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.


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.

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