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?

Corporate Matters: Covering Your Partner's Tax Tab

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A district court, affirming a bankruptcy court decision, recently held that a partner can be secondarily liable for a partnership's unpaid employment taxes and that the I.R.S. could proceed with collection without having commenced specific individual action against the partner.

Case History

In Pitts v. U.S., Wendy K. Pitts, a California resident, was a general partner of DIR Waterproofing (“DIR”), a California general partnership. On March 1, 2012, Pitts filed a Chapter 7 bankruptcy petition in the U.S. Bankruptcy Court for the Central District of California. As of that date, DIR had unpaid Federal Insurance Contribution Act taxes and unpaid Federal Unemployment Tax Act taxes for various quarters in 2005, 2006, and 2007. It also had unpaid penalties.

Commencing in 2007, the I.R.S. recorded a number of tax liens naming DIR and Pitts as the taxpayers for the unpaid amounts. The I.R.S. identified Pitts as a DIR partner on the liens. At the time of the district court proceeding, the liens still encumbered the property of Pitts.

On June 21, 2007 and August 7, 2007, the I.R.S. issued Notices of Federal Taxes Due naming DIR as the taxpayer and Pitts as a partner.

As of the time of the summary judgment proceeding in June 2013, DIR still owed at least $114,859 in tax debt, plus unassessed interest. However, the I.R.S. never assessed DIR's taxes against Pitts or brought a judicial action against her.

Action Item 2: Neutralizing the Effects of Hybrid Mismatch Arrangements

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On the heels of the discussion drafts issued in March, the Organization for Economic Cooperation and Development (“O.E.C.D.”) released the initial components of its plan to fight base erosion and profit shifting (the “B.E.P.S. Action Plan”). Action Item 2 addresses the effects of hybrid mismatch arrangements and proposes plans to neutralize the tax deficits caused.

These responses aim to tackle the following issues created by the hybrid mismatch arrangements:

• Reduction in overall tax revenue,
• Unfair advantage given to multinational taxpayers with access to sophisticated tax-planning expertise, and
• Increased expense often incurred in setting up hybrid arrangements compared to domestic structures.

This article introduces the different hybrid arrangements, looks at the proposed changes in both domestic law and international tax treaties, and discusses the ripple effect this could have if implemented.

INTRODUCTION

A hybrid mismatch arrangement is one that exploits a difference in the way an entity or instrument is taxed under different jurisdictions to yield a mismatch in total tax liability incurred by the parties. The two possible mismatches that could result are either a “double deduction” (“DD”) or a deduction that is not offset in any jurisdiction by ordinary income (“D/NI”). These mismatches are brought about by the different interpretations afforded to the entities and transactions in relevantjurisdictions. The root cause of the hybrid mismatch is that an entity may be a “hybrid entity” and an instrument may be a “hybrid instrument.” Understanding the different hybrid arrangements is instrumental to understanding the plan proposed by the O.E.C.D.

Insights Vol. 1 No. 8: Updates & Other Tidbits

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U.K. WINDFALL WINDING DOWN

After an arduous path through the courts regarding the creditability of the U.K. windfall tax, the Third Circuit followed the holding of the U.S. Supreme Court and found the tax to be creditable in a case involve PPL Corp.

The U.S. and foreign countries can tax foreign-sourced income of U.S. taxpayers. To lessen the economic cost of double taxation, U.S. taxpayers are allowed to deduct or credit foreign taxes in computing income or net tax due. The amount of the U.S. income tax that can be offset by a credit cannot exceed the proportion attributable to net foreign source income. Code §901(b) specifies that a foreign credit is allowed only if the nature of the foreign tax is similar to the U.S. income tax and is imposed on net gain.

The U.S. entity PPL is a global energy company producing, selling, and delivering electricity through its subsidiaries. South Western Electricity PLC (“SWEB”), a U.K. private limited company, was an indirect subsidiary that was liable for windfall tax in the U.K. Windfall tax is a 23% tax on the gain from a company’s public offering value when the company was previously owned by the U.K. government. When SWEB paid its windfall liability, PPL claimed a Code §901 foreign tax credit. This was denied by the I.R.S. and the long and winding litigation commenced.

Initially, the Tax Court found the windfall tax to be of the same character as the U.S. income tax. The decision was reversed by the Third Circuit Court of Appeals, which held that the tax was neither an income tax, nor a war profits tax, nor an excess profits tax. It took into consideration in determining the tax base an amount greater than gross receipts. Then, the Supreme Court reversed, finding that the predominant character of the windfall tax is an excess profits tax based on net income. Therefore, it was creditable. In August, the Third Circuit followed the Supreme Court’s decision and ordered that the original decision in the Tax Court should be affirmed.

Corporate Matters: Delaware or New York L.L.C.?

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When a client is considering commencing business operations in New York, we are often asked whether it is preferable to form a limited liability company (“L.L.C.”) in New York or in Delaware. As we have mentioned in a previous issues, Delaware is generally the preferred jurisdiction for incorporation and the jurisdiction we typically recommend.

We thought it might be helpful to set out a short summary of issues that one will encounter in choosing between a New York or a Delaware L.L.C. and the relevant advantages and disadvantages of using either state.

Filing Fees

The fee for filing the articles of organization for a New York L.L.C. is $200, while the fee for filing a certificate of formation in Delaware is only $90.00. However, if the Delaware L.L.C. intends to conduct business in New York, it must file an application of authority for a foreign limited liability company, accompanied with a certificate of good standing from Delaware.

The determination of whether the Delaware L.L.C. is conducting business in New York is largely fact specific. The filing fee for the application for authority is $250, and the Delaware fee for a certificate of good standing can range from $50 (for a short form certificate) to $175 (for a long form certificate).