On April 10, 2013, the Obama Administration released the General Explanations of the Administration's Fiscal Year 2014 Revenue Proposals, commonly known as the "Green Book," including various proposals relating to taxation. One such proposal would facilitate investment by foreign pension funds in U.S. real property by exempting such funds from the Foreign Investment in Real Property Tax Act ("FIRPTA"). The alert below discusses the proposal and the positive impact the proposal could have for foreign pension funds and the real estate industry if enacted.
FIRPTA subjects nonresident alien individuals and foreign corporations to U.S. federal income tax on gains from the sale of U.S. real property interests ("USRPIs"), including stock in corporations that predominantly hold U.S. real property. FIRPTA therefore generally subjects foreign investors to the same tax treatment on gains from the disposition of USRPIs that applies to U.S. investors. However, because U.S. pension funds are exempt from U.S. federal income tax (with certain exceptions), application of FIRPTA to foreign pension funds results in disparate tax treatment of U.S. and foreign pension funds.
Foreign pension funds can mitigate some of the tax liability generated under FIRPTA by holding USRPIs through corporate entities capitalized with both debt and equity ("Blockers"). Deductions for interest payments made to the foreign pension fund can offset some portion of the gain of the Blocker from the disposition of a USRPI. However, the effectiveness of such structures is limited by the earnings stripping rules, withholding on interest payments, and other provisions in the Internal Revenue Code and Treasury Regulations.
Proposal's Requirements for Exemption
The Green Book proposal specifies that a foreign pension fund would qualify for exemption only if (1) it is a trust, corporation or other organization or arrangement that is created or organized outside of the United States, (2) it is generally exempt from income tax in the jurisdiction in which it is created or organized, and (3) substantially all of its activity is to administer or provide pension or retirement benefits. Treasury Regulations would be authorized to define the contours of and qualification for the exemption. The proposal does not include details on the treatment of rental or similar income generated by USRPIs.
Consequences of the Proposal
The Green Book proposal to exempt foreign pension funds from FIRPTA would be a boon to both foreign pension funds, which would benefit from the tax savings, and the real estate industry, as more investor capital would be made available for investment. Foreign pension funds' investment in real estate would be further facilitated by simplifying the structure required for optimal tax efficiency, permitting such funds to hold USRPIs directly without incurring tax on gains when the USRPIs are sold. The proposal would also eliminate the burden of withholding imposed on purchasers in transactions with foreign pension fund sellers.
Although statutory language has not been released, we would logically expect that the proposal would also amend FIRPTA to exempt any capital gains dividends and liquidating distributions from REITs from the FIRPTA regime, reversing for foreign pension funds the position announced by the IRS in Notice 2007-55.
An exemption for foreign pension funds raises the question of whether the exemption should be extended to other similar foreign investors, including sovereign wealth funds of foreign governments. Expanding the exemption to include sovereign wealth funds would equalize the treatment of foreign governments and state governments, since state government investors are entitled to complete exemption from U.S. tax, and would further increase the flow of capital into U.S. real property, including infrastructure investments.