Section 897(a)1 provides that any gain or loss of a nonresident alien individual or non-U.S. corporation from the disposition of a “U.S. real property interest” (USRPI) is taken into account for purposes of applying the U.S. income tax rules as if such nonresident alien individual or non-U.S. corporation were engaged in a trade or business within the United States during the relevant tax year and such gain or loss were effectively connected with that U.S. trade or business (ECI). For this purpose, the term USRPI does not only include fee simple interests in U.S. land and buildings but also includes stock of a “U.S. real property holding corporation” (USRPHC), which, generally speaking, is a U.S. corporation more than 50 percent (by value) of its assets of which are attributable to USRPIs. Section 897(h)(1) provides, among other things, that if (and to the extent) an entity taxable as a real estate investment trust (REIT) makes a distribution to a nonresident alien individual or a non-U.S. corporation that is attributable to gain from sales or exchanges by such REIT of USRPIs, then such distribution is treated as gain recognized by such nonresident alien individual or non-U.S. corporation from the sale or exchange of a USRPI, subject to certain limited exceptions. Thus, any such foreign shareholder receiving a Section 897(h)(1) distribution is deemed to be earning ECI and is therefore subject to (i) U.S. net income taxation on such gain constituting ECI, (ii) U.S. branch profits tax on such gain (if the foreign shareholder is a non-U.S. corporation) and (iii) the requirement to file a U.S. federal income tax return. Section 1445(a) generally imposes a 15 percent withholding tax obligation on the amount realized (generally, the gross proceeds and not just the gain) on the transferee (buyer) when a non-U.S. person (seller) disposes of a USRPI. Section 1445(e)(6) provides, among other things, that if a REIT makes a distribution that is, in whole or in part, subject to Section 897(h)(1), then such REIT is required to apply a 21 percent withholding tax to such distributions to the extent one or more foreign shareholders are subject to Section 897(h)(1).
Section 897(l)(1), enacted at the end of 2015 by the Protecting Americans From Tax Hikes Act of 2015 (the PATH Act), provides that a pension fund that is a qualified foreign pension plan is not treated as a nonresident alien or non-U.S. corporation for purposes of Section 897. For purposes of Section 897(l), the term “qualified foreign pension fund” means “any trust, corporation, or other organization or arrangement”
(A) that is created or organized under the law of a country other than the United States,
(B) that is established
(i) by such country (or one or more political subdivisions thereof) to provide retirement or pension benefits to participants or beneficiaries that are current or former employees (including self-employed individuals) or persons designated by such employees, as a result of services rendered by such employees to their employers or
(ii) by one or more employers to provide retirement or pension benefits to participants or beneficiaries that are current or former employees (including self-employed individuals) or persons designated by such employees in consideration for services rendered by such employees to such employers,
(C) that does not have a single participant or beneficiary with a right to more than 5 percent of its assets or income,
(D) that is subject to government regulation and with respect to which annual information about its beneficiaries is provided, or is otherwise available, to the relevant tax authorities in the country in which it is established or operates, and
(E) with respect to which, under the laws of the country in which it is established or operates,
(i) contributions to such trust, corporation, organization or arrangement that would otherwise be subject to tax under such laws are deductible or excluded from the gross income of such entity or arrangement or taxed at a reduced rate, or
(ii) taxation of any investment income of such trust, corporation, organization or arrangement is deferred, or such income is excluded from the gross income of such entity or arrangement or is taxed at a reduced rate.
Summary of the Regulations
- Confirmation of Scope of Exemption. The Proposed Regulations confirm that all of FIRPTA, including the rules concerning ECI distributions under Section 897(h)(1) and the rules concerning withholding in connection with dispositions and distributions are turned off in respect of qualified foreign pension plans. However, consistent with the statutory framework, all of the general, non-FIRPTA rules otherwise applicable to foreign investors (e.g., ECI taxation, dividend and interest withholding) remain fully applicable to qualified foreign pension plans.
- Clarification Concerning Status Certification. IRS Form W-8EXP will be amended to allow non-U.S. pension plans to certify their status as qualified foreign pension plans for withholding tax purposes. A potential withholding agent may request either a certification of nonforeign status or IRS Form W-8EXP and may rely on such certifications for withholding tax purposes.
- Taxpayer-Friendly Broad Interpretation of Qualified Foreign Pension Plan. The IRS and Treasury have determined that the purpose of Section 897(l) is best served by permitting a broad range of structures to be eligible to be treated as qualified foreign pension plans. Thus, each element of the definition of a qualified foreign pension plan has been interpreted in a broad, taxpayer-friendly way to avoid situations in which a non-U.S. arrangement clearly operates as a foreign pension plan but does not, as a technical matter, satisfy all the prongs of a (narrowly interpreted) statutory definition due to quirks of foreign law. Thus:
- The term “organization or arrangement” means one or more trusts, corporations, governmental units (i.e., any foreign government or part thereof) or employers. Thus, foreign private and government-sponsored public pension plans can be qualified foreign pension plans. A plan may also be structured by way of one or more segregated asset pools.
- References to a “foreign country” include references to a state, province or political subdivision of a foreign country. Accordingly, pension plans of non-U.S. provinces (e.g., Ontario in Canada) or non-U.S. cities could be treated as qualified foreign pension plans.
- Multi-employer pension plans or pension plans of trade unions or professional associations could be qualified foreign pension plans.
- For purposes of the 5 percent limit (i.e., no beneficiary may participate in more than 5 percent of the assets or income of the plan), certain constructive ownership rules (Section 267(b) and 707(b)) apply.
- The term “qualified recipient” includes a (i) current employee, (ii) a former employee and (iii) any person designated by such current or former employee to receive qualified benefits (e.g., a spouse).
- To qualify as qualified foreign pension plan, a plan does not need to be restricted to the provision solely of retirement benefits. Because foreign plans often provide ancillary benefits (e.g., death, disability, medical or unemployment benefits), this clarification is particularly helpful. Specifically, an otherwise eligible plan will be a qualified foreign pension plan if all of the benefits that such plan provides to qualified recipients representing at least 85 percent of the present value of the “qualified benefits” that such plan expects to provide in the future are retirement or pension benefits. For this purpose, “qualified benefits” include (i) retirement benefits, (ii) pension benefits and (iii) ancillary benefits (e.g., benefits payable upon diagnosis of a terminal illness, death benefits, disability benefits, medical benefits or unemployment benefits).
- A government-sponsored pension plan automatically satisfies the governmental oversight and information reporting requirements because the government has control over the program and access to the information about the program’s beneficiaries. A private pension plan satisfies the information reporting requirement if such plan, under foreign law, is required to provide the required information to one or more governmental units (e.g., finance ministry, labor ministry, special department) of the foreign country in which such plan is created or formed or if such information is otherwise available to one or more governmental units of such foreign country. This is a very helpful clarification because Section 897(l) appears to refer to information reports provided or available only to the “tax authorities” of the relevant foreign country.
- A pension plan from a country with no income tax regime nonetheless satisfies the “being subject to a special tax regime in its home country” requirement. Other plans satisfy this requirement if, under the income tax laws of their home country, at least 85 percent of the contributions to the plan are deductible or excluded from the gross income or taxed at a reduced rate, or tax on at least 85 percent of the investment income of the plan is deferred or taxed at a reduced rate (including by excluding such investment income from gross income). The Proposed Regulations also add that a plan that is not specifically subject to the special tax treatment described in Section 897(l) is nonetheless treated as satisfying this requirement if such plan establishes that it is subject to a preferential tax regime due to its status as a retirement or pension fund and that the preferential tax regime has a substantially similar effect as the specific tax regime described in Section 897(l) (e.g., an insurance based regime with reserve deductions). However, solely subnational exemptions (e.g., exemption solely from Ontario taxes but not from Canadian federal taxes) do not satisfy this requirement.
- Clarification That the Qualified Foreign Pension Plan Definition Applies to FIRPTA Only. The “pension plan” definitions in U.S. income tax treaties and in the Foreign Account Tax Compliance Act rules are independent of the new definition of a qualified foreign pension plan for FIRPTA purposes. Thus, a plan may be a qualified foreign pension plan for FIRPTA purposes but not a pension plan for purposes of an applicable income tax treaty and vice versa.
- Clarification of Investments by Qualified Foreign Pension Plans Through Their Wholly Owned Entities. The Proposed Regulations confirm that a qualified foreign pension plan may invest through a “qualified controlled entity” (i.e., a trust or corporation organized under the laws of a foreign country all of the interests of which are held directly by one or more qualified foreign pension plans. The IRS and Treasury decided that partnerships do not need to be treated as qualified controlled entities because a “look through” rule applies with respect to a qualified foreign pension plan’s exemption from FIRPTA under the aggregate theory of partnership taxation. The IRS and Treasury confirmed that multiple qualified foreign pension plans can pool their resources in one qualified controlled entity. For purposes of determining whether the interests in a qualified controlled entity are held by qualified foreign pension plans, the IRS and Treasury confirmed that creditor interests (debt leverage) are ignored for this purpose, but they rejected the inclusion of a de minimis rule for impermissible owners (e.g., a private equity sponsor or joint venture partner for certain nontax business reasons).
- Effective Dates. The Proposed Regulations will generally be effective for dispositions and distributions of USRPIs on or after the date of the publication of final regulations. However, certain rules of the Proposed Regulations are applicable with respect to dispositions and distributions of USRPIs occurring on or after June 6, 2019. A taxpayer may rely on the Proposed Regulations with respect to dispositions or distributions occurring on or after December 18, 2015, and prior to the applicability date of the final regulations, if the taxpayer consistently and accurately complies with the rules in the Proposed Regulations.
- Certainty Concerning Qualified Foreign Pension Plan Status. In practice, it has turned out to be challenging to conclude at a high level of certainty that a non-U.S. plan is indeed a qualified foreign pension plan. As a result, the ability to rely on this exemption and to make investments based on this exemption has been limited, thereby preventing the exemption from operating as intended. Based on the Proposed Regulations it should be significantly easier for non-U.S. pension plans and their U.S. advisers to determine whether such non-U.S. plans qualify as qualified foreign pension plans. Accordingly, we would expect more future investments to make use of this exemption.
- Public and Private REIT Structures.
- Qualified foreign pension plans could, based on the exemption, take larger than 10 percent stakes in public REITs. One key obstacle has always been Section 897(h)(1), which, in the eyes of the IRS, is not turned off by Section 892. However, because such a large ownership stake will raise “related party rent” issues, especially for public REITs that own and rent real estate, we do not expect new broad carve-outs in public REIT charters for qualified foreign pension plans. Instead, consistent with current market practice, we would expect that any such strategic investment would be addressed by way of an ownership waiver.
- Private joint venture REITs could benefit from the new exemption because (i) a qualified foreign pension plan is not subject to a maximum ownership limit under Section 897(l) in respect of a REIT and can more easily negotiate an ownership limit waiver with a private REIT sponsor (including compliance concerning potential “related party rent” issues) and (ii) foreign private pension plans could potentially hold a majority stake in a private REIT, as foreign private pension plans cannot benefit from Section 892. Section 892 investors (e.g., foreign public pension plans) would generally be limited to a less than 50 percent ownership stake in the private REIT.
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