Tax

Overview

On April 24, 2024, the Internal Revenue Service (“IRS”) and Treasury Department issued final regulations (T.D. 9992) under section 897 of the Internal Revenue Code of 1986, as amended (the “Code,” and such final regulations, the “Final Regulations”) detailing, among other things, whether a qualified investment entity (“QIE”) is domestically controlled for purposes of section 897(h)(2) of the Code (the “DC-QIE Exception”), and providing much needed clarification regarding the proper classification of qualified foreign pension funds (“QFPFs”) and entities wholly owned by one or more QFPFs (“QCEs”) for purposes of the DC-QIE Exception. The Final Regulations also provide certain transition rules and for the most part, adopt the structure and approach established by the proposed regulations (REG-100442-22) published by the Treasury Department and the IRS on December 29, 2022, (the “Proposed Regulations”). However, the Treasury Department and IRS did not finalize portions of the Proposed Regulations addressing the exemption under section 892 of the Code, which is intended to be addressed in a separate rulemaking. The Final Regulations also modify prior guidance set forth in the Proposed Regulations that addresses when foreign persons are considered to hold, directly or indirectly, stock in a QIE.

The Final Regulations generally affect foreign persons that own stock in a QIE that would be a United States real property interest (“USRPI”) if the QIE were not domestically controlled.

Primer on 897

Under section 897(a)(1) of the Code, when a nonresident alien individual or a foreign corporation disposes of a USRPI, gain or loss on that disposition will be treated as if it is effectively connected with a U.S. trade or business; however, section 897(l) of the Code offers an exemption to section 897(a) of the Code specifically for QFPFs and QCEs by not treating the QFPF and QCE as a nonresident alien individual or foreign corporations for these purposes.

To the extent any of its gain is attributable to the sale or exchange of a USRPI, section 897(h)(1) of the Code treats distribution from a QIE (which is defined under section 897(h)(4)(A) of the Code to include real estate investment trusts (“REITs”) and certain regulated investment companies (“RICs”)) to a nonresident alien individual, a foreign corporation, or another QIE, as a gain recognized by the recipient from selling or exchanging a USRPI unless certain exceptions apply. One such exception is the DC-QIE Exception, which provides that a USRPI does not include any QIE in which at all times during the testing period (generally a 5-year period preceding the date of disposition or distribution) less than 50 percent in value of the stock was held directly or indirectly by foreign persons (e.g. a domestically controlled QIE). Additionally, any distribution by a U.S. publicly traded QIE to a nonresident alien individual or a foreign corporation shall not be treated as gain recognized from the sale or exchange of a USRPI if certain testing period requirements are met.

The Final Regulations – Direct and Indirect Ownership of QIE Stock

The Proposed Regulations and Final Regulations interpret the meaning of “indirect” ownership under section 897(h)(4)(B) to effectuate the policy of the DC-QIE Exception by ensuring that the exception is available only when a QIE is controlled by United States persons. The purpose of this is to hinder the usage of intermediate entities to produce outcomes that go against the objectives of the DC-QIE Exception.

The Proposed Regulations addressed the meaning of direct or indirect ownership by setting forth two categories of potential QIE owners, “look-through persons” and “non-look-through persons.” Under these rules, (1) a “domestic C corporation” (defined as any domestic corporation other than a RIC, RET, or an S corporation) is treated as a non-look-through person, and (2) “non-publicly traded domestic C corporations” are treated as look-through persons if foreign persons held a 25 percent or more interest by value in the corporation’s stock.

While the Final Regulations generally adopt this approach, the Final Regulations make some changes with respect to the determination of indirect ownership for domestic C corporations. Specifically, the Final Regulations expand a rule under the Proposed Regulations that a person holding less than 5% of the stock of a publicly traded QIE is presumed to be a U.S person that is a non-look-through person unless the QIE has actual knowledge that such person is not a U.S. person, to include scenarios where the QIE has actual knowledge that such person is foreign controlled. Additionally, the Final Regulations narrow the scope of the look-through rule applicable to non-public domestic C corporations by increasing the amount of foreign ownership required to look-through from 25 percent or more to more than 50 percent. Although much of the comments to the Proposed Regulations urged to withdraw these look-through rules, the IRS found much of the arguments for doing so as unpersuasive. Nonetheless, the IRS agreed that the look-through threshold should be increased to address compliance concerns and to ensure that the rule is more appropriately limited to situations where significant indirect ownership by foreign persons is indicative that foreign control is present.

The Final Regulations – QFPF

As mentioned above, QFPFs and QCEs are generally not treated as nonresident alien individuals or foreign corporations for purposes of section 897 of the Code. Because of this general exception, there was some uncertainty as to whether a QFPF’s non-foreign status would carry over to the computation of whether a QIE was domestically controlled for purposes of the DC-QIE Exception. If a QFPF’s status would carry over to the DC-QIE Exception, the practical implications would potentially lead to circumstances in which a QIE would be considered as foreign controlled for all intents and purposes but would still qualify for the DC-QIE Exception. The IRS viewed this as potentially expanding the effect of section 897(l) to foreign investors who are neither QFPFs nor QCEs (by exempting such investors from tax under section 897(a)). Accordingly, the Final Regulations provide that QFPFs and QCEs are treated as foreign persons for purposes of the DC-QIE Exception.

Effective Date and Transition Rules

In general, the Final Regulations are effective on or after April 25, 2024 (“Effective Date”). Nevertheless, the Final Regulations incorporate a transition rule that grants preexisting business arrangements an exemption from the look-through rule for 10 years, subject to certain requirements. The transition rules also only apply to the extent the QIE does not acquire a significant amount of new USRPIs and does not undergo a significant change in its ownership. A QIE is considered to have acquired a significant amount of new USRPIs if the total fair market value of the USRPIs it acquires directly and indirectly exceeds 20 percent of the fair market value of the USRPIs held directly and indirectly by the QIE as of the Effective Date.