United States: How New 897(l) Regulations Provide Clarity To Canadian Pension Funds

In this Update

  • With the release of Proposed Regulations on June 6, 2019, the U.S. Treasury Department has taken a major step toward clarifying certain key components of the Section 897(l) exception of the U.S. Internal Revenue Code of 1986, in a way that will be very helpful to many Canadian pension funds.
  • The Proposed Regulations provide clarification in three key areas: (1) the scope of the 897(l) exemption itself; (2) the requirements for qualifying as a QFPF; and (3) the application of the Code’s withholding tax rules to U.S. real estate investments.
  • How Canadian governmental and private pension funds should respond to the new rules.

From the time of its enactment in late 2015, Section 897(l) of the U.S. Internal Revenue Code of 1986, as amended (the Code) has reshaped the way that Canadian (and other non-U.S.) pension funds invest in U.S. real estate. With its sweeping exemption from U.S. tax on U.S. real estate, Section 897(l) has dramatically improved the potential after-tax returns available to “qualified” pension fund investors and has prompted a significant influx of Canadian pension fund capital into this asset class. While the benefits offered by this provision have been extraordinarily attractive for pension funds, the precise scope and limits of Section 897(l) have been stubbornly unclear and this has hampered the ability of some Canadian pension arrangements to benefit from this important opportunity. With the release of Proposed Regulations on June 6, 2019, the U.S. Treasury Department has taken a major (and pragmatic) step forward in clarifying certain key components of the Section 897(l) exception in a way that will be very helpful to many Canadian pension funds.

Following the release of the Proposed Regulations, we recommend that both private and governmental Canadian pension funds consider the following next steps:

  • confirming their status as either a qualified foreign pension fund (QFPF) or a qualified controlled entity (QCE) under the revised qualification framework.
  • reviewing and, if appropriate, revising investment structuring to better align with the QCE concept.
  • In the event of any continuing Section 897(l) qualification or structuring issues, consider promptly submitting comments to the U.S. Treasury Department in order to help address these matters before the Proposed Regulations are finalized.

Background

Under the so-called FIRPTA (Foreign Investment in Real Property Tax Act) rules, found in Sections 897 and 1445 of the Code, non-U.S. persons are subject to U.S. federal income taxation (and U.S. federal income tax return filing obligations) on gains recognized upon the disposition of U.S. real property assets. In addition, the FIRPTA rules also impose U.S. tax (and return filing obligations) on non-U.S. investors receiving certain distributions from REITs that are traceable to a disposition of a U.S. real property asset by the REIT. The FIRPTA rules enforce collection of this tax by imposing withholding taxes on dispositions of U.S. real property assets by (and certain distributions received by) non-U.S. investors. Together these FIRPTA rules form the backbone of U.S. taxation of foreign investors in U.S. real estate and have shaped the structuring of investments in this space for a generation.

In December 2015, this all began to change for non-U.S. pension funds. In particular, as part of the Protecting Americans from Tax Hikes Act (or PATH Act), Congress enacted new Section 897(l) of the Code which was designed, in part, to attract stable and sophisticated foreign capital to help finance the rebuilding of America’s aged infrastructure. Section 897(l) offers a sweeping exemption from FIRPTA taxation to QFPFs and entities, all of the interests of which are held by a QFPF. In March 2018, U.S. President Donald Trump signed the Consolidated Appropriations Act of 2018 into law which, among other things, provided certain technical clarifications to Section 897(l) designed to alleviate some of the concerns expressed by foreign pension funds about the requirements for QFPF status. Notwithstanding these 2018 amendments, there were many lingering questions regarding the scope of 897(l) and which entities qualify as a “QFPF.”

The 897(l) Proposed Regulations

A central tension of Section 897(l) is balancing the need to ensure that the exemption is broad enough to accommodate the wide array of structures that pension fund arrangements utilize in jurisdictions around the world (many of which are profoundly different from U.S. pension fund structures) with the need to ensure that the exemption is restricted to funds that provide bona fide retirement and pension benefits (and that are not otherwise used as a vehicle to facilitate private investment). Scores of comments sent to the Treasury Department by pension funds from around the world have illustrated the many ways in which the statutory language of Section 897(l) is viewed as being unclear or overly restrictive. The Proposed Regulations thoughtfully tackle these difficult issues and lay down a broad-based, and pragmatically flexible, foundation for the 897(l) exception. More specifically, the Proposed Regulations provide clarification in three key areas: (1) the scope of the 897(l) exemption itself; (2) the requirements for qualifying as a QFPF; and (3) the application of the Code’s withholding tax rules to U.S. real estate investments. Each of these areas is summarized below.

1. Who may claim the 897(l) Exemption?

The basic statutory framework of Section 897(l) limits the benefits of this exemption to QFPFs and entities, all of the interests of which are held by a QFPF. Under this formulation, 897(l) benefits were limited to a relatively narrow band of pension fund structures. The Proposed Regulations take a broader approach by creating a series of new interlocking defined terms that work together to flexibly accommodate a wider range of pension fund arrangements. 

More specifically, the Proposed Regulations generally make 897(l) benefits available to “Qualified Holders” which are defined as QFPFs or QCEs. The most significant innovation here is that a QCE includes any non-U.S. trust or non-U.S. corporation, all of the interests of which are held by one or more QFPFs, directly or indirectly, through one or more QCEs or partnerships. This is to be contrasted with the more restrictive statutory language which suggested that a QCE would qualify for 897(l) benefits only if it was wholly owned by a single QFPF. When combined with certain other elements of the Proposed Regulations (in particular, the “qualified segregated account” and very flexible “organization or arrangement” concepts), the QCE concept provides the flexibility needed to bring many different pension fund structures under the protective umbrella of 897(l). This accommodating approach is somewhat hemmed in, however, through (i) a new anti-avoidance type rule (which essentially prevents using QFPFs and QCEs as conduits for selling U.S. real property assets), and (ii) a rule affirming that any (even de minimis) non-QFPF owners will disqualify a corporation or trust from qualifying as a QCE.  Canadian pension funds should review corporate structures involving share arrangements designed to address compliance with the 30% rule in Canadian pension legislation in light of this latter requirement.

This QCE development is particularly noteworthy in Canada because several prominent Canadian federal and provincial governmental pension funds have structural characteristics that are more complex than “traditional” U.S. pension fund structures. In particular, certain Canadian pension funds adopt corporate collective entities to pool investments of several different pension funds and others manage pooled accounts for a group of pension fund “clients.” Similarly, the QCE concept is also very helpful to private Canadian pension funds, that may otherwise wish to invest on a pooled basis including, for example, through so-called master trust arrangements.

Most importantly, with respect to both public or private pension funds, the Proposed Regulations send an unambiguous signal that they are designed to accommodate a broad range of pension fund structures and the QCE concept goes a long way toward achieving this goal. Even though this is clearly a positive step forward, these new rules have limitations and won’t always operate in an intuitive manner. We believe it is now extremely important that Canadian pension funds take a step back and carefully work through the details of exactly how they come within the new 897(l) framework.

2. How to qualify as a QFPF

The root concept underlying the 897(l) rules remains the QFPF definition. One or more QFPFs are needed in order to anchor 897(l) benefits for any given pension fund structure. The statute establishes 5 separate requirements for QFPF status and the Proposed Regulations shed important new light on how these requirements are to be applied in the real world.

(i) Created or organized under non-U.S. Law

In order to qualify as a QFPF, the fund must be created or organized under foreign law. In response to public comments, the Proposed Regulations clarify that “foreign” law includes a subdivision of a foreign country (e.g., provinces).

(ii) Established to provide “Retirement or Pension Benefits”

The Code provides that a QFPF must be established either:

  1. by a foreign government to provide retirement or pension benefits to current or former employees (or persons designated by them) as a result of services rendered by such employees to their employers, or
  2. by one or more employers to provide retirement or pension benefits to current or former employees (or persons designated by them) in consideration for services rendered by such employees to such employers.

The Proposed Regulations clarify that these categories are broad enough to capture multi-employer pension funds, certain self-employed individuals and certain pension funds organized by trade unions and/or professional associations. 

The Proposed Regulations also recognize that many pension funds deliver a range of benefits to their beneficiaries, which include “retirement or pension benefits” as well as a broader range of “ancillary benefits,” which are defined to include death, disability, survivor, medical, unemployment and similar benefits. The preamble to the Proposed Regulations indicates that, “[t]he Treasury Department and the IRS have determined that section 897(l) was not intended to exclude common foreign pension arrangements that provide a relatively small amount of ancillary benefits to participants….” To achieve this result, the Proposed Regulations require that (a) all of the benefits provided by a QFPF are qualified benefits (defined as retirement, pension or ancillary benefits), and (b) at least 85% of the present value of the qualified benefits that the fund reasonably expects to provide are retirement or pension benefits. Unfortunately, the Proposed Regulations do not specify when (or how often) this 85% test is to be applied.

(iii) No 5% participant

In order to qualify as a QFPF, the fund may not have a single recipient that has a right to more than 5% of the assets or income of the QFPF. The Proposed Regulations now provide that certain constructive ownership rules will apply for purposes of applying such 5% test. 

(iv) Government regulation and information reporting

Section 897(l) provides that a QFPF must (a) be subject to government regulation, and (b) provide annual information about its beneficiaries to the relevant foreign tax authorities, or such information must otherwise be available to such authorities. The Proposed Regulations bring greater specificity to this sometimes confusing requirement, including by clarifying that the type of information to be reported (or otherwise made available) is the amount of qualified benefits provided to qualified recipients by the QFPF during the taxable year (if any). The Proposed Regulations also helpfully provide that a foreign governmental pension plan is generally deemed to satisfy the information reporting requirement.

(v) Tax treatment

Under Section 897(l), a QFPF must establish that (a) contributions to the QFPF are deductible by the contributor or excluded from the gross income of such QFPF, or (b) the QFPF’s investment income are exempt from tax or taxed at a reduced rate, in each case under the QFPF’s local law. The Proposed Regulations relax this requirement somewhat by providing that, only at least 85% of the contributions (in the case of (a)) or 85% of the investment income (in the case of (b)) must qualify for the preferential treatment described above. The Proposed Regulations provide additional flexibility by allowing a fund to otherwise establish that it is subject to a preferential tax regime similar to those described above.

The Proposed Regulations also provide certain ground rules for determining how to apply the five tests summarized above. These ground rules appear, for the most part, to improve the ability of pension arrangements to demonstrate that they satisfy these five tests. Most notably, the Proposed Regulations allow certain pension arrangements to aggregate multiple entities together in order to satisfy certain of the tests described above. These ground rules and their application are illustrated in various examples included with the Proposed Regulations. 

3. How do U.S. withholding taxes apply to U.S. real estate investments?

In many cases, an investment by a non-U.S. person in U.S. real estate may be subject to a range of U.S. withholding taxes, including under Sections 1441, 1445 and/or 1446. In addition, any transferee (or other withholding agent) facing a QFPF in a disposition (or distribution) transaction will need to know what forms are required in order to prevent withholding. The Proposed Regulations attempt to establish a method for navigating through this thicket of intersecting withholding requirements. While the details of these rules are beyond scope of this summary, the Proposed Regulations generally allow a QFPF or QCE to establish its entitlement to 897(l) benefits by delivering either a FIRPTA certificate of “non-foreign status” or an IRS Form W-8EXP (which the IRS will modify for this purpose) and also provide certain other co-ordinating rules.

Going forward with 897(l)

The Proposed Regulations represent a significant leap forward in bringing greater clarity and comfort to Canadian pension funds that wish to take advantage of the important U.S. tax benefits offered under Section 897(l). In adopting this broad-based regulatory framework, the U.S. Treasury Department is clearly attempting to be receptive to taxpayer concerns and signalling that it is willing to accommodate a wide array of foreign pension fund arrangements. While the changes adopted in these rules are directionally helpful, they do heighten the technical complexity of the overall regime and do create new limitations. Accordingly, we believe that now is the time for Canadian pension funds to (a) conduct a careful reassessment of their standing under the 897(l) rules; (b) identify any structural or organizational modifications that may be appropriate in light of the new rules; and (c) if they find they have intractable issues under the new rules, consider making these issues known to the Treasury Department before the Proposed Regulations are finalized.

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions