The Protecting Americans from Tax Hikes Act of 2015 (the PATH Act), which was signed into law on December 18, 2015 (the Enactment Date), contains a number of provisions modifying (i) the application of Section 897 (FIRPTA) of the Internal Revenue Code of 1986, as amended (the Code) and (ii) certain tax rules governing Real Estate Investment Trusts (REITs). These provisions are of particular relevance to non-US and other investors in US real estate. Most of the provisions, such as the exemption from tax under FIRPTA for certain non-US pension funds, are taxpayer-friendly; however, some, such as the restriction on REIT spinoffs, are not. The following is a brief summary of a number of the key provisions.
Non-US investors (excluding US citizens and US permanent residents living abroad) generally are not subject to US federal income tax on their US-source capital gains unless any such gain is effectively connected with a US trade or business (ECI) or, if the investor is an individual, such individual has a “substantial presence” (based on day count) in the United States. Notwithstanding this general rule, FIRPTA generally treats gain from the disposition of a “US Real Property Interest” (USRPI) by a non-US investor as ECI, subject to US federal income tax and FIRPTA withholding. In addition, FIRPTA generally treats a distribution from a REIT to a non-US investor as ECI to the extent the distribution is attributable to gain from sales or exchanges by the REIT of a USRPI. The FIRPTA rules are subject to a number of exceptions, certain of which are modified by the enactment of the PATH Act.
Publicly Traded REIT Ownership
Under FIRPTA, the stock in a US corporation that is a so-called “US Real Property Holding Corporation” (USRPHC) (generally, a corporation the preponderance of the assets of which consist of USRPIs) is treated as a USRPI. Investors that do not actually or constructively own more than five percent of certain stock of a publicly traded USRPHC during a specified testing period, however, were not treated as owning a USRPI for purposes of FIRPTA under prior law. The PATH Act increases this limit from five percent to 10 percent with respect to publicly traded REITs, while retaining the five percent limit for other publicly traded USRPHCs.
Additionally, the PATH Act provides an exemption from FIRPTA for certain non-US publicly traded entities resident in US tax treaty jurisdictions (Qualified Shareholders) with respect to both gain from the sale of stock in a REIT and distributions from a REIT attributable to gain from sales or exchanges of a USRPI. This exemption does not apply, however, to the extent that (i) an investor in the Qualified Shareholder is not itself a Qualified Shareholder and (ii) such investor directly or indirectly owns more than 10 percent of the stock in the underlying REIT.
Both of these changes take effect on the Enactment Date and apply to any disposition on and after the Enactment Date and any distribution by a REIT on or after the Enactment Date that is treated as a deduction for a taxable year of such REIT ending after such date.
FIRPTA Exemption for Non-US Pension Funds
The PATH Act provides a new exemption from FIRPTA for certain non-US retirement or pension funds (Qualified Foreign Pension Funds) and for any entity, all of the interests of which are held by a Qualified Foreign Pension Fund. A Qualified Foreign Pension Fund is any trust, corporation, or other organization or arrangement that:
- is created or organized under the law of a country other than the United States;
- is established to provide retirement or pension benefits to participants or beneficiaries that are current or former employees;
- does not have a single participant or beneficiary with a right to more than five percent of its assets or income;
- 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,
- with respect to which, under the laws of the country in which it is established or operates, either (a) contributions to it that would otherwise be subject to tax are deductible or excluded from the gross income of such entity or taxed at a reduced rate, or (b) taxation of any of its investment income is deferred or such income is taxed at a reduced rate.
This exemption is intended to provide consistent treatment for non-US pension funds and US pension funds, the latter of which generally are exempt from US federal income tax. Notably, the PATH Act did not extend this favorable treatment either to non-US insurance companies or to non-US sovereign wealth funds, although each such category of investor is, like non-US pension funds, an important source of capital flowing into the US real estate market. Moreover, the extent to which the new exemption applies to certain non-US governmental pension plans and other retirement arrangements benefitting non-US government employees is unclear.
The exemption for non-US pension funds applies to dispositions and distributions after the Enactment Date.
Determination of Domestic Control
Under previous law, gain from the sale of stock of a REIT (and, prior to 2015, of certain Regulated Investment Companies (RICs)) generally was not subject to tax under FIRPTA if less than 50 percent of the value of the entity’s stock was held directly or indirectly by non-US persons during a specified testing period. The PATH Act permanently restores this rule for certain RICs retroactively to January 1, 2015.
Furthermore, for purposes of determining whether a stockholder of any class of stock that is regularly traded on an established US securities market is a US or non-US person, the PATH Act provides that a person holding less than five percent of such class is treated as a US person unless the REIT or RIC has actual knowledge that such person is not a US person. The PATH Act also contains rules for determining whether stock in lower-tier REITs (and certain RICs) owned by upper-tier REITs (and certain RICs) should be treated as owned by a US or non-US person. These changes take effect on the Enactment Date and will make it easier for non-US investors to take advantage of the favorable rules applicable to sales of stock in domestically controlled REITs (and RICs).
USRPHC Cleansing Rule with Respect to Qualified Investment Entities
Under previous law, stock of a USRPHC would cease to be a USRPI if the USRPHC did not hold any USRPIs as of the date of a disposition of the USRPHC’s stock, and all of the USRPIs previously held by such USRPHC at any time during the shorter of (i) the period of time that the selling shareholder held the USRPHC Stock or (ii) the five-year period ending on the date of the disposition, were disposed of in a transaction in which the full amount of gain (if any) was recognized (or such USRPIs ceased to be USRPIs under this rule). The PATH Act adds a requirement that neither the USRPHC nor any predecessor of the USRPHC has been a RIC or a REIT at any time during the applicable holding period. This additional requirement applies to dispositions made on or after the Enactment Date.
Increased Rate of FIRPTA Withholding
Dispositions of USRPIs by non-US persons generally are subject to US withholding tax. The PATH Act increases this withholding tax rate from 10 percent to 15 percent. However, dispositions are eligible for a 10 percent withholding tax rate where (i) the amount realized for such property does not exceed $1million and (ii) the property is acquired for use by the transferee as a residence. This withholding tax rate increase applies to dispositions of USRPIs beginning 60 days after the Enactment Date.
Please note that amounts withheld under this rule generally are available, as under prior law, to offset the non-US person’s US federal income tax liability on gain from the disposition of the USRPI and are eligible for refund to the extent that the amount withheld exceeds such underlying tax liability. As such, the increased withholding tax rate is a measure merely aimed at encouraging compliance with US federal income tax rules and does not represent an actual tax increase.
In general, a corporation may make a tax-free distribution to its shareholders of stock of a controlled corporation pursuant to Section 355 of the Code, provided that certain requirements are satisfied. Under the PATH Act, such tax-free treatment generally does not apply if either the distributing corporation or controlled corporation is a REIT. However, a distribution may qualify as tax-free if either: (i) both the distributing corporation and controlled corporation are REITs immediately after the distribution or (ii) at all times during the three-year period ending on the date of the distribution, the distributing corporation was a REIT, the controlled corporation was a taxable REIT subsidiary (TRS), and the distributing corporation had direct or indirect control of the controlled corporation under Section 368(c) of the Code. Finally, under the PATH Act, neither a distributing nor a controlled corporation that was not previously a REIT will be eligible to make an election to be treated as a REIT for 10 years following a tax-free spinoff.
This provision was aimed at a number of specific transactions in which corporations that did not qualify as REITs, but owned significant real estate, sought to spin off their real estate assets and benefit from the REIT rules with respect thereto on a going-forward basis.
The foregoing provisions under the PATH Act are effective for distributions on or after December 7, 2015. However, under a special grandfathering rule granting relief to taxpayers who already planned on such transactions, these provisions do not apply to any distributions pursuant to a transaction described in a ruling request initially submitted to the IRS on or before December 7, 2015, provided that the request has not been withdrawn and with respect to which a ruling has not been issued or denied in its entirety as of such date.
Other REIT Provisions
In addition to the rules pertaining to the treatment of REITs under FIRPTA and the restriction on REIT spinoffs, the PATH Act contains a number of highly technical and nuanced REIT-related provisions, an in-depth discussion of which is beyond the scope of this update. These provisions include:
- the permanent reduction of the recognition period for the corporate-level tax imposed on a REIT’s built-in gains to five years (effective for tax years beginning in 2015);
- the reduction in the percentage of total assets that a REIT can hold in securities of TRSs from 25 percent to 20 percent (effective for tax years beginning in 2018);
- the expansion of permissible services in which a TRS may engage (effective for tax years beginning in 2016);
- the repeal of the so-called “preferential dividend rule” for publicly offered REITs (effective for tax years beginning in 2015);
- the expansion of the definition of the term “real estate assets” for purposes of the REIT rules to encompass assets such as certain debt instruments issued by publicly offered REITs and certain personal property leased in connection with real property (effective for tax years beginning in 2016); and,
- the inclusion of gain from the sale or other disposition of a non-mortgage debt instrument issued by a publicly offered REIT as qualifying income for purposes of the 95 percent income test (but not for the 75 percent income test) (effective for tax years beginning in 2016).
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The PATH Act changes to FIRPTA, including with respect to REITs, contain a number of investor-friendly provisions that have appeared in various bills over the past several years but were not previously thought ever to see the light of day. As such, the PATH Act is of great, positive, significance to non-US investors in the US real estate market. Certain of such investors may want to consider restructuring how they hold their investments so as to enable them to take better advantage of the revised rules.