Foreign Income & Taxpayers
The legislative history of the Foreign Investment in Real Property Tax Act (FIRPTA, part of the Omnibus Reconciliation Act of 1980, P.L. 96-499) suggests that Sec. 897 was intended to create one set of uniform rules that would apply to domestic corporations, partnerships, and trusts. However, Sec. 897, as ultimately enacted, and the regulations issued thereunder primarily address corporations and various corporate transactions. To date, the IRS has not issued meaningful guidance with respect to partnership transactions. This item identifies several issues taxpayers should be aware of to the extent they invest in partnership structures that hold U.S. real property interests (USRPIs).
Partner- or Partnership-Level Determination
FIRPTA adopted the entity theory of partnerships and treats a partnership as a person pursuant to Temp. Regs. Sec. 1.897-9T(c). A common issue in this context is whether a partnership that sells an interest in a publicly traded domestic corporation is eligible for the publicly traded exception under Sec. 897(c)(3). In general, Sec. 897 imposes a substantive tax on gains realized by a foreign person on the sale of a USRPI. Pursuant to Sec. 897(c)(3), a USRPI does not include an interest in a publicly traded corporation if such shares are regularly traded on an established security market, provided that the “person” held 5% or less of the shares during the relevant determination period.
Because the publicly traded test refers to a person, and a partnership is treated as a person, it follows that if a partnership has a 5% or less interest in a domestic corporation that satisfies the publicly traded exception, such interest would not be a USRPI. Consequently, the sale of such interest would not result in gain or loss effectively connected to a U.S. trade or business. The partnership and the domestic corporation would not be obligated to adhere to the reporting requirements that ordinarily are required to establish that an interest in a domestic corporation is not a USRPI (Regs. Sec. 1.897-2(h)(3)). However, there is an argument that the person to be tested for application of the 5% rule is the person that would be taxed on the disposition. Under this theory, the 5% test would apply at the partner level rather than the partnership level. No clear authority exists to resolve this issue.
Amount Attributable to a USRPI
If a partnership has a greater-than-5% interest in a publicly traded corporation and the 5% test is applied at the partnership level, it must be determined whether the corporation is a U.S. real property holding company (USRPHC), as any interest in a domestic corporation, other than an interest solely as a creditor, is presumed to be a USRPI pursuant to Sec. 897(c)(1)(A)(ii).
Unlike an interest in a domestic corporation, which can be a USRPI in its entirety if the domestic corporation either is or has been a USRPHC at any time during the determination period, an interest in a partnership is a USRPI only to the extent of the underlying assets. Accordingly, if a foreign person sells an interest in a partnership that holds both USRPIs and non-USRPIs, pursuant to Sec. 897(g), the foreign person must determine what proportion of the amount realized is attributable to USRPIs.
To date, regulations have not been issued under Sec. 897(g) to clarify how to determine what is attributable to a USRPI. According to the statute’s conference report (H.R. Conf. Rep’t No. 96-1479, 96th Cong., 2d Sess. (1980)), a foreign investor in a partnership would be taxed on the disposition of an interest to the extent that the gain represented the investor’s pro rata share of appreciation in the value of USRPIs of the entity. This language seems to suggest that the term “attributable to USRPIs” should be equal to the partner’s pro rata share of the appreciation in the underlying USRPI assets. However, in the absence of guidance, the appropriate methodology for making this determination remains unclear.
Withholding Considerations
For purposes of withholding under Sec. 1445, the transferee is required to withhold 10% of the amount realized only if the entire partnership interest is a USRPI. A partnership interest is treated as a USRPI in its entirety for this purpose if 50% or more of the value of the gross assets consists of USRPIs and 90% or more of the value of the gross assets consists of USRPIs plus any cash or cash equivalents (50/90 test). Withholding is not required if the partnership does not satisfy the 50/90 test and the partnership complies with the reporting requirements under Temp. Regs. Sec. 1.1445-11T(d). A substantive tax still may be imposed under Sec. 897 even if the partnership does not satisfy the 50/90 test.
Applicable Transactions
Another area of uncertainty is whether Sec. 897(g) applies to all transactions that result in a disposition of a partnership interest (e.g., a redemption) or only to a sale of the partnership interest. Although Sec. 897(g) clearly refers to a sale of a partnership interest, the conference report refers to a disposition of a partnership interest. In the corporate context, FIRPTA applies to any type of disposition for U.S. federal income tax purposes (Sec. 897(a)). There is no guidance to explain why Sec. 897(g) was written to address only a sale of a partnership interest and not a disposition of a partnership interest, but the disparity between the statute and the conference report may be due to requiring nonsale transactions to satisfy Sec. 897(e), which requires coordination with nonrecognition provisions.
Nonrecognition Provisions
Sec. 897 overrides general nonrecognition provisions unless the transaction can satisfy either Sec. 897(d) or Sec. 897(e). With respect to partnership distributions, nonrecognition is preserved under Sec. 897(e) to the extent a USRPI is exchanged for a USRPI, the sale of which would be subject to tax. Sec. 897(e)(2) grants Treasury the authority to issue regulations providing the extent to which changes in interest in, or distributions from, a partnership shall be treated as a sale of property at fair market value. To date, the IRS has not issued regulations.
Temp. Regs. Sec. 1.897-6T(a)(2) defines a nonrecognition provision to include partnership distributions under Sec. 731. As stated above, for purposes of Sec. 897, a partnership interest is a USRPI to the extent of the underlying assets. Consequently, in the context of a Sec. 731 distribution, to satisfy Sec. 897(e), it must be determined what portion of the partnership interest constitutes a USRPI and how much of the property received in the distribution constitutes a USRPI. If the partner does not receive a USRPI in exchange, then the distribution could result in a taxable transaction under Sec. 897(e) or Sec. 897(g).
Observations
The lack of detailed legislative history, in conjunction with minimal regulatory guidance, has created ambiguity in applying Sec. 897 in the context of partnership transactions. However, when one attempts to interpret and apply Sec. 897 to partnership transactions, it is important to remember that the underlying policy goal of FIRPTA is to create equity between U.S. and foreign investors. Under this presumption, absent an abusive transaction, a foreign investor should not be placed at a disadvantage when investing in a partnership structure versus acquiring the property directly.
EditorNotes
Annette Smith is a partner with PwC, Washington National Tax Services, in Washington, D.C.
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 PwC.
