Subscribers Login  

This is the second of a series of commentaries intended to highlight some of the questions that arise in modern practice under FIRPTA where the answers are unclear, and where the Treasury Department and the IRS could usefully provide guidance addressing a host of questions that have existed for many years. One area that would profit by immediate guidance involves the application of the 5% public shareholder exception in §897(c)(3).

Section 897(c) contains a multifaceted definition of the key term “U.S. real property interest” (USRPI). Paragraph (2) of that subsection defines the term “U.S. real property holding corporation” (USRPHC), an interest in which is generally treated as a USRPI. Paragraph (3) in effect provides an exception to the definition of USRPHC as follows:

If any class of stock of a corporation is regularly traded on an established securities market, stock of such class shall be treated as a [USRPI] only in the case of a person who, at some time during the shorter of the periods described in paragraph (1)(A)(ii), held more than 5 percent of such class of stock.

Where this exception applies, a foreign person may dispose of stock of a USRPHC without tax under FIRPTA. Since the sale of stock of a USRPHC is otherwise a fully taxable event to a foreign person (that is, the taxable portion is not limited to the portion of the gain attributable to the USRPHC's U.S. real property holdings), much turns on the proper application of this exception.

Changes in Percentage Ownership. The statute makes clear that the relevant measuring period for determining whether a person owns more than 5% of a qualifying class of stock is the shorter of the period after June 18, 1980, during which the taxpayer held such interest or the five-year period ending on the date of disposition. Given that it has been more than 27 years since the 1980 measuring date, the reference to the 1980 date is deadwood and all shareholders will be looking at the shorter of their actual holding period or the last five years prior to the date of disposition. Throughout this commentary the shorter of those two periods will be referred to as the “measurement period.”

The statute is also clear that the foreign person must have owned 5% or less of the qualifying class of shares during the entire measurement period. Apparently, there is no de minimis rule--if ownership goes over the 5% mark for even one day in the measurement period, the entire exception is vitiated. This is an extremely harsh “all or nothing” rule that places enormous pressure on having clear answers to questions presented by the exception.

Problem #1: F, a foreign individual, owned 5,000 shares of stock of X, a USRPHC, for five years. The 5,000 shares constituted, at all times during such period, less than 5% of the single class of publicly-traded shares of X. In the sixth year, F purchased 1,000 additional shares of X on the public exchange, increasing his interest to just over 5%. In year seven, F sold 3,000 shares of X stock.

Under the literal language of the statute, none of F's gain on the year seven sale qualifies for the §897(c)(3) exception, because F did not own 5% or less of X's shares during the entire measurement period. However, it might be argued that because F has a different holding period for the 1,000 shares acquired in year six than he did for the 5,000 original shares, F should have two different measurement periods. Other rules of the Code require separate tracking of holding periods and permit identification of shares to separate blocks acquired on different dates.¹ A better answer might be that F should be permitted to identify the 3,000 shares as coming from the original block of stock that qualified for the exception.

Regs. §1.897-9T(b) appears to take the view that all of F's shares must be aggregated, such that F's sale of 3,000 shares would not be protected. However, this regulation is not clearly drafted. The regulation speaks in terms of aggregating only non-publicly-traded shares, perhaps because the regulation in question was focusing on non-traded shares convertible into traded shares.² Further guidance on this issue is needed.

Changes in Publicly-Traded Status of Shares. The statute is not entirely clear whether the class of shares must be publicly traded during the entire measurement period. A literal reading of the statute might suggest that if a foreign person held 5% or less of the class of stock of a corporation at all times, and the class became publicly traded only a day before the shares were disposed of, the exception should be available. Conversely, it would appear that if the class had been publicly traded during most of the measurement period, but ceased to be so the day before the disposition, no relief would be available.

Problem #2: N, a foreign individual, owned less than 5% of the single class of shares of Y, a USRPHC, for three years. Y stock was not publicly traded during this three-year period. In year four, the shares of Y were listed on the New York Stock Exchange, and N sold all of his shares immediately thereafter.

Here the regulations seem to provide some relief to N. Regs. §1.897-1(c)(2)(iii) provides that if at any time during the calendar year shares of Y were publicly traded, an interest in Y would be a USRPI only if held by a person who exceeded the 5% mark during his measurement period.³ Thus, it appears to be unimportant when the shares became publicly traded, so long as they were publicly traded at some time during the calendar year in which the disposition occurred. A foreign person who sold his shares in connection with or after a de-listing would also be protected by this regulation, assuming he did not wait until a later calendar year.

Threshold Exchanges for Publicly-Traded Shares. Most IPOs are effected not by a simple listing of a previously privately-held corporation, but by a threshold incorporation transfer of one type or another. In most cases, such threshold exchanges will qualify for tax-deferred treatment under §351 of the Code.

Problem #3: Foreign corporation A owns fee title to an office building located in the United States, clearly a USRPI. A contributes the office building to Newco, a U.S. corporation, in a transaction qualifying under §351 of the Code. Shortly thereafter, Newco is taken public.

Problem #4: Foreign individual B owns a partnership interest in a partnership that owns a USRPI. The partnership is incorporated in a transaction qualifying under §351 and the resulting U.S. corporation is taken public.

In both of these cases, the question is whether the threshold §351 exchange qualifies for tax deferral under §897(e). The relevant portion of §897(e) provides that “any nonrecognition provision shall apply for purposes of this section to a transaction only in the case of an exchange of a [USRPI] for an interest⁴ the sale of which would be subject to taxation under this chapter.”

The question is thus whether the stock received in these examples is property “the sale of which would be subject to taxation under this chapter.” The answer to that question might depend, inter alia, upon: (1) whether the holder received 5% or less of the corporation with no expectation that his interest would increase to more than 5%; (2) whether the holder received more than 5% of the stock but would be diluted to less than 5% by the planned IPO a moment later in time; or (3) whether the holder received less than 5% of the stock but had a plan to increase his holdings in the future to more than 5% by open market purchases. In any case, it is important to know when the shares received will be tested under §897(c)(3) in order to answer the question whether there will be a tax on their later sale. Absent some fixed rule, it is literally impossible for the holder to make that determination, given that §897(c)(3) incorporates a measurement period.

The regulations under §897(e) do not shed light on this conundrum. The most plausible reading of the rule is that one must test the interest received at the moment it is received, possibly also taking into account common law step transaction principles. However, there is one statement in the regulations that appears to incorporate an “open transaction” approach to the question of whether the interest received would be subject to taxation. Regs. §1.897-5T(d)(1)(i) provides generally that a U.S. corporation was not considered subject to tax on a later sale of an interest if it could have liquidated tax-free under the now-repealed General Utilitiesdoctrine. Recognizing that the General Utilities doctrine was repealed in 1986, the regulation switches off this rule where the interest had not actually been disposed of by the U.S. corporation before the effective date of General Utilities repeal. It is completely unclear, however, how a U.S. corporation that received an interest in a nonrecognition transfer prior to 1986 would have been able to rely on this rule at the time of receipt!

Problem #5: Same as problem #4, except that, rather than being incorporated, the partnership is taken public as a publicly-traded partnership qualifying to be taxed as a partnership under §7704.

In Problem #5, there is no nonrecognition transfer. It is the logical equivalent of simply taking a private corporation public. It therefore appears that foreign person B can rely on the §897(c)(3) exception as long as it would otherwise apply. Given that the overall economic results as between Problems #4 and #5 are the same, Treasury might reasonably write a regulation that interprets §897(e) as having been satisfied in any case in which the taxpayer receives solely shares of publicly-traded stock constituting 5% or less of a publicly-traded class.

Shares Held Indirectly. Section 897(c)(3) speaks in terms of shares held by a “person.” On its face, then, the exemption would be unavailable if a partnership owned more than 5% of the stock of a USRPHC, even if no partner owned more than 5% indirectly through the partnership.

Regulations should be issued providing a look-through rule for this purpose, similar to the look-through rule provided under the portfolio interest exemption.⁵ Absent some policy reason to do otherwise, a partnership should generally be treated as an aggregate of its partners, not as the relevant taxpayer. Section 897(c)(4)(B) provides a general look-through rule for partnerships that, while not technically applicable under §897(c)(3), clearly supports the conclusion that look-through treatment is appropriate in this context.⁶

Conclusion. The likely purposes of the §897(c)(3) exception are to encourage foreign investment in the U.S. capital markets and to eliminate the substantial compliance burdens that would be imposed on corporations and their shareholders if even small portfolio shareholders were subject to FIRPTA.

The 5% exception was originally proposed by the House as a substitute for the Senate's requirement that a USRPHC (then known as a “U.S. real property holding organization”) be owned by not more than 10 persons.⁷ At the same time, the House limited the class of USRPHCs, the disposition of which could give rise to tax, to domestic USRPHCs.

The reason the 5% threshold was chosen was that, at the time, FIRPTA was to be enforced via a complex reporting system rather than withholding. The House reasoned that it would be easy to pick up 5% owners merely by perusing SEC reports.

As this author pointed out in her first installment of this series, FIRPTA was designed around a paradigm of the closely-held corporation, and both the Senate and the House versions acknowledged that fact. FIRPTA is difficult to apply to widely-held corporations. Regulations should be issued under §897(c)(3) to effectuate the 5% exception consistent with legislative intent.

This commentary also will appear in the January 11, 2008, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Rubin and Hudson, 912 T.M., Federal Taxation of Foreign Investment in U.S. Real Estate, and in Tax Practice Series, see ¶7120, Foreign Persons' U.S. Activities.