Introduction To The Taxation Of Foreign Investment In US .
Introduction to the taxationof foreign investment inUS real estateJuly 2015
Contents2Introduction3Taxation of US entities and individuals6US tax implications of specific investment vehicles9Treaty protection from taxation11Dispositions of US real estate investments14Sovereign Wealth Funds16Foreign Account Tax Compliance Act18Appendix A: Foreign corporate blocker structure19Appendix B: Leveraged corporate blocker structure20Appendix C: REIT structure21ContactsIntroduction to the taxation of foreign investment in U S real estate1
IntroductionImpact of taxes on real estateReal estate is very much a tax-driven industry. As a result,changes in US tax policy have an impact on the relativeattractiveness of real estate as an investment class fornon-US investors. Increases to the US tax rates on capitalgains, the taxation of the disposition of real estate, and UStax reporting requirements are often cited as examples ofpolicies that create obstacles to investment. Over the years,real estate organizations in the United States have offeredproposals that would provide some relief and have soughtclarification of existing rules. These efforts have met withvarying degrees of success. For example, in recent yearsthere have been numerous relief provisions added andclarifications to tax rules governing the operations of RealEstate Investment Trusts (“REITs”). However, recent effortsto modify or simplify the US tax code, including provisionsaddressing the taxation of non-US investment in US realestate, have had little success.In 2014, the House Ways and Means Committee underthen Chairman Dave Camp issued a discussion draft of aproposed Tax Reform Act of 2014. Included in this proposalwere numerous provisions to simplify and reform theUS tax code. Many provisions included in this draft hadbeen announced in previous proposals by both Houseand Senate taxwriters but also contained new approachesfor sweeping corporate and international tax reform. Asof the date of this publication, there has been no specifictax reform bill passed through Congress other thanthe Tax Increase Prevention Act on December 16, 2014which extends for one year a number of temporary taxdeductions, credits and incentives that expired at the endof the previous year.During the past year, the Senate Finance Committeeannounced that it has formed five bipartisan workinggroups to examine specific issues in tax reform leading upto the development of a legislative proposal for overhaulof the US tax code. The findings and recommendationsof these groups were expected to be compiled in acomprehensive report to be released in 2015. Current2Ways and Means Committee Chairman Paul Ryan has alsopublicly indicated that the House taxwriters will have anaggressive timeline for tax reform proposals this year.As of this writing, the Senate Finance Committee produceda bill which, in part, would liberalize the Foreign Investmentin Real Property Tax Act (“FIRPTA”) rules as they apply topublicly traded REITs. Among several other changes andrelated revenue raisers, the bill would move the FIRPTAexception for holding public REIT shares from 5% to 10%.Following this bill, Ways and Means Committee membersintroduced the Real Estate Investment and Jobs Act of2015, which contained similar provisions as the SenateFinance Committee bill plus added a provision exemptingnon-US pension funds from FIRPTA. Clearly, there isrelatively broad support for liberalizing FIRPTA.It remains to be seen whether the tax reform proposalsbeing discussed by the House and Senate may ultimatelybecome legislation. While it appears that common groundis being sought on certain provisions, such as FIRPTA,thisis just one portion of the comprehensive tax reform andoverhaul of the entire tax code that Congress continues todebate. This debate will likely continue up through the nextPresidential election in November 2016.Notwithstanding the uncertainty of tax reform, the realestate industry continues to show a marked recovery inasset prices, transactions and capital availability. As such, itremains important that investors have an understandingof the tax rules currently in place in order to effectivelydevelop a US real estate strategy.The following is an introduction to some of the moresignificant tax issues that should be considered by non-USinvestors in this regard.
Taxation of income fromUS real estateThe US Internal Revenue Code (“Code”) includes provisionsfor the taxation of international investors, although insome cases the tax imposed by the Code may be reducedunder an applicable income tax treaty. Thus, internationalinvestors normally structure their investments to takeadvantage of treaty benefits whenever possible.Rental income and gains from the sale of real estatelocated in the United States is US source income. Asa general rule, dividends and interest paid by a UScorporation are US source income. In some cases, interestpaid by a foreign corporation or a foreign or domesticpartnership is also US source income.Taxation of US entities and individualsUS trade or businessThe United States taxes its citizens, residents, and domesticcorporations and trusts on all their income regardless ofwhere it is earned, i.e., on a worldwide basis. Noncitizenslawfully admitted to the United States as permanentresidents (green card holders) or physically present in theUnited States for at least 183 days during any year, or agreater number of days over a three-year testing period,are considered US residents. The income tax is imposedon net income, i.e., gross income from all sources reducedby allowable deductions, such as interest expense, taxes,and depreciation. In general, business losses in excess ofincome are first carried back two years and then may becarried forward 20 years to reduce income in those years,although a business may elect to waive the carrybackperiod. Currently, US corporate income tax rates rangefrom 15% to 35%, which apply to ordinary businessincome as well as to capital gains. The US income tax ratesfor individuals and trusts are separated into tax bracketsand range from 10% to 39.6%. Under current law, forthose in the higher end income bracket, capital gains aretaxed at a rate of 25% (to the extent of gain attributableto depreciation recapture) and 20% (to the extent of gainin excess of prior years depreciation). Certain “qualifieddividends” are taxed likecapital gains.In general, a foreign corporation or international investorthat engages in considerable, continuous, or regularbusiness activity in the United States is considered tobe engaged in a trade or business within the UnitedStates. Mere ownership of unimproved real property orresidential property held for personal use (for instance, anapartment or condominium) does not create a US trade orbusiness. Further, ownership of a single piece of propertyrented to one tenant on a net lease basis (i.e., where thetenant is required to pay all expenses connected with thereal estate) does not give rise to a US trade or business.Leasing commercial buildings on a net lease basis may ormay not create a US trade or business. Where, however,a foreign corporation, international investor (or agents ofeither) actively manage commercial property and pay allexpenses, taxes, and insurance, the activities constitute aUS trade or business.Taxation of foreign entities and internationalinvestorsForeign corporations and trusts, and individuals whoare neither US citizens nor US residents (“internationalinvestors”) are subject to US income tax only on incomethat is either effectively connected with a US trade orbusiness (“effectively connected income,” or “ECI”),regardless of source, or, if not ECI, is US source income.A partner of a partnership that is engaged in a UStrade or business under the above guidelines will alsobe considered to be engaged in a US trade or business.Conversely, an investor who owns shares in a corporationthat is engaged in a US trade or business will not beconsidered to be engaged in a US trade or business byvirtue of the investor’s share ownership.Effectively connected incomeThe effectively connected income of a foreign corporationor international investor is taxed on a net basis atgraduated rates like those applicable to US corporations,citizens, and residents.Generally, US source income is ECI if one of two alternativetests — the business-activities test and the asset-usetest — is met. The business-activities test looks toIntroduction to the taxation of foreign investment in U S real estate3
whether the activities of the US business are a materialfactor in generating the income. The asset-use test looksto whether the income is derived from assets used orheld for use in the conduct of a US business. Both testsare applicable to income from real estate. For example,rental income earned on a building used in a US trade orbusiness is ECI under these tests.Under a special set of rules for gains on dispositions ofreal property interests (“FIRPTA”), gains from the sale of aUS real property interest (“USRPI”), such as real estate, orinterests in partnerships, trusts, and US corporations thatown primarily US real estate, are taxed as ECI regardlessof whether the taxpayer is actually engaged in a US tradeor business. The same treatment may also apply to adistribution by a REIT attributable to the REIT’s gains fromthe disposition of US real property.Noneffectively connected incomeA 30% tax is generally imposed by the Code on the grossamount of most types of income of a foreign corporationor nonresident alien individual which are not ECI but thatare US source income. (The one type of US source incomethat is generally not covered by this tax is income fromthe sale of property.) The rate of this “gross basis” tax canin some cases be reduced or eliminated by a tax treaty orby a specific statutory exemption. For example, “portfoliointerest,” bank deposit interest, and interest on certainshort-term obligations is exempt from this tax underdomestic US law.The portfolio interest exemption applies to qualifiedinterest payments made to nonbank entities where theforeign lender owns less than 10% of the US borrower.The debt must be in registered form (i.e., transferableby one holder to another only when the transferee isidentified to the issuer).The tax on US source income that is not ECI (“non-ECI”) isgenerally collected via withholding at source, i.e., whenthe income is paid to a foreign person. For this reason, thegross basis tax is sometimes referred to as “withholding tax.”Where applicable, the gross basis tax is likely to applyto US source income in the form of dividends, interest,royalties, and certain rental income that is earned by aforeign corporation or international investor who is notengaged in a US trade or business.4Net basis electionsCode §§ 871(d) and 882(d) allow a foreign corporationor international investor that derives income from realproperty, but that is not engaged in a US trade or business(e.g., the investment is raw land or net leased property)to elect to be taxed on a net basis at graduated ratesas if the income were ECI. This “net basis election” canbe beneficial, because the production of realty incomegenerally involves substantial expense. Upon making theelection, the investor is relieved of the 30% tax on grossrents and is allowed to deduct expenses associated withthe real estate, such as depreciation and interest. Oftenthese expenses exceed income and therefore no US taxis due. The Code net basis election may be revoked onlywith consent of the Secretary of the Treasury and appliesto all US real estate held at the time of the election, as wellas to property that may be acquired in the future. Further,the net basis election applies to all income from realproperty that is located in the United States and held forthe production of income. The election does not, however,apply to certain income, including: Interest income on a debt obligation secured by amortgage on US real property; Rental income from personal property; and Income from real property, such as a personal residence,that is not held for the production of income.Branch profits taxThe earnings and profits of a foreign corporation that arederived from its ECI are generally taxed when withdrawnfrom the corporation’s US trade or business (or “branch”).The tax, called the branch profits tax (“BPT”), is 30% ofthe corporation’s “dividend equivalent amount,” unless atreaty specifies a lower rate or prohibits the BPT. A foreigncorporation may be exempt from the BPT for the taxableyear in which it completely terminates all of its US trade orbusiness. A branch will not be deemed to have completelyterminated, however, if the foreign corporation has any USassets, or generates any ECI, within three years of the yearof termination.A foreign corporation that is not engaged in a US trade orbusiness generally is not subject to the BPT, unless it makesa net basis election or is deemed to have ECI because itsells a US real property interest.
Because the BPT is imposed in addition to the net basisUS corporate tax, a foreign corporation subject to BPTmay pay a combined US tax on its earnings at an effectiverate in excess of 50%, unless the BPT rate is reducedby an applicable treaty. Often, this increased tax liabilitymay make a real estate investment through a foreigncorporation operating via a US branch uneconomical.Tax on excess interestIf a foreign corporation has ECI, and deducts interestexpense in computing its US tax on its ECI, a tax may beimposed on the corporation as if the amount deductedhad been interest income received by it from a subsidiaryUS corporation. The tax is imposed either at the statutory30% rate, or at a lesser (or zero) treaty rate if a treaty isapplicable. The base of this tax is the excess, if any, of thededuction over the amount of (US source) interest paid bythe foreign corporation’s US trade or business.US withholding tax on payments made to theforeign investorBy US corporations — If a foreign corporation orinternational investor establishes a US corporation to holdthe real estate investment, then dividends, and interestpaid by the corporation to the investor are considerednon-ECI and the payor must deduct and withhold 30% forpayment to the IRS, unless this rate is reduced by treaty,or, in the case of interest, unless the interest qualifies for astatutory exemption, such as the one for portfolio interest.the gross basis tax on its own income that is US sourcenon-ECI and that is allocable to its foreign partners.Foreign and US partnerships are also required to withholdtax on a foreign partner’s distributable share of thepartnership’s net ECI (e.g., the partnership’s gains fromsales of US real estate).By REITs — A REIT is a type of US corporation. Dividendspaid by REITs in general are subject to the US withholdingrules applicable to dividends paid by any US corporation,with two exceptions. Distributions attributable tothe REIT’s disposition of US real estate are subject towithholding tax at 35%. Treaties often provide somewhatless of a reduction in the US withholding tax imposed on aREIT’s dividends than they do on a regular C-corporation’sdividends.Documentation — In almost all situations where incomeis paid to a non-US investor, some form of prepaymentdocumentation from the investor will be required todetermine the proper rates and reporting of withholdingtaxes. These documentation rules can be complex andneed to be considered in conjunction with any proposedinvestment.By foreign corporations — If the foreign corporation orinternational investor creates a foreign corporation to holdthe investment, dividends paid by the foreign corporationare not subject to US tax. Interest paid by the foreigncorporation’s US trade or business is US source income. Itis taxed and subject to withholding tax like interest paid bya US corporation.By partnerships — Interest paid by a partnershipthat engaged in a trade or business in the United Statesgenerally is US source income, and generally subjectto the tax and withholding rules described above. AUS partnership is required to withhold and pay the IRSIntroduction to the taxation of foreign investment in U S real estate5
US tax implications of specificinvestment vehiclesUS corporationsAn international investor may choose to own US realestate indirectly through a US corporation formed tohold the property. When a US corporation holds the realestate investment, both the taxation of the entity and thetaxation of the repatriated earnings must be considered.Additionally, gain from the disposition of stock of a UScorporation is also subject to US taxation if the stock ofthe US corporation constitutes a “US real property interest”(“USRPI”).Tax on the US corporation — US corporations aretaxable on their worldwide income on a net basis withdeductions for operating expenses. Unless the corporationis a REIT, it is not allowed a deduction for dividends paidto its shareholders. Currently, the top corporate US taxrate is 35%. State and local income taxes will also applyto income from sources in those jurisdictions. There is nota preferential tax rate for capital gains when earned by aUS corporation. Thus, a US corporation selling appreciatedreal estate is taxable on its gain at 35%. If the regulartax results in little or no US tax liability, corporations mayinstead be subject to an alternative minimum tax of 20%computed on an alternative tax base which reflects “addbacks” of certain tax preference items, such as accelerateddepreciation, and limitations on the use of net operatinglosses. Because the United States generally imposes taxon dividends paid by US corporations, even when paid tonon-US persons, US corporations are not subject to theBranch Profits Tax (“BPT”).Because international investors may seek to use relatedparty financing arrangements to reduce a corporation’staxable income subject to US tax, there are limits on aUS corporation’s ability to deduct interest expenses paidto related foreign persons that receive treaty protectionfrom US tax on the interest income, and interest expenseson debt guaranteed by foreign related persons. The“earnings stripping” provisions of Code § 163(j) areessentially thin capitalization rules that impose limits onthe current deductibility of such interest in years in whichthe corporation’s net interest expense exceeds 50% of thecorporation’s “adjusted taxable income.” A safe harbor isprovided if the corporation maintains a debt-to-equity ratioof 1.5 to 1 or less.6Repatriation of earnings — Several methods areavailable to repatriate earnings of a US corporation.First, the investor can simply receive any or all of thecorporation’s earnings as a dividend. While dividendsare subject to a 30% withholding tax under the Code,tax treaties generally reduce that rate, when they apply.Dividends received may be subject to more favorabletaxation schemes in the investor’s home country thanother forms of earnings repatriation.An alternative to earnings repatriation can be the receipt ofinterest on loans made to the corporation by its shareholder.This method has two major advantages over repatriation bydividend distributions. First, the corporation may realize aninterest deduction for the amount paid to its shareholderas opposed to the lack of deduction for amounts paid asa dividend. This deduction lowers the corporation’s UStaxable income and its US corporate tax liability. Second, therate of US gross basis tax on interest received by a foreignlender is usually limited by US tax treaties, where applicable,to a rate lower than the rate of tax that can be imposed ondividends. Interest may also be exempt under domestic USlaw, e.g., the portfolio interest exemption.Another alternative to earnings repatriation is therealization of proceeds from the disposition of thecorporation’s stock. If the corporation is a US Real PropertyHolding Corporation (“USRPHC”), or was a USRPHC duringa five-year lookback period, the gain resul
interest,” bank deposit interest, and interest on certain short-term obligations is exempt from this tax under domestic US law. The portfolio interest exemption applies to qualified interest payments made to nonbank entities where the foreign lender owns less than 10% of the US borrower. The de
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