Sec. 892 provides foreign governments with an exemption from U.S. federal tax for income from investments in U.S. stocks and securities. However, Temp. Regs. Sec. 1.892-3T(a)(2) provides that in no event will the benefits of Sec. 892 be available to the sale of a partnership interest by a foreign government. What, then, if a foreign government sells an interest in a partnership that holds only stocks and securities?
Under the regulations, Sec. 892 would not apply, although such a sale is unlikely to result in U.S. tax in many circumstances. As a result, if the partnership holds stock in corporations that are U.S. real property interests (USRPIs), the gain could be subject to U.S. federal income tax. However, it is unclear how these regulations interact with the Foreign Investment in Real Property Tax Act rules in Sec. 897.
The Sec. 892 exemption specifically applies to income or gain from investments in the United States in stock and securities. Under Temp. Regs. Sec. 1.892-3T(a)(3), these securities do not include partnership interests. Moreover, under Sec. 892(a)(2)(A)(i), the exemption is not available for any income from commercial activity or any income received by or from a "controlled commercial entity"—any entity that is engaged in commercial activity if the foreign government owns, directly or indirectly, at least 50% of the entity (by either vote or value) or any other interest that gives it practical control over the entity.
Sec. 892 principally benefits foreign governments when they receive dividends from U.S. corporations—interest in many cases already will be exempt from tax under the portfolio-interest exemption of Sec. 881(c)—and when they sell noncontrolling interests in U.S. corporations that are USRPIs. Absent Sec. 892, gains from such sales would be taxed under Sec. 897.
Sec. 897(a) provides that any gain or loss on the sale of a USRPI by a foreign person is subject to U.S. federal tax as if such gain or loss were effectively connected with the conduct of a U.S. trade or business. Under Sec. 897(c)(1)(A), a USRPI includes both a direct interest in real property located in the United States and an interest in a U.S. corporation that is, or was at any time during the shorter of the five-year period preceding the disposition or the taxpayer's holding period of the stock, a U.S. real property holding corporation (USRPHC). Under Sec. 897(c)(2), a corporation is a USRPHC if the value of its real property interests (in the United States and elsewhere) and its trade or business assets is at least 50% attributable to USRPIs. This rule is subject to several exceptions, including that a USRPI does not include stock in a USRPHC that is publicly traded if the taxpayer owns less than 5% (10% in the case of real estate investment trust (REIT) stock) of the publicly traded class of shares.
However, a foreign government can hold up to 50% of such a corporation and be exempt from tax on gain from sales of that stock because, even though Sec. 897 generally would tax the gain, it would be gain from the sale of stock that is exempt under Sec. 892 unless the entity in which stock is sold is a controlled commercial entity. While Temp. Regs. Sec. 1.892-5T(b) provides that any USRPHC is treated as engaged in commercial activity, the USRPHC is a controlled commercial entity only if the foreign government controls it. Thus, a foreign government that directly owns a noncontrolling interest in a USRPHC may sell that interest without having to pay U.S. federal tax on any gain.
If the government instead invests in a partnership that holds an interest in a USRPHC, the treatment potentially differs depending on whether the partnership sells the USRPHC—in which case the foreign government's distributive share of gain from the sale of stock is potentially exempt under Sec. 892—or whether the foreign government sells its partnership interest—in which case Temp. Regs. Sec. 1.892-3T(a)(2) provides that the benefits of Sec. 892 are not available. Other than applying the entity theory to partnerships to conclude that the sale of a partnership interest is not the sale of the underlying assets (a principle the IRS has been willing not to follow when policy argues in favor of abandonment; see Rev. Rul. 91-32), there appears to be no compelling policy reason to impose tax in the latter scenario but not in the first.
However, Sec. 897(g) provides that, under regulations to be issued, when a foreign person sells an interest in a partnership that has USRPI assets, the gain from the sale of the partnership interest will be treated as gain from the sale of a USRPI to the extent allocable to the USRPI. The IRS has not yet issued regulations under Sec. 897(g) other than regulations addressing withholding.
Because Sec. 897(g) applies an aggregate approach that requires treating the sale as a sale of a USRPI to the extent the partnership has a USRPI, it is reasonable to conclude that, if the partnership's USRPI is a USRPHC, then the sale of the partnership interest should be treated as a sale of a USRPHC to the extent of USRPHC assets of the partnership, rather than as a sale of a partnership interest.
One potential counter to such an analysis is Notice 2007-55, in which the IRS concluded that REIT capital gain dividends are not eligible for Sec. 892 benefits because they were treated as gain from the sale of a USRPI. The notice did not distinguish between sales of USRPIs held directly by the REIT and USRPHCs held by the REIT. However, in the context of Sec. 897(g), the requirement that the gain attributable to partnership USRPIs should be treated as gain from the disposition of "such property" argues in favor of treating gain attributable to USRPHCs held by the partnership as gain from the sale of stock and therefore eligible for Sec. 892 benefits.
Under this logic, Temp. Regs. Sec. 1.892-3T(a)(2) would not operate to turn off the benefits of Sec. 892 because, rather than treating the foreign government as selling a partnership interest, Sec. 897(g) treats it as selling stock in a USRPHC, which may be eligible for Sec. 892 benefits if the foreign government does not hold a controlling interest in the USRPHC. This conclusion would seem to make sense from a policy perspective because (1) under Sec. 892, foreign governments are not subject to U.S. federal income tax on gains from the sale of noncontrolling interests in U.S. corporations, even if those corporations are USRPHCs, and (2) Sec. 897(g) mandates an aggregate approach to the sale of a partnership interest to the extent the partnership holds a USRPI.
Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.
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