherit they will be subject to CFC and PFIC rules

US Real Property Structuring Alternatives – Domestic Corporation

• Advantages – Anonymity – Limited liability for shareholders

• Disadvantages – Exposure to US estate tax at death – Taxed at rates of up to 35% at corporate level – Loss of stepped up basis on real property – Loss of preferential rates for long-term capital gains – Potential double income taxation

• Dividends subject to 30% withholding (subject to reduction under treaty)

US Real Property Structuring Alternatives – Partnerships, Disregarded Entities, Trusts

• Advantages – Avoidance of US estate taxation possible

• Treatment of foreign partnership interest is unclear • Although unclear foreign DRE may be optimal (see Pierre case) • Treatment of trust dependent on its terms

– Single level of income taxation – Preferential rates of taxation on long-term capital gains – Limited liability possible for members, certain partners and trust

beneficiaries – May address privacy concerns

• Disadvantages – Uncertain exposure to US estate tax

Planning Considerations

• Leveraging the US real property with nonrecourse debt reduces the value of the real property estate tax – However, see Estate of Fung - consult state law as

nonrecourse debt may be difficult in certain jurisdictions • Gift US real property held in corporation

– NDAs not subject to gift tax on transfers of intangible property, regardless of situs

• If NDA is insurable, obtain life insurance – Does not eliminate tax, but provides liquidity – Life insurance proceeds payable on the life of a NDA are

treated as non-US situs property even if the NDA was insured by a US carrier

The Foreign Investment in Real Property Tax Act – An Introduction

• The Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) imposes a tax on capital gains derived by foreign persons from the disposition of US real property interests (“USRPIs”) (IRC §897)

• To back-stop the tax imposed under IRC § 897 and ensure its collection, Congress subsequently enacted IRC §1445 (“FIRPTA withholding), which imposes a withholding tax, typically on the purchaser of a USRPI

• Special FIRPTA withholding rules apply to trusts and estates.

The Foreign Investment in Real Property Tax Act – In a Nutshell

• While NRAs are generally exempt from tax on gains derived from the sale of US property, FIRPTA is a key exception

• Instead, FIRPTA provides that the gains from the sale or exchange of a USRPI are taxed to the NRA at preferential rates, if applicable – Non-recognition provisions generally do not apply to FIRPTA unless the

seller receives USRPI in exchange • To ensure collection of this tax, the FIRPTA withholding rules

impose a 15% withholding tax on the amount realized, typically on the transferee of a USRPI (though with notable exceptions) – 10% tax prior to February 17, 2016

• FIRPTA withholding may be claimed as a credit on final US tax obligation

The Foreign Investment in Real Property Tax Act – USRPIs

• What is a USRPI? (IRC §897, Treas. Reg. §1.897-1) – a direct “interest in real property” (other than as a

creditor) located in the United States or the Virgin Islands • Interest includes

– Fee interest – Leaseholds – Options and – Appreciation rights

• Real property includes – land – unsevered natural products of the land (e.g. growing crops and timber,

mines, wells and other natural deposits) – improvements (e.g. buildings) and – personal property “associated with the use” of real property (e.g. fixtures

and furniture)

The Foreign Investment in Real Property Tax Act – USRPIs (cont’d)

• What is a USRPI? (IRC §897, Treas. Reg. §1.897-1) – an interest (other than as a creditor) in a domestic corporation that

has been a US real property holding corporation (“USRPHC”) at any time within the five-year period ending on the date of the disposition of such interest

– In addition to USRPIs and USRPHCs, gains from the sale or exchange of interests in a partnerships, trust and estates may also be treated as derived from the sale or exchange of USRPIs

• Money or other property received by a foreign person in exchange for all or part of its interest in a trust or estate is treated, to the extent attributable to USRPIs, as proceeds received from the sale or exchange of a USRPI (IRC § 897(g))

• Further for purposes of FIRPTA withholding, an interest in a partnership is treated as a USRPI in its entirety if 50% or more of the value of gross partnership assets consists of USRPIs and 90% or more of the value of the gross partnership assets consists of USRPIs plus cash and cash equivalents (the “50/90 test”)

The Foreign Investment in Real Property Tax Act – USRPHC

• What is a USRPHC? (IRC §897(c)(2)) – In general, a USRPHC is a US corporation, which:

• hold USRPIs, the fair market value of which equals or exceed 50% or more of the

• the sum of the fair market value of USRPIs, non-US real property interests and other trade or business assets of the corporation on any “applicable determination date”

– Look through rules apply to subsidiaries for applying the above test on a proportionate basis if

• Parent corporation owns more than 50% of subsidiary corporation • Or any interest in a partnership

– USRPHC does not include publicly-trade corporation unless NRA owns, directly or indirectly, 5% or more of any class of stock

– Many exceptions and nuances to the definition of USRPHC

Taxation of USRPI Dispositions

• In general, IRC §897 treats gains from the disposition of USRPIs as effectively connected income – This means gains realized by a NRA may be availed

of preferential rates for long-term capital gain – Accordingly, an NRA may benefit from a

• 20% long-term capital gain rate • 25% rate for IRC §1250 recapture income

Taxation of USRPI Dispositions

• The FIRPTA regime applies to “dispositions” of USRPIs • Gifts of USRPIs

– Not subject to taxation, donee merely takes carryover basis – Exception if USRPI is subject to debt in excess of basis

• Other non-recognition transactions are generally taxable unless: – The USRPI is exchanged for another USRPI (e.g. a USRPHC) – The USRPI received by foreign transferor would be subject to US

taxation upon disposition – Foreign transferor complies with reporting requirements set forth in

Treas. Reg. §1.897-5T(d)(1)(iii) unless an exception applies – Other non-recognition transactions include, among others capital

contributions, certain distributions, like-kind exchanges and involuntary conversions

– (IRC 897(e) and Treas. Reg. §1.897-6T)

FIRPTA Withholding

• In order to ensure collection of tax, Congress enacted FIRPTA withholding under IRC §1445

• Accordingly, the FIRPTA withholding tax does not represent the final tax due

• Merely an advance toward the final US tax obligation determined under IRC §897

• The NRA must still file an income tax return for the year of the sale showing the gain and tax due, taking into account a credit for the FIRPTA withholding tax

Who is Responsible for FIRPTA Withholding?

• If seller is NRA, foreign corporation (without IRC § 897(i) election), foreign partnership, foreign trust or foreign estate, transferee must deduct and withhold 15% on gross amount realized, regardless of gain or loss – If transferee does not withhold, he is liable for any uncollected

taxes • If seller is domestic partnership, transferee has no

withholding obligation; rather, the entity must withhold at 39.6% of foreign partner’s distributive share of gain upon distribution (Treas. Reg. §1.1446-3(c)(2)(i))

• The obligation of a fiduciary to withhold in trust and estate issues depends on a number of factors discussed further below

Exceptions to FIRPTA Withholding

• No FIRPTA withholding is required – If seller/transferor has no amount realized (Treas. Reg.

§1.1445-1(b)(1)) – Seller is not a foreign person – subject to certificate or

statement of non-foreign status requirement (Treas. Reg. §1.1445-2(b))

– For certain non-recognition transfers – subject to notice or certificate requirement (Treas. Reg. §1.1445-2(b))

• Note: no certificate required for sale of a principal residence if amount realized is $300,000 or less

• A certificate or statement from the seller/transferor is typically required for exemption from FIRPTA withholding

FIRPTA Withholding for Trusts and Estates

• Foreign trusts and estates (no distinction for whether foreign trust is grantor or non-grantor) – Disposition

• FIRPTA withholding of 15% applies to transferee/purchaser, not fiduciary

– Distribution • See below

FIRPTA Withholding for Trusts and Estates (cont’d)

• Domestic trusts and estates – Disposition of USRPI by grantor trusts

• Fiduciary must withhold tax on 35% of the gain realized by the trust to the extent that the gain is allocated to a NRA grantor who is treated as owning the trust (Treas. Reg. §1.1445-5(c)(1)(iv))

– Disposition of USRPI by non-grantor trusts and estates • No FIRPTA withholding on disposition, but rather upon

distribution of cash or other property to NRA beneficiaries • Fiduciary must maintain a “USRPI account” to post all gains

and losses from USRPI dispositions from each year (Treas. Reg. §1.1445-5(c)(1)(iii)(A))

FIRPTA Withholding for Trusts and Estates (cont’d)

• Domestic trusts and estates (cont’d) – Disposition of USRPI by non-grantor trust and estates

(cont’d) • Fiduciary must withhold 35% of any distribution to a NRA

beneficiary, up to the balance of the USRPI account on the date of distribution as distributions are deemed to come from USRPI account first

• The USRPI account is reduced by distributions to all beneficiaries (foreign and domestic)

• The balance of a USRPI account at the end of the year does not carryover to the next year (i.e. it begins at zero) (Treas. Reg. §1.1445-5(c)(1)(iii)(A))

• Treatment of installment sales unclear

FIRPTA Withholding for Trusts and Estates (cont’d)

• Domestic and foreign trusts and estates – Distribution

• Fiduciary must withhold 15% of the fair market value of an USRPI distributed to a NRA beneficiary, but only to the extent that the distribution is taxable under yet-to-be-issued IRC §897 regulations

– Distributions from trusts and estates are generally not taxable absent IRC §643(e) election

• As such, no FIRPTA withholding is required • However, keep in mind the USRPI account rules discuss

above

Questions?