Abstract This article deals with the cross-border tax issues resulting from (i) the purchase of real estate, (ii) the holding of this real estate and its renting out to lessees and (iii) a sale of the real estate at some point in time in the future, as well as (iv) gratuitous transfers through gifts or by way of death, and all of this under the tax law of the USA. The real estate may be purchased directly or indirectly through the acquisition of shares in a local company holding the real estate. The purchaser of the real estate may be a non-resident company or a non-resident individual. Introduction The four combinations mentioned in the abstract above may be depicted graphically as on page 40 of this issue of Trusts & Trustees, in the article ‘Cross-Border Planning For Real Estate: Austria’ by Niklas Schmidt. Acquisition of real estate In the USA, typically no taxes are directly imposed on the buyer of real estate. However, some exceptions exist based on subnational (ie state, county, or city) laws and customs. Below are a few examples of taxes a buyer should review at the subnational level. Direct acquisition Transfer taxes When real estate changes ownership, there is a transfer tax (typically triggered when ownership title changes).1 Transfer taxes are imposed at the state, county, or local level or a combination of the above, and transfer taxes are usually imposed on the seller. However, the transfer taxes incidence can be negotiated in the sale contract. A buyer should look to the local statutes and determine if a transfer tax will apply and on whom it is imposed. The buyer should investigate whether local custom shifts the burden onto the buyer. Finally, the buyer will want to be sure that the sale contract does not shift the obligation without the buyer’s express agreement. Prepaid property taxes Because property taxes are paid at the beginning of a period in some jurisdictions, the previous owner of the real estate may have already paid the property taxes. If this is the case, the buyer will often be expected to reimburse the seller for a prorated portion of the property taxes. The reimbursement of the pro rata amount will be made directly to the seller because the obligation to the government has already been satisfied.2 Indirect acquisition Controlling interest transfer taxes are essentially the same as transfer taxes imposed on individuals buying real estate directly (see section 7.1.1(a)). The transfer tax here is triggered by the purchase, transfer, or other disposition of a controlling interest in an entity. What constitutes a ‘controlling interest’ for these purposes will be defined by the state, county, or local government.3 The law of the jurisdiction in which the real estate is located is the governing law, not the law of the jurisdiction of incorporation, or where the transferor or transferee resides. Holding of real estate Direct holding Property taxes Property taxes are taxes based on the value of the property. Property taxes are typically imposed annually or semi-annually, and the value of the property is reassessed periodically. Property taxes are imposed at the state, county, or local level or a combination of the above. Income taxes If a foreign owner of real estate receives rent or interest arising from US real estate, that income will be subject to one of two income taxing regimes applicable to non-residents, namely either a 30 per cent withholding tax at source or a tax at graduated rates. 30 per cent gross income tax on fixed or determinable, annual or periodic income A foreign investor in US real estate who receives rent or interest from US real estate must pay a 30 per cent tax on the investor’s gross income (ie without the allowance of any deductions connected with such income) unless the foreign investor’s real estate activities constitute the conduct of a US trade or business.4 The 30 per cent will generally be withheld by the payor. The 30 per cent rate of tax may be reduced under an applicable US income tax treaty, however, most US income tax treaties do not provide for a reduced rate of tax on rent and royalties derived from US real property interests (USRPI). Graduated tax rates on net income that is effectively connected income If the US real estate activities of the foreign investor constitute the conduct of a US trade or business (as defined in the IRC), all US source income of such investor (including interest, dividends, rents, and royalties) that is effectively connected with the foreign investor’s US trade or business is subject to the graduated rates of tax that apply generally to US persons.5 More importantly, the graduated rates are applied to taxable income obtained by reducing the gross effectively connected income (ECI) by allowable deductions.6 Determining whether a foreign person is engaged in a US trade or business is generally a facts and circumstances test which looks to both the activities performed by the foreign person and any agents of the foreign person.7 However, an investor in US real property can choose to be taxed on the income arising from the real property under either the fixed or determinable, annual or periodic (FDAP) or ECI regimes.8 To make the election, the non-resident investor must derive gross income from US real property and, in the case of an individual, the property must also be held for the production of income.9 Note that under Foreign Investment in Real Property Tax Act (FIRPTA) (discussed in section 7.3.1(a) and 7.3.2(a)), any gain derived by a foreign person from the disposition of a USRPI not held for the production of income is treated as ECI irrespective of the fact that such foreign person is not engaged in a US trade or business in the year of disposition.10 A non-resident investor may elect to be taxed under the ECI method to allow the use of deductions. For example, the non-resident investor could use depreciation deductions, interest deductions arising from debt-financed acquisition or improvements, and property taxes to reduce gross income. If a non-resident investor makes an election, the non-resident must file a tax return.11 Failure to file a return will result in a loss of deductions or credits.12 The only exception to the filing requirement is for foreign individuals not engaged in a US trade or business whose US income tax liability is fully satisfied by withholding at source.13 Branch profits tax An extremely important consideration for a foreign corporation contemplating a direct ownership of US real estate business is the branch profits tax of IRC section 884 because, potentially, it subjects such a foreign corporation to significantly higher US income taxes as compared to other forms of ownership of US real estate business, eg by an individual directly, or through a US corporation or a partnership (whether USA or foreign).14 A foreign corporation that is engaged in a US real estate business (or any other US trade or business) is not only subject to the US net income tax on its ECI, but also to the branch profits tax of IRC section 884.15 It imposes a tax on profits of a foreign corporation’s US branch operations that are deemed repatriated from the USA, as well as on interest deemed paid by the branch to foreign lenders and ‘excess interest’ (ie the excess of interest deducted by the branch over interest paid by the branch).16 The branch profits tax is generally imposed at a 30 per cent rate on effectively connected earnings and profits (ECEP) of a foreign corporation engaged in a US trade or business as adjusted for any reinvestments and repatriations of ECEP,17 but may be lower under an applicable treaty. Persons subject to the branch profits tax include foreign corporations that are engaged in a US trade or business or that receive income treated as effectively connected with the conduct of a US trade or business. A foreign corporation not directly engaged in a US trade or business is treated as receiving ECI, thus subjecting it to the branch profits tax, if: it is a partner in a partnership (or a beneficiary of an estate or a trust) that is engaged in a US trade or business18; it realizes gain from the sale of a direct USRPI19; it owns vessels or aircraft that produce ECI20; or it owns US real property with respect to which it has made a net election under IRC section 882(d).21 Indirect holding General The holding of US real estate by a US company where a foreign individual owns shares of the US company is treated differently than US real estate owned by a foreign company where the foreign individual owns shares of the foreign company. In the first instance, the US company is treated as a US Real Property Holding Corporation (USRPHC), discussed below. Whereas, a foreign company that holds US real property will be subject to the ECI regime plus, potentially, the branch profits tax, as discussed above. A foreign individual may also hold US real property in a US partnership or limited liability company. Although these entities are not subject to the FIRPTA withholding tax (discussed below at section 7.3.1(a)), they are still subject to the partnership withholding tax on ECI under IRC section 1446.22 Additionally, depending on the terms of a trust established and governed under US law, the trust may be a passthrough for US tax purposes or a separate taxpayer. This could impact proper US tax reporting obligations. Further, as of 1 January 2017, the Internal Revenue Service (IRS) provided in TD 9796, RIN 1545-BM94, that it will treat certain single member limited liability companies as a regarded entity for certain reporting purposes, where the owner is a foreign person. The informational reporting will require the entity to obtain an employer identification number and file informational returns aimed at disclosing all transactions with foreign related parties. Property taxes See section 7.2.1(a). Corporate income tax Income earned by a US corporation will be subject to the corporate tax rate of 35 per cent.23 Sale of real estate Direct sale FIRPTA Gain or loss derived from a direct disposition of a USRPI by a foreign person is subject to US income tax as effectively connected gain or loss.24 The character of such gain or loss depends upon whether the real property qualifies as a capital asset. US real estate will not qualify as a capital asset if: it is an inventory item or it is property held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business25; or it is property used in the taxpayer’s trade or business.26 If US real estate does not qualify as a capital asset, any gain or loss derived from the disposition of such property is ordinary income or loss. Note, however, that ordinary income or loss treatment may be modified by IRC section 1231 if the US real property qualifies as an IRC section 1231 asset. Under IRC section 1231, any net gain is treated as a long-term capital gain and any net loss is treated as an ordinary loss. Real property used in the taxpayer’s trade or business and held for the long-term holding period will qualify as an IRC section 1231 asset.27 As a general rule, IRC section 1445 requires that, on a disposition of a USRPI by a foreign person, the transferee must withhold 15 per cent of the total amount realized by the foreign person (10 per cent of the amount realized on dispositions under USD1,000,000 or made on or before 16 February 2016). The IRC section 1445 regulations28 define the term ‘amount realized’ as the sum of: the cash paid or to be paid to the seller; the fair market value of other property transferred or to be transferred to the seller; and the outstanding amount of any liability assumed by the purchaser or to which the USRPI is subject immediately before and after the transfer. The 15 per cent withholding tax imposed on the foreign transferor of a USRPI (10 per cent on or before 16 February 2016) is not the amount of tax actually due from the transferor. It is merely an advance payment towards the foreign transferor’s final US tax obligation arising from the disposition of a USRPI. The foreign transferor still must file a US income tax return (on Form 1040NR, 1041, or 1120 F) for the year of the sale by the applicable filing deadline.29 Such return must show the amount of gain derived from the disposition of the USRPI (along with other income, if any) and the amount of US income tax due on the gain computed at graduated rates of tax applicable to US persons. The amount of the foreign transferor’s final US tax obligation is determined by crediting the withholding tax against the amount of tax due on the return. There are a few exceptions to the withholding requirement for a non-resident. For example, FIRPTA withholding does not apply to persons who purchase property for use principally as a residence, so long as its cost is USD300,000 or less. The non-resident may also be able to obtain a certificate from the IRS to waive withholding.30 Transfer taxes See section 7.1.1(a). Indirect sale If a non-resident individual or foreign corporation sells a US corporation, there may be ECI and FIRPTA withholding if the corporation is a USRPHC, which is considered a USRPI.31 (See section 7.3.1(a) for a more in-depth discussion of FIRPTA). A USRPHC is a domestic corporation that, within the 5-year period preceding the date of the disposition of the real property,32 had US real property assets equaling or exceeding 50 per cent of the fair market value of its interest in (i) USRPI, (ii) real property located outside the USA, and (iii) other assets used or held in a trade or business.33 Alternatively, a corporation is presumed not to be a USRPHC if the accounting ‘book value’ of its USRPIs is 25 per cent or less of the total accounting book values of the three classes of assets otherwise taken into account for purposes of the USRPHC definitional test (ie USRPIs, foreign real property, and trade or business assets).34 Gratuitous transfer of real estate Direct transfer Gift tax If a non-resident gifts US real property or stock in a corporation, there will likely be gift tax implications. The US gift tax applies to a non-resident alien with respect to all transfers, direct or indirect, of real or tangible (but generally not intangible) property situated within the US where the value of the transfer exceeds the USD10,000 adjusted for inflation (currently USD14,000), per donee annual exclusion.35 Taxable gifts of a non-resident alien are taxed cumulatively over the lifetime of the donor at graduated rates ranging from 18 per cent to 40 per cent.36 If the non-resident transfers the property to a spouse, there may be a marital deduction, but only if the donee spouse is a US citizen on the date of the gift.37 Corporations do not have a gift tax exemption (though there may be a charitable contribution deduction if a gift is made to a qualified charity). A foreign corporation that makes a distribution (including a distribution in liquidation or redemption) of a USRPI to a shareholder (whether domestic or foreign) must recognize gain (but not loss) on the distribution.38 Estate tax US real property directly owned by a non-resident alien is subject to US estate tax at a rate up to 40 per cent if held (or deemed held) by the non-resident alien at the time of his death.39 Unless the foreign corporation is treated as a conduit or is disregarded as a sham, a non-resident alien would not be subject to US estate tax with respect to the shares of a foreign corporation.40 If, however, a foreign corporation or foreign partnership that owns the US real property transfers the foreign company shares or foreign partnership interest, this transfer may not be subject to US estate or gift tax, as the interest is not a US situs asset. With respect to foreign partnerships, whether the partnership interests themselves are considered US situs depends on the facts and circumstances, and whether the foreign partnership has considerable operations/activities in the USA.41 Generation-skipping transfer tax In general terms, the generation-skipping transfer tax (GSTT) is imposed on inter vivos transfers or transfers at death to a beneficiary who is two or more generations below the donor or decedent.42 A tax is assessed if a generation is skipped (eg a gift from grandparent to grandchild) in the giving of a gift; this is in addition to the amount of gift and estate tax. The current GSTT exemption is USD1,000,000 for lifetime gifts and USD5,490,000 for bequests. Indirect transfer Gift tax A gratuitous transfer by a non-resident alien of his stock in a foreign corporation will not be subject to US gift tax.43 Estate tax If a non-resident alien dies while holding shares of US corporate stock, such shares (as US situs property) will be included in the non-resident alien’s US gross estate.44 Leigh-Alexandra Basha is a Partner at McDermott Will & Emery in Washington, DC, USA, and focuses her practice on domestic and international estate and tax planning. She counsels an affluent international client base on a wide range of sophisticated matters, including estate and trust administration, family wealth preservation, tax compliance, as well as business succession, expatriation and pre-immigration planning. Leigh is co-head of the Firm’s Washington, DC, Private Client Practice Group. Footnotes 1. Thirty-seven states plus DC impose some form of real estate transfer tax. Real Estate Transfer Taxes (ncsl.org, September 2012) <http://www.ncsl.org/research/fiscal-policy/real-estate-transfer-taxes.aspx> accessed September 2017. 2. ‘Do Buyers Pay the Property Taxes at Closing?’ (SFGate.com, 9 March 2017) <http://homeguides.sfgate.com/buyers-pay-property-taxes-closing-7892.html> accessed September 2017. 3. Sixteen states currently impose a tax on the transfer of a controlling interest. ‘M&A: Real Estate Transfer Taxes in a Sale of a ‘Controlling Interest’ of a Company’ (The Corporation Secretary’s Blog, 27 September 2011), <https://thecorpsecblog.com/2011/09/27/ma-real-estate-transfer-taxes-in-a-sale-of-a-%e2%80%9ccontrolling-interest%e2%80%9d-of-a-company/ > accessed September 2017. 4. Internal Revenue Code of 1986, as amended (hereafter, ‘IRC’) s 871(a)(1)(individuals); IRC s 881(a)(1)(A)(corporations). 5. IRC s 871(b) (individuals); IRC s 882(a). 6. IRC s 873 (individuals); IRC s 882(c)(corporations). 7. See Rev Rul 70-424, 1970-2 CB 150 (foreign corporation taxable on profits of sales arranged by US corporation acting, per agreement, as exclusive US sales agent of foreign corporation’s product); Handfield v Comr (1955) 23 TC 633. 8. IRC s 871(d)(individuals) or IRC s 882(d)(corporations). 9. IRC s 871(d)(1); Treasury Reg s 1.871-10(a). 10. IRC s 897(a); See also 871(d). 11. Treasury Reg s 1.6012-1(b)(1)(i) (individuals); Treasury Reg s 1.6012-2(g)(1)(i)(corporations). 12. Treasury Reg s 1.874-1(a) (individuals); Treasury Reg s 1.882-4(a)(corporations). 13. Treasury Reg s 1.6012-1(b)(2(i). 14. Portfolio 912-2nd: US Taxation of Foreign Investment in US Real Estate, Detailed Analysis, B. Branch Profits Tax. 15. ibid. 16. ibid. 17. IRC s 884(a), (b). 18. IRC s 875(1); Treasury Reg s 1.884-0(a); Treasury Reg s 1.884-1(f)(1); Rev Rul 85-60, 1985-1 C.B. 187. 19. See IRC s 897(a); Treasury Reg s 1.884-1(f)(1) (does not include gain on sale of USRP Hold Co—see below for the definition of USRP Hold Co); Treasury Reg s 1.884-1(2)(iii). 20. IRC s 863(c); IRC s 887(b); see also S Rep No 313, 99th Cong, 2d Sess 403 (1986), 1986-3 CB (Vol 3) 1, 403. 21. Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, 99th Cong, 2d Sess (Committee Print 5 April 1987) (the ‘Blue Book’) 1040. 22. Treasury Reg s 1.1446-3(c)(2)(i) (withholding under s 1445 is superseded by withholding under s 1446). 23. See IRC s 61 (gross income defined), IRC s 11 (tax imposed on corporations). 24. IRC s 897(a)(1). 25. IRC s 1221(a)(1). 26. IRC s 1221(a)(2). 27. See IRC s 1231(b)(1). 28. Treasury Reg s 1.1445-1(g)(5). 29. Treasury Reg s 1.1445-1(f)(1). 30. IRC s 1445(b)(4); Treasury Reg s 1.1445-3(a). 31. IRC s 897(c)(1)(A). 32. IRC s 897(c)(1)(A)(ii). 33. IRC s 897(c)(2); See also Treasury Reg s 1.897-2(b)(1). 34. Treasury Reg s 1.897-2(b)(2)(i). 35. IRC ss 2501(a)(1), (2), 2503(b), and 2511(a), (b). See also Rev Proc 2016-55 (7 November 2016). 36. IRC s 2502(a); IRC s 2001(c) (as extended and amended by PL 112–240, s 101(a)(3)). 37. IRC s 2523(a). 38. Treasury Reg s 1.897-5T(c)(1). 39. IRC s 1478; IRC s 2103; Treasury Reg s 20.2104-1(a)(1). 40. IRC s 1480; IRC s 2103; Treasury Reg s 20.2105-1(f). 41. To qualify for this treatment the formalities of a company must be followed. In the foreign partnership context, this statement depends on whether the partnership is conducting a US trade or business; however, this argument is unclear and should be researched extensively. 42. IRC ss 2601, 2611, 2612, and 2613. 43. IRC s 2501(a)(2). 44. IRC s 2103; IRC s 2104(a); Treasury Reg s 20.2104-1(a)(5). © The Author(s) (2018). Published by Oxford University Press. All rights reserved.
Trusts & Trustees – Oxford University Press
Published: Feb 1, 2018
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