FIRPTA and the Return of Capital Distributions

Editor: Annette B. Smith, CPA

Foreign Income & Taxpayers

At first glance, the Foreign Investment in Real Property Tax Act, P.L. 96-499 (FIRPTA), appears relatively straightforward. By application of Sec. 897(a), gain or loss of a foreign person from the disposition of a U.S. real property interest (USRPI) is subject to a substantive U.S. federal income tax liability, and the purchaser must withhold 10% of the amount realized under Sec. 1445. However, FIRPTA is quite complex, as Secs. 897 and 1445 can be ambiguous and filled with traps for the unwary. One such area of complexity involves return of capital distributions.

Withholding Requirements

A key distinction between Sec. 897 and Sec. 1445 is that the former treats gain or loss from the disposition of a USRPI as income effectively connected with a U.S. trade or business, thereby creating a tax liability under Sec. 871(b) or 882(a) on the gain recognized, while the latter may impose withholding on the amount realized. Thus, because a return of capital does not result in gain or loss, Sec. 897 would not apply. However, for purposes of Sec. 1445, the amount of withholding is based on the total fair market value of the distribution without regard to whether there is gain on the transaction; accordingly, withholding is required on both the portion of the distribution that is a return of capital and the portion that is gain (i.e., the amount in excess of the property’s basis). However, withholding is not required to the extent the distributing domestic corporation obtains a withholding certificate from the IRS reducing or eliminating the withholding tax.

Under Sec. 1445(e)(3), if a domestic corporation that is a U.S. real property holding corporation (USRPHC) as defined in Sec. 897(c)(2) or that has been a USRPHC during the shorter of the time the taxpayer owned the interest or the five-year period ending on the date of disposition (a former USRPHC) distributes property to a foreign person in a distribution to which Sec. 301 applies and that is not made out of earnings and profits, the domestic corporation is required to withhold 10% of the amount realized on the distribution. Consequently, because only a distribution made out of earnings and profits is a dividend, both a return of capital and a distribution in excess of capital (basis) are within the scope of Sec. 1445(e)(3). The regulations potentially expand the withholding requirements to all domestic corporations (i.e., not just USRPHCs or former USRPHCs) by requiring the corporation to withhold if the foreign person’s interest in the corporation constitutes a USRPI under Sec. 897 (Regs. Sec. 1.1445-5(e)(1)(i)). With certain exceptions, shares in all domestic corporations are presumed to be USRPIs unless the taxpayer establishes otherwise.

The regulations provide a coordination rule for Sec. 301 distributions of property. In general, a distribution from a USRPHC or a former USRPHC is subject to the withholding provisions of both Sec. 1441 (including the withholding provisions of Secs. 1442 and 1443) and Sec. 1445. A USRPHC or former USRPHC may satisfy its withholding obligations by following the procedures set forth in Regs. Sec. 1.1441-3(c)(4)(i)(A) or (B). Consequently, a USRPHC or former USRPHC may choose to withhold entirely under Sec. 1441, or it may choose to withhold in part under Sec. 1441 and in part under Sec. 1445.

A USRPHC or former USRPHC that chooses to withhold only under Sec. 1441 must withhold 30% on the entire amount of the distribution, regardless of whether any portion of the distribution represents a return of capital or capital gain. Alternatively, if the USRPHC or former
USRPHC chooses to withhold under both Secs. 1441 and 1445, it must make a reasonable estimate of the portion of the distribution that constitutes a dividend and withhold 30% under Sec. 1441 and 10% under Sec. 1445(e)(3) on the remainder of the distribution, or on such smaller portion based on a withholding certificate obtained in accordance with Regs. Sec. 1.1445-5(e)(2)(iv). It is important to note that if the USRPHC or former USRPHC does not obtain a withholding certificate prior to the distribution, it must withhold 10% of the return of capital and excess of capital distribution.

USRPIs

The above-described procedures apply by statute to domestic corporations that are current or former USRPHCs. However, the regulations expand the withholding requirements to all domestic corporations if the foreign shareholder’s interest in the corporation is a USRPI. Sec. 897(c)(1) establishes a statutory presumption that any interest (other than an interest solely as a creditor) in any domestic corporation is a USRPI unless the taxpayer establishes that the domestic corporation is not and was not a USRPHC during the relevant time frame. Consequently, if the foreign shareholder does not establish that its interest in the domestic corporation is not a USRPI, the domestic corporation would be required to withhold 10% on the return of capital and excess of capital distribution under Sec. 1445(e)(3), notwithstanding that the domestic corporation is not a current or former USRPHC.

In order to establish that a foreign shareholder’s interest in a domestic corporation is not a USRPI, the foreign shareholder and the domestic corporation must follow the procedures set forth in Regs. Secs. 1.897-2(g) and (h). In general, the foreign shareholder may establish that the interest was not a USRPI as of the date of the disposition by requesting and obtaining a statement from the domestic corporation no later than the due date, including extensions, on which a tax return otherwise would be due, that its interest was not a USRPI (non-FIRPTA notice) as of the date of disposition. In addition, a domestic corporation should provide a non-FIRPTA notice to the transferee prior to the date of disposition in order to avoid withholding. The domestic corporation must forward the non-FIRPTA notice to the IRS no later than 30 days after it is provided to the transferor and transferee. Importantly, the only person who needs to receive a non-FIRPTA notice prior to the disposition is the transferee.

The relevant non-FIRPTA notice procedures for distributions described under Sec. 1445(e) are set forth in Regs. Sec. 1.1445-5(b). Withholding is not required on dispositions of USRPIs by domestic partnerships, trusts, and estates, and on distributions of USRPIs by foreign corporations if, prior to the transfer, the entity or fiduciary obtains a statement issued by the domestic corporation under Regs. Sec. 1.897-2(h), certifying that the interest is not a USRPI.

In the context of a return of capital, the foreign shareholder is treated as though it transferred shares of the domestic corporation back to the domestic corporation in exchange for cash. Thus, the transferee would be the domestic corporation. The conservative approach would be for the domestic corporation to provide a non-FIRPTA notice to itself, as transferee, prior to the date of the return of capital. However, the regulations issued under Sec. 1445(e) do not refer to Regs. Sec. 1.1445-5(b), nor do the regulations suggest that the domestic corporation is required to provide such notice.

Observations

A simple distribution that generally has no U.S. federal income tax liability can result in a 10% withholding tax liability under Sec. 1445(e)(3) if the appropriate procedures are not followed. Thus, to mitigate the risk of withholding (and interest and penalties), if the domestic corporation is a USRPHC or a former USRPHC, it must obtain a withholding certificate. Alternatively, if the domestic corporation is not a USRPHC or a former USRPHC, the foreign shareholder must establish that its interest in the domestic corporation is not a USRPI.

EditorNotes

Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington, DC.

For additional information about these items, contact Ms. Smith at (202) 414-1048 or annette.smith@us.pwc.com.

Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.