Foreign Investors In REITs: Opportunities Under FIRPTA Reform Proposals

by Pepper Hamilton LLP
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Real estate investment trusts (REITs) have long been a tax-efficient vehicle for foreign persons seeking to invest in U.S. real estate. Now, two legislative proposals titled the Real Estate Investment and Jobs Act of 20131 have been introduced in both the House and the Senate. These reforms are part of President Obama’s program to encourage private infrastructure investment,2 and they are intended to attract foreign capital to the U.S. real estate market by reducing tax barriers to investment. Specifically, these bills propose to change withholding tax rules applicable to investments in U.S. REITs under the Foreign Investment in Real Property Tax Act of 1980 (commonly known as FIRPTA).

Tax Advantages of REITs for Foreign Investment – Current Law

In general, U.S. tax is imposed on a foreign person’s gain on the disposition of U.S. real estate. The gain is treated as income that is effectively connected with a U.S. trade or business, withholding tax is imposed at a rate of 10 percent on the gross proceeds of the sale, and a foreign investor is required to file U.S. tax returns and pay income tax at regular U.S. tax rates.3 Taxation also applies to the disposition of stock in a corporation that is a "United States real property holding corporation" because more than 50 percent of its assets consist of U.S. real estate.4 Foreign persons seeking a stake in the U.S. real estate market face significant tax hurdles, and careful planning is required to maximize the after-tax return of any investment.5

REITs, while subject to complex tax rules, can be tax-efficient vehicles for foreign investment in real estate. A REIT that distributes all of its taxable income is not subject to U.S. corporate-level tax. In addition, foreign shareholders of a REIT benefit from the following exceptions to FIRPTA tax:

  • the sale of stock in a publicly traded REIT is exempt from tax as to a shareholder of 5 percent or less of the REIT6
  • dividend distributions attributable to real estate sale gain made by a publicly traded REIT are exempt from FIRPTA as to shareholder of 5 percent or less (such dividends are nevertheless subject to the regular dividend withholding tax at 30 percent, or a lower treaty rate if applicable),7 and
  • the sale of stock in a "domestically controlled" public or private REIT is exempt from tax (this rule allows a foreign investor to own up to 49 percent of a public or private REIT when the other 51 percent is owned by U.S. persons).8

Real Estate Investment and Jobs Act of 2013 – Proposed Reforms

Expansion of Publicly Traded Exemption to 10 Percent Holders

Under the proposed legislation, the permitted ownership levels for the publicly traded REIT exception would be increased from 5 percent to 10 percent. A shareholder of up to 10 percent of a U.S. public REIT would be able to sell REIT stock and receive distributions of real estate sales gain without imposition of FIRPTA tax. The 10 percent ownership threshold would bring REIT withholding tax rules more in line with those for other "portfolio" investments and would allow foreign investors to potentially double their existing ownership levels in a U.S. public REIT.9

Domestically Controlled REITs

Both of the bills would overturn a controversial IRS Notice that applied U.S. tax to liquidating distributions of domestically controlled REITs.10 Heavily criticized, this notice contradicted the general rule that a liquidating distribution is treated as an amount received in full payment in exchange for the stock. The proposed change would restore pre-2007 tax treatment so that a liquidating distribution to a foreign shareholder of a domestically controlled REIT would be exempt from U.S. tax. This change would significantly ease exit planning for foreign investors in private REITs with less than 50 percent foreign ownership.

The new rules would also help public REITs that have faced uncertainty in determining whether or not they qualify as "domestically controlled." In the past, public REITs whose stock was primarily held in street name were unable to reliably determine the percentage of stock held by foreign persons. Under the new rules, public REITs may presume that stock held by less than 5 percent owners is held by U.S. persons (absent actual knowledge to the contrary). Stock in a REIT that is held by another REIT would be presumed held by a foreign person unless the shareholder is itself a domestically controlled REIT. The new ownership presumptions would ease withholding tax compliance by allowing REITs to rely upon publicly available ownership information to determine their status as domestically controlled or foreign-controlled.

New Exemption for Qualified Shareholders

The reform proposals contain a new exception for REIT stock held by shareholders of certain publicly traded foreign investment vehicles. Stock of a U.S. public or private REIT owned by a "qualified shareholder" would not be treated as a U.S. real property interest, and therefore no tax would be imposed on gain from the sale of such REIT stock. In addition, distributions of real property gains to qualified shareholders would not be subject to FIRPTA tax (though such distributions would remain subject to the regular dividend withholding tax at 30 percent, or a lower treaty rate if applicable). These rules would apply to a qualified shareholder except to the extent that an investor in the qualified shareholder (other than an investor that is itself a qualified shareholder) holds (directly or indirectly through the qualified shareholder) more than 10 percent of the stock of the REIT.

Under the House bill,11 a "qualified shareholder" must meet all of the following four requirements:

  • be eligible for the benefits of a tax treaty with the United States that includes an exchange of information program

  • be a "qualified collective investment vehicle" (as defined below)

  • have its principal class of stock listed and regularly traded on a recognized stock exchange, and

  • maintain records of the identity of each person who owns more than 10 percent of its principal class of stock.

A "qualified collective investment vehicle" is an entity that is described in any one of the following three categories:

  • is eligible for a reduced rate of withholding on ordinary dividends paid by a REIT, even if the entity holds more than 10 percent of the stock of the REIT12

  • is a taxable corporation engaged primarily in the trade or business of operating or managing real estate entities or assets,13 or

  • is so designated by the Secretary of the Treasury and is either (a) fiscally transparent or (b) required to include dividends in its gross income but is entitled to a deduction for distributions to its investors.14

The new exception for qualified shareholders would allow qualified collective investment vehicles to avoid tax with respect to gain on sale of stock of a public or private U.S. REIT, with an unlimited ownership threshold (except to the extent that an investor in the qualified shareholder owns more than 10 percent, directly or indirectly, of the U.S. REIT). In contrast, the current exception for ownership of publicly traded REIT stock is 5 percent (and would be 10 percent under the proposed reforms) and the current exception for domestically controlled REITs limits foreign ownership to 49 percent of a U.S. REIT. Under the new rules, a qualified shareholder could, for example, own 100 percent of the common stock of a captive REIT without being subject to FIRPTA tax, provided that none of the investors in the qualified shareholder holds more than a 10 percent stake in the qualified shareholder.15

Pepper Perspective

These reforms, if enacted, would greatly enhance the value of REITs as vehicles for foreign investment in the United States. However, because REITs are subject to complex rules related to income, assets, share ownership, and distribution of income, a REIT will not always be appropriate for every investor.

Endnotes

1 Real Estate Investment and Jobs Act of 2013. H.R. 2870 (introduced July 31, 2013) and S. 1181 (introduced June 18, 2013).

2 The "Rebuild America Partnership": The President’s Plan to Encourage Private Investment in America’s Infrastructure, http://www.whitehouse.gov/the-press-office/2013/03/29/rebuild-america-partnership-president-s-plan-encourage-private-investmen (March 29, 2013).

3 Sections 897 and 1445 of the Internal Revenue Code of 1986, as amended (the Code). References to "Section" herein refer to Sections of the Code.

4 Section 897(c)(2).

5 For the purposes of this article, we assume that the foreign person investing in a REIT is not otherwise subject to tax on a net basis in the United States. If the foreign person is subject to net basis tax because, for example, the person is otherwise engaged in a U.S. business, the discussion in this article may not be applicable.

6 Section 897(c)(3).

7 Section 897(h)(1).

8 Section 897(h)(2).

9 See Sections 871(h) and Section 881(c), which provide exemptions from withholding tax on "portfolio interest" received by persons owning less than 10 percent of the debtor. REIT distributions to 10 percent or less shareholders will still be subject to U.S. dividend withholding tax, subject to reduction under an applicable tax treaty.

10 Notice 2007-55 (July 2, 2007).

11 The Senate bill provides a similar rule.

12 For example, listed Australian property trusts (LAPTs) would benefit from this exception. See Article 10(4)(d) of the tax treaty between the United States and Australia.

13 This exception will not apply to a fiscally transparent entity, a foreign REIT or any other foreign corporate entity that is entitled to a deduction or exclusion for dividends paid to its shareholders or that is subject to a requirement to distribute any portion of its taxable income annually.

14 The proposed legislation does not provide any standards for the Secretary to follow in determining which foreign entities should be granted status as a "qualified collective investment vehicle" and thus appears to grant considerable discretion to the Secretary to significantly broaden this exception to a large class of pass-through vehicles organized in foreign jurisdictions.

15 The captive REIT would need to satisfy the statutory 100-shareholder requirement by issuing a class of preferred shares to more than 100 persons.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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