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Regs incorporate PATH Act changes to dispositions of foreign investments in U.S. real property

T.D. 9751, 02/17/2016, Reg. § 1.897-2, Reg. § 1.897-3, Reg. § 1.445-1, Reg. § 1.1445-2, Reg. § 1.1445-3, Reg. § 1.1445-4, Reg. § 1.1445-5, Reg. § 1.1445-6, Reg. § 1.1445-11T

TD 9751: PATH Act Changes to Section 1445.

IRS has issued final and temporary regs that reflect changes made by the Protecting Americans from Tax Hikes Act of 2015 (PATH Act, P.L. 114-113, 12/18/2015) to the income tax and withholding that nonresident aliens and foreign corporations are subject to on the disposition of a U.S. real property interest (USRPI) under Code Sec. 897 and Code Sec. 1445.

Background. Foreign investors are generally not subject to U.S. tax on U.S. source capital gain unless it is effectively connected with a U.S. trade or business or it is realized by an individual who meets certain presence requirements. Gain from the disposition of a U.S. real property interest (USRPI), however, is treated as income effectively connected with a U.S. trade or business under the Foreign Investment in Real Property Tax Act (FIRPTA) and is subject to tax under Code Sec. 897 and withholding under Code Sec. 1445.

Specifically, Code Sec. 897(a)(1) provides that gain or loss from the disposition of a USRPI will generally be taken into account under Code Sec. 871(b)(1) for a nonresident alien individual and under Code Sec. 882(a)(1) for a foreign corporation as if they were engaged in a trade or business within the U.S. during the tax year and such gain or loss were effectively connected with that trade or business.

A USRPI includes any interest (other than solely as a creditor) in any domestic corporation unless the taxpayer establishes that the corporation was at no time a U.S. real property holding corporation (USRPHC) during the applicable testing period (generally, the 5-year period ending on the date of the disposition of the USRPHC). (Code Sec. 897(c)(1)(A)) A USRPHC means any corporation if the fair market value of its USRPIs equals or exceeds 50% of the total fair market value of its USRPIs, its interests in real property located outside the U.S., and any other assets that are used or held for use in a trade or business. (Code Sec. 897(c)(2)) However, under a so-called “cleansing exception,” an interest in a corporation isn’t a USRPI if the corporation doesn’t hold USRPIs as of the date its stock is sold and the corporation disposed of all of the USRPIs that it held during the applicable testing period in transactions in which the full amount of gain (if any) was recognized. (Code Sec. 897(c)(1)(B))

A withholding tax obligation is generally imposed on the transferee when a foreign person disposes of a USRPI. (Code Sec. 1445(a)) A foreign person is any person other than a U.S. person. (Code Sec. 1445(f)(3))

A withholding obligation is generally imposed on a domestic corporation that is a USRPHC on distributions to foreign persons to which Code Sec. 302, or Code Sec. 331 through Code Sec. 346, apply. (Code Sec. 1445(e)(3)) Similar rules are also applicable to distributions to foreign persons under Code Sec. 301 that are not made out of the earnings and profits of the domestic corporation. (Code Sec. 1445(e)(3))

Code Sec. 1445(e)(4) generally requires a domestic or foreign partnership, the trustee of a domestic or foreign trust, or the executor of a domestic or foreign estate to withhold on the distribution of any USRPI to a partner or beneficiary who is a foreign person. Under Code Sec. 1445(e)(5), the transferee of a partnership interest or of a beneficial interest in a trust or estate is required to deduct and withhold tax to the extent provided in regs. Any amounts withheld under Code Sec. 1445 are credited against the foreign transferor’s U.S. tax liability. (Reg. § 1.1445-1(f)(1))

New regs. The final regs update Reg. § 1.897-2, and Reg. § 1.1445-1 through Reg. § 1.1445-5 to reflect changes made by the PATH Act. In addition, an informational footnote noting the increased withholding rate under the PATH Act (see below) is added to the temporary reg Reg. § 1.1445-11T(d)(2)(iii).

These PATH changes include:

•For dispositions after Feb. 16, 2016, the withholding rate under Code Sec. 1445(a), Code Sec. 1445(e)(3), Code Sec. 1445(e)(4), and Code Sec. 1445(e)(5) increases from 10% to 15% of either the amount realized or the fair market value of the interest, as applicable. (PATH Act §324(a)) However, the 10% withholding rate continues to apply for a disposition of property that is acquired by the transferee for his use as a residence with respect to which the amount realized is greater than $300,000 but does not exceed $1 million. (PATH Act §324(b)) This PATH Act change is reflected in Reg. § 1.1445-1(b).

•For dispositions on or after Dec. 18, 2015, the cleansing exception doesn’t apply if the corporation or its predecessor was a real estate investment trust (REIT) or a regulated investment company (RIC) at any time during the shorter of the period that the shareholder held the interest or the 5-year period ending on the date of the disposition of the shareholder’s interest in the corporation. (PATH Act §325) This PATH Act change is reflected in Reg. § 1.897-2(f)(2)(iii).

•For dispositions and distributions after Dec. 18, 2015, Code Sec. 897(l), as added by the PATH Act, provides that Code Sec. 897 doesn’t apply (i) to USRPIs held directly (or indirectly through one or more partnerships) by, or (ii) to distributions received from a REIT by, a qualified foreign pension fund (as defined in Code Sec. 897(l)(2)) or an entity wholly owned by a qualified foreign pension fund. Code Sec. 897(l)(3) provides that IRS will prescribe such regs as may be necessary or appropriate to carry out the purposes of Code Sec. 897(l). In addition, the definition of foreign person in Code Sec. 1445(f)(3) is amended to exclude entities described in Code Sec. 897(l) that aren’t treated as foreign persons for purposes of Code Sec. 1445, except as otherwise provided by IRS. (PATH Act §323) This PATH Act change is reflected in Reg. § 1.1445-2(b)(2)(i)(C).

New address for filings. Additionally, for certain filings that are described in regs under Code Sec. 897 and Code Sec. 1445, the final regs provide that the mailing address is the address specified in the Instructions for Form 8288 under the heading “Where To File.” This PATH Act change is reflected in Reg. § 1.897-2, Reg. § 1.897-3, Reg. § 1.1445-1, Reg. § 1.1445-2, Reg. § 1.1445-3, Reg. § 1.1445-4, Reg. § 1.1445-5 , and Reg. § 1.1445-6.

Effective date. The revisions to Reg. § 1.1445-2 to incorporate the exemption under Code Sec. 1445(f)(3) for entities described in Code Sec. 897(l) apply to dispositions and distributions after Dec. 18, 2015. The revisions to Reg. § 1.897-2 regarding the cleansing exception apply to dispositions on or after Dec. 18, 2015. The new withholding rates apply to dispositions of, and distributions with respect to, USRPIs that occur after Feb. 16, 2016.

References: For taxation of a disposition of investments in U.S. real property, see FTC 2d/FIN ¶  O-10700; United States Tax Reporter ¶  8974; TaxDesk ¶  643,000; TG ¶  30551. For withholding on a disposition of investments in U.S. real property, see FTC 2d/FIN ¶  O-13001; United States Tax Reporter ¶  14,454; TaxDesk ¶  644,001; TG ¶  30730.