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Section 897 guidance addresses REITs, RICs, foreign government tax exemption
January 2023
In brief
Treasury and the IRS on December 28 published proposed regulations (the Proposed Regulations) regarding the definition of domestically controlled qualified investment entity (DC QIE) under Section 897 (FIRPTA). The Proposed Regulations also revise the definition of a “controlled commercial entity,” under Section 892, for entities that are treated as qualified foreign pension funds (QFPFs) under Section 897.
Income (or loss) derived from the disposition of a US real property interest (USRPI) by a nonresident alien individual or a foreign corporation generally is treated as effectively connected with a US trade or business. A US corporation is treated as a US real property holding corporation (USRPHC) and, as such, a USRPI, unless the taxpayer establishes that not more than 50% of its assets are USRPIs during the lesser of (1) its ownership period or (2) the last five years. This rule applies to QIEs (generally, real estate investment trusts or certain regulated investment companies). However, if a QIE is a DC QIE (i.e., less than 50% of the value is owned by non-US persons), the entity is not treated as a USRPHC. The Proposed Regulations provide guidance regarding the determination of whether a QIE should be treated as a DC QIE.
The Proposed Regulations suggest a “look-through” regime for the purposes of determining whether a QIE is domestically controlled. Of particular note is the decision to propose a rule that would require domestic non-publicly traded C corporations to be looked through under certain conditions. In addition, the Proposed Regulations provide that QFPFs and their wholly owned subsidiaries are not to be treated as US persons for the purposes of determining whether a QIE is domestically controlled.
The Proposed Regulations also provide that, for purposes of the rules related to taxation of foreign sovereigns, a corporation that is a USRPHC solely due to owning interests in other corporations would not be deemed to be engaged in commercial activity provided the foreign sovereign does not control interests in those other corporations.
The Proposed Regulations regarding Section 897 generally would be effective for transactions that occur after the regulations are finalized. The preamble states that the rules would apply to a determination of DC QIE status even if the determination relates to periods before the adoption of final regulations, or even before the issuance of the proposed regulations. The preamble notes that the IRS may challenge positions taken contrary to the items noted above for transactions that occur before regulations are finalized as the IRS views these rules as clarifications of existing law.
The Proposed Regulations regarding Section 892 would be effective for tax years beginning on or after December 28, 2022 and taxpayers may rely on the Proposed Regulations until they are finalized.
Action Item: If a company is relying on the DC QIE exemption, consideration should be given as to how these rules impact its DC QIE. An analysis should be undertaken to confirm any such entity is still treated as domestically controlled after applying the new “look-through” rules and rules related to the treatment of QFPFs.
In detail
Proposed limited “look-through” regime for domestic control
Background
Income (or loss) derived from the disposition of a USRPI by a nonresident alien individual or a foreign corporation generally is treated as effectively connected income with a US trade or business. Under Section 897(c)(1), A USRPI includes any interest (other than solely as a creditor) in any US corporation unless the taxpayer establishes that the US corporation is not and was not a USRPHC during the shorter of (1) the ownership period or (2) the five-year period ending on the date of disposition.
Under Section 897(c)(2), a USRPHC is generally any corporation if the fair market value of its USRPIs is 50% or more of the total fair market value of its USRPIs, foreign real property and assets held for use in its trade or business.
Under Section 897(h)(4), a QIE is any real estate investment trust (REIT) and certain regulated investment companies (RIC). A QIE may or may not be a USRPHC. However, even if the stock of a QIE is a USRPHC, the stock of such QIE is not a USRPI if the QIE is domestically controlled. Thus, income from the sale or exchange of a DC QIE is not treated as income from the sale or exchange of a USRPI even if the DC QIE is a USRPHC.
A QIE is treated under Section 897(h)(4) as a DC QIE if non-US persons, directly or indirectly, own less than 50% of the value of the QIE during the shortest of (1) the period starting on June 19, 1980 and ending on the date of the disposition; (2) the five-year period ending on the date of disposition; or (3) the period during which the QIE existed (the Testing Period).
Proposed Regulations
The Proposed Regulations provide rules regarding determining domestic control status when interests in a QIE are held through other entities. The proposed rules suggest a limited “look-through” approach. Treasury states in the preamble its position that the look-through approach balances the policies of the DC QIE exception with the requirements of the statute to consider “indirect” ownership of QIE stock by non-US persons in determining whether a QIE is domestically controlled.
Under this “look-through” approach, if an interest in a QIE is held by a “look-through person,” the owners of the look-through person would be the relevant persons for purposes of determining whether the QIE is a DC QIE. To that end, the QIE stock is imputed to the look-through person’s owners on a pro-rata basis based on their proportionate interests in the look-through person. Solely for the purposes of determining whether a QIE is a DC QIE, the Proposed Regulations define “look-through” and “non-look-through” persons who may hold the stock of a QIE at any given time.
The Proposed Regulations would define a “look-through” person as any person other than a “non-look-through” person. The Proposed Regulations note that this definition of “look-through” person includes, for example, a RIC, a REIT, an S corporation, a non-publicly traded partnership (domestic or foreign), and a trust (domestic or foreign).
Observation: The proposed treatment of non-US partnerships as “look-through” is a positive development for taxpayers as it clarifies that a foreign partnership would not be treated as a foreign person for purposes of determining domestic control.
A “non-look-through” person is defined as an individual, a nontaxable holder (which includes not-for-profit organizations as well as the United States, any State, any territory of the United States, or a political subdivision of any State or any territory of the United States, or any Indian tribal government), a foreign corporation (including a foreign government), a publicly traded partnership (domestic or foreign), an estate (domestic or foreign), an international organization, a qualified foreign pension fund (including any part of a qualified foreign pension fund), or a qualified controlled entity.
Of particular note, the Proposed Regulations would treat a domestic C corporation as generally a “non-look-through” person unless the domestic C corporation is a “foreign-owned domestic corporation.” A “foreign-owned domestic corporation” is any nonpublic domestic C corporation in which foreign persons hold directly or indirectly 25% or more of the fair market value of the nonpublic domestic C corporation’s outstanding stock. The Proposed Regulations provide that the same look-through rules that apply in determining whether a QIE is domestically controlled also apply for purposes of determining whether a nonpublic domestic C corporation is a foreign-owned domestic corporation.
The Proposed Regulations would provide that C corporations that are determined to be “foreign-owned domestic corporations” are treated as “look-through” persons for purposes of determining the indirect owners in QIEs.
Observation: The application of the look-through rules to “foreign-owned domestic corporations” seems inconsistent with PLR 200923001. The concept of looking through a US corporation also seems inconsistent with the Protecting Americans from Tax Hike Act, which specifically provided that, for purposes of determining domestic control, one looks through a QIE that is neither regularly traded on an established securities market nor a regulated investment company that issues redeemable securities. Such a rule would have been superfluous if the general rule was that one looks through US corporations (which would include a QIE).
Observation: Taxpayers that have conducted a DC QIE analysis treating a US corporation as a “non-look-through” person regardless of the US corporation’s ownership composition may want to revisit their analysis to determine the impact this rule would have if finalized.
Treatment of qualified foreign pension funds for purposes of the domestic control test
Background
Entities that are qualified foreign pension funds (QFPFs) or qualified controlled entities (QCEs) are not treated as nonresident alien individuals or a foreign corporations for purposes of the section of the Code that includes the domestically controlled REIT rules. Some taxpayers may have interpreted the statutory provision as indicating that a QFPF was not treated as a foreign person for purposes of determining domestic control.
Proposed Regulations
The Proposed Regulations provide that QFPFs and QCE are treated as foreign persons for purposes of determining domestic control. In addition, the regulations indicate that the IRS may challenge a taxpayer that takes a contrary position before the issuance of final regulations.
Ownership of US publicly traded QIE stock
Background
Generally, a person that holds less than 5% of any class of a US publicly traded QIE at all times during the testing period is treated as a US person unless the QIE has actual knowledge that such person is not a US person.
Conversely, any stock in a QIE held by another QIE (i) that is regularly traded on an established securities market or (ii) that is a RIC that issues redeemable securities within the meaning of the Investment Company Act of 1940 (an entity described in (i) or (ii), a “public QIE”) is treated as held by a foreign person, unless the public QIE is domestically controlled. If the public QIE is domestically controlled, its stock is treated as held by a US person.
Proposed Regulations
The Proposed Regulations generally would treat a deemed US person holding less than 5% of a class of stock of a QIE that is regularly traded on an established securities market as a US person that is a non-look-through person with respect to that stock, unless the QIE has actual knowledge that such person is not a US person. . In addition, a public QIE would be treated under the Proposed Regulations as held by a non-look-through person. A public QIE is generally treated as a non-US person unless it is treated as a domestically controlled REIT, in which case it would be treated as a US person.
The Proposed Regulations provide that the rule regarding US publicly traded QIE stock applies notwithstanding any other rules regarding domestically controlled QIEs. Thus, the Proposed Regulations provide that a QFPF that holds less than 5% of a US publicly traded QIE stock at all times during the testing period (and absent actual knowledge that the person is not a US person) is treated as a US person that is a non-look through person with respect to that stock even though the QFPF would otherwise be treated as a foreign person under the Proposed Regulations.
Foreign Government Income Exemption
Background
Generally, under Section 892, certain US income derived by foreign governments is exempt from US federal income tax. This exemption does not apply to income that is (1) derived from the conduct of a commercial activity, (2) received directly or indirectly by or from a controlled commercial entity (described below), or (3) derived from the disposition of an interest in a controlled commercial entity.
A controlled commercial entity is any entity engaged in commercial activity if the foreign government holds directly or indirectly 50% or more of the vote or value or effective control of the entity. For these purposes, a USRPHC and any foreign corporation that would be treated as a USRPHC if it were a domestic corporation are treated as engaged in a commercial activity and are treated as a controlled commercial entity if the ownership or control thresholds mentioned above are met.
Proposed Regulations
The Proposed Regulations would provide guidance regarding the application of the commercial activity rules to corporations that are USRPHCs solely by reason of owning interests in other corporations not controlled by foreign governments. Specifically, under the Proposed Regulations, such a corporation would not be treated as engaged in commercial activity. The rule would apply to tax years ending on or after December 28, 2022.
Observation: Prior to the Proposed Regulations, if a corporation, including a QFPF, also was treated as a USRPHC, it would be treated as a commercial entity and the corporation might lose its ability to qualify for the tax benefits available to foreign governments. Thus, notwithstanding that a QFPF can invest in USRPIs without being subject to US federal income tax, doing so may have had a negative impact on the availability of a US federal income tax exemption available to sovereigns on certain portfolio assets (stocks, bonds, etc.). The Proposed Regulations would represent a welcome change that aligns the policy of the QFPF exemptions (incentivizing investment in US real estate) with the US government's policy of sovereign immunity underlying the foreign government income exemption.
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