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This is the fourth in 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 has existed for many years. This commentary will focus on the mechanics of FIRPTA's withholding rules, which in many respects have not been updated since the 1980s and which leave some issues to the withholding agent's imagination.

Certifying as to Non-Foreign Status

Any sale of U.S. real property is potentially subject to FIRPTA. The usual means of complying with FIRPTA's broad withholding tax requirements is for the buyer to procure a non-foreign affidavit from the seller.¹ The form is quite elaborate, and has been modified from time to time by updated regulations, most recently to deal with disregarded entities. Given the frequency with which this form must be delivered, and the relatively small number of transactions in which FIRPTA is remotely implicated, the IRS should issue regulations allowing sellers to provide buyers with a copy of a Form W-9 in lieu of a separate non-foreign affidavit tailored to the purposes of FIRPTA.

Proving that a Domestic Corporation is Not a USRPHC

A foreign person that sells stock of a U.S. corporation obviously cannot deliver a non-foreign affidavit to the buyer. The buyer will therefore be required to withhold tax under FIRPTA unless it can get comfortable that the stock of the U.S. target does not constitute a U.S. real property interest (USRPI)--that is, that the U.S. target is not a U.S. real property holding corporation (USRPHC).

The FIRPTA withholding tax regulations contemplate that a buyer of stock of a domestic corporation from a foreign seller will not be required to withhold tax if the buyer receives a certificate that the corporation is not a USRPHC. However, rather than formulating an independent rule that would apply in the context of a stock purchase, the regulations piggyback on the certification mechanics contained in the §897 substantive rules of FIRPTA, which were intended to be used by foreign shareholders who wish to ascertain whether the stock of a domestic corporation they hold is a USRPI. As described below, this mechanism creates unnecessary steps and is rather routinely ignored.

Regs. §1.897-2(g), which is part of FIRPTA's substantive rules and not part of the §1445 withholding rules, provides that a foreign person disposing of an interest in a U.S. corporation “must” establish that the interest is not a USRPI. The regulation is worded in the mandatory voice, because, whether or not the buyer withholds tax under §1445, the seller will be obligated to file a U.S. tax return on disposing of a USRPI. The -2(g) regulation sets out various ways in which the foreign seller can meet its burden. The usual way is to obtain a statement from the U.S. corporation whose stock is being sold, to the effect that its stock is not a USRPI.² The regulation provides that such a statement cannot be relied upon by the foreign seller unless the U.S. corporation complies with notice requirements set forth in Regs. §1.897-2(h). Regs. §1.897-2(h)(2) requires that the statement from the domestic corporation be sent to the IRS.

Regs. §1.897-2(g) provides, in coordination with §1445, that withholding is not required “if the transferee is furnished with a statement by the corporation under paragraph (h) of this section that the interest is not a U.S. real property interest.” Regs. §1.1445-2(c)(3) provides that no withholding is required “if the transferor provides the transferee with a copy of a statement, issued by the corporation pursuant to §1.897-2(h).” The regulation goes on to state that the target corporation may provide the statement directly to the transferee at the transferor's request, and can also provide the statement in response to a direct request from the transferee.

In almost all real-world cases, it is the buyer who will be asking for the corporation's non-USRPHC certificate, so that the buyer can get comfortable that it is not exposed to withholding agent liability. The pertinent documents memorializing the sale will require the U.S. target to deliver the statement on or before closing. As a practical matter, many practitioners take the view that the certificate that the domestic target delivers to the buyer need not be filed with the IRS, much less be a “copy” of a certificate previously filed with the IRS under the -2(h) regulations. Although this somewhat cavalier attitude might not mirror the requirements of the regulations, it makes sense for two reasons.

First, the vast majority of domestic targets are not USRPHCs. Requiring an IRS filing each time there is a sale of stock of a domestic corporation by a foreign person seems neither practical nor necessary. Second, and more important, the buyer is personally liable as a potential withholding agent and is unlikely to take its responsibility lightly. There does not appear to be any specific penalty imposed on the buyer for the target's failure to file the -2(h) statement with the IRS, but no penalty is needed because the penalty for getting it wrong is withholding agent liability. The IRS should rely on the mechanics of withholding here as it does elsewhere, and should not require a notice to be filed with it as a condition to exemption from withholding. New regulations should streamline the process and allow a direct delivery of a non-USRPHC certificate to the buyer.

As this commentary was being written, the IRS issued Rev. Proc. 2008-27.³ The revenue procedure provides what is billed as a “simplified procedure” for taxpayers to request “relief” from late filings under FIRPTA, including but not limited to late filings of Regs. §1.897-2(h) certificates with the IRS. It appears from this new guidance that the IRS believes that the filing of this certificate with the IRS is a prerequisite for withholding tax relief under Regs. §1.1445-2(c)(3), although the regulation itself is not so clearly drafted (which is why most taxpayers do not file a copy of their non-USRPHC certificates with the IRS, and most buyers as potential withholding agents don't require it). Rather than representing simplification, this is a step backward in terms of useful guidance. The revenue procedure should be modified to eliminate any IRS filing requirement in the circumstances outlined above.

FIRPTA Withholding and Partnerships

In general. Many of the withholding tax rules applicable to partnerships are unusually counterintuitive and occasionally unclear, which probably encourages noncompliance. By far the most unfair rule is the one that treats a foreign partnership as a foreign person for all FIRPTA purposes.⁴ This rule requires withholding on the disposition by a foreign partnership of a USRPI, even if all of the partners are U.S. persons. Unlike the withholding tax regime under §1441, there is no mechanism under §1445 by which a foreign partnership can certify to the transferee or other withholding agent that its partners are not subject to FIRPTA. It does not even seem possible to obtain a withholding tax certificate upon advance application to the IRS in such circumstances!⁵

The §1446 regulations pre-empt the §1445 regulations where both apply. Regs. §1.1446-3(c)(2)(ii) states that a foreign partnership may credit any amount withheld under FIRPTA “against its section 1446 tax liability for that taxable year only to the extent such amount is allocable to foreign partners.” This statement is a tautology, since quite obviously the foreign partnership could not credit any §1445 withholding to its U.S. partners, as to whom §1446 imposes no withholding obligation! (Nor would the U.S. partners allow the partnership to credit their shares of the §1445 tax to the foreign partners--they will need to apply for their own refunds.) The rule would at least make sense if a foreign partnership were treated as an aggregate and therefore subject to FIRPTA withholding only to the extent that it had foreign partners. As things are, it is gratuitous.

The §1445 regulations should be modified to treat partnerships as aggregates. The regulations should adopt a pass-through certification system similar to the Form W-8IMY used under §1441, or allow foreign partnerships to act as withholding agents in the same way that domestic partnerships can.

Dispositions of Partnership Interests

The withholding tax rules applicable where a person disposes of an interest in a partnership have not been updated in many years. Pending the issuance of further regulations under §897(g), a disposition of a partnership interest is subject to withholding under Regs. §1.1445-11T only where 50% or more of the value of the partnership's gross assets constitute USRPIs and 90% or more of the value of the partnership's gross assets consists of USRPIs plus cash and cash equivalents. In that case, the partnership interest is treated as a USRPI in full, such that withholding is required on the full amount realized by the selling foreign partner. A similar rule applies for substantive tax purposes under §897(g), except that the tax applies only to the extent the seller's gain on the sale of his partnership interest is “attributable” to USRPIs.⁶ No rule suggests that §897(g) applies if the percentage safe harbor tests are not exceeded, and the statute does not appear to be self-executing.

Rules like §897(g) probably seemed like a fine idea to Congress in 1980. The then-prevailing model of foreign investment in U.S. real estate assumed that U.S. real property would be owned by a single individual or family, or otherwise would be closely-held, and it was largely at this model that FIRPTA was aimed. Today, it is more usual to see a giant fund with hundreds of partners, some foreign and some not, investing through many tiers of entities, that hold real estate or stock of domestic corporations that might (or might not) be USRPHCs. Writing rules to attempt to enforce §897(g) in this context seems an impossible task. The current safe harbor serves well as a deterrent to abuse, and should be made permanent. Regulations should also make clear that Rev. Rul. 91-32⁷ does not “trump” the safe harbor.

Taxable Distributions by Partnerships

A third partnership withholding rule has never been implemented by regulations--and perhaps understandably so. Section 1445(e)(4) authorizes regulations providing for withholding on “taxable distributions” by partnerships. It is not clear what a taxable distribution by a partnership might be, since almost all distributions by partnerships are, by definition, not taxable. Perhaps the rule was intended to apply to a case in which a partnership distributes cash to a partner in an amount that exceeds the partner's basis in its partnership interest, or to distributions covered by §751(b). If so, it is not difficult to understand why the IRS has never issued even proposed regulations under this authority. Presumably, any such regulations would have to treat a distribution that decreases one partner's share of partnership USRPIs while increasing the remaining partners' shares thereof as a deemed distribution of a portion of the USRPI to the partner whose interest was decreased.

Again, outside of simple, closely-held cases, implementing such a rule would be nearly impossible. A good compromise would be to write rules similar to those under §897(g), providing a fairly generous safe harbor to screen out all but the most egregious cases, and then focusing on the cases in which partnerships might be able to make use of taxable distributions in an abusive manner.

This commentary also will appear in the July 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.