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Presenting a live 110‐minute teleconference with interactive Q&A
Tax Challenges for Foreign Investors in U.S. Real EstateStructuring Investments That Minimize Overall Income, Capital Gains and Estate Tax Burden
1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
TUESDAY, NOVEMBER 29, 2011
Today’s faculty features:
1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
Alan I. Appel, Counsel, Bryan Cave, New York
Louis S. Weller, National Director, Real Estate Transaction Planning, Deloitte Tax, San Francisco
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Tax Challenges for Foreign Investors in U STax Challenges for Foreign Investors in U.S. Real Estate:
Structuring Investments That MinimizeStructuring Investments That Minimize Overall Income,
Capital Gains and Estate Tax Burden
November 29, 2011 Alan I Appel Louis S. Weller, EsqAlan I. Appel
Bryan Cave LLP1290 Avenue of the Americas
New York, NY 10104Tel (212) 541-2292
Louis S. Weller, EsqDeloitte Tax LLP
555 Mission Street San Francisco, CA 94105
Tel (415) 783-4459 F (415) 783 9029 Fax (212) 261-9865
Fax: (415) 783-9029 [email protected]
Foreign Investors Gain Share in U S CREForeign Investors Gain Share in U.S. CREForeign Investment in U.S. CRE
Percent($ Billion)
Source: Real Capital Analytics, as of August 2011YTD represents through July 2011
6
C iti f F i I t t i U S CREComposition of Foreign Investment in U.S. CREForeign Investment in U.S. CRE by Region
2010 - $9.7 billion 2011 YTD - $11.9 billion2007 - $37.3 billion
7
Source: RCA, May 2010 (for 2007 data), August 2011 (for 2010, 2011 data)
YTD represents through August 2011
General Issues to Consider on Inbound Real Estate Investment
• Choice of Investment Entity
Withh ldi R t I t t & Di id d• Withholding on Rent, Interest & Dividends
• FIRPTA Withholding Upon Sale
• Portfolio Interest Exemption
• Branch Profits Tax
• Earnings Stripping Limitations
• Estate Tax Consequences
8
P i i l T iPrincipal Topics• Basic income tax rules
Capital gains– Capital gains– Operating income– Interest and dividends
• Withholding– FIRPTA– Rent, interest and dividendsRent, interest and dividends– Partnership withholding
• Estate and gift taxesSt t i• Structuring– Foreign business entities– U.S. business entities– Trusts
9
Basic Income Tax Rules
10
Basic Income Tax Rules – Gains
• Foreign Investment in Real Property Tax Act of 1980• Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) – § 897– Gain from sale or exchange of “United States real property
interest” (“USRPI”) taxed as if foreign seller were engaged in the conduct of a trade or business in the United States and the gain were effectively connected with such trade or businessbusiness
– Therefore, foreign sellers are taxed on gains at the same rates applicable to U.S. sellers – gain can qualify for long-term capital gains treatment in the hands of a foreign sellerterm capital gains treatment in the hands of a foreign seller
– Nonrecognition provisions do not apply unless in the exchange the seller receives property that would itself be taxable in sale or exchangetaxable in sale or exchange
11
B i I T R l G iBasic Income Tax Rules – Gains• Definition of USRPI (Treas. Reg. § 1.897-1)
– Interest in real property:• Real property includes land, buildings, and other improvements• Includes growing crops and timber, and mines, wells and other g g p , ,
natural deposits – but once extracted or severed, crops, timber, ores, minerals, etc. are no longer USRPIs
• Includes “associated personal property”• Includes direct or indirect right to share in appreciation in value, gross
or net proceeds or profits from real property• Does not include mortgage loan at fixed rate of interest (or variable
rate such as prime LIBOR etc )rate such as prime, LIBOR, etc.)– Interest in domestic corporation that was a U.S. real property
holding corporation (USRPHC – see next slide) at any time during the 5 year period preceding salethe 5-year period preceding sale
12
U.S. Real Property Holding Corporation• Basic definition (§ 897(c)(2)):
– Fair market value of USRPIs held on any “applicable determination date” equals or exceeds
– 50% of sum of FMVs of (i) USRPIs; (ii) non-U.S. real property interests; and (iii) other trade or business assets
• Look-through rule for assets held through entities; in theLook through rule for assets held through entities; in the case of corporations, more than 50% control requirement
• USRPI does not include interest in corporation that has sold all of its USRPIs in taxable transactions
• Interest in regularly trade class of stock is a USRPI only if taxpayer owned 5% or more of classtaxpayer owned 5% or more of class
13
Basic Income Tax Rules – Operating Income• If income is effectively connected with a U.S. trade or
business, tax is imposed on foreign taxpayer at regular U.S. rates (individual or corporate)
• Foreign taxpayers may elect to treat real estate income• Foreign taxpayers may elect to treat real estate income as effectively connected (e.g., income from triple net leased property) – § 871(d)
• Tax base is the gross income net of allocable deductions, including operating costs, management fees and interest expenseexpense
• Normal expense limitation rules apply, e.g., at-risk, passive activity loss rules, capitalization of expenses,
i t i i AHYDO tearnings stripping, AHYDO, etc.
14
Basic Income Tax Rules Interest andBasic Income Tax Rules – Interest and Dividends• Interest
– U.S. source interest paid to a foreign person, taxed at 30% of gross
– Numerous exceptions if interest is not ECI• Short-term OID• Bank interest• Portfolio interest exemption (exceptions where loan made by ( y
foreign bank, “10-percent shareholder” or “10-percent partner”; also not applicable if interest is contingent)
• Many treaties eliminate or reduce rate of tax
• Dividends– Dividend paid by U.S. corporation to foreign person, taxed at
30% of grossg– Treaties typically reduce rate to 5% or 15%
15
Taxation of Foreign Corporations• If foreign corporation is engaged in a U.S. trade orIf foreign corporation is engaged in a U.S. trade or
business, including through ownership or sale of U.S. real property, taxed at regular U.S. corporate rates (34% or 35%)35%)
• In addition, subject to branch level taxes (§ 884). Branch taxes intended to treat U.S. trade or business as if it were a separate U.S. corporation:– Dividend tax rate x “dividend equivalent amount”
Interest tax rate x interest allocated to U S branch– Interest tax rate x interest allocated to U.S. branch– Treaties often reduce or even eliminate branch taxes
• Dividend equivalent does not apply to liquidation proceeds, if formalities met
16
Withholding
17
Withholding – FIRPTA (§ 1445)• 10% of gross amount realized from sale of USRPI (some• 10% of gross amount realized from sale of USRPI (some
states also require withholding on sale by nonresident)• Exemptions:
– Non-foreign affidavit– Non-USRPHC affidavit– Excess withholding can be avoided based on maximum tax - seeExcess withholding can be avoided based on maximum tax see
IRS Form 8288-B and Rev. Proc. 2000-35– Sales price <$300,000 on property that will be transferee’s
residence (amount not indexed for inflation in >30 years)residence (amount not indexed for inflation in >30 years)– Regularly traded stock– Situations where withholding required under partnership
withholding rules (§ 1446)withholding rules (§ 1446)
18
Withholding Rent Interest DividendsWithholding – Rent, Interest, Dividends(§ 1441)
• Payor must withhold 30% of gross amount of U.S. source “fixed or determinable annual or periodic” income paid to p pforeign person
• Applies to rent, interest, dividends and services income (except income subject to wage with holding)(except income subject to wage with-holding)
• Treaties can reduce or exempt payments from withholding, if foreign person certifies its entitlement to g, g ptreaty benefits (typically on Form W-8BEN)
• See slide on interactions with § 1445 regarding corporate distributionsdistributions
19
Withholding – Partnerships (§ 1446)• A partnership must withhold on its foreign partner’sA partnership must withhold on its foreign partner s
“effective connected taxable income” (ECTI)• Rate is highest rate under § 1 or § 11
– Long-term capital gains rate can apply to individual partner
• Estimated tax payments are due on 15th day of the 4th, 6th 9th & 12th (sic) months of partnership’s tax year; true6th, 9th & 12th (sic) months of partnership s tax year; true up on 15th day of 4th month of next year
• Publicly traded partnerships (Treas. Reg. §1.1446-4)– Withholding based on distributions not income allocations– Preferential rates may not be used– Rules not extended to other types of large partnerships
• Overwithholding is pervasive problem20
Withh ldi I t tiWithholding - Interactions• Section 1445/1446
– Domestic partnership – § 1446 trumps § 1445– Foreign partnership – § 1445 amount withheld allocable to foreign
partner treated as satisfying § 1446 withholding requirement with p y g § g qrespect to such partner
• Section 1441/1446 – generally no overlapException: US source independent personal services § 1441– Exception: US-source independent personal services - § 1441 trumps 1446. Treas. Reg. § 1.1446-3(c)
• Section 1441/1445 – corporation has choice– Withhold under § 1441 and not under § 1445– Withhold under § 1441 on portion estimated to be dividend and §
1445 on remainder of distribution
21
Withholding – FATCA (§§ 1471-1474)
• Foreign Accounts Tax Compliance Act (FATCA) ll b d th f thi t tigenerally beyond the scope of this presentation
• FATCA can require withholding on payments of U.S. source income to foreign financial institutions andsource income to foreign financial institutions and non-financial foreign entities
• Note that FATCA withholding can apply to proceeds f l f USRPI i ti f t k i USRPHCof sale of USRPI consisting of stock in USRPHC
22
Estate and Gift Taxes
23
Gift Tax• Nonresident alien is taxed on gifts of tangible (but notNonresident alien is taxed on gifts of tangible (but not
intangible) property located in the United States• Gift of U.S. real property is subject to gift tax• Gift of stock (whether corporation domestic or foreign) not
subject to taxLess certain but gift of partnership interest probably not• Less certain but gift of partnership interest probably notsubject to tax
• Points to note:– No unified credit– No step-up in basis on inter vivos gift
QDOT required for taxable gifts to spouse who is not a U S– QDOT required for taxable gifts to spouse who is not a U.S. citizen
24
Estate Tax• Estate of nonresident alien is subject to estate tax on
property located in the United States. Includes:– U S real property and property located on itU.S. real property and property located on it– Stock in U.S. corporation (whether or not publicly traded)– Uncertain treatment of partnership interests
No real authority• No real authority• IRS position is that interest is located in the United States if
partnership is engaged in U.S. trade or business• But various other respectable theories (place of organization of• But various other respectable theories (place of organization of
partnership, domicile of partner)
25
Planning
26
Before Planning BeginsBefore Planning Begins• Understand investor characteristics - type, location
Ascertain in estment characteristics and objecti es• Ascertain investment characteristics and objectives:– Use – personal use, business, investment
Types of income generated from real estate: Rent interest– Types of income generated from real estate: Rent, interest, dividends, capital gains, services and others
– Capital – equity, debt (many different flavors and sources)
– Exit – anticipated timing, method
• Consider choice of entity – wholly-owned, joint ventures, passive investment vehicles (e.g., REITs)
• Withholding and compliance
• Estate and gift taxes27
Home Country Taxation
• No planning should be undertaken before considering h th h t t ti i l twhether home country taxation is relevant
• U.S. taxation of foreign investors may be modified by treatytreaty– No exception from U.S. taxation of gain from real estate but
treaties can reduce or eliminate tax on interest and dividendsAlmost all treaties contain “limitation on benefits” provisions– Almost all treaties contain limitation on benefits provisions to counteract abusive use of treaties
28
Obj ti D i St tObjectives Drive Structure• Tax objectives:
– Avoid cross-border double taxation (U.S./foreign)– Mitigate taxation of operating income– Avoid double taxation of corporate earningsg– Obtain long-term capital gains treatment on sale– Avoid gift and estate taxes– Limit overwithholding– Limit overwithholding– Limit contact with U.S. tax system
• Nontax objectives– Preserve confidentiality– Facilitate inter-family transfers– Limited liabilityLimited liability
29
Structuring May Mean Picking Your Poison
Corporate rates;double taxation
Pass-through entity: capital gains preference; double taxationgains preference;no double taxation
THERE IS NO PERFECT SOLUTION
Personal taPersonal taxcompliance/estate tax risk
Corporate structure: Nopersonal tax filings or estate
30
tax
Options - 1p
Foreign 1 % 3 %Individual • 15% tax or 35% tax
• Privacy Concerns
l t t
• Estate Tax
• but only one level of tax!real estate • but - only one level of tax!
31
Options -2p
N E t t TForeign
• No Estate Tax
• Branch Profits Tax
Individual
Foreign• Privacy Concerns
• Sale of Stock - Tax Free BUT!
ForeignCorp.
• Tax-Free Refinancing Distributionsreal estate
32
Options - 3p
N B h P fit TF i • No Branch Profits Tax• Dividend Withholding Tax
ForeignIndividual
• Estate Tax
• Privacy ConcernsU.S. Corp.
• Sale of Stock – Taxable
• Taxable Refinancing Distributionsreal estate
33
Options - 4
IndependentTrustee
ForeignIndividual
Foreign BeneficiariesTrust
U S R l
Beneficiaries
DelawareLLC U.S. Real
EstateLLC
34
Non-Grantor Foreign Trust
The tax consequences that may be anticipated under the foregoing structure are as follows:
• The transfer of cash to the Trust is not subject to U.S. gift tax. • Under U.S. tax law, the Trust will be treated as if it were an individual. It will
be entitled to the benefits of the 15% tax applicable to capital gains the 25%be entitled to the benefits of the 15% tax applicable to capital gains, the 25% tax applicable to depreciation recapture, and 35% tax on operating profits.
• There will be no further tax as funds are distributed to the beneficiaries. • The assets in the Trust should not be subject to U.S. estate tax at the time of
the individual’s demise provided that (i) the individual does not retain the right to the income of the Trust during his lifetime -- although he may receive discretionary distributions along with other beneficiaries, (ii) the Trust is not revocable or amendable by the individual, and (iii) the individual does not
35
retain any dominion or control over the Trust or its assets.
Best Option!?
Foreign Individual • No Branch Profits Tax
No Estate Tax
Foreign Corp.
• No Estate Tax• No Disclosure• Sale of Stock
U S Corp
• Sale of Stock
• Taxable Refinancing DistributionsU.S. Corp.
Real Estate
36
Real Estate
Multiple Properties
FOREIGN INDIVIDUAL
Foreign Corp.
US Corp.
US 1 US 2 US 3
37
US 1 US 2 US 3
Multiple Properties (cont’d)
FOREIGNFOREIGN INDIVIDUAL
Foreign Corp.
US 1 US 2 US 3
38
US 1 US 2 US 3
Traditional Partnership
For. Ind.For. Ind. For. Ind.
L P
For. Corp.
G.P.L.P.
US Corp.
Ltd.PS
L.P.Weigh income tax savings v. Estate T E
39
PSTax Exposure
Tax Planning with Shared Appreciation MortgagesTax Planning with Shared Appreciation Mortgages
40
Tax Planning with Shared Appreciation Mortgages
– Section 897(a) imposes U.S. tax on “gain from the disposition of a US real property interest” recognized by p p p y g ynon-US persons.
– US real property interests include stock (& participating debt) in a U.S. corporation if the FMV of its US real ) pproperty is equal to or greater than 50% its assets.
– Section 1445(a) requires the transferee of a US real property interest to withhold 10% of the proceeds in p p y prespect of the tax due under Section 897.
41
Tax Planning with Shared Appreciation Mortgages
• Therefore, if non-U.S. taxpayers invests directly in U.S. real estate or through entity gain from the disposition of the real property or theor through entity, gain from the disposition of the real property or the interest in the entity would be subject to U.S. federal income tax at graduated rates.
• In addition, if non-U.S. taxpayer invests through foreign corporationIn addition, if non U.S. taxpayer invests through foreign corporation also likely subject to branch profits tax.
• One possible option to avoid FIRPTA is for foreign investor to use shared appreciation mortgage to invest synthetically in U.S. real estate.– Shared appreciation mortgage is loan that provides for interest
that is contingent on the gain from the sale of the property.
42
Tax Planning with Shared Appreciation Mortgages
• Regulation Section 1.897-1(h), Example 2– Foreign corporation makes $1 million loan to domestic
indi id al hich is sec red b mortgage on real propertindividual which is secured by mortgage on real property purchased with loan proceeds.
– Loan agreement entitles lender to fixed monthly payments, constituting repayment of principal plus fixed interest rate.g p y p p p
– Lender also entitled to receive certain percentage of the appreciation in value of real property at the time that the loan is retired.Sh d i ti l t t d U S l t– Shared appreciation loan treated as U.S. real property interest (USRPI), but receipt of final payments do not constitute “disposition” of USRPI for purposes of Section 897.
43
Tax Planning with Shared Appreciation Mortgages
• Example 2 concludes that Section 897 is not triggered on receipt of final loan payment because payment constitutes p p y p yprincipal and interest, not gain for tax purposes.
• Thus, appreciation payment is treated as interest for tax purposes.C t lif f ti f ithh ldi d tf li• Cannot qualify for exemption from withholding under portfolio interest rules because payment is “contingent interest.” Section 871(h)(4).
• However, taxpayer could rely on treaty with zero percentHowever, taxpayer could rely on treaty with zero percent withholding on contingent interest.
44
Portfolio Interest Friendly Structure
FP FP’sBrother
Portfolio Interest Friendly Structure
100%
Brother
100%Option
FC
99% 9%
FC 2
91% V tPortfolio
Option
US
Value Vote 91% Vote1% Value
PortfolioInterest
45
Real Property
Foreign Investment in REITS –gIssues and Planning Opportunities
46
B i f O i f REIT T R lBrief Overview of REIT Tax Rules
• Taxation of ShareholdersNet long term capital gains retain their character when– Net long-term capital gains retain their character when distributed in most cases
– Designation of capital gain dividends– Ordinary income (rents interest etc ) and net short-Ordinary income (rents, interest, etc.) and net short
term gains transformed into dividend income not typically eligible for treatment as qualified dividend income
47
REITs under Section 897REITs under Section 897prior to American Jobs Creation Act of 2004 (“JOBS Act”)
• Any distribution, to extent attributable to gain from a sale or exchange by REIT of a USRPI was typicallysale or exchange by REIT of a USRPI was typically considered a FIRPTA gain to non-U.S. shareholders (“historic” Section 897(h))
G i t d t l t– Gain taxed at regular rates– Tax returns– 35% withholding
B h fit t– Branch profits tax
48
REITs under Section 897REITs under Section 897prior to Jobs Act
• Non-US investor’s sale of stock of a domestically-controlled REIT did not trigger tax or withholdingcontrolled REIT did not trigger tax or withholding under Section 897– A REIT is domestically-controlled if at all times during a
testing period less than 50% in value of the stock was heldtesting period less than 50% in value of the stock was held directly or indirectly by foreign persons.
– The relevant testing period is (generally) the shorter of the five-year period ending on the date of the disposition or of e yea pe od e d g o t e date o t e d spos t o o othe distribution, or the period during which the REIT was in existence.
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REITs - Withholding
• FIRPTA Withholding - Treas. Reg. § 1.1445-835% withholding with respect to capital gain dividends or if larger– 35% withholding with respect to capital gain dividends or, if larger, largest amount that could have been designated as capital gain dividends.
– Catch-up withholding for designations of prior distributions asCatch up withholding for designations of prior distributions as capital gain dividends.
• IRC § 1445(e)(3) – 10% withholding tax on non-dividend distributions by USRPHCs.y
50
REIT T T tiREITs – Tax Treaties
• The 2006 US Model Treaty provides:• The 2006 US Model Treaty provides: – (i) the 5% dividend rate shall not apply in the case of REIT
dividends, – (ii) for a 15% rate on REIT ordinary dividends (0% if paid to a
pension fund) if:pension fund) if: • (a) the beneficial owner of the dividends is an individual or
pension fund, in either case holding an interest of not more than 10% in the REIT;
• (b) the dividends are paid with respect to a class of stock that is• (b) the dividends are paid with respect to a class of stock that is publicly traded and the beneficial owner of the dividends is a person holding an interest of not more than 5% of any class of the REIT's stock; or
• (c) the beneficial owner of the dividends is a person holding an(c) the beneficial owner of the dividends is a person holding an interest of not more than 10% in the REIT and the REIT is diversified.
51
REIT T T tiREITs – Tax Treaties
• Under the 2006 Model Treaty a REIT shall be "diversified" if the• Under the 2006 Model Treaty, a REIT shall be diversified if the value of no single interest in real property exceeds 10% of its total interests in real property. For the purposes of this rule, foreclosure property shall not be considered an interest in real propertyproperty.
• The 2006 US Model Technical Explanation states that distributions of gains “attributable to the alienation of a US real
i ” f REIT ill b di id d b illproperty interest” from a REIT will not be a dividend, but will rather be taxable in US as gain from real property.
52
REITs Tax TreatiesREITs – Tax Treaties• Recent treaties are identical, e.g., Japan and Belgium, or
substantially similar e g UK and new Canadian protocolsubstantially similar, e.g., UK and new Canadian protocol.• No ownership limit for dividend exemption for pension funds in
Canadian and Swiss treaties. Note an 80% of class of shares limit in Dutch treaty MOUlimit in Dutch treaty MOU.
• Explicit statement in protocol to Dutch treaty that pension fund dividend exemption inapplicable to REIT dividends of gains from dispositions of USRPIs.
• Special rule allowing Australia listed property trusts to get 15% rate except to the extent 5% holders would not qualify for 15% rate if they received the REIT dividend directly.
• Older treaties do not distinguish between REIT and C corporation dividends, allowing some foreign investors to get dividend withholding rates below that of the 2006 Model Treaty (for example, treaties with Hungary and Poland provide for withholding rates as low as 5% inHungary and Poland provide for withholding rates as low as 5% in some circumstances for REIT dividends).
53
The “New” Section 897(h)The New Section 897(h) –Foreign Investment in “Qualified Investment Entities”
• Section 897(h)(1), as amended by the JOBS Act (along with subsequent legislation) uses the term “qualified investment entity ” which includes both REITs and RICs (provided the RICentity, which includes both REITs and RICs (provided the RIC is a USRPHC without regard to whether the investments of such RIC are excluded from USRPI status because of the 5% public shareholder exception and/or the “domestically-controlled”shareholder exception and/or the domestically controlled exception).
• RICs which are USRPHCs are generally no longer treated as qualified investment entities after December 31 2007 but willqualified investment entities after December 31, 2007, but will continue to be required to withhold on certain FIRPTA gains passed through to shareholders after such time (i.e., if the RIC were to receive a capital gain distribution from a REIT).p g )
54
Th “N ” S ti 897(h)The “New” Section 897(h) –Foreign Investment in “Qualified Investment Entities”
• Section 897(h) now provides that any distribution by a REIT with respect to any class of stock which is regularly traded on anrespect to any class of stock which is regularly traded on an established securities market located in the U.S. is not treated as gain recognized from the sale or exchange of a USRPI with respect to a shareholder who did not own more than 5% of therespect to a shareholder who did not own more than 5% of the REIT at any time during one year period ending on the date of the distribution.
55
JOBS A t d REIT ( ti d)JOBS Act and REITs (continued)• The JOBS Act also added Section 857(b)(3)(F). This
section provides that a shareholder who gets the “ordinary income” benefits of Section 897(h)(1) as amended with respect to any capital gain dividend shall not include such p y p gdividend in income under Section 897(b)(3)(B) or (D), but rather will include such amounts in gross income as an ordinary REIT dividend. y– Recharacterized capital gain distributions will be taxed under the
ordinary dividend distribution rule, generally 30% withholding tax, subject to reduced rate or exemption under tax treaty or Section 892892.
– The non-U.S. investor who can avail itself of these rules will not have to file a U.S. tax return because of the capital gain distribution, and branch profits tax is no longer applicable to such distribution toand branch profits tax is no longer applicable to such distribution to a non-U.S. corporate investor.
56
Withh ldiWithholding
• As noted previously, to the extent a distribution from a REIT is from gain on the disposition of a USRPIa REIT is from gain on the disposition of a USRPI under Section 897(h)(1), the distributing entity must generally withhold 35% under Section 1445(e)(6). (Prior to TIPRA the obligation of a REIT to withhold(Prior to TIPRA, the obligation of a REIT to withhold 35% on such distributions was embodied solely in the regulations.)
57
C S fDomestically-Controlled REIT Financing Structure forNon-U.S. Investors
Call optionover REIT Non-U.S.
i t
Bank
over REITcommon stock investors
REITShareholders
CaymanSPV
Tax-free
REIT Portfolio InterestLoan
Tax freeinterest
PropertyPortfolio
58
Domestically-Controlled REIT Financing Structure for Non-U.S. Investors
• The structure (comprised of a loan and a call option) is designed to allow to foreign taxpayers to participate in the economicto allow to foreign taxpayers to participate in the economic performance of the shares in a domestically-controlled REIT without triggering U.S. withholding taxes.
• Loan is structured in a manner that results in tax-free interest payments.
• Call option allows the foreign taxpayers to share in appreciation in value of REIT shares without triggering FIRPTA (foreign investment in U S real property tax act) taxinvestment in U.S. real property tax act) tax.– No single call option can give foreign taxpayer the right to acquire 10
percent or more of the REIT’s voting shares.
59
Domestically-Controlled REIT Financing Structure for Non-U.S. Investors
• Assumes REIT is domestically-controlled REIT.This means that less than 50 percent of the value of the– This means that less than 50 percent of the value of the REIT shares are owned “directly or indirectly” by foreign persons during the last 5 years.
– For this purpose, only the actual owners of stock are taken p p , yinto account.
– The actual owners of the REIT shares are the persons that are required “…to include in gross income in his return the di id d i d th t k ”dividends received on the stock.”
– Option holders should not be treated as owners for purposes of determining whether a REIT is domestically-controlled.
60
Alt ti D ti ll C t ll d REIT St t PLR 200923001Alternative Domestically-Controlled REIT Structure - PLR 200923001
Publiclytradedforeign
USRPHCU.S.
C corp
Preferred
100% owner
Foreignpartnership
Common shares
foreigncorp
U.S.C corp
USPRHCU.S.
SingleMember
Preferredshares
U.S.and
foreignC corp
Preferredshares
C corp
Commonshares
Common shares
LLC
U S
foreigninvestors
REITSale of commonshares
U.S.limited
partnership
61
Alternative Domestically-Controlled REIT Structure - PLR 200923001
• All of the REIT’s preferred shares will be owned by U.S. persons and more than 50 percent in the value of the REIT will continue to bemore than 50 percent in the value of the REIT will continue to be owned by U.S. C corporations.
• The issue was whether stock “held directly or indirectly by foreign persons” includes the REIT shares held by the two U S Cpersons includes the REIT shares held by the two U.S. C corporations for purposes of determining whether the REIT is a domestically-controlled REIT.
IRS l d th t “[b] d l l th i f ti d t ti• IRS ruled that “[b]ased solely on the information and representations submitted, and on the facts and circumstances of this case, including the representation that [the two U.S. C corporations] are each fully taxable domestic Subchapter C corporations for U.S. federal income t d t th i REIT RIC h b id tittax purposes and are not otherwise a REIT, RIC, hybrid entity, conduit, disregarded entity, or other flow-through or look-through entity, we conclude that [the two U.S. C corporations] will be considered domestic holders of their respective [REIT shares] for
f d t i i h th [th REIT] i d ti ll
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purposes of determining whether [the REIT] is a domestically controlled QIE within the meaning of Section 897(h)(4)(B).”
TIPRA “Wash Sale” ProvisionTIPRA Wash Sale Provision• Non-US stockholders who wished to avoid having to pay US tax on
capital gain distributions from a REIT would sell shares (avoiding US withholding and income tax because the REIT was domestically-controlled or under the public shareholder exception) prior to such distributions and then re-purchase the shares after the distribution.S ( )( ) f f• Section 897(h)(5) will transform certain of such sales proceeds otherwise exempt from FIRPTA under this strategy into FIRPTA gains. Specifically, amounts received by non-U.S. shareholders on a sale of shares in a REIT will be treated as FIRPTA gains to the extent suchshares in a REIT will be treated as FIRPTA gains to the extent such amounts are equal to distributions constituting FIRPTA gains (e.g., capital gain distributions) which were avoided in a “wash sale” of shares (sixty-one-day period commencing thirty days prior to thatshares (sixty-one-day period commencing thirty days prior to that distribution). – Inapplicable if sales exempt under 5% exception.
Also applies to substitute dividend payments– Also applies to substitute dividend payments. – No withholding obligation for REIT on such transactions.
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A idi FIRPTAAvoiding FIRPTA• Liquidating Distribution Structuring Technique
– In PLR 9016021, a private REIT with non-U.S. shareholders sold assets and distributed the sales proceeds pursuant to plan of liquidation.
– The IRS ruled that these distributions were payments in exchange for the stock under Section 331, as opposed to Section 897(h) distributions attributable to gains from sales of USRPIs. This result obtained notwithstanding the REIT was entitled to a dividends paid deduction for the distributions under Section 561.
– Effect of ruling was to permit shareholders to recover basis.– Taxpayers took the position that liquidating distributions from
domestically - controlled REITs and/or “cleansed” REITs were not taxable under FIRPTA.
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Avoiding FIRPTA
• PLR 200453008 withdrew PLR 9016021 for reconsiderationTh IRS did t li itl t i it ti th t th– The IRS did not explicitly note in its revocation that the holding of PLR 9016021 was incorrect.
– However, the revocation of PLR 9016021 obviously indicates th t th IRS h d b t ti l d bt di it i i lthat the IRS had substantial doubts regarding its original position.
• Current proposals to amend FIRPTA would legislate result of PLR 9016021
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Withholding on Foreign Sovereign FundWithholding on Foreign Sovereign Fund REIT Investments
• Notice 2007-55Notice 2007-55 – In a typical pre-Notice transaction, a foreign governmental investor
(“FGI”) would purchase a non-controlling interest in a private, domestically-controlled REIT. Often, the REIT would be a single y gasset entity.
– The expectation was that the FGI would receive ordinary dividends from the REIT over the course of the remaining life of the REIT (for
l fi t ) S h di id d l l texample, five to seven years). Such dividends are clearly exempt from U.S. withholding and income tax.
– When it came time to liquidate the investment, the REIT would sell its assets and distribute the sales proceeds (and any remainingits assets and distribute the sales proceeds (and any remaining assets) to its shareholders (including FGI) in complete liquidation.
– FGI would then take one or both of the following positions: (i) all distributions from a REIT are exempt from taxation and withholding p gunder Section 892, and/or (ii) Section 897(h)(1) is inapplicable to liquidating distributions.
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Withh ldi F i S i F dWithholding on Foreign Sovereign Fund REIT Investments
• Notice 2007-55 – IRS intends to challenge transactions in which foreign government
treats REIT capital gain distributions as (i) not subject to Sectiontreats REIT capital gain distributions as (i) not subject to Section 897(h)(1), and/or (ii) as exempt from tax under Section 892.
• In Notice 2007-55 the IRS concluded– Foreign government is a person under Treas. Reg. § 1.897-9T(e)Foreign government is a person under Treas. Reg. § 1.897 9T(e)
with respect to USRPIs. – Treas. Reg. §§ 1.897-9T(e) and 1.1445-10T(b) provide that a
foreign government is subject to taxation under both Section 897 S 1 f S “and Section 1445 on the disposition of a USRPI “except to the
extent specifically otherwise provided in the regulations issued under section 892.” Section 892 regulations have no specific exemption for foreign– Section 892 regulations have no specific exemption for foreign governments under Sections 897 or Section 1445.
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Withh ldi F i S i F dWithholding on Foreign Sovereign FundREIT Investments
• In Notice 2007-55 IRS noted that the Section 892 regulations provided:– “Income derived from sources other than described in this
paragraph [§ 1.892-3T(a)(1)] (such as income earned from a U.S. real property interest described in section 897(c)(1)(A)(i)) is not exempt from taxation under Section 892. Furthermore, any gain derived from the disposition of a U.S. real property interest defined in Section 897(c)(1)(A)(i) shall in no event qualify for exemptionin Section 897(c)(1)(A)(i) shall in no event qualify for exemption under Section 892.”
– The IRS believes this language makes it clear that gain from the disposition of a USRPI which is described in Section 897(c)(1)(A)(i) p ( )( )( )( )is not exempt from taxation under Section 892.
• IRS noted that gain derived by a foreign government from the disposition of a USRPHC is exempt under Section 892 provided the USRPHC i t t ll d i l tit d S tiUSRPHC is not a controlled commercial entity under Section 892(a)(2)(B).
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Withh ldi F i S i F dWithholding on Foreign Sovereign FundREIT Investments
• Notice 2007-55– IRS will challenge the assertion by any foreign taxpayer that
Section 897(h)(1) does not apply to distributions in complete ( )( ) pp y pliquidation under Section 331 or Section 332.
– Regulations will clarify that the application of Section 897(h)(1) and withholding under Section 1445(e) is not li it d t S ti 316 di t ib ti b lifi d i t tlimited to Section 316 distributions by qualified investment entities.
– Regulations will clarify that the term “distribution,” as used in Section 897(h)(1) and Section 1445(e)(6) will include anySection 897(h)(1) and Section 1445(e)(6) will include any distribution included under Sections 301, 302, 331, and/or 332, where the distribution is attributable, in whole or in part, to gain from the sale or exchange of a USRPI by a qualified investment entity or other pass-through entity.
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Withh ldi F i S i F dWithholding on Foreign Sovereign Fund REIT Investments
• On November 2, 2011 IRS published proposed regulations (REG-146537-06) on the taxation under section 892.
Address that a single act of selling a passive investment in U S real– Address that a single act of selling a passive investment in U.S. real estate, although fully taxable, could also cause a controlled entity to lose its tax exemption on all other U.S. source income if section 897 were interpreted to treat the sale of U S real estate as a897 were interpreted to treat the sale of U.S. real estate as a commercial activity.
– Provide that a disposition, including a deemed disposition under section 897(h)(1) of a USRPI does not by itself constitute thesection 897(h)(1), of a USRPI does not by itself constitute the conduct of a commercial activity. No modification made to the rule that the income derived from the disposition of a USRPI (other than an interest in a U.S. real property holding company) continues to be p p y g p y)ineligible for an exemption from tax under section 892.
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Applications of Section 1031Applications of Section 1031
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Section 1031(a)Section 1031(a)
•“No gain or loss shall be recognized on the exchange• No gain or loss shall be recognized on the exchange of property held for productive use in trade or business or for investment if such property is exchanged solely for property of like- kind which is to be held either for productive use in trade or business or for investment”
–Mandatory applicationMandatory application–Not limited by taxpayer type
•Section 1031(a)(2) excludes most entity interests and fi i l i t t iti f d f lfinancial instrument positions from deferral
–DRE’s are excepted
•Section 1031(a)(3) sanctions deferred exchanges
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Section 1031(a)(3) sanctions deferred exchanges
Like-Kind
• Most Fee Interests in Real Estate are Like Kind to h theach other:
– IMPROVED TO UNIMPROVED OK– RESIDENTIAL TO COMMERCIAL OK
• Leases of 30+ years are Like Kind to Fee Interests
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Section 1031(h)
• U.S. real estate not like kind to non-U.S. real estate– Therefore, cannot escape U.S. taxation by exiting through
exchange
• Foreign for Foreign is still allowed– Would be relevant only for U.S. taxpayer
• Personal Property used outside U.S. isn’t like kind to personal property used in U S with “use” defined bypersonal property used in U.S. with use defined by reference to periods 2 years before (for relinquished asset) AND 2 years after exchange (for replacement
t)asset)
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Pl i P i i lPlanning Principles Using Like-Kind Exchanges
• Since almost all real estate types are like-kind, shifting from FIRPTA unfriendly to FIRPTA friendly assets can be accomplished tax freeaccomplished tax free– Low leverage, high income to high leverage, low income
• For highly appreciated residential property where gain g y pp p p y gexceeds Section 121 exclusion, conversion to rental can allow deferral on sale through exchange
• Since stock sales may be free of tax find stock buyer• Since stock sales may be free of tax, find stock buyer willing to acquire stock, sell assets and defer tax on corporate level built in gain through like-kind exchange– But see Dulles World Properties, Tax Court Docket __________
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QUESTIONS?Q
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This presentation contains general information only and the presenters are not, by means of this presentation rendering legal tax accountingpresentation, rendering legal, tax, accounting, business, financial, investment, or other professional advice or services. This presentation is not a
b tit t f h f i l d i isubstitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making y y gany decision or taking any action that may affect your business, you should consult a qualified professional advisor Neither the presenters nor the firms withadvisor. Neither the presenters nor the firms with which they are affiliated shall be responsible for any loss sustained by any person who relies on this
t tipresentation.
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