Revisiting FIRPTA and return-of-capital distributions

Editor: Christine M. Turgeon, CPA

Thirteen years ago, this author wrote a Tax Clinic item describing the compliance requirements under Sec. 1445(e)(3) for distributions in excess of earnings and profits (E&P) from a U.S. corporation to a foreign shareholder (Fine, “FIRPTA and the Return of Capital Distributions,” 42 The Tax Adviser 451 (July 2011)). The prior item focused on return-of-capital distributions and described the general mechanics of Sec. 1445(e)(3), Regs. Sec. 1.1445-5(e)(1)(i), and the coordination rules under Regs. Sec. 1.1441-3(c)(4)(i). 

Although there is no substantive tax due on a return-of-capital distribution, to mitigate the risk of withholding tax, interest, and penalties because of the statute’s and regulations’ broad language, the prior item observed that foreign shareholders and U.S. corporations should consider complying with the non-U.S. real property interest notice procedures described in Regs. Secs. 1.897-2(g) and 1.897-2(h). Or, alternatively, a U.S. corporation (specifically, a current or former U.S. real property holding corporation (USRPHC)) should consider applying for a withholding certificate from the IRS by filing Form 8288-B, Application for Withholding Certificate for Dispositions by Foreign Persons of U.S. Real Property Interests, to eliminate the withholding tax on a return-of-capital distribution. 

This present item focuses on the treatment of return-of-capital distributions from current or former USRPHCs and real estate investment trusts (REITs). 

Prior to 2023, the IRS Foreign Investment in Real Property Tax Act (FIRPTA) unit appeared to routinely grant applications for withholding certificates unless the application was incomplete (e.g., a missing basis calculation). However, over the past year, applications for withholding certificates — particularly for return-of-capital distributions — have been rejected both for timely and untimely applications. 

Pursuant to Regs. Secs. 1.1445-3 and 1.1445-6, a Form 8288-B should be filed by the date of the transaction. However, according to Internal Revenue Manual §21.8.5.4.1(3), if there is no tax due (e.g., a return-of-capital distribution), the FIRPTA unit can accept a late application. If an application is rejected, the withholding agent (e.g., the distributing USRPHC) is required to remit the withholding tax with Forms 8288, U.S. Withholding Tax Return for Certain Dispositions by Foreign Persons, and 8288-A, Statement of Withholding on Certain Dispositions by Foreign Persons, within 20 days of the rejection. If the withholding tax is not remitted, the withholding agent will receive a letter requesting that the withholding tax be paid. Considering the recent application rejections, it seems timely to revisit the technical reasons for why (and if) withholding is required on return-of-capital distributions from USRPHCs and REITs. 

Non-REIT USRPHCs 

Sec. 1445(e)(3) generally requires a USRPHC to withhold 15% of the amount realized on a distribution of property to a foreign shareholder under Sec. 302 or Part II of Subchapter C (e.g., a distribution in liquidation). The last sentence of Sec. 1445(e) (3) states, “Rules similar to the rules of the preceding provisions of this paragraph shall apply in the case of any distribution to which section 301 applies and which is not made out of the earnings and profits of such a domestic corporation” (emphasis added). Because a return-of-capital distribution is a distribution in excess of E&P, best practice historically has been for either the foreign shareholder or the USRPHC to file Form 8288-B and request a withholding certificate from the IRS on the premise that the withholding tax exceeds the maximum tax liability (zero). 

A foreign person generally is subject to tax on any sale or exchange of a U.S. real property interest, including distributions that are treated as a sale or exchange of stock under Secs. 331, 302, and 301(c)(3) (Temp. Regs. Sec. 1.897-5T(b)(2)). The quoted sentence above was added to Sec. 1445(e)(3) by the Small Business Job Protection Act of 1996 (SBJPA), P.L 104-188, and was effective for distributions occurring after Aug. 20, 1996. According to the legislative history of the SBJPA, the sentence was added because there was no withholding mechanism for Sec. 301(c) (3) distributions from a USRPHC. Specifically, the House report on the SBJPA (H. Rep’t No. 104-586, 104th Cong., 2d Sess. 167 (1996)) stated: 

Although a section 301 distribution in excess of earnings and profits is also treated as a disposition for purposes of computing the FIRPTA liability of a foreign recipient of the distribution, there is no corresponding withholding provision expressly addressed to the payor of such a distribution. 

Notwithstanding the reference to a distribution in excess of E&P, the only type of Sec. 301 distribution that can result in a FIRPTA liability under Sec. 897 to a foreign recipient is a distribution in excess of basis. Further, the House report does not mention return-of-capital distributions — it discusses only amounts treated both as received by the foreign shareholder and as a sale or exchange of stock (i.e., a Sec. 301(c)(3) distribution). 

Withholding mechanisms generally are designed to protect the withholding agent. The reason for the broad reference to distributions in excess of E&P vs. a distribution in excess of basis may be because basis and capital gain are shareholder-level calculations. A distributing USRPHC may not know a shareholder’s basis and is therefore allowed to withhold on the entire distribution in excess of E&P under Sec. 1445(e)(3). However, if the parties have a clear calculation of basis and the distributing USRPHC knows that the distribution is not going to exceed basis, withholding potentially may not be required because the last sentence of Sec. 1445(e)(3) may be viewed to serve as the withholding mechanism for Sec. 301(c)(3) distributions. 

Further, withholding mechanisms are intended to be upfront payments of a portion or all of the substantive tax owed. As mentioned above, there is no substantive tax on a return-of-capital distribution, and there does not appear to be a reason why withholding should be required on a distribution that does not result in any gain or loss and is not a transaction that is subject to Sec. 897. 

Withholding on a return-of-capital distribution appears to be an interest-free loan to the IRS and causes an administrative burden for the foreign shareholder. The foreign shareholder would have to file a U.S. tax return to claim a refund of 100% of the withheld tax. Notably, if the foreign taxpayer chooses to file a U.S. tax return and can establish that the tax due is zero, the IRS cannot collect the withholding tax, and the withholding forms are deemed filed. Further, penalties generally may not be imposed (with some exceptions), although interest still can be assessed (Regs. Sec. 1.1445-1(e)(3)). It should be noted this rule cannot be used as a planning technique to avoid a withholding payment. 

REIT USRPHCs 

In addition to withholding requirements on capital gain dividend distributions under Sec. 1445(e) (6), REITs that are USRPHCs also are subject to Sec. 1445(e)(3) as well as Secs. 1441, 1442, and 1443 on ordinary dividends (similar to any U.S. corporation), and certain regulations coordinate the withholding mechanisms. The coordination rule of Regs. Sec. 1.1441-3(c)(4) generally provides that a non-REIT USRPHC can choose to withhold on the entire distribution under Sec. 1441, 1442, or 1443, regardless of whether any portion represents a return of basis or capital gain. Or it can withhold under Sec. 1441, 1442, or 1443 on the amount treated as a dividend and then withhold under Sec. 1445 on the remainder of the distribution (Regs. Secs. 1.1441-3(c)(4)(i)(A) and (B)). 

However, a REIT cannot choose to withhold entirely under Sec. 1441, 1442, or 1443 — it must withhold under Sec. 1445 where applicable. The coordination rule carves out return-of-capital distributions from Sec. 1445 withholding for REITs. Specifically, Regs. Sec. 1.1441-3(c)(4) (i)(C)(2)(i) provides that a REIT is required to withhold under Sec. 1445 on the portion of the distribution “in excess of a shareholder’s adjusted basis in the stock of the REIT” (emphasis added) unless the interest is not a U.S. real property interest (e.g., the REIT is domestically controlled) or if the distribution is paid to a withholding qualified holder. Thus, based on the coordination rule, a REIT USRPHC does not have to withhold on a return-of-capital distribution and does not have to apply for a withholding certificate to mitigate the risk of withholding tax. 

There appears to be no technical reason why the coordination rule was drafted in a manner that carved out return-of-capital distributions for REITs but not for USRPHCs, particularly because there is no mention in Sec. 1445(e)(3) or the regulations thereunder to explain the disparate treatment. REITs generally are subject to the same rules as regular C corporations with respect to Sec. 301 distributions. There is no REIT-specific mechanism to identify a distribution as a return-of-capital distribution. Both REITs and regular C corporations designate distributions as dividends or nondividend distributions on a Form 1099-DIV, Dividends and Distributions. Thus, the same issues appear to be present with respect to a REIT and a non-REIT USRPHC (i.e., whether the distribution is a return-of-capital distribution or capital gain is a shareholder-level calculation). From a policy perspective, it is difficult to explain why a REIT would be carved out from withholding on return-of-capital distributions while USRPHCs may be required to withhold. 

Observations 

Prior to making a return-of-capital distribution, USRPHCs should consider the impact of withholding, not withholding, and/or filing a Form 8288-B and potentially receiving a rejection. If a USRPHC chooses not to withhold, it should consider having internal documentation supporting its position of why it chose not to withhold and clear basis calculations from its foreign shareholder. Lastly, a foreign shareholder may wish to consider whether filing a U.S. tax return could help support a potential position to not withhold. 

Editor Notes

Christine M. Turgeon, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in New York City.

For additional information about these items, contact Turgeon at christine.turgeon@pwc.com.

Contributors are members of or associated with PricewaterhouseCoopers LLP.