The Internal Revenue Service (IRS) issued proposed regulations under Sections 892 and 897 of the Internal Revenue Code of 1986, as amended, on December 29, 2022. Final regulations under Section 897 regarding the exemption for “qualified foreign pension funds” from taxation under the Foreign Investment in Real Property Tax Act of 1980 were issued the same day.
The proposed regulations under Section 892 should benefit foreign government investors in private funds and other entities that own US real estate by making it easier for those investors to structure their holdings of those investments in a manner that preserves such investors’ eligibility for the Section 892 exemption. By contrast, the proposed regulations under Section 897 would make it more difficult for US real estate investment trusts (REITs) to qualify as “domestically controlled”.
The proposed regulations will become effective when finalized. However, the preamble to the proposed regulations indicates that taxpayers may rely on the proposed regulations under Section 892 until the final regulations are issued.
BACKGROUND – SECTION 892 AND THE DEEMED COMMERCIAL ACTIVITY RULE
Section 892 generally exempts foreign government investors from US federal income tax on income from investments in stocks, bonds, and other securities. However, any such income that is derived from a “commercial activity” or that is derived by or from a “controlled commercial entity” is not eligible for the exemption. A “controlled entity” of a foreign government (i.e., an entity in which the foreign government owns, directly or indirectly, 50% or more of the value or voting interests or over which the foreign government otherwise has effective practical control) will be a “controlled commercial entity” if it is engaged in any “commercial activity” anywhere in the world.
Under a special rule (the Deemed Commercial Activity Rule), a “controlled entity” is deemed to be engaged in a “commercial activity”, and thus is deemed to be a “controlled commercial entity,” if it is a “United States real property holding corporation” (USRPHC). To avoid the impact of the Deemed Commercial Activity Rule, foreign government investors carefully monitor their direct and indirect US real estate investment holdings. This monitoring is intended to ensure that a “controlled entity” does not become a “controlled commercial entity” by reason of the Deemed Commercial Activity Rule, which would deprive the “controlled entity” of the benefits of the Section 892 exemption for all of its US source investment income to which the exemption would otherwise apply.
For example, many foreign government investors hold US real estate rich investments, including investments in real-estate-focused private equity funds, in “controlled entities” that also hold significant non-US assets. Under certain circumstances, the Deemed Commercial Activity Rule may constrain the ability of foreign government investors to make US real estate or infrastructure investments.
OVERVIEW – PROPOSED REGULATIONS UNDER SECTION 892
The proposed regulations relax the Deemed Commercial Activity Rule by providing that a “controlled entity” that would be a USRPHC solely by reason of owning interests in one or more corporations that are not controlled by the foreign government will not be subject to the Deemed Commercial Activity Rule. Thus, under the proposed regulations, a “controlled entity” will be able to benefit from the Section 892 exemption even if most or all of its portfolio consists of minority interests in USRPHC investments, assuming that the only reason that the “controlled entity” would be a USRPHC is the ownership of those minority investments and that the “controlled entity” does not otherwise engage in “commercial activities.”
For “controlled entities” that are also “qualified foreign pension funds” (QFPFs) (or “qualified controlled entities” that are wholly owned by one or more QFPFs), the proposed regulations provide that the Deemed Commercial Activity Rule does not apply at all.
PRACTICAL IMPACT – PROPOSED REGULATIONS UNDER SECTION 892
The proposed regulations provide a relaxation of the Deemed Commercial Activity Rule for “controlled entities”. While foreign government investors will still need to monitor their activities to ensure that their “controlled entities” are not USRPHCs and are not conducting “commercial activities” anywhere in the world, they will have greater flexibility in how they choose to hold their US real estate investments, including minority interests in private equity funds that invest in real estate or infrastructure. The relaxation of the Deemed Commercial Activity Rule should reduce the administrative burden of monitoring compliance with the rule and may, for certain foreign government investors, permit additional US real estate or infrastructure investments.
Moreover, the Treasury Department and the IRS have taken an important step to harmonize the Section 892 exemption with the separate Section 897(l) exemption for QFPFs (and “qualified controlled entities” that are wholly owned by one or more QFPFs). The preamble to the proposed regulations acknowledges that, since QFPFs and their “qualified controlled entities” are exempt from taxation under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), they should not be required to limit their US real estate investments or engage in extensive monitoring and balancing of their US real estate investments in order to maintain their eligibility for the Section 892 exemption on their other income and gains.
BACKGROUND – SECTION 897, QFPFS, AND DOMESTICALLY CONTROLLED REITS
Section 897 generally subjects nonresident aliens and foreign corporations to tax on gain from the disposition of “United States real property interests” as if the nonresident alien or foreign corporation were engaged in a trade or business within the United States during the taxable year and as if such gain were effectively connected with such trade or business. However, Section 897(l) provides that QFPFs are not treated as nonresident alien individuals or foreign corporations subject to tax on such gains.
Section 897 also provides that gain from the sale of stock of a “domestically controlled” US REIT is not subject to tax under FIRPTA. A “domestically controlled” US REIT is a US REIT in which non-US persons hold directly or indirectly less than 50% of the interests in the US REIT. Certain foreign investors prefer to invest in US real estate through “domestically controlled” US REITs so that they may dispose of those investments through sales of equity interests in the “domestically controlled” US REITs, as gains from such sales are exempt from taxation under FIRPTA.
OVERVIEW – PROPOSED REGULATIONS UNDER SECTION 897
Despite the fact that the statutory language of Section 897(l) states that QFPFs are not treated as nonresident alien individuals or foreign corporations for purposes of Section 897, the proposed regulations provide that QFPFs are not considered US persons for purposes of determining “domestically controlled” US REIT status. Thus, for example, if a US REIT is held by US natural persons, US tax exempt entities, QFPFs, and foreign investors that are not QFPFs, the US REIT would not be “domestically controlled” if the QFPFs and the other foreign investors collectively hold 50% of more of the value of US REIT’s equity interests.
The proposed regulations also provide certain look-through rules to determine whether a US REIT is “domestically controlled”. Notably, under the look-through rules, to determine whether a US REIT is “domestically controlled”, you must look through domestic C corporations that are “foreign-owned”. A “foreign-owned” domestic C corporation is defined as any non-publicly traded US corporation where 25% or more of the value is owned by foreign persons. Thus, for example, a taxable US corporate blocker established by foreign investors to invest in a US REIT will be treated as foreign to the extent of its foreign ownership to determine whether the REIT is “domestically controlled”.
This look-through approach is contrary to a 2009 private letter ruling that ruled that fully taxable domestic C corporations are considered domestic holders for purposes of determining whether a REIT is “domestically controlled,” even when they are wholly owned by foreign shareholders.
Although the above discussed rules do not apply until the regulations are finalized, the preamble to the proposed regulations indicates that the IRS may challenge taxpayers that take a contrary position under current law.
PRACTICAL IMPACT – PROPOSED REGULATIONS UNDER SECTION 897
The preamble to the proposed regulations makes it clear that the IRS and the Treasury Department are concerned that non-QFPF investors may be relying on ambiguous statutory language to obtain an unintended and unwarranted benefit. In the example above, if the QFPFs were treated as US persons for purposes of testing “domestically controlled” status, the US REIT would be domestically controlled if the foreign investors (other than the QFPFs) were to hold less than 50% of the value of the US REIT’s equity interests, even if the QFPFs and the other foreign investors together own a 50% or greater interest. In that scenario, the special exemption from FIRPTA taxation afforded to QFPFs could, as a practical matter, provide an additional benefit to non-QFPF foreign investors.
Similarly, the preamble to the proposed regulations addresses the IRS’s and the Treasury Department’s concern that foreign investors may be able to use closely held domestic C corporations to achieve “domestically controlled” US REIT status and thereby secure at least a partial tax exemption for gains derived from selling equity interests in the US REIT that would not have been available without interposing the domestic C corporation. As with the QFPF rule, the domestic C corporation look-through rule is intended to limit the scope of the FIRPTA exemption that can be obtained through planning for “domestically controlled” US REIT structures.
In addition to the potential impact on foreign investors seeking to benefit from the “domestic control” exemption, the proposed regulations may create new planning constraints for private fund sponsors that are raising significant capital from non-US investors for US real estate strategies. Fund sponsors should carefully review existing fund structures that may be relying on “domestically controlled” US REIT status, in order to assess the impact that the proposed regulations may have on those structures. Additionally, fund sponsors will want to review fund agreements and side letters to determine whether any aspects of those agreements may be impacted in the event the proposed regulations are finalized.
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