United States tax law requires that all persons, whether foreign or domestic, must pay income tax on dispositions of interests in US real estate (US real property interests). Domestic persons are subject to this tax as part of their regular income tax.
Foreign persons and entities are taxed only on certain items of income, which do not include most capital gains. The US Internal Revenue Code treats the gain on a disposition of an interest in US real property effectively as income subject to regular federal income tax. To ensure tax collection from foreign taxpayers, the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA ) requires buyers of US real property interests to withhold 10 per cent of the sales price. The seller may apply to the Internal Revenue Service (IRS) to reduce this 10 per cent to the amount of tax estimated to be due. FIRPTA applies in virtually all cases where a foreign owner of a US real property interest disposes of that interest.
In contrast, other types of foreign investment, such as corporate stock, are not subject to US tax on the gain made.
As a result, FIRPTA discriminates against foreign investment in real property, and clearly has had a chilling effect on foreign investment in US real estate and infrastructure.
Special rules already apply where a foreigner hold interests in US real property through real estate investment trusts, or REITs. If the REIT is domestically controlled, meaning less than 50 per cent then a foreigner can sell his shares in the REIT without being subject to tax under FIRPTA , even if the REIT’s assets consist entirely of US real estate. However, the REIT must generally withhold 35 per cent of cash distributions to foreigners to the extent those distributions are attributable to sales of US real property, but no withholding is required on distributions to foreign shareholders in publicly traded REITs who own no more than 5 per cent of the REIT shares.
A Senate report has been released which could give an impetus to the enactment of reforms to FIRPTA reforms. The Senate Finance Committee has released reports from its bipartisan working groups on tax reform, including a report from the International Tax Reform Working Group, co-chaired by Senators Rob Portman (a Republican Senator from the state of Ohio) and Charles Schumer (a Democrat Senator from the state of New York).
The bipartisan report recommends an international tax reform plan and a deemed repatriation proposal which would include revenue for a long-term extension of the highway trust fund, a federal fund devoted to road construction, finance for mass transit and remediation of leaking underground storage tanks. The proposal to use international tax reform as a source of funding transportation infrastructure investment has attracted bipartisan support in both the House of Representatives and the Senate, and could result in the enactment of tax legislation this year. Paul Ryan, Chairman of the House Ways and Means Committee, which makes recommendations to the House on all bills for raising revenue, welcomed the Senate report, and said he would act on the international tax reform legislation later this year.
The Senate working group report also included recommendations in support of FIRPTA reforms. According to the report, the working group believes that FIRPTA discourages foreign capital from flowing into much needed infrastructure investments in the US. The co-chairs thus agreed that two specific FIRPTA reforms “should be included in any international tax reform package.”
These two reforms would:
- increase the ownership stake an individual foreign investor can take in a US publicly traded REIT without triggering FIRPTA liability from 5 per cent to 10 per cent; and
- exempt foreign pension funds from the restrictions imposed by FIRPTA .
Congressional tax writers in any event will be giving serious consideration in the second half of the year to an international tax reform package which would fund a long-term extension of the highway trust fund. The FIRPTA reform provisions could be included.
President Obama supports exempting foreign pension funds from FIRPTA, and has included this proposal in his plan to encourage increased investment in America’s infrastructure. The President has said that “foreign investors including large foreign pension funds regularly cite FIRPTA as an impediment to their investment in US infrastructure and real estate assets. With US pension funds generally exempt from US tax upon the disposition of US real property investments, the Administration proposes to put foreign pension funds on an approximately equal footing”.