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This is the third in a series of short articles 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. Although the subject matter presented in this installment will arise only infrequently and therefore may not at first seem to be of interest to the general reader, it provides a good illustration of the myriad ways in which the guidance issued under FIRPTA over 20 years ago does not withstand scrutiny under modern conditions. The topic also presents an opportunity to take a random walk through some of the more byzantine regulations under FIRPTA.

The General PTP Rule

As noted in installment two, an interest of 5% or less in a class of stock of a corporation that is regularly traded is not a U.S. real property interest (USRPI), even if the corporation is a U.S. real property holding company (USRPHC). Such an interest can therefore be sold free of FIRPTA tax.¹

The regulations provide a similar 5% rule for publicly traded partnerships (PTPs) that are taxable as partnerships under §7704.² That rule provides as follows:

If any class of interests in a partnership or trust is, within the meaning of §1.897-1(m) and (n), regularly traded on an established securities market, then for purposes of sections 897(g) and 1445 and §1.897-2(d) and (e) an interest in the entity shall not be treated as an interest in a partnership or trust. Instead, such an interest shall be subject to the rules applicable to interests in publicly traded corporations pursuant to paragraph (c)(2)(iii) of this section. Such interests can be real property interests in the hands of a person that holds a greater than 5 percent interest. Therefore, solely for purposes of determining whether greater than 5 percent interests in such an entity constitutes U.S. real property interests the disposition of which is subject to tax, the entity is required to determine pursuant to the provisions of §1.897-2 whether the assets it holds would cause it to be classified as a U.S. real property holding corporation if it were a corporation. …

Note that this rule “turns off” the general rule of §897(g), which in most cases treats an amount received by a foreign person from the sale of an interest in a partnership as an amount received from the sale of a USRPI to the extent that the partnership owns USRPIs. There can be little doubt that the drafter of this regulation believed it to be, on balance, favorable to foreign partners of PTPs. Although the regulations under §§897(g) and 1445 provide for certain “de minimis” presumptions,³ applying a look-through rule in the context of a widely held partnership can be extraordinarily difficult.

Unfortunately, where the PTP is a foreign partnership, if this regulation were applied to it, the result could be to place the foreign partners in a position far worse than they would have been in had §897(g) applied.

Some Preliminary Interpretational Difficulties

The regulations applicable to publicly traded corporations assume that the corporation is a domestic USRPHC. They do so for the simple reason that the sale of an interest in a foreign corporation, whether or not publicly traded, is never subject to FIRPTA, even if that corporation owned 100% USRPIs. The same presumption appears to underlie the above-cited regulation applicable to PTPs. That is, it appears that the drafter of the PTP regulation assumed that a PTP would always be a domestic partnership. The regulation states that “[s]uch interests [the interests in the PTP] can be real property interests in the hands of a person that holds a greater than 5 percent interest.” This statement makes sense only if the PTP is treated as a domestic USRPHC. Similarly, the regulation states that the entity is required to determine its status under Regs. §1.897-2 as if it were a USRPHC. That exercise is done only if the entity in question is domestic.

Yet the regulation is not by its terms limited to domestic partnerships and, in fact, literally seems to cover foreign PTPs as well as domestic ones.

There are in theory three different rules that could apply to interests in a foreign PTP. First, one could treat the foreign PTP as any other partnership to which §897(g) applies. However, the above-cited regulation seems to preclude this somewhat sensible result. Second, one could argue that an interest in a foreign PTP can never be treated as a USRPI or subject to §897(g), since the regulations seems to treat the foreign PTP as a corporation, and an interest in a foreign corporation can never be a USRPI or subject to §897(g). This result, while it represents the most natural reading of the regulation, might be thought of by some as violating the “too good to be true” rule. If interests in a foreign partnership are not subject to §897(g) and are not USRPIs, a foreign partner would be able to sell its interest free of tax to a buyer that, if a §754 election is in effect, will be able to step up the partnership's inside basis in its property, with the result that FIRPTA tax will be avoided permanently.⁴ This is a result far superior to the result that could be achieved by the seller of a 5% or smaller interest in a domestic publicly traded corporation.

A third approach would be to treat a foreign PTP as a publicly traded domestic corporation under the regulations, and apply the 5%-or-less rule to its interest holders. Although nothing in the regulation treats a foreign PTP as domestic (it simply assumes it to be so), and it is almost impossible to believe that the regulations could do so absent statutory authority, it is the author's understanding that this is the approach that the IRS currently believes to be the correct interpretation of its regulation. Unfortunately, this approach can give rise to results that are wholly at odds with the statutory and regulatory scheme.

Determining Whether the Foreign PTP Is a USRPHC

Under the third approach, it will be critical to know whether the foreign PTP in question is or is not a USRPHC (or would be if it were a domestic corporation). If it is not a USRPHC, then the sale of an interest in it will not be subject to tax at all (§897(g) having been turned off). If it is a USRPHC, the sale of an interest of 5% or less will be nontaxable but the sale of a greater interest will be taxable.

In determining USRPHC status, the regulations take into account just three categories of assets: (1) USRPIs; (2) interests in real property located outside the United States; and (3) assets used in a trade or business.⁵ All other assets, particularly passive investment assets, are generally excluded from the numerator and the denominator of the 50% test. An important exception applies to investment companies. If 90% or more of a corporation's assets consist of cash, stock, securities, and similar investment assets, those investment assets will be presumed to be used in a trade or business.⁶ This rule is necessary to prevent an investment company from being treated as a USRPHC merely by reason of owning a dime's worth of USRPIs.

If, as is typically the case, a foreign PTP owns most of its assets through lower-tier foreign corporations, it is extremely important to know into which bucket those shares fall. There are in theory two different ways to “count” interests in foreign corporations under FIRPTA. First, one could ask whether a majority of the foreign corporation's assets consists of USRPIs, and if the answer is “yes,” treat a share in the foreign corporation as a USRPI in its entirety; a cliff rule. Second, one could adopt a look-through or “to the extent” rule, treating interests in a foreign corporation as USRPIs only to the extent that foreign corporation actually owns USRPIs.

The regulations address this question, first, by setting out a rebuttable presumption that “for purposes of determining whether another corporation is a [USRPHC], an interest in a foreign corporation is a [USRPI] unless it is established that the foreign corporation is not a [USRPHC].”⁷ They then adopt both rules noted above: a cliff rule for interests in non-controlled foreign corporations and, in general, a look-through rule for interests in controlled foreign corporations.⁸ For this purpose, a controlling interest is an interest in a lower-tier corporation representing 50% or more by value. Given that either the cliff rule or the look-through rule could potentially apply at any level through multiple tiers of corporations, it is not surprising that the regulations explicitly state that one cannot look all the way down through tiers of entities to apply the USRPHC test; instead, each level is analyzed separately proceeding up a chain of entities.⁹

The look-through rule is subject to an important exception. Regs. §1.897-2(e)(3)(iii)’s flush language warns that a first-tier corporation is not treated as holding a proportionate share of a lower-tier controlled corporation's assets if those assets are subject to the special investment company rule of Regs. §1.897-1(f)(3)(ii), described above. The result of this “investment company kick-out” appears to be that the entire interest in the lower-tier investment company is excluded from the numerator and denominator of the 50% fraction.¹⁰ Although nothing in the regulation says so, it appears that this kick-out was intended to prevent abuse of the USRPHC rules. Absent the kick-out, an operating or real estate company with too many “bad” passive assets could drop those assets into a subsidiary that qualified, on a stand-alone basis, for the investment company 90% safe harbor. It might then argue that because the passive assets are “good” assets in the subsidiary's hands, they remain good assets in the parent's hands under the look-through rule.

A possibly unintended side effect of the investment company kick-out is that if a higher-tier corporation owns an interest in a lower-tier corporation, and that lower-tier corporation is a pure holding company owning only shares of other lower-tier corporations, the higher-tier corporation will not be treated as owning any assets at all by virtue of its interest in the lower-tier company. That is because the holding company would literally meet the definition of an investment company such that the kick-out would apply. So, suppose that a lower-tier entity in a chain is a pure holding company. Anything it owns indirectly through lower-tier corporations--even controlled corporations owning only active business assets or foreign real property--is excluded entirely from the USRPHC determination of any higher-tier entity, either in the denominator or the numerator. The net effect of this strange rule is that a company can own, indirectly, nothing but non-U.S. real estate and other trade or business assets yet be classified as a USRPHC if it owns a dime's worth of USRPIs directly, including by virtue of the cliff rule with respect to noncontrolled subsidiaries.

The moral of the story seems to be that, as applied to foreign PTPs, the rule of Regs. §1.897-1(c)(2)(iv), which was designed to be taxpayer favorable, often will lead to a worse result than a straightforward application of the statute (§897(g)) would. If the foreign PTP owns few “real” USRPIs, §897(g) would be difficult to deal with but would have little tax cost. But if the PTP owns its other assets through noncontrolled subsidiaries or investment companies, 100% of the interests in the foreign PTP can become USRPIs, a result clearly not contemplated by §897(g)--or any other portion of the statute.

Some Problems Common to All PTPs

The PTP regulation shuts off §897(g) only if the partnership is, in fact, publicly traded. Given that volume restrictions apply, it is possible--and probably more likely on foreign stock exchanges than in the United States--that a partnership can be publicly traded at some points in its life cycle and not others, and that it may switch into and out of publicly traded status more than once.

This can also be a problem for publicly traded corporations, but in that case all that is at stake is whether a 5% or lesser shareholder can avail itself of the §897(c)(3) exception. In the context of PTPs, the stakes are higher. If the PTP ceases to be treated as publicly traded, the regulation would cease to apply to it and §897(g) would apply instead. Shuttling back and forth between the §897(g) and PTP regimes presents problems of reporting and compliance that are nearly unimaginable.

A second problem is limited to PTPs traded on foreign exchanges, which most foreign PTPs would be. While the PTP regulation treats a PTP as a corporation, and arguably as a domestic corporation, the operative rules applicable to domestic corporations that are traded on a foreign stock exchange are difficult, if not impossible, to apply to a PTP. To be treated as publicly traded, the operative rules require that the shares be in registered form and that the corporation attach to its U.S. tax return (which the regulation appears to assume will be a corporate Form 1120) certain disclosures regarding its “shareholders,” including persons who are “beneficial owners” of greater than 5% interests in the corporation.¹¹ It is difficult to imagine how a PTP, particularly a foreign one, could comply with these rules; it is also difficult to believe that the IRS could argue that interests in PTPs traded on foreign exchanges, as opposed to domestic ones, cannot qualify for the 5% rule.

Conclusion

Arguably it was an act of executive grace for the regulations to engraft a PTP exception modeled after the 5% domestic corporation exception. Still, one cannot help wonder why the act could not have been better thought through. It appears that the drafters did not consider the possibility that a PTP could be foreign. At the least, the regulation should be amended to exclude foreign PTPs from its scope. In the meantime, one can guess that most foreign PTPs are not even aware of the rule and, even if they are, that they are probably taking the position that it could not possibly apply to them.

This commentary also will appear in the March 14, 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.