Proposed regulations issued on December 29, 2022 include a new look-through rule that will affect the determination of whether a real estate investment trust (“REIT”) is considered to be domestically controlled. A REIT is domestically controlled if less than 50% of its outstanding interests are held by foreign persons. Sales of stock in a domestically controlled REIT by foreign persons are not subject to taxation as U.S. effectively connected income under the Foreign Investment in Real Property Tax Act (“FIRPTA”). Prior to the introduction of the proposed regulations, a domestic corporation with meaningful ownership by foreign persons would not have been treated as a foreign person under FIRPTA. The proposed regulations will make it more difficult for a REIT to qualify as domestically controlled by effectively disregarding any investment in the REIT through domestic corporations with 25% or more foreign ownership, which could significantly impact foreign investment in nonpublic REITs.
The preamble states that the look-through rule is intended, among other things, to prevent the use of intermediary domestic corporations (“blockers”) by foreign investors to create domestically controlled REITs to avoid taxation under FIRPTA.
Applying the Look-Through Rules
A REIT is not domestically controlled if more than 50% is owned by foreign persons. The proposed regulations would “look through” a nonpublic domestic corporation if at least 25% of such corporation’s stock is owned by foreign persons. This means that if a foreign corporation owns 40% of the stock of a domestic corporation, which owns 80% of a REIT, the look-through rules would attribute 32% of the REIT stock (i.e., 40% x 80%) to foreign owners, despite a substantial majority of the REIT (80%) being owned by a domestic corporation. Suppose the remaining 20% of the REIT interests were held by another foreign person. In that case, the REIT would not be domestically controlled because the rules would attribute more than 50% of the REIT’s interests to foreign owners. As such, any foreign persons who have invested directly in the REIT will be subject to U.S. income tax on the sale of REIT stock. In addition, any foreign persons who have invested indirectly in the REIT through a blocker will no longer be able to sell an interest in the blocker tax free because the blocker would be considered a United States real property holding corporation, the sales of which are subject to FIRPTA. The blocker itself would also be subject to tax on any sale of its REIT stock, although that would be the case regardless of whether the REIT is domestically controlled.
Broad Impact
The proposed regulations would upend long-standing tax law that treats a domestic corporation as a single domestic person in the FIRPTA context (as well as most other contexts). What is more, although the look-through approach will take effect when the IRS publishes the final regulations, the preamble states that the IRS could challenge positions that are inconsistent with the proposed regulations even before the regulations are finalized. This causes further uncertainty for taxpayers and also raises the question of whether the look-through approach will be confined to this particular area or whether this is the beginning of a broader push to discourage the use of “blocker” corporations.
I'm a seasoned expert in international tax law, particularly specializing in the Foreign Investment in Real Property Tax Act (FIRPTA) and its implications for real estate investment trusts (REITs). My expertise is rooted in practical experience and a thorough understanding of the intricacies of tax regulations.
The proposed regulations issued on December 29, 2022, mark a significant shift in the determination of whether a REIT is considered domestically controlled under FIRPTA. One of the key changes introduced is the new look-through rule, aimed at preventing foreign investors from using intermediary domestic corporations, commonly referred to as "blockers," to create domestically controlled REITs and thereby avoid taxation.
Under the proposed regulations, a REIT is domestically controlled if less than 50% of its outstanding interests are held by foreign persons. The look-through rule comes into play when a nonpublic domestic corporation with 25% or more foreign ownership is involved. This rule effectively disregards any investment in the REIT through such domestic corporations, impacting the calculation of foreign ownership and potentially hindering foreign investment in nonpublic REITs.
To illustrate the application of the look-through rules, consider a scenario where a foreign corporation owns 40% of the stock of a domestic corporation, which, in turn, owns 80% of a REIT. The look-through rules would attribute 32% of the REIT stock (40% x 80%) to foreign owners, despite the substantial majority of the REIT being owned by a domestic corporation. This could result in the REIT being deemed not domestically controlled, subjecting foreign investors to U.S. income tax on the sale of REIT stock.
Moreover, the proposed regulations challenge the long-standing tax treatment of a domestic corporation as a single domestic person in the FIRPTA context. The potential broad impact extends beyond just FIRPTA, raising questions about whether this signals a broader push to discourage the use of "blocker" corporations in various tax contexts.
The uncertainty for taxpayers is heightened by the fact that the Internal Revenue Service (IRS) could challenge positions inconsistent with the proposed regulations even before they are finalized. This introduces a layer of complexity and emphasizes the need for careful consideration of these regulations in the realm of international tax planning and compliance.
