For foreign investors to make the best use of ever-evolving U.S. tax laws, which got a major overhaul in 2017 with the passage of the Tax Cuts and Jobs Act, proper tax planning, tax projections and documentation are all required.
The decisions that are made as investments are structured, financed and executed—and later when they are sold—can have a major impact on how much federal tax is paid, and it makes sense to understand in advance the intricacies of the tax laws and regulations that apply.
FIRPTA ‘Blocker’ Investment Structure
To understand how this works, let’s start with how most transactions are structured and how that impacts the payment of taxes under the Foreign Investment in Real Property Tax Act (FIRPTA). In the typical inbound investment in United States commercial real estate, the investment is structured so that foreign investors contribute capital to a 100-percent-foreign-owned corporation that is set up in a non-tax jurisdiction such as the Cayman Islands.
The foreign parent contributes the funds to a 100-percent-owned U.S. C Corporation, which in turn makes a capital contribution to a U.S. Limited Liability Corporation to purchase the real estate. At tax time, the C Corporation files a U.S. tax return and is subject to U.S. income tax, while the foreign investors have no obligation to file a U.S. tax return. The C Corporation relieves or “blocks” the investor from a U.S. filing obligation. That’s why these companies are known as “blocker corporations.”
However, the decisions that are made within this structure can have a large impact on how much is paid in taxes. For example, there is the question of whether or not the blocker corporation uses leverage. In an unleveraged blocker, the foreign parent contributes all the funds to the U.S. C Corporation as equity. In a leveraged blocker, the foreign parent would fund the blocker with a combination of debt and equity. The interest paid on the debt component is generally deductible and allows the blocker corporation to reduce its taxable income. (For the interest to be deductible and the debt respected by the IRS, however, the blocker corporation must be adequately capitalized and the terms of the loan must be “arm’s length.”)
Rental Operation Distributions, Alternatives and Tax Consequences
Distributions are made by the LLC to the blocker corporation from the rental real estate operations and the disposition of the real estate.
With rental real estate operation distributions, the blocker corporation will either use these funds to pay interest and principal on the debt to the foreign corporate parent, retain the funds or make a distribution to the foreign parent. If the blocker retains the funds, there are no tax consequences. If the blocker uses the funds to make a payment on the debt, the interest is tax deductible. To the extent the payment offshore is allocated to loan principal, less interest—and therefore less tax shelter—will be available in future tax years.
If the blocker makes a distribution to the foreign parent but has no current or accumulated earnings and profit, it is a non-taxable return of capital. The distribution is reported on its corporate income tax return using Form 5452 to let the IRS know that the distribution is not subject to tax. But there are regulations to consider. Even though there is no gain, under Section 1445 of the Internal Revenue Code, a 15-percent withholding tax is required on the fair market value of the distribution, unless the blocker obtains a withholding certificate from the IRS reducing or eliminating the withholding tax.
To the extent there is current or accumulated earnings and profit, distributions will be treated as a dividend and are subject to the fixed or determinable annual or periodic (FDAP) tax rules. Under code Section 1441, distributions are subject to a 30-percent federal withholding tax to the extent of current or accumulated adjusted retained earnings and profits. However, there are conditions that can mitigate this withholding. If, for example, the offshore corporation is located in a country with an U.S. tax treaty, it is possible that the treaty may reduce the rate of withholding or, in some cases, completely eliminate it. The withholding is in addition to any tax paid by the blocker and is not refundable nor creditable. The distribution and any related withholding is reported to the IRS annually on Forms 1042, 1042T and 1042S.
Tax Planning to Reduce FDAP Withholding Tax
At the end of the tax year, a calculation of earnings and profits is made to determine if the 30-percent withholding requirement under FDAP applies. If distributions are made during the year based on a projection that there will not be earnings and profits for the tax year, but it turns out that there are, then the 30-percent federal withholding tax will be incurred.
To eliminate or reduce earnings and profits, and avoid a non-refundable and non-creditable withholding tax, a cost segregation study can be used to accelerate depreciation. One downside to this may be the new limitation on net operating loss carry-forwards under the Tax Cuts and Jobs Act. Beginning this year, a blocker corporation can only use a net operating loss to offset up to 80 percent of its taxable income, unless the loss was incurred before 2018, in which case it will be grandfathered, allowing 100-percent use.
Tax Treatment of Sale Liquidation Distributions
If the property is sold, the blocker corporation will pay any required U.S. income taxes. However, if the blocker does not own interest in any other United States real estate directly or indirectly, and if it adopts a plan of liquidation, the distribution to the foreign parent is not subject to any federal income tax withholding.
Overall, foreign investment in U.S. real estate requires preparation in order to minimize taxes as distributions are made from the blocker corporation to the foreign parent. Proper tax planning, tax projections and documentation are all required, and the use of a professional advisor with deep experience in U.S. tax law is advised. This is especially true as the Tax Cuts and Jobs Act continues to change the applicable body of U.S. tax law.
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