On December 18, 2015, President Obama signed into law H.R. 2029, which contains a new exemption from U.S. tax on gain from the sale of U.S. real estate for non-U.S. pension plans. The new exemption is effective immediately.
Prior to the enactment of this provision, non-U.S. persons, including Canadian pension plans, were taxed on the sale of U.S. real estate or on the sale of stock of U.S. corporations treated as “U.S. real property holding companies” under U.S. FIRPTA (Foreign Investment in Real Property Tax Act) rules. Under Section 892 of the U.S. Internal Revenue Code, certain pension arrangements benefitting foreign governmental employees (as opposed to private sector pension plans) are eligible for an exemption from FIRPTA taxation, but only on the sale of minority interests in U.S. real property holding companies. If the non-U.S. pension plan was taxed on real estate dispositions, it was taxed at rates applicable to U.S. persons and the plan generally had to file a U.S. tax return.
The new provision provides a broad exemption from FIRPTA for “qualified foreign pension funds” or “any entity all of the interests of which are held by a qualified foreign pension fund.” This exemption applies to FIRPTA tax on the sale of interests in U.S. real estate or stock in U.S. real property holding companies, including the sale of such assets held indirectly through one or more partnerships. The exception also exempts qualified foreign pension funds from U.S. tax on distributions received from a U.S. real estate investment trust (REIT). Non-U.S. persons other than qualified foreign pension funds generally continue to be subject to U.S. tax on such sales or distributions.
Importantly, this exemption from FIRPTA (unlike the more limited Section 892 exemption) is not limited to foreign governmental pension plans but also applies more broadly to private pension plans, so long as they satisfy the requirements of being a qualified foreign pension fund. Under the new legislation, a qualified foreign pension fund is defined as “any trust, corporation, or other organization or arrangement
- which is created or organized under the law of a country other than the United States,
- which is established to provide retirement or pension benefits to participants or beneficiaries that are current or former employees (or persons designated by such employees) of one or more employers in consideration for services rendered,
- which does not have a single participant or beneficiary with a right to more than five percent of its assets or income,
- which 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, (a) contributions to such trust, corporation, organization or arrangement which would otherwise be subject to tax under such laws are deductible or excluded from gross income of such entity or taxed at a reduced rate, or (b) taxation of any investment income of such trust, corporation, organization or arrangement is deferred or such income is taxed at a reduced rate.”
Many common pension arrangements established in Canada for employees would appear to meet this test. However, a number of questions exist, including whether certain pension funds, which may not be required to provide annual information reporting to the Canada Revenue Agency or a comparable provincial authority, will be eligible for the exemption.
In addition, the legislative language is unclear as to whether the exemption is limited to indirect ownership through a single subsidiary and/or through tiers of partnerships or, alternatively, whether the exemption encompasses a broader range of indirect ownership arrangements. Accordingly, Canadian pension funds who hold U.S. real estate assets indirectly should carefully review each intermediary in the chain of ownership to determine whether they are positioned to claim the benefits of this new provision. It should be noted that the IRS is granted authority under this legislation to issue regulations to carry out the purposes of this provision so it is possible that future regulations may clarify which forms of indirect ownership are eligible for this new statutory exemption.
Implications for Canadian Pension Plans
Despite some of these potential sources of ambiguity, the legislation is a very welcome development and is expected to provide a powerful incentive for non-U.S. pension funds to increase the amount of capital devoted to U.S. real estate and infrastructure investments. As noted above, Canadian private and governmental pension plans currently invested in, or considering investments in, U.S. real estate should consider whether existing or proposed structures to hold the U.S. real estate investments should be re-engineered to adapt to the new exemption. For example, if such plans are investing in real estate funds that have established “blocker entities” for non-U.S. investors (to trap taxable real estate gain in the blocker) those structures may now be less efficient for qualifying Canadian pension plans. In these cases, a restructuring may enhance the investors’ after-tax return. Similarly, Canadian governmental investors, who were constrained to comply with the often ambiguous requirements of section 892 to obtain the benefit of the section 892 exemption on the sale of stock of minority investments in U.S. real estate holding companies, may no longer be required to satisfy those tests. These investors may wish to restructure into simpler structures that are less costly to maintain.
Further, Canadian pension plans qualifying under the new exception will be able to invest in private U.S. REITs even if such REITs are not “domestically-controlled REITs” (DCRs). Under existing law, interests in DCRs are not treated as U.S. real estate interests, and so gain on a sale of stock of such REITs is not taxed to Canadian pension plans. Under the new exception, even if the REIT is not a DCR, gain on a sale of REIT shares will not be taxed.
Finally, although the new provision exempts gain on the sale of U.S. real estate from FIRPTA taxation, it does not provide eligible investors with a full exemption from all potential U.S. federal income taxes that may arise in connection with their investment in U.S. real estate. For example, qualified foreign pension plans generally will continue to be subject to U.S. withholding tax on rental income earned from U.S. real estate and, in the case of U.S. real property held (directly or indirectly through partnerships) in connection with U.S. trade business activities, operating income earned from (as well as gain from the proceeds of disposition of) such U.S. real property, will continue to be subject to the U.S. effectively connected income rules.