Most of the attention in recent times in relation to institutional investment in the US has focused on the major international elements of the 2017 US tax reform such as the cut in the corporate tax rate, the transition tax and the GILTI, FDII and BEAT regimes dealt with in our earlier tax brief. The 2017 tax reform included other less noticed changes including one relating to foreign partners in limited partnerships (LPs) investing in the US. Further an important change in relation to investment by foreign pension funds in US real estate has been developing over recent years. This Riposte briefly outlines these important but less noticed developments and the problems that can arise when they come together.
1. Exemption for foreign pension funds investing in US real estate
In 1980 the US adopted a comprehensive tax regime for foreign investors acquiring US real estate including land rich entity rules (commonly referred to as FIRPTA) backed up by a withholding tax which was one of the models for Australia’s recent withholding on capital gains derived by foreign investors. In 2015 and 2018 an exception was developed to remove foreign pension funds from the FIRPTA rules and the accompanying withholding as a way of encouraging investment in US infrastructure. As usual the drafting of the US legislation was principled-based leaving clarification to regulations which recently appeared in proposed (draft) form. When finalised the regulations will generally operate back to the 2015 start date for the exemption though some parts will only apply from the date of publication of the draft regulations.
The exemption applies to qualified foreign pensions funds (QFPFs) which the proposed regulations define very flexibly to deal with the great variety of special tax rules for pension or superannuation funds around the world, in contrast to the fairly narrow Australian exemption from dividend and interest withholding tax for foreign superannuation funds. There are five elements that are elaborated in the regulations for QFPFs:
- Creation or organisation under a non-US law
- By government or one or more employers to provide retirement or pension benefits to employees
- With no single beneficiary holding on an associate inclusive basis more than 5% of the fund
- Subject to government regulation and reporting to the tax administration on an annual basis and
- Subject to exemption from tax or reduced tax on contributions or fund income.
Many elements of flexibility and stretching are introduced into the details of these tests by the regulations, which should mean that Australian industry and retail funds will generally qualify though the 5% rule will eliminate SMSFs.
In addition to which foreign pension funds qualify for the exemption, the proposed regulations deal with the way in which pension funds around the world organise their investment through pooling and other strategies which mean they will usually invest with an intermediary rather than in the ultimate investment. For this purpose the regulations introduce qualified controlled entities (QCEs) which can also benefit from the exemption.
To qualify the QCE must be a corporation or trust owned 100% by QFPFs. Submissions were made in the drafting process that flexibility should also be introduced in this area but they were rejected on the basis that the exemption is exclusively available to pension funds, not other kinds of investors. Similarly the regulations deal with the possibility of non-qualifying persons being involved in a fund and exiting it before the ultimate investment attracting US tax is exited. In this case the 100% requirement has to be satisfied over a period which can reach up to 10 years.
The proposed regulations in effect confirm a way around this strictness as it has been clear from the beginning of the exemption in 2015 that QFPFs can benefit from the exemption even though the investment is channelled through one or more tax transparent partnerships. Examples in the proposed regulations adopt the same treatment for interposed partnerships even though the express legislative reference to interposed partnerships has since been removed. When investing through a partnership, which in practice in investment situations will be a tax transparent LP, it is not necessary that all partners be QFPFs or QCEs for the exemption to apply to the QFPF or QCE’s share of the partnership profit.
2. Investing generally in the US through limited partnerships
On the other hand the 2017 US tax reform has made things more difficult generally for foreign persons investing in the US via tax transparent LPs. In 2017, a court decision held that a foreign partner investing in a US LP was not subject to US tax on the profit made on redemption of their interest except for the real estate element involved even though the LP was engaged in mining in the US and the partner was taxable in the US from the income from mining or disposal of its assets by the business. An appeal from the decision by the US IRS was recently rejected on the basis that it was the circumstances of the redemption of the interest and not the underlying activities of the partnership which determined the taxation of the profit on redemption.
The 2017 tax reform included a provision designed to reverse the decision to make the redemption taxable and also revised the withholding regime applying to foreign partners in partnerships deriving income taxable in the US. Again the legislation is brief and proposed regulations on the substance of the reform were released in December 2018 and on the withholding changes in May 2019.
While doubts have been expressed whether the new law or the sets of regulations are soundly based given the analysis in the judicial decisions, the result is that from the IRS and withholding agent perspectives foreign investors in the US will be subject to tax enforced by a new withholding mechanism in a much wider category of cases than was accepted by the court decisions. Concerns have also been raised about the practicality of various aspects of the new withholding regulations in relation to disposition of partnerships interests especially as non-payment of the tax can impact on the purchaser of an interest in the LP and there are strict procedures that have to be complied with to avoid withholding at the partnership level.
3. Investment by QFPFs in LPs
Circling back to QFPFs, many investments from offshore in US real estate and other US investments will be made via two LPs, one offshore from the US to mix the funds coming from offshore and one onshore in the US which brings together US and foreign investment in the underlying investment. In many cases the funds will be effectively under the same control and the offshore fund is a feeder fund for the onshore fund. While Australian superannuation funds that qualify as QFPFs can claim the exemption for investment in US real estate in such cases, this common structure involves new levels of complication under the various proposed regulations.
Reconciliation between general withholding on foreign partners and the lack of FIRPTA withholding if the QFPF exemption applies appears in the new FIRPTA proposed regulations but the position in a two-tiered LP structure where the offshore LP sells an interest in a land-rich onshore LP does not seem to be dealt with. Further the procedures are still being worked through and forms revised by the IRS. All-in-all great care is necessary for Australian superannuation funds investing in two-tier LP structures to ensure that withholding occurs as required and that any QFPF exemption to which they are entitled is protected from withholding.
 Grecian Magnesite Mining v IRS, 11 June 2019, available at https://www.cadc.uscourts.gov/internet/opinions.nsf/5BDD6D9C86D7BCAB8525841600507BFC/$file/17-1268.pdf.