August 29, 2018 / North America
Since the enactment of the Protecting Americans from Tax Hikes Act (PATH) in December 2015, private Real Estate Investment Trusts (REITs) have become the vehicle of choice for many foreign pension funds investing in U.S. real estate. A pension fund that is “qualified foreign pension fund” (QFPF) that invests in a REIT may achieve returns that are largely, or in some cases wholly, exempt from U.S. taxation. The main benefit of investing through a private REIT is that capital gains from the sale of U.S. real estate and the sale or liquidation of the REIT itself is largely free of U.S. income tax. Without a REIT, those gains would be taxable at a 21 percent or 20 percent federal rate, depending upon the type of pension fund. Ordinary income (including operating income) of a REIT will continue to be subject to U.S. income tax. However, the amount of such taxable income can be reduced by depreciation and, to a limited extent, interest.
Careful attention to the REIT qualification criteria is key. In addition to making new investments through a REIT, pension funds with existing U.S. real estate investments should consider whether moving them into a REIT can be achieved tax-free. If so, the upside of structuring into a REIT can be very material.
1. FIRPTA and QFPFs Generally
Under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), foreign investors are generally taxable on gain realized upon the disposition of a United States real property interest (USRPI). The definition of USRPI is quite broad, and includes direct interests in U.S. real estate, interests held through pass-through vehicles such as partnerships, and interests in United States real property holding corporations (USRPHC). A USRPHC is a corporation that has USRPIs with a fair market value (FMV) equal to at least 50 percent of the FMV of all of the corporation’s assets.
With the enactment of the PATH Act in December 2015, QFPFs are no longer subject to FIRPTA. At first, this would seem to open the door to a broad exemption from taxation on real estate gain. However, in practice, the scope of the exemption is limited. For example, a real estate fund structured as a partnership results in flow-through income to the fund’s foreign investors. The activities of most real estate funds give rise to a United States trade or business (USTB) for tax purposes. This generally means that gain on the sale of real estate in the fund (or sale of the fund interest) is treated as effectively connected income (ECI) with a USTB. ECI is taxable to a foreign investor independent of FIRPTA. Accordingly, in such case a QFPF is not afforded special tax treatment.
A QFPF is generally defined as a trust, corporation or other organization or arrangement organized under the law of a foreign country:
Which is established by the country (or political subdivisions thereof), or by one or more employers, to provide retirement or pension benefits to beneficiaries that are current or former employees (or their designees) on account of services rendered;
Which does not have a single participant or beneficiary with a right to more than 5 percent of its assets or income;
Which is subject to government regulation and with respect to which annual information about its beneficiaries is provided, or is otherwise available, to the relevant tax authorities in the country in which it is established or operates; and
With respect to which: i) contributions to the entity or arrangement which would otherwise be subject to tax under the relevant foreign law are deductible or excluded from the gross income of such entity or arrangement or taxed at a reduced rate, or ii) taxation of any investment income of such entity or arrangement is deferred, or such income is excluded from the gross income of such entity or arrangement or is taxed at a reduced rate.
Although there are some elements of the definition that are likely to be clarified in future regulations, the definition is generally viewed as being broad enough to cover a wide variety of foreign pension arrangements.