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By: Scott L. Semer, Torys LLP.
FOR OVER 30 YEARS, NON-U.S. INDIVIDUALS AND ENTITIES who invest in U.S. real estate have been subject to tax both on operating income and gains realized upon exiting the investment. There have been limited exceptions, primarily for gains earned by shareholders holding less than 5% of public real estate investment trusts (REITs) and shareholders of domestically controlled REITs that exit by selling the shares of the REIT rather than having the REIT sell the property it owns. Foreign governmental pension plans and sovereign wealth funds that are entitled to the special exemption provided to foreign governments under section 8921 have also been able to avoid tax by taking non-controlling positions in REITs, again provided that they exit by selling shares of the REIT.
The taxation of gains occurs pursuant to section 897, often referred to as FIRPTA, an acronym for the Foreign Investment in U.S. Real Property Tax Act of 1982, which added section 897 to the Code.
Operating income is taxable either as active business income under section 871(b), for individuals, or section 882, for corporations, or as passive rental income that is subject to a 30% gross basis withholding tax under sections 871(a) or 881. Due to the fact that the 30% withholding tax applies to the gross amount of passive rents, without any deduction for operating costs or depreciation, taxpayers can elect to treat passive rents as if they were active business income subject to net basis taxation instead of the gross withholding tax.2
At the end of 2015, in an attempt to encourage additional foreign investment in U.S. real estate, and in particular to help provide foreign capital to fund much-needed investment in U.S. infrastructure, Congress created a new exemption in section 897(l) from FIRPTA for qualified foreign pension funds (QFPFs).
To qualify as a QFPF, a pension fund needs to meet certain requirements, including being part of a plan or arrangement established to provide tax-free or deferred pension or retirement benefits to a broad-based class of current or former employees and satisfying certain reporting rules. More guidance, likely in the form of regulations, is expected to be released in the near future clarifying how these rules apply to the great variety of forms of foreign pensions that can potentially qualify.
A foreign pension that qualifies as a QFPF is entitled to a complete exemption from FIRPTA. While the legislation generated numerous headlines, the stories often neglected to mention that 897(l) exempts a QFPF only from the FIRPTA tax on gains from U.S. real estate. The taxation of current income from U.S. real estate, whether earned as active operating income or as passive rents, continues to be subject to tax either on a net basis or subject to the same 30% gross basis withholding tax.
Moreover, if a QFPF earns active operating income from U.S. real estate, either by owning the real estate directly or through a partnership (or a limited liability company (LLC) or other entity treated as a partnership for U.S. tax purposes), gains realized upon exit will likely be subject to tax as effectively connected income under section 882. Because 897(l) provides an exemption only from the section 897 FIRPTA tax, it will have no effect on the tax imposed by section 882.
As a result, QFPFs will continue to be reluctant to invest directly or through a pass-through entity in U.S. real estate, because they will either be subject to the prohibitively expensive 30% withholding tax on the gross amount of rental income, without any deduction for depreciation or operating costs, or be subject to the 35% corporate level tax on their net income from the property, which will also require that they file a U.S. tax return to report and pay tax on this income.
Instead, most QFPFs are likely to invest in U.S. real estate through REITs, which convert operating income into deductible dividends that do not require a QFPF to file a tax return. While the dividends are potentially subject to the same 30% withholding tax as passive rents, the amount of taxable dividends paid by a REIT are calculated after deducting the expenses, including depreciation, of owning the property. The net income that is then paid as deductible dividends will be subject to 30% withholding tax (unless reduced by treaty, as discussed below), but this produces a much better result than subjecting the rental income to 30% withholding on the gross amount, without any deduction for operating costs, or paying 35% net corporate level tax on income from a direct investment and also having to file a U.S. income tax return. Moreover, for certain QFPFs organized in a jurisdiction that has a tax treaty with the United States that includes a special article governing pension investors, such as the U.S. tax treaties with Canada, the Netherlands, and Mexico, the dividend withholding tax can be eliminated provided the pension investor is not related to the REIT. For purposes of the Netherlands treaty, relatedness is an 80% standard, while for Canada it is likely a 50% standard.
A REIT is a fairly unique entity for tax purposes, and its attractiveness will only increase with the passage of section 897(l). Although treated as a corporation under the Code, which means it therefore serves as a blocker to prevent a foreign investor such as a QFPF from having to file a U.S. tax return, it avoids corporate level tax by paying deductible dividends. Essentially, a REIT is a means of integrating the corporate income tax with respect to investments in real estate. To qualify as a REIT, however, an entity needs to meet a variety of formal requirements as well as income and asset tests designed primarily to restrict a REIT to serving as a vehicle for investing in rental real estate.3
In order to satisfy the income tests, the REIT will need to earn qualifying rental income. This will require that the REIT rent the property it owns to unrelated tenants. For office properties, residential rental real estate, and retail investments, this will be rather straightforward, though a REIT that owns these types of assets will still need to carefully monitor the types of services it provides to its tenants and ensure that they comply with the various REIT rules and restrictions.
For investments in hotels and health care properties, such as congregate care and assisted living facilities, the REIT will usually lease the property to a taxable REIT subsidiary (TRS), which then hires an eligible independent contractor (EIK) to operate the hotel or health care property pursuant to a special REIT regime available only for these types of assets. The TRS is typically wholly owned by the REIT and earns a profit or spread equal to the difference between the operating income from the property and the rent it pays to the REIT. This profit is subject to corporate level tax, but the rent earned by the REIT is subject to the usual rules that allow the REIT to pay out that income as deductible dividends. The EIK is a third-party operator that is in the business of managing health care properties or hotels for a fee. Constructive ownership rules are designed to ensure that the REIT and the EIK have an arm’s-length relationship and seek to prevent overlapping ownership that exceeds a 10% threshold, applying the constructive ownership rules of section 318 with certain special modifications.
Less traditional rental properties, such as those that would not typically earn rental income, can potentially be held in a REIT if the entire property can be master leased to a third-party operator, who then operates the property and pays qualifying rental income to the REIT. The lease with the operator can include a percentage component based on the gross revenue, but not profit, of the tenant. For infrastructure assets, for example, the REIT could potentially own the real estate components of the infrastructure project and lease these assets to a tenant who will operate the property and own any non-real estate assets that are necessary for its operations. For example, an investment in a power plant could potentially be structured through a REIT that owns the land, building, and other fixed assets and then leases these assets to an unrelated operator who pays qualifying rental income to the REIT and earns income from generating or distributing power or otherwise operating the plant. Similar structures can potentially be used for energy assets such as pipelines or transmission lines, with the REIT owning the real estate assets, such as the land and fixed assets like pipelines or transmission towers, and leasing those assets to an operator who earns operating income from the ultimate customers and pays qualifying rental income to the REIT.
Similar structures can be used for farmland, vineyards, and other non-traditional REIT assets. The critical elements of these structures ensure that the operator is unrelated to the REIT and that it pays arm’s-length rental income to the REIT that is respected as rent for tax purposes.
To be unrelated, the REIT and the operator need to have less than 10% overlap in ownership, as determined pursuant to constructive ownership rules based on section 318, with certain unique modifications. To qualify as good REIT income, the lease will need to be on arm’s-length terms and any percentage component will need to be based on gross revenue rather than the profits of the tenant. Moreover, the relationship between the operator/tenant and the REIT, including potential renegotiation of the lease terms, cannot in substance be used as a way to base the rental income on the operator’s profits.
As a result of these restrictions, an investment in a REIT owning these types of assets will not be economically identical to owning these assets directly and being subject to the business risks of the underlying operations. Instead, the business will essentiality be divided into a real estate component and an operating component, and while the gross revenue percentage rental sharing formula will cause these two components to be generally aligned, there will be a risk that they will diverge, for example, if the expenses of operating the business prove to be significantly different than the parties expected, such that gross revenues differ unexpectedly from the net operating profit. As a result, a QFPF that seeks to invest in this manner will need to be comfortable with this potential divergence as a trade-off for being able to use the tax advantages of the REIT structure.
For QFPFs that are not entitled to the benefits of section 892 or a tax treaty with a special exempt pension investor article, dividends from the REIT will usually be subject to 30% withholding.4 As noted, however, the amount of dividends the REIT needs to pay to avoid incurring any income tax at the REIT level will be reduced by depreciation deductions and other expenses incurred by the REIT. The REIT can potentially also be financed in part with shareholder debt in the case of a QFPF organized in a jurisdiction that has a treaty that eliminates withholding on interest income, which often applies even if that interest income is paid by a related party.5 The interest deductions then further reduce the amount of deductible dividends the REIT needs to pay to avoid tax at the REIT level.
The principal benefit of the REIT structure for a QFPF will be that any gains on exit will generally be exempt from U.S. tax. This will be the case whether those gains are earned by selling the REIT shares or if the REIT sells the property and distributes the proceeds to the QFPF. Unlike the exemption from FIRPTA provided for domestically controlled REITs and section 892 governmental investors, a property sale and liquidation will produce the same exemption as a sale of REIT shares, greatly simplifying the proposed exit.
The ability of a QFPF to take advantage of the section 897(l) exemption from FIRPTA by having the REIT sell assets rather than having to sell REIT shares will expand the class of buyers who can acquire the asset, as some buyers are reluctant to buy REIT shares due either to their lack of familiarly with REIT structures or because certain buyers, such as individuals and certain foreign investors, are either not qualifying holders of a REIT or can’t tax-efficiently buy a REIT.6 A QFPF can therefore ensure that the REIT structure remains in place only during its ownership of the asset and allow a future buyer to hold the asset however it chooses and not have to worry about acquiring REIT shares and maintaining or liquidating the REIT.
Where the REIT earned qualifying income by renting its assets to a third party independent operator, the lease with the tenant can either be inherited by the new buyer, or the lease can include a mechanism, such as a termination fee, to be terminated or unwound when a new investor acquires the real estate assets from the REIT.
Compared to the exemption available for domestically controlled REITS, which requires that the REIT be majority owned by U.S. investors, and the section 892 exemption, which requires that the foreign governmental investor own less than 50% of and not control the REIT, the exemption from FIRPTA for QFPFs applies regardless of how much of the REIT the QFPF owns and regardless of whether the QFPF controls the REIT. While obtaining an exemption from dividends paid by the REIT under the special pension investment article of a treaty or under section 892 may still require owning 50% or less of the REIT, if the QFPF is willing to live with 30% withholding on dividends paid by the REIT, which as noted, need to be paid only with respect to the net income from the property, as reduced by depreciation deductions and deductible interest, the QFPF can own up to 100% of the REIT and have as much control rights as it wants and still be exempt on any gains when it sells interests in the REIT or the REIT sells its properties. Moreover, the exemption applies regardless of whether the exit takes place at once, via a sale of all of the REIT’s property and a liquidation of the REIT, or if the REIT sells it properties over time and distributes some gains while continuing to earn rental income from other properties until they are sold. Thus, a QFPF can invest in REITs that own multiple properties and take advantage of its exemption when the REIT sells each property separately, even if those sales take place over multiple years. The REIT can therefore seek to maximize the selling price for each real estate asset by selling it to a separate buyer who is willing to pay the best price for the asset they want without having to acquire other assets owned by the REIT, which would be the case if they were required to buy all of the shares of the REIT.
As a result, while it is important to know what the new law changes and what it doesn’t, through creative use of REITs, a QFPF can use the new exemption provided by section 897(l) to greatly expand its ability to invest tax-efficiently in U.S. real estate. While less traditional rental assets such as infrastructure will present interesting challenges, a creative collaboration between tax advisors and business professionals presents the opportunity to take maximum advantage of the new law’s benefits. It will be fascinating to see how these structures develop over the next several years as QFPFs use section 897(l) to expand the available portfolio of potential U.S. real estate investments they consider.
Scott L. Semer is a partner at the New York office of Torys LLP and serves as a lecturer in law at Columbia Law School. He specializes in advising foreign pension funds and private equity funds, and in the taxation of cross-border investments and derivatives, mergers and acquisitions, and real estate joint ventures.
RESEARCH PATH: Real Estate > Real Estate Investment Trusts > REIT Transactions > Articles > Qualified Foreign Pension Funds
For more information on the organization of REITs, see
> BASIC REIT STRUCTURES AND ENTITY TYPE
RESEARCH PATH: Real Estate > Real Estate Investment Trusts > REIT Transactions > Practice Notes > Mergers and Acquisitions
For more information on ownership of REITs, see
> OWNERSHIP RESTRICTIONS
RESEARCH PATH: Real Estate > Real Estate Investment Trusts > REIT Qualification > Practice Notes > REIT Qualification
For more information on foreign investors in REITs, see
> FOREIGN INVESTOR ISSUES
For more information on REIT asset limitations, see
> REIT ASSET TESTS AND QUALIFICATIONS
For more information on REIT income requirements, see
For more information on what constitutes rent received by REITs, see
> WHAT QUALIFIES AS “RENT” IN THE REITCONTEXT
RESEARCH PATH: Real Estate > Real EstateInvestment Trusts > REIT Qualification > PracticeNotes > REIT Qualification
1. Section references are to the U.S. Internal Revenue Code of 1986, as amended. 2. See section 871(d) for individuals and section 882(d) for corporate entities. 3. Mortgage REITs can also serve as vehicles for investing in real estate mortgages, but because they convert interest income, which is often exempt by treaty or as portfolio interest, into dividends potentially subject to 30% withholding tax, mortgage REITs are not typically a tax-efficient vehicle for foreign investors. 4. While some treaties provide a lower rate of withholding for dividends, this lower rate usually doesn’t apply to REITs, except in limited circumstances such as where the investor owns less than 10% of the REIT and the REIT owns a diversified portfolio of real estate assets. 5. The amount of deductible interest that can be paid will be limited by rules such as the earnings stripping limitations of section 163(j), and the debt will need to have arm’s-length terms to be respected as debt for U.S. tax purposes. 6. A REIT cannot be closely held, which restricts the ability of five or fewer individuals (determined after applying certain constructive ownership rules) from buying a majority interest in a REIT. Foreign investors that are not QFPFs may be reluctant to buy a REIT that has property with a value that exceeds its basis because it will be difficult for them to unwind the REIT structure without incurring the risk of being subject to tax under the special FIRPTA rule of section 897(h)(1).