It is common knowledge that foreign investors who invest in U.S. publicly traded equities are exempt from tax on their capital gains. This is because the United States, like most industrialized nations, does not generally extend its taxing power to capital gains realized by foreign investors, in order to encourage investment in domestic markets. As with most bits of common knowledge, however, this rule is not absolute and in certain cases foreign investors can become subject to U.S. tax on their capital gains; even capital gains realized on the sale of publicly traded stock. When this occurs, it often comes as a rude shock to the foreign investors and to the investment managers of the funds in which the foreign persons invest. Managers of activist funds that have foreign investors should understand how and when an investment in U.S. equities can turn taxable in order to avoid, plan for or minimize the damage. This article provides an overview of this area so that fund managers will not be caught unaware.

The most common reason that U.S. stocks can become taxable in the hands of foreign persons is the application of a 1980 statute known by its acronym, FIRPTA, referring to the Foreign Investment in Real Property Tax Act, which was enacted by a xenophobic Congress in 1980 when foreign investment in U.S. real estate was reaching record levels. In a protectionist move, Congress decided to eliminate the perceived tax advantage that foreign investors had over U.S. investors, specifi cally their ability to outbid U.S. investors because the foreigners did not have to include taxes in their pricing assumptions. FIRPTA makes gains realized from investments in U.S. real property taxable in foreign investors’ hands. In order to squelch the ability of foreigners to package U.S. real property into corporations and then merely buy and sell the stock of the property-holding companies, FIRPTA has a lookthru rule that extends its scope to dealings in the stock of companies where at least half of the fair market value of the company’s trade or business assets is attributable to U.S. real property assets. Companies that meet this fair market value test are called, in FIRPTA nomenclature, U.S. Real Property Holding Corporations (“USRPHCs”). In an effort to not disrupt the operation of U.S. stock exchanges, a carve-out from the application of FIRPTA was provided for investments in publicly traded stocks where the investor does not hold more than 5% of the class of stock being traded. Ownership of more than 5% of a class of publicly traded stock is the FIRPTA trap. Once foreign investors cross this 5% ownership threshold, their entire investment (not just the amount over 5%) becomes fully taxable. What is worse, even if their position is subsequently reduced below 5%, the FIRPTA taint — and the corresponding taxability of the gain — remains in place for gains realized during the next fi ve years.

Before delving into the technical rules in the FIRPTA statutes, it is worth pointing out how this FIRPTA trap arises in common situations. If an activist fund manager were to invest in a pure-play real estate company, it should not be surprised to learn that FIRPTA would apply. However, in many cases where the real estate is not the primary value driver for the company, FIRPTA can apply as well. A few examples may help to illustrate:

  • Investment in a distressed restaurant chain. Due to the distressed nature of the business, goodwill may be nonexistent or at a historically low value and the portfolio of owned and leased locations may be at least half of the company’s asset value.
  • Investment in auto parts manufacturer. In the current environment for auto-related manufacturing, another distressed-company play, because the test focuses on the fair market value of the assets rather than their book or tax basis values, the fair market value of factories, warehouses, and other facilities may exceed the value of the other assets of the company.
  • Investment in a hotel, retail, prison or similar facility operator. Despite the fact that these are operating businesses and that investor valuations may be determined on a multiple of earnings or cash fl ow, when the FIRPTA test is applied it may be that the fair market value of the real estate emerges as a signifi cant component of value. In addition, personal property associated with operations can be treated for FIRPTA purposes as real property in certain cases (e.g., in the case of a hotel, beds, furniture, televisions, telephone systems, laundry equipment and lobby furnishings can all be treated as real estate assets for purposes of applying the test).
  • Investment in an owner/operator of cell towers: In general, these companies merely lease space and own transmission and related equipment. Nonetheless, the FIRPTA regulations require that the value of personal property associated with the use of real estate must be included in the determination of real estate values. This rule may mean that cell tower operating companies will have almost all of their asset value as real estate for FIRPTA-testing purposes.

Even if the target company passes the FIRPTA test at the time of investment, consideration should be given as to how the company will fare under the test over time. Spinoffs or other dispositions of unwanted or non-core assets could cause a company to become a USRPHC in the future, thereby creating taxability to foreign investors just at the time when the activist business plan is beginning to bear fruit. Once a corporation becomes a USRPHC, it will retain that status for fi ve years, even if the value of its U.S. real property assets declines to less than 50%. This rule creates a common problem for start-up or other early-stage companies where, for example, a biotech lab may constitute the majority of a company’s assets prior to its development of products, patents, goodwill or other intangible assets of value.

The technical rules and regulations implementing FIRPTA are numerous: 12 pages of statutes and almost 150 pages of regulations. The goal of this article will be to highlight only the most critical rules generally applicable to activist investors in order to permit such investors to recognize the risk of FIRPTA’s application. For particular investments, seeking the advice of a tax lawyer (at Schulte Roth & Zabel, preferably) is highly advisable.

The 5% Exception for Publicly Traded Stock

A class of publicly traded stock only becomes stock of a USRPHC (and, therefore, subject to FIRPTA) when a foreign person owns more than 5% of that class of stock at any time during the fi ve years prior to the date of disposition of the stock. Publicly traded stock is defi ned as stock of a corporation that is regularly traded on an established securities market. An established securities market includes any over-the-counter market where an interdealer quotation system regularly disseminates quotations by multiple brokers or dealers. Activist players in the distressed and bankruptcy markets should note that if the stock of the target becomes de-listed, the publicly traded stock exception could evaporate and even a position of less than 5% could become subject to FIRPTA. Similarly, a suspension of the trading in stock of a company for failure to fi le its fi nancials and annual reports may, if the suspension is for a meaningful amount of time, cause the stock to no longer be treated as “regularly” traded and the exception could be lost.

Constructive Ownership

To determine whether a foreign person owns more than 5% of the stock in a corporation, constructive ownership rules apply which can attribute ownership of target stock from spouses and other family members, and from partnerships, trusts, and corporations that own target stock to the extent that the foreign investor also owns interests in such entities. The mere fact that two investment funds may share the same fund manager will not generally cause the ownership positions of such funds to be aggregated.

Testing at Master or Feeder Level

One question that frequently arises in a fund context is the level at which the 5% test applies. For example, in an activist fund context, if the fund has more than 5% of the stock of the target corporation, but no foreign investor has a 5% pro rata share of that investment, is there a FIRPTA problem? The rules on tiered ownership are somewhat ambiguous but the better answer appears to permit a look-thru approach in the case of funds operating in partnership, LLC or other pass-thru form. The following diagram illustrates this approach:

It should be noted that in a case where the foreign feeder fund is a corporation for U.S. income tax purposes, the look-thru ends and the 5% test is applied at that level. In such a case, if the foreign feeder is deemed to own more than 5% of the target stock, the foreign investors themselves would suffer the economic effect of the imposition of U.S. tax collectively, even if no single foreign investor owned more than 5% of the underlying U.S. company stock.

Determining USPRHC Status

The statute creates a presumption that stock in any U.S. corporation is stock in a USRPHC unless the taxpayer can prove otherwise. This puts the burden of proof on the shareholder. However, a shareholder’s ability to prove the issue is signifi cantly constrained by a lack of information. Recognizing this, the applicable regulations shift the determination burden to the corporation. Under the regime set forth in the regulations, a foreign shareholder that wants to rely on the 5% publicly traded stock exception need only make a request of the corporation for a determination of the corporation’s USRPHC status. If the corporation fails to respond, the foreign shareholder can request that the IRS make the determination instead. This regime may work in the case of private equity investors, but is anathema in the case of the activist manager. Before launching its assault on the target corporation, an activist manager with foreign investors should be thinking about the FIRPTA problem. During the analysis of the target, its business plan and the nature of theactivist approach, the manager should undertake a study to determine if the real estate asset values in the target are likely to cause it to be a USRPHC. Obviously, such a determination will not be conclusive, and the manner for obtaining conclusive advice — asking the target to make the determination — is not an option for an activist investment fund. If a target anticipates that the activist investors are FIRPTA-sensitive, it may make a determination of its status using assumptions that favor the valuation of real property assets or, in the most extreme cases, may change its asset mix in order to convert itself into a USRPHC. In this sense, USRPHC status may serve as a sort of mild poison pill defense to make itself a less appealing target to a foreign investor-funded activist approach.

An activist investor may get a general idea of how a target will likely fare in the USRPHC test based on publicly available data. The regulations provide an alternative test for USRPHC status based on book values. A corporation is presumed to not be a USRPHC if it determines that its U.S. real property interests make up 25% or less of the total book value of the company’s trade or business assets. While this presumption can provide some comfort and penalty protection, it is often not as useful as it may appear. In the fi rst instance, meeting this alternative test does not guarantee that the company is not a USRPHC. If the target corporation determines that it is not a USRPHC using the book value test, that determination will control until the IRS makes a contrary determination or until the target no longer meets the test. The presumption that the company is not a USRPHC if it meets this alternate bookvalue test only applies to the extent the target company makes the book value determination. However, in an activist context, where the investing fund (as opposed to the target) makes the determination based on the best available data at the time that it makes its investment decision, no presumptive protection exists and if it turns out that the target fails the fair market value test (even in hindsight) any assumed comfort from using the bookvalue test can be lost.

Withholding Rules Make This the Fund’s Problem

While it might be tempting for a fund manager to assume that FIRPTA liability and compliance is something that can be left to each affected foreign investor, this is not the case. Withholding obligations at the domestic fund partnership will force the fund manager to have to confront the questions of whether or not the 5% publicly traded stock threshold has been breached by any of the foreign investors and, if so, whether or not the target is a USRPHC. If both of these result in a fi nding that a sale of target stock would be taxable to a foreign investor, the fund and its manager will have an obligation to withhold at the highest applicable tax rate against the foreign investors’ gain on the sale.

Failure to withhold, even if based on a good-faith but ultimately erroneous belief that a target is not a USRPHC, will result in the fund and, potentially even the fund manager, becoming liable for the amount which should have been withheld, plus interest and penalties. The issues raised in this article are intended to serve only as warnings of what can happen if FIRPTA is ignored when planning and executing an activist strategy. If the decision is made that achieving a greater than 5% position in the target’s stock is consistent with the fund’s strategy, then it is prudent to ensure that foreign investors — and fund managers — are not blindsided by the changing tax consequences