The Protecting Americans from Tax Hikes Act of 2015 (the “PATH Act”), signed into law on December 18, 2015, has resulted in a number of changes to the taxation of investments in U.S. real property by foreign investors. Among the most significant of such changes, the PATH Act increased the U.S. federal withholding tax rate on dispositions of U.S. real property interests, introduced a new exemption for foreign pension funds, expanded the publicly-traded exemption for public Real Estate Investment Trusts ("REITs") and created a favorable presumption rule for determining the domestically-controlled status of public REITs. The PATH Act also effectively put an end to tax-free REIT spinoffs, which had become a popular transaction for public companies with significant real estate assets.
The Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) subjects foreign investors to U.S. federal income tax on the sale of U.S. real property interests ("USRPIs"). Under FIRPTA, foreign investors are generally subject to tax on gain from the sale of either a direct interest in U.S. real property or an indirect interest in USRPIs, such as the sale of stock of a U.S. corporation that is a U.S. real property holding company (“USRPHC”), the sale of an interest in a partnership that holds USRPIs, or the sale of a USRPI by a domestic partnership in which the foreign investor is a partner.
A domestic corporation is a USRPHC if 50% or more of the value of its business assets is attributable to USRPIs. Gain from the sale of stock in REITs is also generally subject to FIRPTA, but only if the REIT is a USRPHC (and therefore stock in a mortgage REIT is generally exempt from FIRPTA). Under a special look-through rule, capital gain distributions from REITs attributable to gain from the sale of USRPIs are also subject to U.S. federal income tax.1
Foreign corporations are generally subject to federal income tax at a rate of 35% on all gain from USRPIs, regardless of the character or holding period, and an additional branch profits tax of 30% (subject to reduction under certain U.S. tax treaties, and not applicable to the sale of stock of a USRPHC) on any net after-tax gain. Non-corporate foreign investors are not subject to branch profits tax and may qualify for the preferential rate for long-term capital gain if the USRPI is a capital asset with a holding period of one year or longer.
To enforce this taxation of foreign investors, FIRPTA imposes a withholding tax on the gross proceeds from the sale of USRPIs (increased from 10% to 15% under the PATH Act, as discussed below). In the case of a foreign investor in a domestic partnership that sells a USRPI, the partnership must generally withhold tax on the amount of gain from the sale at a rate of 35% (rather than 15% of gross proceeds). In each case, the foreign investor is required to file a U.S. federal income tax return and either claim a refund if the amount withheld was greater than the tax due, or pay additional tax if the amount withheld was less than the tax due.
After the PATH Act
The PATH Act increases the federal withholding tax rate for sales of USRPIs by foreign investors from 10% to 15%, effective for sales and dispositions taking place after February 16, 2016. Final and temporary regulations implementing the new withholding rules were published by the IRS on February 19, 2016. However, the PATH Act also expanded certain pre-existing exemptions and created new exemptions to the taxation of foreign investors on sales and disposition of USRPIs.
Exemption for Certain Foreign Pension Funds
Before the PATH Act, foreign pension funds were generally subject to federal income tax on gain from the sale of USRPIs, even if they qualified for benefits under a U.S. tax treaty. As a result of the PATH Act, effective for sales and dispositions taking place after December 18, 2015, qualified foreign pension funds and entities wholly owned by such funds are generally exempt from FIRPTA tax, including gain from the direct sale of USRPIs, indirect gain from the sale of stock of a USRPHC or from the disposition of USRPIs through one or more partnerships, and capital gain distributions from a REIT that are attributable to USRPIs.2 For these purposes, a qualified foreign pension fund is generally defined as an entity that is established under foreign law to provide retirement or pension benefits, does not have a single beneficiary with a right to more than 5% of its assets or income, is subject to regulation and annual reporting in its home jurisdiction, and enjoys a tax advantage in its home jurisdiction either because contributions to the entity are deductible or taxation on the entity’s income is deferred or taxed at a lower rate.
The PATH Act opens up significant planning opportunities for foreign pension funds to reduce or even eliminate U.S. federal tax on gain attributable to direct and indirect interests in U.S. real estate (but does not alter the general rules applicable to U.S. federal taxation of foreign pensions funds’ income from U.S. sources and operations). Therefore, the PATH Act should encourage foreign pension funds to form private investment funds to invest in U.S. real estate as well as to invest in private and public REITs and other U.S. real estate investment vehicles.
Expansion of Exemption for Public REITs
Before the PATH Act, gain from the sale of stock of publicly traded USRPHCs and partnership interests in publicly-traded partnerships was exempt from FIRPTA if the holder owned 5% or less of the publicly traded stock of the USRPHC (including REITs and RICs) or partnership interests in the publicly-traded partnership. The same exemption applied for capital gain distributions to 5% or less holders of publicly-traded REITs and RICs. (For these purposes, ownership includes both direct and constructive ownership.) Under the PATH Act, the ownership limitation has been increased from 5% to 10%, but only for publicly-traded REITs and capital gain distributions of publicly-traded REITs, effective for sales and distributions on or after December 18, 2015.
New Presumption Rule for Domestically Controlled Public REITs
Under FIRPTA, a foreign investor was generally exempt from U.S. federal income tax on the gain from the sale of stock in “domestically controlled” REITs. A REIT is domestically controlled if 50% or more in the value of the REIT is held by U.S. persons. Under the PATH Act, a holder that holds less than 5% of the stock of a publicly traded REIT for the entire testing period will generally be presumed to be a U.S. person, unless the REIT has actual knowledge the holder is not a U.S. person. However, this presumption rule does not apply to holders that are REITs or RICs, which are instead subject to a modified look-through rule. This provision took effect December 18, 2015 and will significantly facilitate the determination of the domestically controlled status of public REITs, and exemption from FIRPTA for their shareholders.
New REIT Exemption for Certain Qualified Collective Investment Vehicles
Under the PATH Act, gain from the sale of stock in REITs and capital gain distributions from REITs are not subject to tax as gain from the sale of an USRPI for certain “qualified shareholders”, effective for sales and distributions on or after December 18, 2015. A qualified shareholder is a certain type of “qualified collective investment vehicle,” which is a foreign publicly-traded entity that, in addition to certain other qualifications, either qualifies for treaty benefits under an applicable U.S. tax treaty, or is a publicly traded foreign partnership on the New York Stock Exchange or Nasdaq stock market.
Restriction on REIT Spinoffs
In recent years, several public companies with significant real estate holdings have implemented tax-free spin-offs combined with an immediate REIT election for the property-holding corporation, which typically leases the property back to the operating company. Motivated by a concern that this type of transaction allows built-in gain in real estate to permanently avoid corporate-level tax, the PATH Act disqualifies spin-offs for tax-free treatment if either the distributing corporation or the distributed corporation is a REIT. Moreover, neither the distributing corporation nor the distributed corporation may make a REIT election for 10 years following a tax-free spin-off. This provision is effective for all spin-offs taking place on or after December 7, 2015.
More to Come
Future regulations are expected from the Treasury to provide additional guidance on several of these provisions, including the new exemption from FIRPTA for foreign pension funds.