On April 25, 2024, the Department of Treasury (Treasury) and the Internal Revenue Service (IRS) published final regulations concerning the definition of domestically controlled qualified investment entities (DC-QIE) (the Final Regulations). Treasury and the IRS previously issued proposed regulations on December 29, 2022 (the Proposed Regulations). The Final Regulations modify the domestic corporation look-through rule and provide a potentially useful transition rule, but otherwise generally adopt the Proposed Regulations.
Background
Under Internal Revenue Code (Code) section 897, gain derived by a nonresident alien or non-US corporation from the sale or other disposition of a United States Real Property Interest (USRPI) is taxed as effectively connected with a US trade or business. A USRPI generally includes (i) an interest in real property and (ii) any interest (other than an interest solely as a creditor) in any domestic corporation, unless the taxpayer establishes that such corporation was at no time a US real property holding corporation (USRPHC) during the shorter of (1) the taxpayer's holding period in the interest, or (2) the five-year period ending on the date the taxpayer disposes of the interest.
The Code provides that a corporation (domestic or non-US) is a USRPHC on a particular date if the fair market value of its USRPIs equals or exceeds 50% of the sum of the fair market values of its: (1) USRPIs; (2) interests in real property located outside the United States; and (3) other assets used or held for use in a trade or business. Interest in a domestically controlled QIE is excluded from the definition of USRPI (DC-QIE exception). A QIE is defined as a real estate investment trust (REIT) that satisfies the requirements of section 856, or a regulated investment company (RIC) that satisfies the requirements of section 851, that is a USRPHC or would be a USRPHC if certain exceptions do not apply.1 A domestically controlled QIE is defined as a QIE in which at all times during the testing period less than 50% of the fair market value of the outstanding stock was “held directly or indirectly” by non-US persons.
Key Changes from the Proposed Regulations
Domestic Corporation Look-Through Rule
In order for a holder’s interest in a QIE to avoid characterization as a USPRI, the QIE must be domestically controlled, rather than foreign controlled. Section 897(h)(4)(B) requires consideration of direct and indirect ownership of a QIE to determine whether it is controlled by non-US persons. To address indirect ownership, the Proposed Regulations included the “Domestic Corporation Look-Through Rule.” As initially proposed, the Domestic Corporation Look-Through rule would look through a non-publicly traded domestic C corporation to consider the US or non-US status of its owners, if 25 percent or more of interests (by value) was held by non-US persons.
Treasury and the IRS received many comments concerning the Domestic Corporation Look-Through Rule arguing for its repeal or modification. Although the Final Regulations did not adopt any of the comments provided by the public, Treasury and the IRS did take into account the general concerns relating to the application of this proposed rule by increasing the foreign ownership requirement to look-through a non-publicly traded domestic C corporation from 25 percent or greater to more than 50 percent. Accordingly, consideration of non-US ownership for purposes of the Domestic Corporation Look-Through Rule requires a corporation to be majority non-US owned, which, according to Treasury and the IRS, better reflects the purpose of the look-through rule.
Transition Rules
The Proposed Regulations were proposed to apply to transactions occurring on or after the date Final Regulations were published. However, due to the requirement that a QIE is only considered domestically controlled if it is less than 50 percent foreign owned during the entire testing period, the Proposed Regulations could be applicable prior to the date on which the Final Regulations were published in the Federal Register.3 Commentators raised retroactivity concerns and suggested that the Domestic Corporation Look-Through Rule should only apply on a prospective basis such that there could be no application prior to the date on which the Final Regulations were published in the Federal Register.
The Final Regulations generally adopt these comments by exempting QIEs in existence as of April 24, 2024 (the Finalization Date), provided that the QIE did not: (1) acquire a significant amount of new USRPIs; or (2) undergo a significant change in ownership. The acquisition of new USRPIs will be considered significant if the new USRPIs exceed 20 percent of the fair market value of the USRPIs held by the QIE as of the Finalization Date. The QIE will be considered to have undergone a significant change of ownership if non-look-through persons increase their ownership of the QIE by more than 50 percent relative to the amount held by non-look-through persons as of the Finalization Date. This transition rule is only in effect for 10 years and applies only until April 24, 2034.
Eversheds Sutherland Observation: Existing fund structures that are still in their investment period should be examined to determine whether a parallel fund or similar solution might be implemented or a larger restructuring may be advisable.
Treatment of Qualified Foreign Pension Funds
The Final Regulations adopt, without change, the Proposed Regulations regarding entities that are qualified foreign pension funds (QFPFs) or qualified controlled entities (QCEs). As a general matter, QFPFs and QCEs are treated as non-US persons for purposes of ascertaining whether an entity is a domestically controlled QIE.
Treatment of certain Registered Investment Vehicles (RICs)
The final regulations state that a publicly offered RIC, is treated as a non-look-through person unless the tested QIE has actual knowledge that the RIC (despite being publicly offered) is foreign-controlled.4
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1 For purposes of determining whether an entity would be considered a USRPHC, the exception for stock that is regularly traded on an established securities market contained in section 897(c)(3) (providing that if the stock of a corporation is regularly traded on an established securities market then such stock is only treated as USRPI if a person holds more than 5% of the stock) does not apply. Additionally, the exception that generally excludes interests in QIEs from being treated as USRPIs contained in section 897(h)(2) does not apply.
2 467 US 837, 104 S. Ct. 2778 (1984).
3 Section 897(h)(4)(D) defines the testing period as the shorter of: (1) the period beginning on June 19, 1980, and ending on the date of disposition or of the distribution; (2) the 5-year period ending on the date of the disposition or of the distribution; or (3) the period during which the QIE was in existence.
4 A public RIC is defined as a RIC that is not a QIE and the shares of which are (i) regularly traded on an established securities market or (ii) common stock that is continuously offered in accordance with a public offering and held by at least 500 shareholders.
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