On December 28, 2022, the Treasury Department and the Internal Revenue Service (“IRS”) released final regulations regarding the Section 897(l)1 exception from the Foreign Investment in Real Property Tax Act (“FIRPTA”) for qualified foreign pension funds (“QFPFs”) (“Final Regulations”).2 On the same day, the Treasury Department and the IRS also proposed regulations clarifying the treatment of QFPFs under Section 892 and making certain changes to the rules surrounding domestically controlled qualified investment entities and related FIRPTA exceptions (“2022 Proposed Regulations”).3
This Legal Update provides a review of certain rules provided in the Final Regulations and the 2022 Proposed Regulations, including comparisons to the prior proposed regulations.
QFPF Final Regulations
The PATH Act4 added Section 897(l) in 2015, which provides a complete exemption from taxation under Section 897 for gain or loss recognized by a QFPF attributable to the disposition of, and certain distributions with respect to, United States real property interests (“USRPIs”). On June 6, 2019, the Treasury Department and the IRS released proposed regulations under Section 897(l) (“2019 Proposed Regulations”).5 The 2019 Proposed Regulations provided guidance regarding the scope of the Section 897(l) exemption, the requirements for an entity to qualify as a QFPF, and related withholding tax rules under Sections 1445 and 1446.
The Final Regulations retain the general approach and structure of the 2019 Proposed Regulations with certain revisions and clarifications that generally are favorable for trusts or other entities seeking QFPF status. In general, the Final Regulations are effective on December 29, 2022, although certain rules will apply with respect to dispositions and distributions occurring on or after June 6, 2019. In addition, an eligible fund may apply the Final Regulations to dispositions and distributions occurring on or after December 18, 2015, provided that the eligible fund and all other relevant persons consistently apply all applicable rules for all relevant years.
1. Scope of the Exception
Under Section 897(l), a QFPF, or an entity all the interests of which are held by a QFPF, is not treated as a nonresident alien individual or a foreign corporation for purposes of Section 897. As such, under the Code, QFPFs (and entities wholly owned by QFPFs) are exempt from FIRPTA with respect to gain attributable to the disposition of USRPIs. The 2019 Proposed Regulations introduced the concepts of “qualified holders,” “qualified controlled entities” and “qualified segregated accounts.” Under the 2019 Proposed Regulations, gain or loss of a “qualified holder” from the disposition of a USRPI (including a REIT capital gain dividend as described in Section 897(h)) is not subject to Section 897(a) to the extent the gain or loss is attributable to one or more “qualified segregated accounts” maintained by the qualified holder. As defined in the 2019 Proposed Regulations, a qualified holder is a QFPF or a “qualified controlled entity.” The Final Regulations generally adopt the relevant concepts related to the scope of the exception as provided in the 2019 Proposed Regulations.
a. Qualified Controlled Entities (“QCEs”)
The 2019 Proposed Regulations defined a QCE as a trust or corporation organized under the laws of a foreign country, all of the interests of which are held by one or more QFPFs directly or indirectly through one or more QCEs or partnerships. Commentators requested that a de minimis exception should be allowed for the ownership of a QCE by other persons, including the situation where a QCE inadvertently fails to qualify because one of its co-investors ceases to be a QFPF. The Final Regulations do not adopt these suggestions and reject other suggested approaches that would permit an entity to be a QCE despite limited non-QFPF ownership. The preamble to the Final Regulations states that permitting a person other than a QFPF or another QCE to own an interest in a QCE would impermissibly expand the scope of the Section 897(l) exception by allowing investors other than QFPFs to avoid tax under FIRPTA.
The 2019 Proposed Regulations clarified that an “interest” for purposes of determining whether an entity is a QCE is determined under Treasury Regulations Section 1.897-1(d)(5), which provides that an interest in an entity means an interest in such entity other than an interest solely as a creditor. The Final Regulations do not provide additional guidance regarding the type of ownership interest taken into account in determining the QCE status. The preamble to the Final Regulations references Treasury Regulations Section 1.897-1(d)(3), which further defines an interest in an entity other than solely as a creditor. The preamble also states that “whether an interest in an entity constitutes one of the interests listed under [Section] 1.897–1(d)(3) or is instead disregarded is determined based on the facts, taking into account general tax principles.” So there is a risk that a non-economic interest held by a non-QFPF can disqualify an entity's status as a QCE.
b. Qualified Holders
The Final Regulations generally include the same qualified holder rule as provided in the 2019 Proposed Regulations, with certain modifications. The Final Regulations provide two alternative tests that a QFPF or a QCE must satisfy at the time of the disposition of the USRPI or the distribution attributable to gain from such disposition. Under the alternative tests, a QFPF or a QCE is a qualified holder if (1) it owned no USRPIs as of the earliest date during an uninterrupted period ending on the date of the disposition or distribution during which it qualified as a QFPF or a QCE, or (2) it satisfies the applicable testing period requirement.
The testing period is the shortest of (1) the period beginning on the effective date of Section 897(l) (i.e., December 18, 2015), and ending on the date of the disposition or distribution; (2) the ten-year period ending on the date of the disposition or distribution; or (3) the period during which the entity (or its predecessor) was in existence. In other words, the QFPF or QCE must not have held any USRPIs on the date that it most recently became a QFPF or QCE, or it must have continuously qualified as a QFPF or QCE for the ten-year period prior to the applicable disposition or distribution (or, if shorter, since December 18, 2015 or the entire period for which the QFPF or QCE has been in existence).
The Final Regulations include transition rules that provide limited exceptions to compliance with the qualified holder rule. While commentators suggested other approaches with respect to the qualified holder rule, such as a tolling period to remedy the loss of QFPF status, shorter maximum testing period, and mark-to-market or tracing alternatives to the testing period rule, the Final Regulations do not adopt these suggestions.
c. Qualified Segregated Accounts
The 2019 Proposed Regulations defined a “qualified segregated account” as “an identifiable pool of assets maintained for the sole purpose of funding qualified benefits to qualified recipients.” The 2019 Proposed Regulations provided separate standards for assets held by eligible funds and assets held by QCEs. The Final Regulations adopt the same rules, but clarify that in the case of assets held by eligible funds a qualified segregated account is maintained so long as contributions to the plan are not more than what is reasonably necessary to fund the qualified benefits to be provided to qualified recipients, even though funds may revert back to the government or employer under the foreign law. This will be a welcome change for pension funds organized under foreign laws that permit a reversion of prior plan contributions in the case of overfunding. However, the Final Regulations do not adopt the recommendation that an eligible fund’s interest in a corporation can be treated as a segregated account.
2. Requirements Applicable to a QFPF
a. Established to Provide Retirement and Pension Benefits
The 2019 Proposed Regulations generally provided that a pension fund is considered a QFPF if it is established by either (1) the foreign country in which it is created or organized to provide retirement or pension benefits to participants or beneficiaries that are current or former employees or persons designated by such employees as a result of services rendered by such employees to their employers, or (2) one or more employers to provide retirement or pension benefits to participants or beneficiaries that are current or former employees or persons designated by such employees in consideration for services rendered by such employees to such employers. The Final Regulations generally adopt the rule set forth in the 2019 Proposed Regulations, with additional clarifications (including certain relief for an eligible fund that inadvertently fails to qualify as a QFPF).
Commentators expressed concern that certain retirement accounts (that are not employer funds) may be mandated by the government but actually established by a private pension administrator and managed by private investment managers. The Final Regulations now provide that an eligible fund may be established by or at the direction of a foreign jurisdiction or an employer even though persons that are not the foreign jurisdiction or employer administer the eligible fund.
The Final Regulations also provide that, with respect to employer funds, individuals who were never employees (or spouses or designees) but that are otherwise eligible under the plan may constitute qualified recipients provided such persons do not exceed 5% of the overall eligible recipients and provided that they do not have a right to more than 5% of the fund’s assets or income. The preamble to the Final Regulations also confirms that, with respect to government funds, any person eligible to participate in such a fund is a qualified recipient.
The 2019 Proposed Regulations required that all of the benefits that an eligible fund provides are “qualified benefits” to qualified recipients (the ‘‘100% Test’’), and that at least 85% of the present value of the qualified benefits that the eligible fund reasonably expects to provide in the future are retirement or pension benefits (the ‘‘85% Test’’). For this purpose, qualified benefits were defined as retirement, pension or ancillary benefits. The Final Regulations make several helpful clarifications including: (i) creating a new de minimis rule that allows up to 5% of the present value of the benefits the eligible fund reasonably expects to provide to qualified recipients in the future to be neither ancillary nor retirement/pension benefits, (ii) providing a specific definition of retirement and pension benefits and expanding the definition of ancillary benefits, which makes it easier not to exceed the new 5% limit, (iii) providing a “tie-breaker” rule whereby benefits that could qualify as either pension/retirement or ancillary benefits are deemed to be in the former category, (iv) for purposes of determining whether an eligible fund meets the 85% Test and the 5% limit, allowing any reasonable method to be used to determine the present value of benefits, provided that the determination must be made at least annually, and allowing the use of a 48-month alternative calculation test, and (v) clarifying that certain types of loans to participants, rollover distributions and hardship withdrawals are not taken into account for purposes of the 100% Test, the 85% Test, or the 5% limit. The Final Regulations also include a new recordkeeping rule which requires an eligible fund to maintain records sufficient to establish that it satisfies these requirements.
b. Information Reporting
Section 897(l)(2)(D) includes an information reporting requirement that a QFPF must satisfy. The Final Regulations combine the two separate provisions on information reporting in the 2019 Proposed Regulations into one provision and provide that the information reporting requirement in Section 897(l)(2)(D) is satisfied if a fund annually provides information about the amount of qualified benefits provided to qualified recipients to the relevant governmental authorities or such information is otherwise made available. The Final Regulations resolve a potential qualification issue where a fund did not itself actually provide information to the applicable government authorities because the information was otherwise available. Moreover, under the Final Regulations, a fund will not fail to satisfy such requirement if it is not required to provide information to the relevant governmental authorities in a year in which no qualified benefits are provided to qualified recipients.
c. Preferential Tax Treatment under Local Law
Regarding the requirement in Section 897(l)(2)(E) that an eligible fund receive preferential tax treatment under foreign law (specifically, with respect to contributions and investment income), the 2019 Proposed Regulations provided that the requirement does not take into account preferential tax treatment provided by a state, province, or political subdivision of a foreign country. The Final Regulations adopt the approach that subnational taxes satisfy the requirement of section 897(l)(2)(E), provided that income taxes imposed under the subnational tax law are treated as covered taxes under an income tax treaty between that foreign jurisdiction and the United States.
3. Withholding Rules
a. Foreign Partnerships Wholly Owned by Qualified Holders
The Final Regulations clarify that a foreign partnership that is wholly owned by qualified holders is not subject to withholding under Section 1445. Under the Final Regulations, a qualified holder and a foreign partnership all of the interests of which are held by qualified holders (including through one or more partnerships) may certify its status as a “withholding qualified holder,” which is not treated as a foreign person for purposes of the withholding rules under Sections 1445 and 1446.
Similar to the QCE rule, the Final Regulations do not provide any exception for a foreign partnership that has non-qualified holders. On the other hand, qualified holders investing through a foreign partnership that is not a withholding qualified holder are still eligible for the exemption on their distributive share of FIRPTA gains.
b. Documentation Requirements
The Final Regulations provide that a “withholding qualified holder” may submit a certification of non-foreign status for purposes of avoiding FIRPTA withholding, but with certain modifications. Generally, a transferee of a USRPI is required to withhold 15% of the gross proceeds unless, before or at the time of the transfer, the transferor furnishes to the transferee a certification that is signed under penalties of perjury which states that the transferor is not a foreign person and sets forth the transferor’s name, identifying number and address. Similarly, an entity is generally required to withhold on certain distributions to a foreign interest holder, but may rely on a certification that is signed under penalties of perjury which states that the interest holder is not a foreign person and sets forth the interest holder’s name, identifying number and address. Under the Final Regulations, if the transferor or interest holder is a QFPF or a QCE it must also state that it is not treated as a foreign person because it is a withholding qualified holder. This requirement was not included in the 2019 Proposed Regulations because the term “withholding qualified holder” was introduced in the Final Regulations. The Final Regulations also clarify that a withholding qualified holder may provide its foreign taxpayer identification number if it does not have a US taxpayer identification number. In light of the foregoing changes, QFPFs and QCEs should consider providing (and withholding agents should consider requesting) updated certificates that establish QFPF or QCE status in the manner required by the Final Regulations.
The Final Regulations also clarify that an IRS Form W-8EXP (to be revised by the IRS) is an acceptable type of certification of non-foreign status, but make it clear that an IRS Form W-9 may not be used for this purpose. Before the IRS releases the revised Form W-8EXP, a withholding qualified holder should use the certification of non-foreign status described above (and not a Form W–9).
The Final Regulations provide that an entity may rely on a certification of non-foreign status (by reason of being a withholding qualified holder) for a period of two calendar years following the close of the calendar year in which the certification was given. Therefore, withholding agents that are entities will be required to obtain new certifications from their interest holders that are QFPFs or QCEs on a fairly regular basis in order to continue to rely on those certifications for withholding purposes.
c. Coordination with Sections 1441 Withholding
Foreign persons receiving distributions from US corporations are potentially subject to US withholding tax under two separate withholding regimes. Ordinary dividends are generally subject to withholding under Section 1441. In addition, certain distributions that are related to dispositions of USRPIs are subject to withholding under Section 1445. In general, coordination rules ensure that a single distribution is subject to withholding under either Section 1441 or Section 1445, but not both. The 2019 Proposed Regulations provided that distributions made by a United States real property holding company (“USRPHC”) or qualified investment entity (“QIE”) to a qualified holder are only subject to the withholding requirements of Section 1441 rather than applying the normal coordination rules. The Final Regulations amend the coordination rules to reach the same result intended under the 2019 Proposed Regulations. Under the Final Regulations, withholding qualified holders are not subject to withholding under Section 1445 on distributions from USRPHCs that are not treated as dividends or on capital gain dividends from REITs or other QIEs. Dividends from USRPHCs (other than REITs or other QIEs) and ordinary dividends from REITs or other QIEs that are not capital gain dividends continue to be subject to withholding under Section 1441.
The Final Regulations also state that, with respect to capital gain dividends from publicly traded REITs or other QIEs that are not treated as gains attributable to the sale or exchange of a USRPI by reason of the small shareholder exception in Section 897(h), withholding will apply under Section 1441. It appears the intent of this provision is to clarify that such distributions, which are reclassified as ordinary REIT dividends under Section 857, are correspondingly subject to the normal withholding rules for ordinary REIT dividends.
Section 892 Proposed Regulations
The 2022 Proposed Regulations include proposed regulations under Section 892 clarifying the application of Section 892 to QFPFs and proposing certain other clarifying changes (the “Proposed 892 Regulations”).6 Section 892(a)(1) exempts income derived by a foreign government from US taxation except for (i) income derived from the conduct of a commercial activity, (ii) income received by or from a controlled commercial entity, or (iii) income derived from the disposition of an interest in a controlled commercial entity.7 A controlled commercial entity is an entity that is controlled by a foreign government and that is engaged in commercial activities. Under Treasury Regulation Section 1.892-5T(b)(1), a USRPHC is treated as engaged in commercial activity, and thus as a controlled commercial entity if it is controlled by a foreign government.8 Under existing law, a QFPF could qualify as a controlled commercial entity if it meets the requirements to be a USRPHC and is controlled by a foreign government. For example, if a controlled entity of a foreign government owns USRPIs that constitute 50% of the fair market value of the sum of its USRPIs, its non-US real property interests, and its other assets held for use in a trade or business, the controlled entity would be treated as a controlled commercial entity, even if such investments were minority investments. The Proposed 892 Regulations introduce an exception from this rule for QFPFs that are USRPHCs.
In addition, the Proposed 892 Regulations offer a limited exception to such rule that would apply to all types of entities that are USRPHCs solely by reason of direct or indirect ownership interests in one or more corporations not controlled by the applicable foreign government. The proposed changes may alleviate some concerns around the so-called ”USRPHC trap” that has historically caused many controlled entities of foreign governments to prefer investing through domestically controlled REITs in order to minimize their USRPIs.
The Proposed 892 Regulations also incorporate a correction to a long-standing confusing passage in the existing regulations under Section 892.9 More notably, the Treasury Department and the IRS also reopened the comment period for the 2011 proposed regulations under Section 89210 until February 27, 2023.11
Proposed FIRPTA Regulations
The 2022 Proposed Regulations also include proposed regulations under Section 897 that change the rules relating to the determination of whether a QIE is domestically controlled (such determination, the “Domestic Control Determination,” and such domestically controlled QIE, a “DC-QIE”) for purposes of the exceptions under FIRPTA for DC-QIEs (the “Proposed FIRPTA Regulations”).
1. FIRPTA Background
FIRPTA generally requires non-resident alien individuals or foreign corporations to recognize gain or loss on the disposition of a USRPI as if the nonresident alien individual or foreign corporation was engaged in a trade or business within the United States during the taxable year of such disposition and such gain or loss was effectively connected with that trade or business.12 Section 897(c)(1)(A) defines a USRPI as an interest in real property, and any interest (other than solely as a creditor) in any domestic corporation unless the taxpayer establishes that such corporation was at no time a USRPHC during the five-year period prior to the disposition of interests in such USRPHC.13 Section 897(h)(1) provides that any distribution by a QIE to a nonresident alien individual, a foreign corporation, or other QIE, to the extent attributable to gain from sales or exchanges by the QIE of USRPIs, is treated as gain recognized by such nonresident alien individual, foreign corporation, or other QIE from the sale or exchange of a USRPI, subject to certain exceptions.14 Further, Section 897(h)(2) provides that a USRPI does not include an interest in a DC-QIE.15 A QIE is domestically controlled under Section 897(h)(4)(B) if less than 50% of the value of its stock is held directly or indirectly by foreign persons at all times during the five-year period ending on the date of the relevant disposition.16
2. QFPF Status for Domestic Control Determination
The first change in the Proposed FIRPTA Regulations clarifies the treatment of QFPFs for purposes of the Domestic Control Determination. As originally enacted under the PATH Act, the QFPF exception from FIRPTA stated that Sec. 897 “does not apply to any USRPI held directly (or indirectly through one or more partnerships) by, or to any distribution received from a REIT by a [QFPF] or any entity all of the interests of which are held by a [QFPF].”17 Later, Congress made certain technical amendments to Sec. 897(l), revising it to provide that “neither a QFPF nor an entity all the interests of which are held by a QFPF is treated as a nonresident alien individual or foreign corporation for purposes of Sec. 897.”18 Some commentators suggested that the changes under the Technical Corrections Act allowed QFPFs and QCEs to be treated as domestic persons for purposes of the Domestic Control Determination.19 The IRS rejected this suggestion in the Proposed FIRPTA Regulations, relying on textual arguments,20 congressional intent,21 judicial limitations on the impact of laws designated as technical corrections,22 and policy arguments.23 Consequently, the Proposed FIRPTA Regulations explicitly treat QFPFs and QCEs as foreign persons for purposes of the Domestic Control Determination. Proposed Regulation Section 1.897-1(c)(3)(iv)(A) would also explicitly treat international organizations as foreign persons for such purposes, for similar reasons as QFPFs and QCEs. QIEs that have been treating QFPFs, QCEs, and international organizations as domestic for purposes of the Domestic Control Determination will need to reevaluate their status as DC-QIEs in light of the Proposed FIRPTA Regulations.
3. Attribution for Domestic Control Determination
The second change in the Proposed FIRPTA Regulations introduces a “limited look-through approach” for purposes of the Domestic Control Determination.24 There are no constructive ownership rules in Section 897(h)(4)(B), and it isn’t clear that the reference to “indirect” ownership implies which, if any, constructive ownership rules should apply. The applicable regulations only indicate that the actual owners of stock under Treasury Regulation Section 1.857-8 would be considered for purposes of the Domestic Control Determination.25 In Priv. Ltr. Rul. 200923001, the IRS ruled privately that a REIT would not look through C corporations in making a Domestic Control Determination, even where such C corporations and the REIT itself were ultimately entirely owned by a foreign corporation. In the ruling, the IRS noted that the C corporations are the entities which include distributions from the REIT as income on their tax returns and actually pay US tax on such distributions, and cited Treas. Reg. § 1.857-8.26 The representation on which such ruling turned also specified that each of the relevant C corporations was not otherwise a REIT, RIC, hybrid entity, conduit, disregarded entity, or other flow-through or look-through entity.27 Additionally, in the Path Act, Congress introduced special ownership rules for the Domestic Control Determination involving publicly traded REITs and REITs with publicly traded owners, providing that (1) all holders of less than 5% of any class of publicly traded REIT stock are treated as US persons unless the REIT has actual knowledge that a holder is not a US person, and (2) stock in a REIT held by a publicly traded REIT will be treated as held by a foreign person unless the shareholder REIT is itself domestically controlled.28 The PATH Act also introduced a look-through rule for stock in a REIT held by a shareholder that is a private REIT. Many practitioners have considered the PATH Act changes as consistent with the ruling of the IRS in Priv. Ltr. Rul. 200923001, given that such changes provided both deemed foreign ownership rules and a look-through rule that apply to specific types of domestic corporations (REITs) rather than applying to domestic C corporations generally.
The Proposed FIRPTA Regulations provide an extensive look-through and attribution regime, as well as special rules that directly contradict Priv. Ltr. Rul. 200923001. New Proposed Regulation Section 1.897-1(c)(3) divides potential intermediary entities into “look-through persons” and “non-look-through persons.” Under Proposed Regulation Section 1.897-1(c)(3)(ii), the owners of look-through persons are treated as proportionately owning stock held by such look-through persons (the “Look-Through Attribution Rule”), while non-look-through persons are treated as holding stock of QIEs themselves (the “Non-Look-Through Rule,” together with the “Look-Through Attribution Rule,” the “Proposed Domestic Control Attribution Rules”). Proposed Regulation Section 1.897-1(c)(3)(ii)(D) provides that non-look-through persons include:
- Domestic C corporations (other than foreign-owned domestic corporations that are not publicly traded)
- Nontaxable holders (exempt organizations under Sec. 501(a), the United States, any State, territory or political subdivision thereof and any Indian tribal government or subdivisions thereof)
- Foreign corporations (including foreign governments pursuant to Sec. 892(a)(3))
- Publicly traded partnerships (domestic or foreign)
- Estates (domestic or foreign)
- International organizations (as defined in Sec. 7701(a)(18))
- Qualified foreign pension funds (including any part of a qualified foreign pension fund)
- Qualified controlled entities
Interestingly, the Look-Through Attribution Rule does not seem to differentiate between publicly traded partnerships that are classified as corporations and those that are classified as partnerships (e.g., by virtue of the qualifying income exception). Rather, all publicly traded partnerships are treated as non-look through persons.
Conversely, Proposed Regulation Section 1.897-1(c)(3)(ii)(C) provides that look-through persons include:
- Regulated investment companies (“RICs”)
- S corporations
- Non-publicly traded partnerships (domestic or foreign)
- Trusts (domestic or foreign, whether grantor trusts or otherwise)
Proposed Regulation Section 1.897-1(c)(3)(iii) includes certain special rules under this framework. First, Proposed Regulation Section 1.897-1(c)(3)(iii)(A) provides that a person holding less than 5% of US publicly traded QIE stock at all times during the five-year period ending on a relevant disposition, determined without regard to the Non-Look-Through Rule, is treated as a United States person that is a non-look-through person, unless the QIE has actual knowledge that such person is not a United States person. Second, under Proposed Regulation Section 1.897-1(c)(3)(iii)(C), a public QIE is treated as a foreign person that is a non-look-through person unless the public QIE is a DC-QIE (such rules, the “Public QIE Rules”). These rules mirror those introduced in Section 897(h)(4)(E) under the PATH Act and discussed above regarding publicly traded QIEs for purposes of the Domestic Control Determination.29
Finally, Proposed Regulation Section 1.897-1(c)(3)(iii)(B) adds an exception to the treatment of domestic C corporations as non-look-through persons where the domestic corporation is “foreign-owned.” Under Proposed Regulation Section 1.897-1(c)(3)(v)(B), a non-public domestic corporation is a “foreign-owned domestic corporation” if it is not publicly traded (per Proposed Regulation Section 1.897-1(c)(3)(v)(G), no class of its stock is regularly traded on an established securities market within the meaning of Treasury Regulation Section 1.897-1(m) and 1.897-9T(d)) and foreign persons directly or indirectly hold 25% or more of the fair market value of such domestic corporation, subject to the same Proposed Domestic Control Attribution Rules discussed above and the Public QIE Rules.
The exception for foreign-owned domestic corporations runs directly counter to Priv. Ltr. Rul. 200923001, despite some practitioners’ interpretation of congressional support for that ruling via the PATH Act. QIE investment structures that were created based on the assumption that domestic C corporations are treated as domestic persons for purposes of the Domestic Control Determination, regardless of such C corporations’ upper-tier ownership, or that rely on the interposition of domestic C corporations to achieve desired DC-QIE status, may need to be reevaluated in light of the Proposed FIRPTA Regulations.
4. Other Changes
In addition to the Domestic Control Determination, the Proposed Regulation Section 1.897-1(c)(4) incorporates the Proposed Domestic Control Attribution Rules to Section 897(h)(4)(C), which provides that a distribution of a USRPI by a DC-QIE will be treated as a sale giving rise to gain to the extent of the QIE’s foreign ownership percentage, subject to certain exceptions.
Finally, the Proposed FIRPTA Regulations replace the definition of “domestically controlled REIT” in Treasury Regulation Section 1.897-1(c)(2)(i) with the definition of “domestically controlled QIE” in Proposed Regulation Section 1.897-1(c)(3), reflecting amendments to Section 897(h) made after the existing FIRPTA regulations were issued expanding the application of Section 897(h) to certain RICs.
Applicability of 2022 Proposed Regulations
Generally, proposed regulations are not effective until they are finalized and filed as such in the Federal Register, which is the case for the Proposed 892 Regulations and the Proposed FIRPTA Regulations. Additionally, the preamble to the Proposed FIRPTA Regulations explicitly states that the proposed regulations with respect to the Domestic Control Determination may be relevant for periods before finalization to the extent that the five-year testing period prior to any disposition subject to tax under FIRPTA includes periods before final publication.30 The preamble also indicates the IRS may challenge positions contrary to Proposed Regulation Sections 1.897-1(c)(3) and (c)(4) before the issuance of final regulation as to the Domestic Control Determination.31 These last two statements suggest that the Proposed FIRPTA Regulations could effectively apply before the issuance of final regulations. Because a five-year look-back rule applies for determining whether a QIE is domestically controlled, once the Proposed FIRPTA Regulations are finalized the changes to the Domestic Control Determination will apply to a QIE’s ownership for the prior five years (potentially for periods that even predate the Proposed FIRPTA Regulations). Further, it appears the IRS intends to attempt to enforce the proposed changes to the Domestic Control Determination even before they are finalized.
1 Unless otherwise stated, all section references are to the Internal Revenue Code of 1986, as amended (the “Code”), and the Treasury regulations promulgated thereunder.
2 T.D. 9971, 87 Fed. Reg. 80,042 (Dec. 29, 2022), available at https://www.govinfo.gov/content/pkg/FR-2022-12-29/pdf/2022-27978.pdf.
3 Guidance on the Foreign Government Income Exemption and the Definition of Domestically Controlled Qualified Investment Entities, 87 Fed. Reg. 80,097 (Dec. 29, 2022), available at https://www.govinfo.gov/content/pkg/FR-2022-12-29/pdf/2022-27971.pdf.
4 The Protecting Americans from Tax Hikes Act of 2015, Pub. L. 114-113, div. Q (the “PATH Act”).
5 Exception for Interests Held by Foreign Pension Funds, 84 Fed. Reg. 26,605 (June 7, 2019), available at https://www.govinfo.gov/content/pkg/FR-2019-06-07/pdf/2019-11291.pdf.
6 87 Fed. Reg. 80,097, supra note 2.
8 Treas. Reg.§ 1.892-5T(b)(1).
9 Specifically, Treas. Reg.§ 1.892-5T(b)(1) currently reads that a USRPHC “or a foreign corporation that would be a [USRPHC] if it was a United States corporation” shall be treated as engaged in commercial activity. However, Sec. 897(c)(c)defines a USRPHC as “any corporation,” whether domestic or foreign. The proposed regulations would replace the quoted language with “which may include a foreign corporation.”
10 Income of Foreign Governments and International Organizations, 76 Fed. Reg. 68,119-68,124 (Nov 3, 2011).
11 Income of Foreign Governments and International Organizations; Comment Period Reopening, 87 Fed. Reg. 80,108 (Dec. 29, 2022) (REG 146537–06).
17 Sec. 323(a) of the PATH Act.
18 Sec. 101(q) of the Tax Technical Corrections Act of 2018, Pub. L. 115-141, div. U (the “Technical Corrections Act”).
20 Id. Sec. 897(a) imposes tax on nonresident alien individuals (“NRAs”) and foreign corporations (“FCs”) and Sec. 897(h)(1) imposes tax on distributions to NRAs and FCs, which a QFPF is not under current Sec. 897(l), but the determination of whether a QIE is domestically controlled under 897(h)(4)(B) refers to ownership by “foreign persons,” rather than NRAs and FCs.
21 87 Fed. Reg. at 80.099-80,100. The PATH Act introduced Sec. 897(l) and introduced deemed domestic and deemed foreign ownership rules in Sec. 897(h)(4)(E) for publicly traded QIEs. Further, the Joint Committee on Taxation explained the Technical Corrections Act was “merely intended to clarify the language specifying which entities qualified for the benefit provided by the new subsection.” See STAFF OF THE JOINT COMM. ON TAX'N, General Explanation of Tax Legislation Enacted in the 115th Congress (JCS-2-19) (General Explanation) 145 (2019).
22 87 Fed. Reg. at 80,100. “[A]s a technical correction, the modification to section 897(l) cannot expand on the policy Congress intended to enact in the PATH Act,” citing Fed. Nat’l Mortgage Assoc. v. United States, 56 Fed. Cl. 228, 234, 237 (2003), rev’d and remanded on other grounds, 379 F.3d 1303 (Fed. Cir. 2004) (“Congress turns to technical corrections when it wishes to clarify existing law or repair a scrivener's error, rather than to change the substantive meaning of the statute. . . . [A] technical correction that merely restores the rule Congress intended to enact cannot be construed as a fundamental change in the operation of the statute.").
23 Id. QFPFs and QCEs are already exempt from tax under 897(a); treating them as domestic for purposes of the Domestic Control Determination only helps other investors.
24 As described above, the Sec. 897(h)(4)(B) provides that a QIE is domestically controlled if less than 50% of the value of its stock is held directly or indirectly by foreign persons at all times during the five-year period ending on the date of the relevant disposition.
25 Treas. Reg. § 1.897-1(c)(2)(i), which the Proposed FIRPTA Regulations strike in favor of the rules described below. Actual owners under Treas. Reg. 1.857-8 are those persons required to include dividends received on the stock of a REIT in gross income on their tax returns.
29 Sec. 897(h)(4)(E), as enacted by Sec. 322 of the PATH Act.