The Protecting Americans from Tax Hikes Act of 2015 (“PATH Act”) provided a tax exemption from gain or loss on certain dispositions of U.S. real property interests (“USRPIs”) for Qualified Foreign Pension Funds (“QFPFs”) under section 897(l) of the Internal Revenue Code of 1986, as amended (the “Code”).

Since enactment, there has been doubt as to whether certain foreign pension fund systems or structures would qualify for such exemption. On June 6, 2019, the U.S. Treasury Department (“Treasury”) and Internal Revenue Service (“IRS”) released proposed regulations to provide guidance. In general, the Proposed Regulations are taxpayer friendly and express a clear intent to include a broad range of foreign pension funds.

Proposed Regulations – Highlights

Qualified Controlled Entities. Entities that are owned by more than one QFPF and multi-tiered structures may now qualify for benefits through the introduction by the Proposed Regulations of the concept of a “qualified controlled entity” (“QCE”). The statute only allowed for an exemption for an entity that was wholly-owned by a single QFPF. Entities that meet the definition of a QCE can start taking advantage of this exception to FIRPTA immediately and on a retroactive basis.

Ancillary Benefits. Up to 15% of the benefits provided by a QFPF may consist of “ancillary benefits,” which are benefits payable upon the diagnosis of a terminal illness, death benefits, disability benefits, medical benefits, unemployment benefits, or similar benefits.

Definitional Clarification. The Proposed Regulations expand the definition of QFPF and resolve several statutory ambiguities in a taxpayer favorable fashion. This will allow many more foreign pensions to qualify for QFPF treatment.

Use of Form W-8 EXP. Form W-8 EXP will be updated to allow QFPFs to certify their exemption from withholding. Until such time, taxpayers are permitted to use a certificate of non-foreign status. Since this is a change in practice, withholding agents should consider requesting these certificates from foreign pension funds.

Effective Date. The Proposed Regulations are generally proposed to apply to dispositions and distributions occurring on or after the date the regulations are finalized. However, taxpayers may generally rely on the Proposed Regulations on a retroactive basis.

Overview of Section 897 – FIRPTA

Under the Foreign Investment in Real Property Tax Act (“FIRPTA”), non-U.S. persons are generally subject to U.S. taxation on the disposition (as defined in the Code) of a USRPI. Therefore, sales, exchanges, redemptions, distributions, or gifts of USRPI generally constitute a disposition for FIRPTA purposes (and are subject to tax).

A USRPI is any interest in real property located in the U.S. and any interest in a U.S. real property holding company (“USRPHC”). A USRPHC is any domestic corporation if the fair market value of its USRPI equals or exceeds 50% of its gross assets (with some exclusions), either at the time of sale or any time during the prior five years.

The rules operate so as to treat gain or loss from the disposition of a USRPI as gain or loss that is effectively connected with the conduct of a U.S. trade or business (effectively connected income or “ECI”). However, with the implementation of section 897(l), pursuant to the PATH Act, certain QFPFs are exempted from FIRPTA taxation.

Overview of Section 897(l) – Qualified Foreign Pension Funds

Section 897(l) provides that QFPFs (and any wholly-owned entity) are not subject to FIRPTA taxation. A QFPF is any trust, corporation, or any other organization or arrangement (“Organization or Arrangement Requirement”) that satisfies the following requirements:

1. Is created or organized under the law of a country other than the U.S. (“Organization Requirement”);
2. Is established to provide retirement or pension benefits to participants or beneficiaries that are current or former employees (or persons designated by such employees), in consideration for services rendered;
3. Does not have a single participant or beneficiary with a right to more than 5% of its assets or income (“5% Limitation”);
4. Is subject to government regulation and provides annual information reporting about its beneficiaries to the relevant tax authorities in the country in which it is established or operates (“Information Requirement”); and
5. Under the laws of the country in which it is established or operates, either:
   • contributions to it that would otherwise be subject to tax under such laws are deductible or excluded from the gross income of the entity or taxed at a reduced rate; or
   • taxation of any of its investment income is deferred or such income is excluded from gross income, or such income is taxed at a reduced rate (“Foreign Tax Requirement”).

Proposed Regulations – In Detail

Qualified Controlled Entities – Expansion for Subsidiaries

Prior to the Proposed Regulations, it appeared that only wholly-owned entities of a single QFPF could qualify for the FIRPTA exemption. The Proposed Regulations have clarified that QCEs may qualify for the exemption. A QCE is defined as a trust or corporation organized under the laws of a foreign country, all of the interest of which are held directly or indirectly by QFPFs. The QFPFs do not need to be organized in the same country or the same country as the QCE.

In determining whether one or more QFPFs hold the entire interest of a foreign trust or corporation, the Proposed Regulations disregard interests in an entity solely as a creditor if the interest does not share in the earnings or growth of the entity. However, the Proposed Regulations do not provide a de minimis exception for interests held by minority shareholders (such as managers or directors).

An entity treated as a partnership for U.S. income tax purposes cannot qualify as a QCE. Treasury and the IRS did not feel that inclusion in the definition of QCE was necessary since the FIRPTA rules already apply on a look-through basis.

Since the Proposed Regulations can generally be relied upon, entities that meet the definition of a QCE can start taking advantage of this exception to FIRPTA immediately and on a retroactive basis.

Qualified Holders and the Anti-Avoidance Rule

Generally, a QCEs and QFPFs are classified under the Proposed Regulations as “qualified holders” eligible for the exemption. However, to prevent circumvention of FIRPTA recognition (such as a scenario where an entity holds a USPRI, is acquired by a QFPF, and then later sells the USPRI without recognizing gain), the Proposed Regulations implement an anti-avoidance limitation. As a result, a qualified holder does not include an entity that at any time during a defined testing period was not a QFPF, part of a QFPF, or a QCE. Note that this limitation only applies to those entities that held USRPI on the date it became a QFPF or QCE.

Segregated Account Requirement

The Proposed Regulations limit the FIRPTA exemption to gain or loss (or distributions) that is attributable to one or more segregated accounts maintained by a qualified holder. A segregated account is an identifiable pool of assets maintained for the sole purpose of funding qualified benefits (generally, retirement, pension, and other ancillary benefits) to qualified recipients (plan participants and beneficiaries). Separate standards are set out for QFPFs and QCEs to determine whether the pool of assets satisfies the segregated account requirement. Generally to qualify, the assets and income of the account must inure exclusively to the benefit of qualified recipients. For this purpose, escheat and similar laws are ignored.

QFPF Definitional Requirements

The Proposed Regulations provide additional clarity on the statutory requirements of a QFPF. The rules are generally taxpayer friendly.

The Proposed Regulations provide that an entity that qualifies as a pension fund for purposes of a U.S. income tax treaty will not automatically be classified as a QFPF under the Proposed Regulations. The entity must satisfy the requirements as provided in the tax code and underlying regulations.

Organization or Arrangement Requirement

The statutory definition of QFPF limits eligible funds to those that are a “trust, corporation, or other organization or arrangement.” The Proposed Regulations expand upon “organization or arrangement,” defining the phrase to mean one or more trusts, corporations, governmental units, or employers.

The definition can be met by combining multiple entities and governmental bodies. For example, an employer pension system could use a pension trust organized by a foreign government to manage the investments. In such instance, the private employer would be treated as part of the organization or arrangement (but only the assets and income that fund the provision of the benefits would be taken into account).

The test can be met without the formation of a separate legal entity. For example, one or more accounts on the books of the balance sheet of a corporation or government can qualify. The Proposed Regulations make clear that multi-employer pension funds can qualify as QFPFs.

Organizational Requirements

A QFPF must be created or organized under the laws of a country other than the U.S. The Proposed Regulations specify that for purposes of this requirement, a state, province, or political subdivision of a foreign country will be treated as referring to the foreign country itself. As a result, pension funds organized or created under a subnational regime will satisfy this requirement.

An organization or arrangement is generally treated as a single entity for purposes of meeting the requirements of a QFPF. However, the Organizational Requirement must be satisfied with respect to each component of the organization or arrangement. That is, each part of an organization or arrangement must independently meet the requirement. As a result, it appears that a disregarded entity that is formed in the U.S. that is part of the pension arrangement could disqualify the arrangement from QFPF status.

Retirement or Pension Benefits

A QFPF must be established by either a foreign country or by one or more employers to provide retirement and pension benefits to participants or beneficiaries that are current or former employees (or persons designated by such employees) as a result of services rendered by such employees to their employers. Specifically, the Proposed Regulations provide that multi-employer pensions funds and government-sponsored public pension funds will satisfy this requirement. Additionally, certain pension funds established by a trade union, professional association, or similar group may also qualify.

Often, foreign pension funds will offer ancillary benefits (such as disability, unemployment, medical, etc.). Prior to the Proposed Regulations, it was unclear to what extent a foreign pension fund could provide such ancillary benefits and still qualify as a QFPF. The Proposed Regulations provide that a QFPF may provide up to 15% of the present value of the qualified benefits to qualified recipients as ancillary benefits. There is uncertainty as to whether this test is performed year-by-year or on some other basis.

5% Limitation

A QFPF may not have a single participant or beneficiary that is entitled to a right of more than 5% of its assets or income. For purposes of determining whether an individual meets the 5% threshold, the Proposed Regulations provide that attribution rules apply. In lieu of providing a rule for determining an individual’s share of a pension fund’s assets or income, the Proposed Regulations provide that the determination should be made based on the underlying facts and circumstances.

Information Requirement

A QFPF must provide annual information about its beneficiaries to the relevant tax authorities in the country in which it is established or operates, or such information must otherwise be available to those authorities. The Proposed Regulations provide that a pension fund will satisfy this requirement if it annually reports to its relevant tax authority the amount of qualified benefits provided to each qualified recipient, or if such information is otherwise available to such taxing authorities. The Proposed Regulations also provide an exception for those years where the fund does not pay qualified benefits to qualified recipients.

In order to accommodate various governmental structures, the Proposed Regulations also provide that a fund will satisfy the Information Requirement if the laws of the local country require reporting to a different governmental unit, or such required information is otherwise available to such governmental units.

Where the government administers the fund itself, the Information Requirement is effectively satisfied as the government has control over and access to the information.

Foreign Tax Requirement

A QFPF (or beneficiaries thereof) must receive preferential tax treatment from its country of establishment or operation. Preferential tax treatment means that either (i) the contributions to the fund are deductible or excluded from gross income of the fund or are taxed at preferential rates; or (ii) the fund’s investment income is deferred or excluded from gross income of the fund or is taxed at preferential rates. The Proposed Regulations provide that funds established in countries with no income tax regimes will be deemed to satisfy the Foreign Tax Requirement.

The Proposed Regulations further provide that the deduction or exclusion requirement means that at least 85% of the contributions or investment income must be excluded from gross income. Further, preferential treatments provided by a foreign country to funds are allowable so long as those preference regimes provide for a similar treatment (i.e. 85% exclusion of contributions or investment income).

For purposes of this requirement, the Proposed Regulations clarify that subnational (i.e. state, province, or political subdivisions of a foreign country) exemptions will not satisfy the Foreign Tax Requirement. The foreign tax exemption or preference must be at the national level.

Updated Withholding Forms

Before the issuance of the Proposed Regulations, there was uncertainty as to how a QFPF could establish its right to a FIRPTA exemption. The IRS has stated that it intends to release an updated Form W-8EXP through which qualified holders may certify their qualified entity status for purposes of FIRPTA. Until such time, taxpayers are permitted to use a certificate of non-foreign status (as described in the existing FIRPTA regulations). Since this is a change in practice, withholding agents should consider requesting these certificates from foreign pension funds.

Effective Dates of Proposed Regulations

The Proposed Regulations are generally proposed to apply to dispositions and distributions occurring on or after the date the regulations are finalized. However, the anti-abuse provisions are proposed to apply to dispositions or distributions after June 6, 2019.

Taxpayers may rely on the Proposed Regulations for dispositions or distributions retroactively (i.e., occurring on or after December 18, 2015 and before the effective date of final regulations). Taxpayers can only rely on the Proposed Regulations if the taxpayer applies the rules “consistently and accurately.”

A&M Taxand Says:

The QFPF exemption provides significant tax benefits on inbound U.S. investments. These Proposed Regulations broaden the field to include more structures and apply on a retroactive basis. Now is the time to reexamine your structure to determine if the QFPF regime applies. Restructuring options may also be available to achieve these benefits.