Understanding FIRPTA Tax, and Tax Treaties
Brad Wagner | February 17, 2018
Did you know that foreign corporations can elect to be treated as a domestic corporation by the U.S. Internal Revenue Service (IRS) for tax purposes? It has advantages and disadvantages.
Savvy investors will weigh the pros and cons. Foreign corporations are subject to taxation and withholding under the Foreign Investment in Real Property Tax Act (FIRPTA). Those treated as domestic corporations can eliminate FIRPTA taxes, but are subject to other portions of the U.S. tax code. Let’s look at some examples.
Advantages and Disadvantages
For a foreign company to be treated as a domestic corporation for tax purposes, all shareholders must agree, realizing that the sale of property will be taxable, even though it is not subject to FIRPTA tax and may have been exempted by a U.S. tax treaty.
For example, a foreign company that sells a U.S. property would normally be subject to FIRPTA tax and withholding. However, if it is being treated as a domestic corporation by the IRS, FIRPTA taxes will not apply. Instead, the company will file a U.S. tax return and pay the same rate of tax on the gain as a U.S. corporation would.
A more complex example might involve a parent foreign company and a subsidiary foreign company. Let’s say that the subsidiary’s only asset is a U.S. property. If it sold that property, it would be subject to FIRPTA tax and withholding. However, if the subsidiary was treated as a domestic corporation, it could liquidate and distribute its property to the parent corporation without any tax liability under FIRPTA. Instead, the parent would pay FIRPTA taxes when it sold the property.
There are also cases in which this strategy is a disadvantage. For example, let’s say a foreign investor owns 100 percent of the stock in a foreign corporation, and that corporation’s only asset is a piece of property in the U.S. If the corporation sold the property, FIRPTA taxes would apply. However, if the investor sold stock in the corporation, FIRPTA tax would not apply. Now, assume that the corporation elects to be treated as a domestic corporation. In that case, the investor would be subject to FIRPTA taxes.
Weighing the Pros and Cons
It is vital to weigh the pros and cons when considering international taxation issues and whether to embrace this strategy. In terms of advantages, foreign companies that elect to be treated as domestic companies are not subject to FIRPTA taxes and withholding when selling U.S. property. Instead, they will file a U.S. tax return and be taxed as a U.S. corporation, with the ability to offset gains in taxable income with any losses that were incurred.
On the other hand, if a foreign corporation elects to be treated as a domestic company, it will forego any advantages that a U.S. tax treaty with its country of origin may have imparted, including any exemption on gains from selling U.S. property. A foreign investor or foreign company treated as a domestic corporation is more likely to be subject to FIRPTA tax upon selling stock, a tax liability that may not have applied if they were taxed as foreign entities.
Understanding the advantages and disadvantages of using this strategy is crucial before making any decisions. Undertake some analysis. Consult a tax expert. For some investors, the work may be extremely worthwhile.