Tax 101: Understanding U.S. Taxation of Foreign Investment in Real Property – Part III

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INTRODUCTION

This is the final article in a three-part series that explains U.S. taxation under the Foreign Investment in Real Property Tax Act of 1980 (“F.I.R.P.T.A.”). This article looks at certain planning options available to taxpayers and the tax consequences of each.

These planning structures aim to mitigate taxation by addressing several different taxable areas of the transaction. They work to avoid gift and estate taxes, and double taxation of cross-border events and corporate earnings, while simultaneously striving for preferential treatment (e.g., long-term capital gains treatment), as well as limiting over-withholding, contact with the U.S. tax system, and liability. Often, such structures are helpful in facilitating inter-family transfers and preserving the confidentiality of the persons involved.

PRE-PLANNING

As with everything else, planning can go a long way when it comes to maximizing U.S. real estate investments. Here are a few questions to ask:

Investor Background

1. Where is the investor located?
2. Where is the investment located?
3. What kind of business is the investor engaged in?

Tax 101: Understanding U.S. Taxation of Foreign Investment in Real Property - Part II

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This article examines the U.S. income, gift, and estate tax consequences to a foreign owner upon a sale or other disposition of U.S. real property, including a sale of real estate, sale of stock of a U.S. corporation, or a sale of a mortgage secured by U.S. real property.

In addition to (or sometimes in lieu of) rental income, many foreign investors hope to realize gain upon a disposition of U.S. real property. The Foreign Investment in Real Property Tax Act of 1980 (“F.I.R.P.T.A.”) dictates how gains are taxed from the disposition of United States Real Property Interests (“U.S.R.P.I.’s”). The law has a fairly extensive definition of U.S. real property for this purpose. Most significantly, the law provides for a withholding mechanism in most cases.

WHAT IS A U.S.R.P.I.?

A U.S.R.P.I. includes the following:

• Land, buildings, and other improvements;
• Growing crops and timber, mines, wells, and other natural deposits (but not severed or extracted products of the land);
• Tangible personal property associated with the use, improvement, and operation of real property such as:
• Mining equipment used to extract deposits from the ground,
• Farm machinery and draft animals on a farm,
• Equipment used in the growing and cutting of timber,
• Equipment used to prepare land and carry out construction, and
• Furniture in lodging facilities and offices.
• Direct or indirect rights to share in appreciation in value, gross or net proceeds, or profits from real property;
• Ownership interests other than an interest solely as a creditor, including:
• Fee ownership;
• Co-ownership;
• Leasehold interest in real property;
• Time-sharing interest;
• Life estate, remainder, or reversionary interest; and
• Options, contracts, or rights of first refusal.

Tax 101: Understanding U.S. Taxation of Foreign Investment in Real Property - Part I

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INTRODUCTION

U.S. real estate has been a popular choice for foreign investors, whether the property is held for personal use, rental or sale, or long-term investment. Since the passage of the Foreign Investment in Real Property Tax Act of 1980 (“F.I.R.P.T.A.”), the governing tax rules have developed and evolved, but have not succeeded in discouraging foreign investment. F.I.R.P.T.A. can be a potential minefield for those unfamiliar with U.S. income, estate, and gift taxation – all of which come into play. This article is the first of a series on understanding U.S. taxation of foreign investment in real property.

TAXATION OF A FOREIGN PERSON

“A foreign person is subject to U.S. income tax only on income that is characterized as U.S. source income.”

As simple as the concept sounds, there are applicable nuances, caveats, exemptions, and exceptions. Therefore, several questions must first be answered to determine the U.S. income tax consequences for a foreign person engaged in U.S. economic activities, including ownership of real property:

1. Is the income derived from a U.S. source and therefore potentially taxable?
2. Is the income taxable or exempt from tax?
3. Is the income passive or active, subject to a flat withholding tax on gross income or, alternatively, to graduated rates on net income?
4. Is the income earned by an individual or corporation or other entity, each of which may have different rules and applicable tax rates?

Tax 101: Tax Planning and Compliance for Foreign Businesses with U.S. Activity

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I. INTRODUCTION

The U.S. tax laws affecting foreign businesses with activity in the U.S. contain some of the more complex provisions of the Internal Revenue Code. Examples include:

• Effectively connected income,
• Allocation of expenses to that income,
• Income tax treaties,
• Arm’s length transfer pricing rules,
• Permanent establishments under income tax treaties,
• Limitation on benefits provisions in income tax treaties that are designed to prevent “treaty shopping,”
• State tax apportionment,
• F.I.R.P.T.A. withholding tax for transactions categorized as real property transfers,
• Fixed and determinable annual and periodical income, and
• Interest on items of portfolio debt.

One can imagine that it is no easy task to identify income that is subject to tax, to identify the tax regime applicable to the income, and to quantify gross income, net income, and income subject to withholding tax. Nonetheless, the I.R.S. has identified withholding tax obligations of U.S. payers as a Tier I audit issue.

Tax 101: Outbound Acquisitions - Holding Company Structures

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When a U.S. company acquires foreign targets, the use of a holding company structure abroad may provide certain global tax benefits. The emphasis is on “global” because standard U.S. benefits such as deferral of income while funds remain offshore may not be available without further planning once a holding company derives dividends and capital gains. This article will discuss issues that should be considered when setting up a company overseas, particularly a foreign holding company, in order to maximize foreign tax credits despite the limitations under the U.S. tax rules, and to reduce the overall U.S. taxes paid. These issues include challenges to the substance of a holding company, recent trends in inversion transactions, the net investment income tax on investment income of U.S. individuals, and the significance of the O.E.C.D. Base Erosion and Profit Shifting report on tax planning structures.

U.S. TAXATION OF INTERCOMPANY DIVIDENDS AMONG FOREIGN SUBS

If we assume the income of each foreign target consists of manufacturing and sales activities that take place in a single foreign country, no U.S. tax will be imposed until the profits of the target are distributed in the form of a dividend or the shares of the target are sold. This is known as “deferral” of tax. Once dividends are distributed, U.S. tax may be due whether the profits are distributed directly to the U.S. parent company or to a holding company located in another foreign jurisdiction. Without advance planning to take advantage of the entity characterization rules known as “check-the-box,” the dividends paid by the manufacturing company will be taxable in the U.S. whether paid directly to the parent or paid to a holding company located in a third country. In the latter case, and assuming the holding company is a controlled foreign corporation (“C.F.C.”) for U.S. income tax purposes, the dividend income in the hands of the holding company will be viewed to be an item of Foreign Personal Holding Company Income, which generally will be taxed to the U.S. parent company, or any other person that is treated as a “U.S. Shareholder” under Subpart F of the Internal Revenue Code.

Tax 101: Taxation of Foreign Trusts

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INTRODUCTION: WHAT IS A FOREIGN TRUST?

In General

A trust is a relationship (generally a written agreement) created at the direction of an individual (the settlor), in which one or more persons (the trustees) hold the individual's property, subject to certain duties, to use and protect it for the benefit of others (the beneficiaries). In general, the term “trust” as used in the Internal Revenue Code (the “Code”) refers to an arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts.

Trusts can be characterized as grantor trusts or ordinary trusts. Ordinary trusts can be characterized as simple trusts or complex trusts; U.S. tax laws have special definitions for these concepts. A simple trust is a trust that is required to distribute all of its annual income to the beneficiaries. Beneficiaries cannot be charitable. A complex trust is an ordinary trust which is not a simple trust, i.e., a trust that may accumulate income, distribute corpus, or have charitable beneficiaries. Ordinary trusts are “hybrid” entities, serving as a conduit for distributions of distributable net income (“D.N.I.”), a concept defined in the Code,52 to beneficiaries and receiving a deduction for D.N.I. distributions, while being taxed on other income (e.g., accumulated income, income allocated to corpus).

A trust can be domestic or foreign. This article will focus on the U.S. tax consequences with respect to “foreign grantor trusts” (“F.G.T.”) and “foreign nongrantor trusts” (“F.N.G.T.”).

Tax 101: Financing A U.S. Subsidiary - Debt vs. Equity

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INTRODUCTION

When a foreign business contemplates operating in the U.S. through a U.S. subsidiary corporation, it must take into account the options available for funding the subsidiary. As a practical matter, a foreign-owned subsidiary may encounter difficulty in obtaining external financing on its own, and thus, internal financing is often considered. It is a common practice for a foreign parent corporation to fund its subsidiary through a combination of equity and debt.

Using loans in the mixture of the capital structure is often advisable from a tax point of view. Subject to the general limitations under the Internal Revenue Code (the “Code”), financing the operations with debt will result in a U.S. interest expense deduction, often with a meaningful reduction of the overall tax rate applicable to the operation. (It should be noted that the U.S. has one of the highest corporate tax rates in the world.) Additionally, repayment of invested capital (in the form of debt principal) will be free of U.S. withholding tax if the investment qualifies as a debt instrument for U.S. tax purposes. If the lender is a resident of a treaty jurisdiction and eligible for treaty benefits, the interest payments will be subject to a reduced rate of taxation – or a complete elimination of taxation – under the treaty. Another reason multinational entities use debt to finance their subsidiaries is the possibility for tax arbitrage resulting from the differing treatment in various countries of debt and equity.

Tax 101: Form 5471 - How to Complete the Form in Light of Recent Changes

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INTRODUCTION

As part of the obligation to file income tax returns, U.S. persons owning 10% or more of the stock of a foreign corporation – measured by voting power or value of the stock that is owned – are obligated to provide information on the foreign corporation. Ownership is determined by reference to stock directly held, indirectly held through foreign entities, and deemed held through attribution from others. The scope and detail of the information to be reported is dependent on the percentage of ownership maintained by the U.S. taxpayer. As the degree of ownership increases, the amount of information increases. The reporting vehicle is Form 5471 (Information Return of U.S. Persons with Respect to Certain Foreign Corporations). For returns that report on tax year 2013, this form also reports on the net investment income tax (“N.I.I.T.”) arising through a controlled foreign corporation (“C.F.C.”).

Great emphasis is put on international tax compliance, and from 2009, the I.R.S. systematically assesses penalties for late filing of Form 5471. In addition, the 2010 Foreign Account Tax Compliance Act (“F.A.T.C.A.”) extended the statute of limitations for the I.R.S. to examine a tax return if certain information returns, including Forms 5471, were not timely or properly filed. The statute of limitations will remain open on the entire tax return and not only on Form 5471 if Form 5471 is not timely filed. Once the form is filed the statute of limitation will begin to run. To assist the I.R.S. to spot inconsistencies, beginning in tax year 2012, the I.R.S. assigned a unique reference identification number to each foreign entity, which allows the I.R.S. to compare forms filed with respect to a certain company over several years.

Tax 101: Undisclosed Offshore Accounts, Are You Eligible for Streamlined Procedures?

Volume 1 No 1    |    Read Article

By Stanley C. Ruchelman and Armin Gray

For persons having undisclosed offshore accounts and contemplating participation in the I.R.S. voluntary disclosure program, one frequently asked question is eligibility for the streamlined procedures (“Streamlined Procedures”) announced by the I.R.S. O.V.D.I. The Streamlined Procedures are effective as of September 1, 2012 and should be considered if there are offshore tax-noncompliance issues. If an individual qualifies, the benefits are substantial: he or she will be eligible for fast-track resolution of the case, the look-back period is limited to three years of delinquent tax returns and six years of F.B.A.R.'s, and he or she will avoid penalties. However, most taxpayers will not qualify as eligibility is limited to a narrow class of taxpayers where intentional tax non-compliance is unlikely to exist.   See more →