On April 24, the Internal Revenue Service (IRS) issued final regulations (Final Regulations) regarding Section 897. In December 2022, the IRS issued proposed regulations under Sections 897 (the Proposed Regulations) and 892 of the Internal Revenue Code of 1986, as amended (the Code), providing guidance related to “domestically controlled” qualified investment entities and exemptions for foreign government investors, respectively. The IRS noted it will address the Section 892 regulations in a separate rulemaking.
For further background on the IRS’s Proposed Regulations, see our previous LawFlash.
While generally adopting the Proposed Regulations, the Final Regulations notably increase the foreign ownership threshold that triggers the “look through” of a domestic “C corporation” that owns an interest in a US real estate investment trust (REIT) for purposes of determining whether the REIT is “domestically controlled” within the meaning of Section 897(h)(4).
Under Section 897[1] (commonly referred to as FIRPTA, for the Foreign Investment in Real Property Tax Act), nonresident aliens and foreign corporations are subject to US federal income tax on the gain recognized by such foreign persons from the disposition of US real property interests (USRPIs). Any gain from the sale of a USRPI is treated as effectively connected with a US trade or business, such that the foreign person is required to file a US federal income tax return and pay US federal income tax with respect to such gain.
In addition to the substantive tax liability under Section 897, Section 1445 provides that a disposition of a USRPI is subject to US withholding tax. Generally, unless an exception for publicly traded stock applies, a USRPI will include equity interests in a domestic REIT that is a US real property holding corporation. However, if a qualified investment entity (QIE), which includes a REIT, is “domestically controlled” (a DC QIE), an equity interest in such DC QIE will not be considered a USRPI. Therefore, a foreign person will not be subject to US federal income tax on the gain recognized from the disposition of an equity interest in the DC QIE.
A QIE qualifies as a DC QIE if foreign persons hold directly or indirectly less than 50% of the QIE’s equity interests. In situations where foreign ownership would be expected to exceed 50% of a REIT, market participants have implemented ownership structures that permit foreign persons to own an indirect interest in the REIT through a US entity that is treated as a taxable C corporation for US federal income tax purposes. Such a structure was reflected in a 2009 private letter ruling (the 2009 PLR) that treated QIE stock held by a domestic C corporation as owned by a domestic person.[2] An apparent change in position by the IRS regarding the application of the 2009 PLR, among other factors, led the Treasury Department and the IRS to issue a look-through rule in the Proposed Regulations that provided certain interest holders of a QIE will be looked-through for purposes of determining whether such QIE is a DC QIE.
Section 897(l) also provides that a qualified foreign pension fund (QFPF) is not treated as a nonresident alien individual or foreign corporation. As a result, a QFPF is not subject to US federal income tax under Section 897(a). Prior to the issuance of the Proposed Regulations, there was ambiguity as to whether to treat a QFPF as a foreign person when testing for domestic control.
Consistent with the Proposed Regulations, the Final Regulations provide certain look-through rules to determine whether a QIE is a DC QIE. The look-through rules address both domestic C corporations and QFPFs.
To determine whether a QIE is a DC QIE, you must look through certain shareholders of a QIE that constitute “look-through persons” while other shareholders, known as “non-look-through persons,” are not required to be looked-through. Non-look-through persons are treated as holding the stock of a QIE. QIE stock held by a look-through person will be treated as being held by such look-through person’s shareholders, partners, or beneficiaries, through successive tiers of look-through persons until the ultimate non-look-through persons are identified.
Under the Final Regulations, non-look-through persons generally include individuals, estates, QFPFs, tax-exempt entities, foreign corporations, publicly traded regulated investment companies (RICs), publicly traded REITs, publicly traded partnerships, and domestic C corporations, subject to the exceptions described below. The Final Regulations also provide that a publicly traded RIC, publicly traded domestic corporation, or publicly traded partnership will be treated as a look-through person if the QIE being tested as a DC QIE has “actual knowledge” that the public domestic C corporation, publicly traded RIC, or publicly traded partnership is foreign controlled. “Actual knowledge” is not defined in the Final Regulations, so it remains unclear what level of due diligence a tested QIE must undertake to comply with the Final Regulations.
In addition, a QIE is permitted to treat all stock that is regularly traded on an established securities market and owned by persons holding less than 5% of that class of stock as being owned by a single non-look-through person unless the QIE has actual knowledge regarding the ownership by any person.
While domestic C corporations are generally treated as non-look-through persons, domestic C corporations that are “foreign-owned” are treated as look-through persons. Under the Proposed Regulations, a domestic C corporation was treated as “foreign-owned” if 25% or more of the fair market value of stock of such corporation is owned by foreign persons. Thus, for example, a taxable US corporate blocker that is wholly owned by foreign investors to invest in a REIT will be treated as “foreign-owned” for purposes of determining whether the REIT is “domestically controlled.”
Several comments to the Proposed Regulations were submitted with respect to the look-through rule as applied to domestic C corporations. The comment letters advocated for the withdrawal of the domestic C corporation look-through rule, asserting that it was not permitted because Section 897 does not contain explicit rules for constructive ownership and that such a rule was contrary to prior guidance. Some comments also claimed that the rule was inconsistent with congressional intent and unnecessary because domestic C corporations are already subject to US federal income tax. While the Treasury Department and the IRS disagreed with the comments, they agreed to narrow the scope of the rule in the Final Regulations to address compliance concerns and to ensure that the rule is more appropriately limited to situations in which significant indirect ownership by foreign persons indicative of foreign control is present. As a result, the Final Regulations increase the threshold of foreign ownership in a domestic C corporation from 25% to more than 50% for purposes of determining whether a domestic C corporation should be treated as a non-look-through person in the DC QIE analysis. The Final Regulations replaced the term “foreign-owned domestic corporation” with the term “foreign-controlled domestic corporation,” which reflects the change in the look-through rule.
Despite the fact that the statutory language of Section 897(l) states that QFPFs are not treated as nonresident alien individuals or foreign corporations for purposes of Section 897, the Proposed Regulations provided that QFPFs are not considered US persons for purposes of determining “domestically controlled” REIT status. Thus, for example, to the extent a REIT is owned 40% by foreign persons that are not QFPFs and 60% by QFPFs, such a REIT would not be a DC QIE (whereas, if the QFPFs were treated as US persons, the REIT would be a DC QIE). While comments recommended that this rule be withdrawn, the Treasury Department and the IRS implemented the rule as set forth in the Proposed Regulations such that a QFPF will be treated as a foreign person for purposes of determining whether a REIT is a DC QIE.
As discussed above, Section 1445 generally imposes a US federal withholding tax on the disposition of a USRPI. When there is a disposition of an asset that could be a USRPI, regulations state that a transferor may provide to the withholding agent certain certifications such that the withholding agent is not required to withhold on the disposition. One type of certification is a certification, obtained from the domestic corporation in which equity interests are being transferred, that an equity interest in such corporation is not a USRPI. The Final Regulations clarify that a transferor may obtain a certification from a domestic corporation certifying that an interest in the corporation is not a USRPI because the corporation is a DC QIE.
Under the Proposed Regulations, the look-through rules were intended to apply to any transaction occurring on or after the date the regulations were finalized. Further, the Proposed Regulations provided that the rules related to DC QIE determinations may also be relevant for certain transactions occurring before the regulations were finalized. Comments to the Proposed Regulations argued that any retroactive effect was improper and advocated for certain types of transition relief, such as only applying the domestic C corporation look-through rule to QIE stock acquired after the regulations were finalized or delaying the application of the domestic C corporation look-through rule. In response to these comments, the Treasury Department and the IRS adopted a 10-year transition rule. Subject to certain exceptions, the 10-year transition rule exempts existing structures from the look-through rule for a period of 10 years from April 25, 2024, the effective date of the Final Regulations. The transition rule will apply only if the existing QIE does not acquire additional USRPIs whose fair market value exceeds 20% of the total fair market value of the USRPIs already held by the QIE. In addition, the QIE cannot have a significant change in ownership, which generally occurs when more than 50% of the QIE stock changes ownership among non-look-through persons relative to their ownership as of April 24, 2024. Transfers of stock in a QIE that is publicly traded are disregarded by any person that owns a less than 5% interest in the stock of the QIE, unless the QIE has actual knowledge of that person’s ownership. The 10-year transition rule period will end on April 24, 2034. While the transition rule provides some welcome relief, the rule provides limited relief to closed-end real estate funds that are still in their investment period and open-ended real estate funds that are likely to continue to acquire new USRPIs.
The Final Regulations are important for sponsors of funds that include QIEs in the fund ownership structure and investors in those funds or other QIEs, as the new look-through rule impacts whether a QIE will be treated as “domestically controlled.” Sponsors should ensure they have the necessary information from investors to make this determination. Fund sponsors and investors in existing structures utilizing DC QIEs should also limit the acquisition by such QIEs of new USRPIs and any changes in ownership if they intend to rely on the new 10-year transition rule. Importantly, any changes in indirect QIE ownership could unintentionally lead to the transition rule no longer applying to the QIE.
Fund sponsors will also want to review fund agreements and side letters to determine whether any aspects of those agreements are impacted by the Final Regulations (e.g., covenants to maintain DC QIE status, for example).
We are happy to help our clients review these concerns and brainstorm best practices. We are monitoring any developments regarding the Proposed Regulations under Section 892 and will address those developments separately when Proposed or Final Regulations are released in future.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following:
[1] Unless otherwise stated, all section references are to the Code.
[2] PLR 200923001 (Feb. 26, 2009).