January 10, 2023
Final regulations issued for qualified foreign pension funds contain some favorable clarifications
In final regulations (T.D. 9971) (the Final Regulations) published December 29, 2022, the United States (US) Treasury Department (Treasury) and Internal Revenue Service (IRS) addressed the qualification for the exemption from taxation under IRC Section 897(l) for gain or loss attributable to the disposition of US real property interests (USRPIs) held by qualified foreign pension funds (QFPFs) and their wholly owned subsidiaries. The Final Regulations also address gain from distributions described in IRC Section 897(h), as well as related withholding requirements under IRC Sections 1445 and 1446 (see Tax Alert 2023-0036 for discussion of the withholding requirements).
The Final Regulations retain the general approach of the proposed regulations that were published on June 6, 2019 (the Proposed Regulations), with few substantive changes, but helpful clarifications. For additional background on the Proposed Regulations, see Tax Alert 2019-1075.
The Final Regulations generally apply to dispositions of USRPIs and distributions described in IRC Section 897(h) occurring on or after December 29, 2022, although certain provisions apply to distributions of USRPIs described in IRC Section 897(h) occurring on or after June 6, 2019. An eligible fund may choose to apply the Final Regulations to dispositions and distributions occurring on or after December 18, 2015 and before December 29, 2022, provided that it applies the rules consistently for all relevant years.
This Alert describes the key clarifications and changes made to the Proposed Regulations by the Final Regulations.
IRC Section 897 treats gain recognized by a foreign person from the disposition of a USRPI as income that is effectively connected with a US trade or business, and therefore, is subject to net basis tax at the graduated, regular US federal income tax rates.
In 2015 (as part of the Protect Americans from Tax Hikes Act of 2015), Congress amended IRC Section 897 to create a new exemption under IRC Section 897(l) for USRPIs held by QFPFs or an entity wholly owned by a QFPF (qualified controlled entity or QCE). IRC Section 897(l) (as amended by technical corrections under the Consolidated Appropriations Act of 2018) provides that a QFPF is not treated as a nonresident alien individual or foreign corporation for purposes of IRC Section 897 and that an entity, all the interests of which are held by a QFPF, will be treated as such a fund. As a result, QFPFs (and their wholly owned subsidiaries or trusts) are exempt from tax on certain dispositions of, and distributions with respect to, USRPIs.
IRC Section 1445 implements the substantive rules of IRC Section 897 by generally imposing a withholding tax on the disposition of USRPIs by foreign persons.
The Final Regulations
The Final Regulations, which retain the general approach and structure of the Proposed Regulations, make important clarifications and liberalize certain requirements that are discussed next.
Qualified segregated accounts
Consistent with the Proposed Regulations, the Final Regulations limit the exemption under IRC Section 897(l) to gain or loss that is attributable to one or more "qualified segregated account[s]" (QSA) that the "qualified holder" (i.e., a QFPF or QCE) maintains.
The Final Regulations retain the definition of a QSA as an identifiable pool of assets maintained for the "sole purpose" of funding "qualified benefits" (generally retirement, pension and ancillary benefits) to "qualified recipients" (generally, plan participants and beneficiaries).
In a welcome clarification, the Final Regulations allow a QSA to satisfy the "sole purpose" requirement notwithstanding that funds may revert to the governmental unit or employer, such as upon plan termination or dissolution (after all obligations have been satisfied), in accordance with applicable foreign law, so long as contributions to the plan are not more than what is reasonably necessary to fund the qualified benefits to be provided to qualified recipients.
Qualified foreign pension fund
To qualify as a QFPF, IRC Section 897(l) requires the entity to be a trust, corporation, or other organization or arrangement (i.e., an "eligible fund") that meets five requirements. The fund must:
Scope of the IRC Section 897(l) exemption
No de minimis ownership by non-QFPFs
The Proposed Regulations required all of the interests in a QCE to be held, directly or indirectly, by one or more QFPFs, with no exceptions. Comments to the Proposed Regulations requested that Treasury permit certain de minimis exceptions, particularly where local law requires a de minimis level of ownership by persons other than QFPFs. A de minimis exception was also requested for the common situation where multiple government business entities of a foreign country (including non-QFPFs) own all interests in a partnership that is treated as a corporation under Treas. Reg. Section 301.7701-2(b)(6). In issuing the Final Regulations, Treasury and the IRS did not accept these suggestions, and require all interests in a QCE to be held, directly or indirectly, by one or more QFPFs. For this purpose, the Final Regulations define an "interest" as an interest in an entity other than an interest solely as a creditor, as that term is defined in Treas. Reg. Section 1.897-1(d)(3) (which includes a stock interest in a corporation, an interest in a partnership as a partner, an interest in a trust or estate as a beneficiary, and certain option instruments).
The Final Regulations, however, contain some limited relief during a transition period for de minimis interests held by a person that provides services to the QCE, which is discussed later.
Qualified holder rule
The Proposed Regulations defined the term "qualified holder" as either a QFPF or a QCE, but exclude from this definition any trust, corporation, governmental unit, or employer that, at any time during the testing period (discussed later), was not a QFPF or QCE. This was added as an anti-abuse rule to prevent the avoidance of FIRPTA.
While the substance of the qualified holder rule has not changed, the Final Regulations clarify the qualified holder rule by identifying it as a separate requirement that must be satisfied to qualify for the IRC Section 897(l) exemption. Specifically, a QFPF or QCE must satisfy one of two alternative tests at the time of the disposition of the USRPI or the distribution described in IRC Section 897(h). The first test applies where the QFPF or QCE did not hold USRPIs when it became a QFPF or QCE, and continued to hold no USRPIs until the date of disposition or distribution. Alternatively, if the QFPF or QCE cannot satisfy the first test because it held USRPIs when it became a QFPF or QCE or at some point thereafter, it can qualify as a qualified holder only if it was a QFPF or QCE during the entire "testing period" applicable to the entity. The "testing period" is defined as the shortest of (i) the period beginning on December 18, 2015, and ending on the date of the disposition or the distribution; (ii) the 10-year period ending on the date of the disposition or the distribution; or (iii) the period beginning on the date the entity (or its predecessor) was created or organized and ending on the disposition or distribution.
The Final Regulations include two transition rules for purposes of determining whether a QFPF or a QCE is a qualified holder. First, for any period from December 18, 2015 to December 29, 2022 (for a QFPF) or to June 6, 2019 (for a QCE), a QFPF or QCE is deemed to constitute a qualified holder if the QFPF or QCE satisfies the requirements in IRC Section 897(l)(2) based on a reasonable interpretation of those requirements (including determining any applicable valuations using a consistent method).
Second, the Final Regulations provide some limited relief for purposes of determining whether a QCE is a qualified holder from December 18, 2015 to February 27, 2023. During this period, a QCE may disregard a 5% or smaller interest owned, directly or indirectly, by any person that provides services to it (e.g., as a manager or director). Importantly, this relief applies only for qualification purposes and does not apply to disregard a de minimis interest at the time the QCE disposes of a USRPI. Thus, any disposition of USRPIs during the period when the trust or corporation had a service provider as an interest holder does not qualify for the IRC Section 897(l) exemption.
Requirements applicable to a QFPF
Pension funds eligible for IRC Section 897(l)(2)(B)
The Final Regulations permit an eligible fund to be established by, or at the direction of, a foreign jurisdiction for purposes of qualifying as a government-established fund. The Final Regulations clarify that an eligible fund is treated as being established by a foreign jurisdiction or an employer notwithstanding that persons other than the foreign jurisdiction or employer administer the fund or otherwise provide services to it. Thus, the Final Regulations expressly note that an arrangement created under a foreign government mandate in which private investment managers make and hold investments in a segregated account, would qualify as being "established by" the foreign government.
Purpose of eligible fund
The Proposed Regulations required all of the benefits that an eligible fund provides to be qualified benefits (discussed later) provided to qualified recipients (100% threshold) and that at least 85% of the present value of the "qualified benefits" that the eligible fund reasonably expects to provide during the entire period the fund expects to exist must be retirement and pension benefits (85% threshold). The Proposed Regulations defined qualified benefits as retirement, pension, or ancillary benefits. This required actuarial projections as well as an estimate of the duration of the fund.
The Final Regulations retain this requirement and provide additional guidance on determining the present value of benefits that an eligible fund reasonably expects to provide. In determining whether the 85% threshold is satisfied, the Final Regulations clarify that an eligible fund must use its most recent present value determination or a 48-month average alternative valuation, which must be computed on an annual basis. The Final Regulations clarify that present value may be determined under any reasonable method.
The Final Regulations introduce the 48-month alternative valuation methodology to permit taxpayers another means to satisfy the 85% threshold when unanticipated events cause a fund to fail the threshold. The Final Regulations consider the 48-month average alternative valuation satisfied if:
In determining whether the 100% or 85% thresholds are satisfied, the Final Regulations exclude three categories of distributions:
Qualified benefits: retirement, pension, and ancillary benefits
The Proposed Regulations defined qualified benefits as retirement, pension, or ancillary benefits. They did not, however, define retirement and pension benefits. In response to comments requesting some additional guidance on why these terms should be defined, the Final Regulations broadly define retirement and pension benefits as payments made to a qualified recipient after reaching retirement age under the terms of the eligible fund, or after an event that results in the recipient being permanently unable to work, and including any such distribution made to a surviving beneficiary of the qualified recipient. The definition further permits retirement and pension benefits to be based on one or more factors that include contributions, investment performance, years of service with an employer, or compensation received by the qualified recipient.
The Final Regulations also expand the definition of ancillary benefits by providing a more robust list of specific types of benefits that qualify as such, including health-related or unemployment benefits. The Final Regulations clarify that ancillary benefits do not include those that are properly defined as, and therefore overlap with, retirement and pension benefits. Given the broad definition of retirement and pension benefits introduced in the Final Regulations, more benefits are likely to be characterized as such rather than ancillary benefits, so the risk of failing the 85% percent threshold may decrease.
Importantly, the Final Regulations also permit an eligible fund to provide a limited amount of non-ancillary benefits. Specifically, no more than 5% of the present value of the qualified benefits the eligible fund reasonably expects to provide to qualified recipients in the future can be non-ancillary benefits. This is determined under the same rules that apply to the present valuation of retirement and pension benefits for purposes of the 85% threshold. This addition should be helpful in situations where foreign law requires funds for certain government programs to be managed in the same way that retirement and pension funds are managed. In particular, this provision may help those funds that provide educational or housing benefits to participants.
For government-established funds, the Proposed Regulations defined a qualified recipient as any person eligible to be treated as a participant or beneficiary of the fund and any person designated by that person to receive qualified benefits. Thus, under the Proposed Regulations, a person's status as a current or former employee had no bearing on their qualification as a qualified recipient of a government fund. In contrast, for employer funds, the Proposed Regulations defined a qualified recipient by reference to the person's designation as either a former or current employee.
Comments noted several scenarios in which an employer fund may consist of a small minority of members who were never employees. In response, the Final Regulations modify the rule for employer-established plans to permit an eligible fund to consist of up to 5% of participants who were never employees. The Final Regulations also expand the definition of qualified recipients to include spouses of current or former employees. The Preamble to the Final Regulations notes that government established funds must be established to provide retirement or pension benefits to participants or beneficiaries that are current or former employees or persons designated by such employees but may include participants on a basis broader than an employee relationship.
Although the Final Regulations do not incorporate all of the changes requested by commentators, the changes and clarifications made are generally helpful in clarifying the requirements that must be met in order to be a QFPF or QCE. Importantly, changes were made to define retirement and pension benefits, clarify the scope of ancillary benefits, and permit qualified benefits to include a de minimis amount of non-ancillary benefits, which should be helpful in determining whether a fund qualifies as a QFPF.
The Final Regulations also provide an alternative valuation test should a fund unexpectedly fail to qualify as a QFPF in a given year. For example, the alternative 48-month valuation test provides taxpayers with another means to satisfy the 85 percent threshold. Taxpayers should consider this alternative when evaluating, and documenting that, the various thresholds are met, and should maintain sufficient documentation as required by the Final Regulations. Eligible funds must keep records adequate to establish that they satisfy these rules.
Taxpayers should also consider the transition rules that are now part of the qualified holder rule and determine whether any action should be taken. For example, if a trust or corporation would fail to qualify as a QCE because a de minimis interest (no more than 5%) is held by a service provider, action may be taken before February 27, 2023, to eliminate that interest and avoid having to apply the tests to evaluate qualified holder status by reference to the date that the interest is eliminated. This relief, however, does not disregard a de minimis service-provider ownership interest at the time the QCE disposes of a USRPI. In other words, a disposition of a USRPI by an entity that is partially held by a service-provider does not qualify for the exemption under IRC Section 897(l).
Some notable changes requested by commentators that the Final Regulations do not incorporate include special rules for life insurance companies or investment companies, a private letter ruling program specific to QFPF qualification, and a "white list" regime whereby regimes regulated in a list of countries could automatically be treated as QFPFs or be subject to a reduced set of qualifying requirements.
Published by NTD’s Tax Technical Knowledge Services group; Maureen Sanelli, legal editor