Sovereign wealth funds (“SWF”) have become a significant class of investors in real property in the United States. Although investing in U.S. real property can be lucrative, the Foreign Investment in Real Property Tax Act (“FIRPTA”) subjects foreign persons’ gains on the disposition of real property to U.S. tax and requires withholding by the buyer. Fortunately, SWFs benefit from various special tax regimes that may effectively exempt them from this regime.
Generally, gain on the disposition of a U.S. real property interest by a non-U.S. investor is treated as effectively connected to a U.S. trade or business, and is subject to a 15% withholding tax. As one would expect, U.S. real property interest includes the typical “dirt, bricks, and water” among other assets (“USRPI”). However, it also includes shares of stock in a corporation if 50% or more of the fair market value of such corporation’s business assets consist of USRPIs (United States real property holding corporation, or “USRPHC”). Thus, when a foreign person disposes of stock of a USRPHC, it is subject to tax and withholding in the United States. This is where SWFs can avail themselves of special treatment. Although SWF investors are still taxed on a USRPI, Section 892 exempts them from FIRPTA upon disposition of stock in USRPHCs. Many SWFs use this exception by investing in U.S. real property through real estate investment trusts (“REIT”), which is beneficial because Section 892 also exempts from tax ordinary income REIT distributions.
Investing in REITs offers various benefits, but there are several caveats investors should consider. First, a SWF must maintain its REIT ownership below 50% to avoid its treatment as a controlled commercial entity, a disposition of which would not qualify for the exemption. A SWF must also make sure it does not fall into the often-overlooked “USRPHC Trap” by having a controlled entity formed in its jurisdiction invest in multiple USRPHCs, which could result in the foreign entity itself becoming a controlled commercial entity. Second, in a publicly traded REIT, a SWF should keep its ownership at 10% or less to avoid a look-through rule, which would treat as a sale of a USRPI any distribution attributable to such sale by the REIT. Finally, because liquidating distributions are typically subject to FIRPTA under the look-through rule, a SWF should contemplate an exit from the investment by sale of the REIT stock.
Another avenue for an exemption from FIRPTA is the Qualified Foreign Pension Fund (“QFPF”) regime. The regime exempts QFPFs from U.S. tax gains on the disposition of U.S. real property as well as any distributions received from a REIT. A SWF must meet several requirements to qualify as a QFPF, such as that it is established to provide retirement benefits to employees, it does not have a single beneficiary with a right to more than 5% of its assets or income, it is subject to government regulation and provides annual information, or that contributions thereto are tax deductible or taxed at a reduced rate or income thereof is not taxed or is taxed at a reduced rate. With the caveats discussed above in mind, the QFPF rules provide several benefits over Section 892. First, it applies to entities formed in a jurisdiction other than that of the SWF. Second, it allows a tax-free exit from a controlling position in a REIT. Third, it allows an asset sale at the REIT level followed by a tax-free capital gains distribution.
Finally, an important framework that a SWF can rely on in the context of U.S. real property investments is income tax treaties. In particular, where Section 892 is not available to exempt from U.S. tax distributions of a real estate investment vehicle (for example, in the case of a U.S. controlled commercial entity or an entity owned by a foreign government that does not qualify as a controlled entity), a treaty can do the job. For example, U.S. treaties with Canada and the Netherlands may grant an exempt status to foreign pension plans comparable to that of Section 892, and many treaties specifically deal with REIT distributions. Such treaty benefits may be available to SWFs in certain circumstances because U.S. tax law treats foreign governments as corporate residents, multiple treaties (e.g., with Canada, France, and Japan) specifically treat SWFs as residents for their purposes, and most treaties include the treaty country as a qualified person for purposes of the limitation-on-benefits article. Nevertheless, income tax treaties pose their own types of issues that must be dealt with on a case-by-case basis.