January 9, 2023
Proposed regulations would make major changes to domestically controlled QIE rules under IRC Section 897, and certain controlled commercial entity rules under IRC Section 892
In proposed regulations (REG-100442-22; Proposed Regulations) published December 29, 2022, the United States (US) Treasury addressed whether qualified investment entities (QIEs), which include real estate investment trusts (REITs), are considered domestically controlled for purposes of the Foreign Investment in Real Property Tax Act (FIRPTA) rules of IRC Section 897. In a move that is bound to create significant controversy, the Proposed Regulations would apply a look-through approach to certain C corporations to determine whether foreign persons directly or indirectly hold a QIE's stock. In particular, look-through treatment would apply to a privately held domestic C corporation that has "foreign persons" (as defined in the Proposed Regulations) owning, directly or indirectly, 25% or more of the fair market value of its stock.
The Proposed Regulations also address the treatment of qualified foreign pension funds (QFPFs) and qualified controlled entities (QCEs) in determining whether a QIE is domestically controlled. The Proposed Regulations would treat QFPFs and QCEs as foreign persons for this purpose. This is the case even though QFPFs and QCEs are not subject to the IRC Section 897(a) FIRPTA tax under IRC Section 897(l), which led some to argue QFPFs and QCEs should be treated similarly to domestic tax-exempt persons, which the Proposed Regulations would treat as domestic persons for purposes of these rules, rather than foreign persons.
The Proposed Regulations also address the treatment of QFPFs and QCEs for purposes of the US tax exemption for income of foreign governments under IRC Section 892. The Proposed Regulations would change the IRC Section 892 regulations so that a foreign corporation that is a QFPF or a QCE and also a US real property holding corporation (USRPHC) would not be treated as engaged in commercial activities and could thus qualify for the IRC Section 892 exemption, if other relevant criteria were satisfied. A similar rule would apply for a foreign corporation that is controlled by a foreign government and would be a USRPHC solely because it owns direct or indirect interests in other corporations that are not controlled by the foreign government.
The Proposed Regulations would only be effective for dispositions of QIE stock occurring after the date final regulations are issued. According to the Preamble, however, the IRS may challenge positions contrary to the Proposed Regulations before the final regulations are issued. Further, and perhaps more concerning, the Proposed Regulations would apply to determine whether a QIE has been domestically controlled throughout the entire testing period (generally five years) before the sale of its stock, even for the portion of the testing period that occurs before the regulations' finalization. This approach, if adopted, could severely limit a QIE's ability to proactively cure, before the effective date, any failure of domestically controlled status that the Proposed Regulations would create.
The Proposed Regulations were published concurrently with final regulations on qualifications for QFPFs and QCEs under IRC Section 897(l) and related withholding provisions. A forthcoming Tax Alert will provide an overview of the final regulations; for discussion of the regulations' withholding provisions, see Tax Alert 2023-0036.
Domestically controlled QIEs
The FIRPTA rules of IRC Section 897 generally characterize gain that a nonresident alien individual or foreign corporation derives from the sale or other disposition of a US real property interest (USRPI) as US-source income that is effectively connected with a US trade or business, and taxable as such. The definition of a USRPI includes stock and other equity interests in a USRPHC, which is any corporation for which the FMV of its USRPIs equals or exceeds 50% of the FMV of its USRPIs, its non-US real property interests, and assets that are used or held for use in a trade or business. Under IRC Section 897(h)(2) and (h)(4)(B), however, a USRPI does not include an interest in a QIE that is domestically controlled (the domestically controlled QIE exception). For a QIE to qualify as a domestically controlled QIE, foreign persons must hold less than 50% of the value of its stock, directly or indirectly, at all times during a lookback or "testing" period that is the shorter of five years ending on the date of disposition, or the period the QIE has existed.
The term "held directly or indirectly" is not explicitly defined. For purposes of this determination, Treas. Reg. Section 1.897-1(c)(2)(i) requires the actual owners of stock, as determined under Treas. Reg. Section 1.857-8, to be taken into account. Under those rules, the "actual owner of stock" is the person who must include in gross income on its return the dividends received on the stock.1 The Protecting Americans from Tax Hikes Act of 2015 (PATH Act), signed into law in December 2015, provides limited rules for determining whether the holder of QIE stock is a US person or a foreign person for purposes of the "held directly or indirectly" rule in IRC Section 897(h)(4)(E). These rules treat a QIE shareholder that is itself a QIE as a foreign person in certain circumstances; QIE stock held by another, publicly traded, QIE is treated as held by a foreign person unless that publicly traded QIE is domestically controlled, in which case the QIE stock is treated as held by a US person. IRC Section 897(h)(4)(E) also provides a look-through rule for QIE stock owned by another, privately held QIE and states in relevant part that "any stock in the QIE held by any other QIE … shall only be treated as held by a US person in proportion to the stock of such other QIE which is … held by a US person."
"Held directly or indirectly" rule incorporates look-through approach
The Proposed Regulations would determine whether a QIE's stock is held "indirectly" by foreign persons for purposes of the domestically controlled QIE rules by applying "general" and "special" look-through rules to stock held by certain entities. Several examples illustrate how to make this determination.
Under the general look-through rules, only a "non-look-through person" would be considered to hold the QIE's stock directly or indirectly. Stock held by, or through, one or more intermediate "look-through persons" would be treated as held proportionally by ultimate owners that are non-look-through persons. A non-look-through person would be an individual, a domestic C corporation (except for foreign-owned domestic corporations described later), a tax-exempt holder, a foreign corporation, a publicly traded partnership, an international organization, a QFPF or any part of a QFPF, or a QCE. (As noted previously, QFPFs and QCEs are treated as foreign persons.) A look-through person would be any person other than a non-look-through person. This would include a RIC, a REIT, an S corporation, a non-publicly traded partnership, or a trust, and any domestic C corporations that would be treated as look-through persons under special rules.
Under the special look-through rules, a privately held domestic C corporation would be considered a foreign-owned domestic corporation, and treated as a look-through person, if foreign persons hold 25% or more of the FMV of the corporation's outstanding stock directly or indirectly. Any person holding less than 5% of US publicly traded QIE stock would be treated as a US person that is a non-look-through person unless the QIE has actual knowledge that the holder is not a US person. A publicly-traded QIE would be treated as a foreign person that is a non-look-through person, unless it is a domestically controlled QIE (in which case it is treated as a US person that is a non-look-through person).
The Preamble notes that Treasury considered treating all domestic C corporations as non-look-through persons, but concluded that look-through treatment for foreign-owned domestic corporations "best serves the purposes" of the domestically controlled QIE exception; one such purpose, according to the Preamble, is to prevent foreign investors from using intermediary domestic C corporations to create domestically controlled QIEs that would allow an exemption from IRC Section 897 that would be unavailable if the foreign investors held the stock in the QIE directly. Unlike other look-through entities such as domestic partnerships, however, a domestic C corporation is itself subject to US taxation on any gain from a disposition of its QIE stock; the Preamble does not fully account for how this important distinction aligns with its conclusion.
The statutory definition of a domestically controlled QIE contains a testing period, generally five years from the date of disposition of the QIE's stock, throughout which the QIE must have been domestically controlled in order for a non-US person not to be subject to FIRPTA tax on the disposition. As the proposed general and special look-through rules would apply throughout the testing period for any such disposition (even if the testing period begins before the effective date of the final regulations), the finalized regulations would apply not only prospectively, but also to investment structures already in place today or put in place before the date the Proposed Regulations are issued as final regulations.
QFPFs and QCEs treated as foreign persons
Comments received in response to the 2019 proposed QFPF regulations (84 FR 26605) recommended not treating a QFPF as a foreign person for purposes of the domestically controlled QIE exception. In support of this recommendation, they noted that the language of IRC Section 897(l)(1) states that, "for purposes of this section," — i.e., the entirety of IRC Section 897 — a QFPF (or QCE) "shall not be treated as a nonresident alien individual or a foreign corporation." This recommendation was rejected. According to the Preamble, Treasury viewed the recommendation as broader than what Congress intended in enacting IRC Section 897(l), which was to provide that, "in determining the US income tax of a qualified foreign pension fund, section 897 does not apply" (emphasis added). Thus, the Proposed Regulations would treat a QFPF (including any part of a QFPF) or a QCE as a foreign person for purposes of the domestically controlled QIE exception.
IRC Section 892 exemption — QFPFs and QCEs
IRC Section 892 exempts from US taxation certain income derived by a foreign government, including income from investments in US stocks or securities, with some significant exceptions. The IRC Section 892 exemption does not apply to income that is (i) derived from the conduct of a commercial activity, (ii) received by or from a controlled commercial entity, or (iii) derived from the disposition of a controlled commercial entity. Under Temp. Treas. Reg. Section 1.892-5T, a "controlled commercial entity" is any entity engaged in commercial activities anywhere in the world if a foreign government owns 50% or more of its interests or otherwise has effective practical control of the entity. A USRPHC (including a foreign corporation "that would be a USRPHC if it [were] a US corporation") is treated as engaged in commercial activity and thus is a controlled commercial entity if the foreign government ownership/control thresholds are met.
Unlike certain other provisions in the Proposed Regulations, the IRC Section 892 provisions would make taxpayer-favorable changes to current rules. Comments to the 2019 proposed QFPF regulations noted that a QFPF or QCE would be a controlled commercial entity under the IRC Section 892 rules if it qualified as a USRPHC and the foreign government ownership/control thresholds were met. In that case, no income received by the foreign government from that QFPF would qualify for the IRC Section 892 exemption. Accordingly, the comments suggested excluding QFPFs and QCEs from the rules that treat a USRPHC as engaged in commercial activity. The Proposed Regulations would incorporate this suggestion. In addition, the Proposed Regulations would not treat as engaged in commercial activity a corporation that is a USRPHC solely because of its direct or indirect ownership in one or more other corporations that are not controlled by the foreign government.
The practical implications of the domestically controlled QIE provisions of these Proposed Regulations, if finalized in their current form, would be very broad and very significant for investment structures that involve domestically controlled REITs with taxable foreign owners. Even measuring their potential impact could require considerable time and effort, e.g., reviewing side letters where fund sponsors have agreed to structure a REIT as domestically controlled, determining who the ultimate owners of a foreign-owned domestic corporation would be, determining what 25% of the FMV of a domestic corporation would be at any given time during a testing period whose starting point is not yet known, or determining whether restructuring is desirable in light of the proposed rules. While burdensome, these actions may be advisable given the Preamble's caution that the IRS may challenge positions contrary to the Proposed Regulations before the final regulations are issued, and the potential application of the Proposed Regulations to portions of testing periods that occur before the final regulations are adopted.
Treasury is soliciting comments and requests for a public hearing on the Proposed Regulations through February 27, 2023, on all aspects of the Proposed Regulations, including on the definition of look-through person and non-look-through person. Stakeholders should consider whether to submit written comments or otherwise engage with Treasury and the IRS on the impact of the Proposed Regulations, and any suggested alternatives, during the comment period.
Published by NTD’s Tax Technical Knowledge Services group; Maureen Sanelli, legal editor
1 PLR 200923001 (June 9, 2009) referred to this rule in concluding that the term "directly or indirectly," for purposes of IRC Section 897(h)(4)(B), did not require looking through domestic C corporations that were "fully taxable domestic Subchapter C corporations for US federal income tax purposes." The legislative history to the PATH Act mentions this ruling in its description of then-current law but does not elaborate on whether its conclusion aligns with the PATH Act's provisions. See Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the Protecting Americans from Tax Hikes Act of 2015, House Amendment #2 to the Senate Amendment to H.R. 2029 (Rules Committee Print 114-40), (JCX-144-15), December 17, 2015. However, one may argue that Congress agreed with the conclusion reached in the PLR since it did not include rules in the PATH Act that require looking through a C corporation (as it did with non-publicly traded REITs).