The US Department of Treasury recently released final regulations providing guidance on the exception from taxation under the Foreign Investment in Real Property Tax Act of 1980 for “qualified foreign pension funds” under Section 897(l) of the Internal Revenue Code, as amended.
The final regulations, released on December 29, 2022 (the Final Regulations), also address withholding requirements under Sections 1441, 1445, and 1446. Proposed regulations under Sections 892 and 897 addressing foreign government investments in US real property and the tests used to determine whether a REIT is “domestically controlled” were issued the same day.
While the Final Regulations generally follow the approach taken in the proposed regulations (the Proposed Regulations) that were published on June 7, 2019, they also include helpful modifications that address a number of concerns raised by stakeholders. Specifically, the modifications in the Final Regulations clarify the eligibility for the “qualified foreign pension fund” (QFPF) exception, expand the scope of benefits that a QFPF may provide beneficiaries, and add flexibility to qualification tests that may provide relief for inadvertent failures to meet the QFPF qualification requirements in a particular taxable year.
Section 897 generally subjects nonresident aliens and foreign corporations to tax on gain from the disposition of “United States real property interests” (USRPIs) as if the gain constituted “effectively connected income.” In addition, Section 897(h)(1) provides a look-through rule that treats distributions from certain real estate investment trusts and regulated investment companies, to the extent attributable to gain from dispositions of USRPIs, as gain from the disposition of USRPIs (Section 897(h)(1) distributions).
Section 897(l) provides, however, that QFPFs (and any entity all of the interests of which are held solely by one or more QFPFs) are not treated as nonresident alien individuals or foreign corporations subject to tax under the Foreign Investment in Real Property Tax Act of 1980. A QFPF is a trust, corporation, or other organization or arrangement (an eligible fund) that satisfies five requirements, including a purpose requirement that requires the eligible fund to provide retirement or pension benefits to current or former employees.
Consistent with Section 897(l), the Proposed Regulations allowed a broad range of arrangements to qualify for the QFPF exception and clarified that foreign trusts or corporations owned entirely by one or more QFPFs (qualified controlled entities), whether directly or indirectly through one or more qualified controlled entities or partnerships, qualified for the exception (QFPFs and such qualified controlled entities are referred to as “qualified holders”).
The Proposed Regulations also clarified and expanded on the five requirements that must be satisfied for QFPF qualification. In particular, the Proposed Regulations adopted objective thresholds that an eligible fund must satisfy to meet the purpose requirement. First, all of the benefits provided to the eligible fund’s beneficiaries must be retirement, pension, or ancillary benefits, which are referred to as qualified benefits. Second, 85% of the present value of the qualified benefits to be provided under the plan must be “retirement or pension benefits.”
In addition, the Proposed Regulations introduced an anti-abuse rule designed to address situations where a foreign person sells a foreign corporation that itself holds a USRPI to a QFPF or a “qualified controlled entity.” Absent an anti-abuse rule, the foreign corporation would be treated as a “qualified controlled entity” and a subsequent disposition of the USRPI by the foreign corporation would qualify for the QFPF exception, potentially allowing built-in gains attributable to the period prior to the sale of the foreign corporation to the QFPF or “qualified controlled entity” to escape taxation.
The anti-abuse rule provides that a QFPF or a “qualified controlled entity” may be treated as a qualified holder only if either (1) it was a QFPF, a part of a QFPF, or a “qualified controlled entity” at all times during an applicable testing period, which is the shortest of (i) the 10-year period preceding the disposition of a USRPI or a Section 897(h)(1) distribution, (ii) the period since December 18, 2015, or (iii) the period of the entity’s existence, or (2) it held no USRPIs at the time it became a QFPF, a part of a QFPF, or a “qualified controlled entity.”
While generally retaining the structure of the Proposed Regulations, the Final Regulations introduce a number of helpful changes to address concerns raised by commentators. Certain changes are highlighted below.
Modifications of the 85% Test
New and Revised Definitions Provide Clarity and Add Flexibility
Other Notable Changes
Not All Comments Are Addressed
Notwithstanding the helpful changes made in the Final Regulations, the Treasury Department did not incorporate all the changes suggested by commentators. In particular, the Final Regulations do not incorporate requests to permit de minimis ownership of qualified controlled entities by non-QFPFs. The Final Regulations also did not modify the qualified holder anti-abuse rule or implement suggested alternatives to that rule.
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