Canada: IRS Should Allow QCIV Self-Designation Under FIRPTA

As part of the Protecting Americans from Tax Hikes Act of 2016 (the ''PATH Act''),1 Congress enacted a new exemption from the Foreign Investment in Real Property Tax Act of 1980 (''FIRPTA'')2 for foreign entities that are ''qualified shareholders'' of certain publicly traded real estate investment trusts (''REITs'') and other entities.3 In order to be a qualified shareholder, a foreign entity must be a ''qualified collective investment vehicle'' (''QCIV''). As discussed below, most entities that are qualified shareholders are likely to require specific designation by the Treasury Department.4 This article suggests procedures that Treasury should adopt for foreign entities to obtain such designation, and provides an example of how the suggested procedures would apply to a publicly listed Canadian REIT.

Congress has not provided guidance on why it required specific designation for foreign entities to qualify as QCIVs or how the designation process should be implemented. The procedure for obtaining designation suggested in this article — referred to herein as ''deemed designation'' — was selected because that method would enable the Treasury Department and the Internal Revenue Service (''IRS'') to make designation available quickly and with a comparatively small burden on government resources.5 Moreover, since the goal of the PATH Act is to encourage foreign investment in U.S. real estate and infrastructure assets, deemed designations would enable the IRS to carry out Congress's intent to provide relief without excessive delay to a class of investors that could potentially contribute significant amounts of capital to the U.S. economy .

The IRS is rumored to be considering doing nothing to provide a designation procedure. Instead, the IRS would make investors wait for an applicable tax treaty to be amended to allow for a reduced rate of withholding with respect to REIT dividends even for a holder of more than 10% of the REIT's stock (which would enable an investor to qualify as a qualified shareholder under §897(k)(3)(B)(i)). Such an approach would effectively write the qualified shareholder exemption out of the Code because the U.S. Model Tax Treaty does not include a provision that would enable investors to qualify under §897(k)(3)(B)(i) and, even if the Treasury Department renegotiates an existing tax treaty, the tax treaty approval process has been blocked for years through the efforts of Sen. Rand Paul (R-Tenn.). With Sen. Paul's recent re-election, there is currently no prospect for any new treaties to become effective. We hope that the Treasury Department and the IRS will give effect to Congress's intent as expressed in the PATH Act and provide some way — such as the procedures described in this article — for foreign institutional investors to access the qualified shareholder exemption.

BACKGROUND

In 1980, Congress enacted FIRPTA, which generally imposes a tax on a foreign person's disposition of an interest in real property located in the United States. This tax on disposition applies to a foreign person's disposition of a ''United States real property interest'' (''USRPI''), which includes direct interests in real property located in the United States as well as interests in partnerships, corporations and certain trusts whose assets include more than a threshold amount of USRPIs. Under §897(h), any distribution from a REIT or regulated investment company (''RIC'') is treated as gain from the disposition of a USRPI to the extent that the distribution is attributable to the disposition of a USRPI by the REIT or RIC.

One goal of the PATH Act, signed into law on December 18, 2015, is to encourage foreign institutional investors to increase their investments in U.S. real estate and infrastructure assets. The Senate conference report on the PATH Act described the purpose of the PATH Act as follows:

It is essential to increase foreign investment in U.S. real estate. Increased investment in building and infrastructure will create American jobs. Increased investment will also provide equity capital for existing U.S. real estate ventures that have outstanding loans that are maturing, and will thus reduce the potential for foreclosures. [FIRPTA] contains tax rules that impose significant penalties on foreign investment in domestic real estate through REITs that do not exist in other types of U.S. corporate investments such as corporate stocks and bonds.6

The PATH Act attempts to meet this goal by providing a number of exemptions from FIRPTA targeted for large institutional investors outside of the United States.7 These exemptions are generally much broader than previously enacted exemptions, and they apply both to dispositions of USRPIs and to distributions from REITs that are recharacterized as gain from the disposition of a USRPI under §897(h)(1). The new provisions include the following:

  • Foreign pension funds that meet certain requirements have been granted a complete exemption from FIRPTA.8
  • An interest in a publicly traded REIT is exempt from FIRPTA for a foreign investor that holds less than a threshold amount of the publicly traded REIT's shares.9 The PATH Act increased the threshold from 5% to 10%.10
  • Publicly traded investment funds that meet certain requirements (referred to as ''qualified shareholders'') have been granted a potentially complete exemption from FIRPTA.11

The exemption for qualified shareholders is the main focus of this article. In order to be a qualified shareholder, a foreign person must either (a) be eligible for the benefits of a comprehensive income tax treaty with the United States that includes an exchange of information program and have its principal class of interests listed and regularly traded on a recognized stock exchange or (b) be a limited partnership in a jurisdiction with an agreement for the exchange of tax information and have at least 50% of the value of its limited partnership units regularly traded on the New York Stock Exchange or NASDAQ Stock Market. In addition, in order for a foreign person that satisfies either (a) or (b) to be a qualified shareholder, it must (c) be a QCIV and (d) meet certain recordkeeping requirements.

A qualified shareholder that is a REIT enjoys an exemption from FIRPTA only to the extent that the qualified shareholder does not have any ''applicable investors.''12 For this purpose, an applicable investor is a person that is not itself a qualified shareholder and that holds more than 10% of the qualified shareholder's stock.

Certain distributions from corporations (including all REITs, which are automatically classified as corporations for U.S. federal tax purposes) are treated as capital gain under applicable provisions of the Code. This is the case for distributions in excess of a shareholder's basis in the corporation's stock, certain distributions in redemption of a shareholder's stock, and certain liquidations of a corporate subsidiary where the parent holds less than 80% of the subsidiary's stock. Under §897(k)(2)(C), these types of distributions are recharacterized as an ordinary REIT dividend when received by a qualified shareholder (except to the extent that there are applicable investors on the qualified shareholder).

As noted above, only QCIVs can be qualified shareholders. Section 897(k)(3)(B) defines a QCIV as a foreign person

  1. which, under a comprehensive income tax treaty, is eligible for a reduced rate of withholding with respect to ordinary dividends paid by a REIT even if such person holds more than 10% of the stock of such REIT,
  2. which—

    1. is a publicly traded partnership that is not treated as a corporation for U.S. federal tax purposes,
    2. is a withholding foreign partnership,
    3. if such foreign partnership were a U.S. corporation, would be a U.S. real property holding corporation (determined without regard to paragraph (1)) at any time during the 5-year period ending on the date of disposition of, or distribution with respect to, such partnership's interests in a REIT, or
  3. which is designated as a QCIV by the Secretary and is either—

    1. fiscally transparent within the meaning of Code section 894, or
    2. required to include dividends in its gross income, but entitled to a deduction for distributions to persons holding interests (other than interests solely as a creditor) in such foreign person.13

As of the time of this writing, the test in clause (i) above is likely to be met only by certain entities formed under the laws of the Netherlands, Australia, or possibly a limited number of other jurisdictions.

The number of entities that qualify under clause (ii) is also likely to be small. Therefore, the test with the broadest potential applicability is the test articulated in clause (iii) above, which requires the Treasury Department, through delegation to the IRS, to designate entities as QCIVs.

To read this article in full, please click here.

Originally published by Bloomberg BNA's Tax Management International Journal.

Footnotes

1. Enacted as part of the Consolidated Appropriations Act, Pub. L. No. 114-113, §322(a)(1).

2 Pub. L. No. 96-499.

3 §897(k)(2). All section (''§'') references are to the U.S. Internal Revenue Code of 1986, as amended, or the Treasury regulations thereunder, unless otherwise indicated.

4 See §897(k)(3)(B).

5 A discussion of procedures to provide QCIV designation was included in a recent bar report submitted to the Treasury Department and the IRS by the New York State Bar Association's Tax Section. New York State Bar Association Tax Section, Report on the Changes to FIRPTA Under the Protecting Americans from Tax ct. 3, 2016) (the ''NYSBA Report'').

6 S. Rep. No. 114-25 (Apr. 14, 2015), 2.

7 Foreign investors should bear in mind that, even if they qualify for an exemption from FIRPTA, income from FIRPTA assets may still be subject to U.S. federal income tax if that income is effectively connected to a trade or business of the foreign investor in the United States.

8 §897(l).

9 §897(c)(3).

10 §897(k)(1).

11 §897(k)(2) and §897(k)(3).

12 §897(k)(2)(D).

13 Emphases added.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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