The combination of a weak U.S. dollar and low interest rates has resulted in an increase in foreign investment in U.S. commercial real estate. From a U.S. federal income tax perspective, the primary obstacle facing foreign persons who invest in U.S. real estate is the Foreign Investment in Real Property Tax Act (FIRPTA), more specifically Section 897 . Under this provision, any gain recognized by a foreign person on the disposition of a "United States real property interest" (USRPI) will be treated as if such gain were effectively connected to a U.S. trade or business and, therefore, subject to U.S. federal income tax at the graduated rates that apply to U.S. persons. Additionally, when Section 897 applies, the purchaser of a USRPI typically is required to withhold and remit to the IRS 10% of the purchase price i n accordance with tion 1445.
One possible strategy to avoid FIRPTA is the use of a shared appreciation mortgage (SAM). In a typical SAM arrangement, a lender provides a developer with a loan bearing a below-market fixed rate of interest, plus a share of the profit on a subsequent disposition of the property. As this article will illustrate, if the transaction is structured correctly the taxpayers investing in U.S. real estate who may have the most to gain from the use of SAMs are non-U .S. taxpayers.
FIRPTA in General. Foreign persons typically are not subject to U.S. federal income tax on U.S. source capital gains unless those gains are effectively connected to a U.S. trade or busi ness. As stated above, Section 897 treats any gain recognized by a foreign person on the disposition of a USRPI as if it were effectively connected to a U.S. trade or business.
A USRPI is broadly defined as ( I ) a direct interest in real property located in the U.S., and (2) an interest (other than an interest solely as a creditor) i n any domestic corporation that constitutes a U.S. real property holding corporation (i.e., a corporation whose USRPls make up at least 50% of the total value of the corporation's real property interests and business assets).
Reg.1.897-l@ru_(j) elaborates on the phrase "an interest other than an interest solely as a creditor" by stating it includes "any direct or indirect right to share in the appreciation in the value, or in the gross or net proceeds or profits generated by, the real property." The Regulation goes on to state that a "loan to an individual or entity under the terms of which a holder of the indebtedness has any direct or indirect right to share in appreciation i n value of, or in the gross or net proceeds or profits generated by, an interest in real property of the debtor is, in its entirety, an interest in real property other than solely as a creditor."
This principle is illustrated by example in f!e _g.1.897-l@fllill : A non-U.S. taxpayer lends money to a U.S. resident to use in purchasing a condomini um. The nonresident lender is entitled to receive 13% annual interest for the first ten years of the loan and 35% of any appreciation in the FMV of the condominium at the end of the ten-year period. The example concludes that, because the lender has a right to share in the appreciation of the value of the condom inium, he has an interest other than solely as a creditor in the condominium (i.e., a USRPI). Accordingly, a SAM that is tied to U.S. real estate is a USRPI for purposes of ectio'Z.
Simply owning a USRPI, however, does not necessarily trigger any adverse tax consequences under Section 897 . Rather, a non-U.S. taxpayer will be subject to tax under that provision only when the USRPI is "disposed of." Although Section _JJ97 does not define "disposition," Reg. 1.897-l(g) provides that disposition "means any transfer that would constitute a disposition by the transferor for any purpose of the Internal Revenue Code and regulations thereunder."
With respect to SAMs, Reg. 1.897-l(h.h_Exam ple 2 , illustrates a significant planning opportunity for non U.S. taxpayers investing in U.S. real estate. In the example, a foreign corporation lends $1 million to a domestic individual, secured by a mortgage on residential real property purchased with the loan proceeds. Under the loan I agreement, the foreign corporate lender will receive fixed monthly payments from the domestic borrower, constituting repayment of principal plus interest at a fixed rate, and a percentage of the appreciation in the value of the real property at the time the loan is retired.
The example states that, because of the foreign lender's right to share in the appreciation in the value of the real property, the debt obligation gives the foreign lender an interest in the real property "other than solely as a creditor." Nevertheless, the example concludes that Section 897 will not apply to the foreign lender on the receipt of either the monthly or the final payments because these payments are considered to consist solely of principal and / interest for U.S. federal income tax purposes. Thus, the example concludes the receipt of the final appreciation payment that is tied to the gain from the sale of the U.S. real property does not result in a disposition of a USRPI for purposes of Section 897 because the amount is considered to be interest rather than gain under Section I 001 . The example does note, however, that a sale of the debt obligation by the foreign corporate lender will result in gain that is taxable under Section 897.
By characterizing the contingent payment in a SAM as interest (and not a disposition of a USRPI) for tax purposes, the Section 897 Regulations potentially allow non-U.S. taxpayers to avoid U.S. federal income tax on gain arising from the sale of U.S. real estate, if structured correctly.
Withholding on U.S.-Source Interest. Non-U.S. taxpayers generally are subject to a 30% withholding tax (unless reduced by treaty) on certain passive types of U.S. source income, including interest. An important exception to this rule exists for "portfolio interest," which is exempt from withholding tax in the U.S. For this purpose, portfolio interest is defined as any interest (including OID) that is paid on a note that is either ( l ) in registered form or (2) that is not in registered form, if there are arrangements reasonably designed to ensure that the note will be sold only to non-U.S. persons and certain other conditions are satisfied.
There are, however, exceptions to portfolio interest. In particular, it does not include certain "contingent interest." For purposes of this provision, contingent interest is interest that is determined by reference to any of the following: ( 1) Any receipts, sales, or other cash flow of the debtor or related person; (2) Any income or profits of the debtor or a related person; (3) Any change in value of any property of the debtor or a related person; (4) Any dividend, partnership distribution, or similar payments made by the debtor or a related person; and (5) any other type of contingent interest that is identified in Regulations, where a denial of the portfolio interest exemption is necessary or appropriate to prevent avoidance of federal income tax.
Therefore, a payment on a SAM that is otherwise treated for U.S. federal income tax purposes as interest will not qualify for the portfolio interest exemption if the payment is contingent on the appreciation of the financed real property. Accordingly, unless a treaty applies to reduce the withholding tax, the contingent interest feature of a SAM would be subject to a 30% withholding tax in the U.S.
Currently, there are at least seven jurisdictions that have concluded income tax treaties with the U.S. that contain provisions that entirely eliminate U.S. withholding tax on contingent interest paid from the U.S. to the respective treaty jurisdiction: ( l ) The Czech Republic; (2) Hungary; (3) Norway; (4) Poland; (5) The Russian Federation; (6) Greece; and (7) Ukraine.
A payment of U.S. source interest made to a resident of one of these treaty jurisdictions generally would
not be subject to U.S. withholding tax, assuming such person otherwise is eligible for treaty benefits. (It should be / noted that the United States and Hungry have signed a new income tax treaty, which would tax contingent interest, , although this treaty is not yet in effect).
For a non-U.S. taxpayer to be eligible for treaty benefits, the taxpayer must be considered a resident of the particular treaty jurisdiction and must satisfy any l imitation on benefits (LOB) provision in the treaty. Under most "modern" income tax treaties, a resident of a treaty country will satisfy the LOB provision if that resident is an individual, or a corporation that is at least 50% owned by citizens or residents of the U.S. or by residents of the jurisdiction where the corporation is formed and not more than 50% of the gross income of the foreign corporation is paid or accrued, in the form of deductible payments, to persons who are neither citizens nor residents of the U.S. or residents of the jurisdiction where the corporation is formed.
Accordingly, a non-U.S. taxpayer that satisfies both the residence and LOB provisions in one of the treaties listed above should not be subject to U.S. withholding tax on the SAM payments, including the contingent payment. In order for a non-U.S. taxpayer that is not resident in one of the treaty jurisdictions listed above to obtain a complete exemption from U.S. withholding tax on the contingent interest payment, that taxpayer must rely on a treaty that has been concluded with the U.S. which has no LOB provision. Currently, four treaty jurisdictions provide an exemption from withholding on payments of U.S.-source interest, including contingent interest, and do not have LOB provisions: ( I) Hungary; (2) Norway; (3) Poland; and (4) Greece.
Therefore, a non-U.S. taxpayer that is not resident in a favorable treaty jurisdiction can obtain a complete exemption from withholding on contingent interest (and therefore avoid FIRPTA) by investing through a corporation formed in one of these three jurisdictions. (As noted above, the United States and Hungry have signed a new treaty, which does include a comprehensive LOB provision). Once the income is received in the respective foreign jurisdiction, there are alternative strategies available to minim ize or eliminate any foreign corporate tax on such income.