IRS Issues Final Regulations Regarding Qualified Foreign Pension Funds as Well as New Proposed Regulations in Connection with FIRPTA
On December 29, 2022, the US Internal Revenue Service (the IRS) and the US Department of the Treasury (the Treasury) issued final regulations (the Final Regulations) under Section 897 of the US Internal Revenue Code (the Code) regarding the exception from US federal income tax available to certain “qualified foreign pension funds” (QFPFs) and certain of their wholly owned subsidiaries on sales of certain “United States real property interests” (USRPIs). The Final Regulations generally retain the framework of the regulations as initially proposed in 2019 (the 2019 Proposed Regulations), with certain clarifications and additional changes. At the same time as the Final Regulations were issued, the IRS and Treasury also released proposed regulations (the 2022 Proposed Regulations) regarding QFPFs and the exemption from US federal income taxation under Section 892 of the Code for certain income derived by a foreign government, as well as in connection with “qualified investment entities” (QIEs) and the determination as to when a QIE is “domestically controlled.”
Under the Foreign Investment in Real Property Tax Act (FIRPTA), Section 897 of the Code imposes US federal income tax on gain received on certain dispositions of USRPIs by individual nonresident aliens or foreign corporations. However, Section 897(l) of the Code provides an exemption from this taxation (the 897(l) Exemption) for QFPFs and certain wholly owned subsidiaries of QFPFs. In addition, Section 892 of the Code provides that certain income derived by foreign governments also is exempt from US federal income taxation. However, the exemption under Section 892 does not apply for income that is derived from “commercial activities” or income received by or from a “controlled commercial entity” (CCE). Under existing law, if a QFPF is a “US real property holding corporation” and is controlled by a non-US government, it is treated as a CCE.
The Final Regulations
Scope of the QFPF Exception/Qualified Controlled Entities
Consistent with the 2019 Proposed Regulations, under the Final Regulations, any QFPF and any “qualified controlled entity” (QCE) (defined as a trust or corporation created or organized under the laws of a non-US jurisdiction all of the interests (other than an interest solely as a creditor) of which are held by one or more QFPFs directly or indirectly through one or more QCEs) is exempt from US federal income taxation under FIRPTA on gain attributable to disposition of USRPIs. Although commentators to the 2019 Proposed Regulations requested a de minimis exception be provided to allow for ownership of QCEs by other parties (including to resolve concerns over situations in which a QFPF ceases to qualify as such inadvertently), the Final Regulations do not adopt this approach. The IRS and Treasury have indicated that they believe such an approach would impermissibly expand the exception to allow investors other than QFPFs to avoid tax (and that other elements of the Final Regulations should adequately address concerns over inadvertent failure to qualify as a QFPF).
Qualified Holder Rule
The 2019 Proposed Regulations provided for a “qualified holder rule,” which generally is incorporated in the Final Regulations with certain modifications. Under the 2019 Proposed Regulations, an entity eligible for the Section 897(l) Exemption (a qualified holder) does not include any entity or governmental unit that, at any time during the “testing period,” was not (determined without regard to this limitation) a QFPF, part of a QFPF, or a QCE. The testing period, which remains unchanged in the Final Regulations, is the shortest of (i) the period beginning December 18, 2015 (the date that Section 897(l) became effective) and ending on the date of the disposition or distribution, (ii) the ten-year period ending on the date of the disposition or distribution, and (iii) the period during which the entity (or its predecessor) was in existence.
Under the Final Regulations there are two alternative tests that an entity must satisfy in order to be a qualified holder at the time of the disposition or distribution. Under the Final Regulations, the entity is a qualified holder if either (i) it owned no USRPIs as of the earliest date during an uninterrupted period ending on the date of the disposition or distribution during which it qualified as a QFPF or QCE or (ii) it satisfies the “testing period” requirement described above.
The IRS and Treasury declined to adopt any other approaches or alternatives to the qualified holder rule received in comments, however the Final Regulations do include two transition rules that provide temporary relief in applying the qualified holder rule. Under the first transition rule, for any period from December 18, 2015 to the date when the requirements of the final regulations first apply to a QFPF or QCE, as applicable (but in any event no later than December 29, 2022 or June 6, 2019, in the case of a QFPF or QCE, respectively), the QFPF or QCE is deemed to satisfy the qualified holder rule if it satisfies the requirements of Section 897(l)(2) of the Code, based on a reasonable interpretation of those requirements (including determining any applicable valuations using a consistent method). The second transition rule provides that a QCE may disregard a de minimis interest owned by any person providing services to the QCE from December 18, 2015 to the date that is 60 days after December 29, 2022 (the transition period). However, the second transition rule does not apply at the time of any disposition or distribution involving a USRPI. Therefore, this second rule essentially allows the entity in question to eliminate any such service provider’s ownership interest during the transition period prior to any relevant disposition or distribution, where the entity otherwise would have failed to qualify as a QCE solely by virtue of such de minimis ownership.
Qualified Segregated Accounts
The 2019 Proposed Regulations provided that a qualified holder is exempt from US federal income tax under Section 897(a) of the Code only with respect to gain or loss that is attributable to “qualified segregated accounts” maintained by the qualified holder. The 2019 Proposed Regulations defined such qualified segregated accounts as an identifiable pool of assets maintained for the sole purpose of funding qualified benefits (i.e., retirement, pension, and ancillary benefits) to qualified recipients (generally, plan participants and beneficiaries). Separate standards applied under the 2019 Proposed Regulations to determine whether such sole purpose requirement was satisfied, depending on whether the pool of assets is maintained by an eligible fund (including a QFPF) or a QCE.
The Final Regulations retain this concept, but, in response to comments received, clarify certain circumstances that will not prevent accounts as being treated as maintained for the sole purpose of providing such qualified benefits to such qualified recipients. Specifically, an eligible fund can satisfy the foregoing even if the funds may revert to a governmental unit or an employer (for example upon dissolution or vesting failures) in accordance with applicable non-US law, provided that contributions to the plan do not exceed what is reasonably necessary to fund the qualified benefits to be provided to qualified recipients.
Requirements Applicable to QFPFs
Established to Provide Retirement and Pension Benefits
Under the 2019 Proposed Regulations, pension funds established by one or more employers and government-sponsored public pension funds were eligible to be considered QFPFs. The 2019 Proposed Regulations provided that an eligible fund is one which was established by either (i) the foreign country in which it is created or organized to provide retirement or pension benefits to participants or beneficiaries that are current or former employees or persons designated by such employees as a result of services rendered by such employees to their employers (Government Established Fund) or (ii) one or more employers to provide retirement or pension benefits to participants or beneficiaries that are current or former employees or persons designated by such employees in consideration for services rendered by such employees to such employers (Employer Fund). The Final Regulations retain this general framework, with several clarifications and modifications.
In response to certain comments regarding the different manner in which eligible funds may be established and administered in non-US jurisdictions, the IRS and Treasury provided under the Final Regulations that a Government Established Fund may be a fund established by or at the direction of a foreign jurisdiction. The Final Regulations also clarify that if an eligible fund is established at the direction of a non-US jurisdiction for the purpose of providing benefits to a governmental entity acting in its capacity as an employer, it will constitute an Employer Fund only. The Final Regulations also clarify that an eligible fund may be administered by persons other than the foreign jurisdiction or employer and still qualify as a Government Established Fund.
Purpose of Eligible Fund
Under the Proposed Regulations, all benefits provided by an eligible fund must be qualified benefits (retirement, pension, or ancillary benefits) provided to qualified recipients (the 100 Percent Threshold) and that at least 85 percent of the present value of the qualified benefits that the eligible fund reasonably expects to provide in the future are retirement or pension benefits (the 85 Percent Threshold). The Final Regulations retain these thresholds, but, in response to comments, the IRS and Treasury provided additional clarification and relief, particularly in connection with valuation methodology, the definition and scope of qualified benefits, the effect of other distributions, and the determination of qualified recipients.
The Proposed Regulations did not include guidance with respect to the determination of the present value of benefits that an eligible fund reasonably expects to provide. In response to comments received, the IRS and Treasury determined that such guidance was needed. As a result, the Final Regulations provide such guidance with respect to methodology and frequency of such determination. The Final Regulations provide that the determination must be made for the entire period during which the fund is expected to be in existence. In addition, under the Final Regulations, an eligible fund may utilize any reasonable method for determining present value. However, despite this flexibility, the Final Regulations also provide that the IRS may determine the present valuation requirement has not been satisfied if the relevant facts and circumstances indicate the method was unreasonable.
The Final Regulations also provide that the determination of the present value of benefits must be made at least on an annual basis. However, the Final Regulations also allow for an alternative test (the Alternative Test), in light of concerns that, although unanticipated events may cause a fund to fail the 85 Percent Threshold in a given year, the fund should still be able to qualify as a QFPF if it demonstrates that it has nonetheless qualified as such over an extended period. Under this Alternative Test, the present valuation requirement is satisfied if the average of the present values of the retirement and pension benefits the fund reasonably expected to provide over its life (as determined by the valuations performed over the 48 months up to and including the most present valuation) satisfies the 85 Percent Threshold. The foregoing average is determined using the values (not the percentages) of the qualified benefits the fund reasonably expected to provide. The Final Regulations also clarify that if a fund has been in existence for less than 48 months, the Alternative Test is applied to the period during which the eligible fund has been in existence.
Definition and Scope of Qualified Benefits
Retirement and Pension Benefits
The 2019 Proposed Regulations did not provide a definition of retirement and pension benefits. Most comments requested that a definition be provided. As a result, the IRS and Treasury have provided a definition in the Final Regulations. For this purpose, retirement and pension benefits mean benefits that are payable to qualified recipients after reaching retirement age under the terms of the eligible fund or after an event in which the eligible fund recognizes a qualified recipient is unable to work, and including any such distribution made to a surviving beneficiary of the qualified recipient. For greater clarity in connection with the distinction between retirement and pension benefits, on the one hand, and ancillary benefits, on the other hand, the Final Regulations also provide that retirement and pension benefits generally are based on contributions and investment performance, in addition to factors such as years of service and compensation (with no regard to manner of payment—e.g., annuity vs. lump sum).
The 2019 Proposed Regulations defined ancillary benefits to mean benefits payable upon the diagnosis of a terminal illness, death benefits, disability benefits, medical benefits, unemployment benefits, or similar benefits. In response to numerous comments, the Final Regulations provide a more detailed list of additional specific types of benefits covered by the ancillary benefits, including incidental death benefits (e.g., funeral expenses), short term disability benefits, life insurance benefits, and shutdown or layoff benefits. In distinguishing unemployment, shutdown, or layoff benefits that might also be considered retirement and pension benefits, the Final Regulations also clarify that such benefits will be considered ancillary benefits only if they do not continue past retirement age and do not affect the payment of accrued retirement and pension benefits. Finally, under the Final Regulations, “similar benefits,” for purposes of the definition of ancillary benefits, is indicated as those which are also either health-related or unemployment benefits. The Final Regulations also contain a “tie-breaker” to resolve any potential overlap between the definitions of retirement and pension benefits and ancillary benefits by providing that any benefit potentially falling within both definitions will be considered only to be retirement and pension benefits.
The Final Regulations also provide that an eligible fund may provide a limited amount of benefits that are neither retirement and pension benefits or ancillary benefits. Such “non-ancillary benefits” are those provided by the eligible fund as permitted or required under the laws of the non-US jurisdiction in which the fund is established or operates that do not otherwise fall within the definition of retirement and pension benefits or ancillary benefits. Such non-ancillary benefits may not exceed five percent of the present value of the qualified benefits the eligible fund reasonably expects to provide to qualified recipients during the entire period during which the eligible fund is expected to be in existence. The measurement of the non-ancillary benefits and determination of present valuation are determined under the same rules for the comparable determinations of present valuation of retirement and pension benefits with respect to the 85 Percent Threshold. Non-ancillary benefits are also incorporated into the revised definition of “qualified benefits” for the Final Regulations so as to ensure they, too, comprise the “qualified benefits” necessary to meet the 100 Percent Threshold.
Other Distributions and Early Withdrawals
The 2019 Proposed Regulations did not explicitly cover the treatment of early withdrawals for purposes of determining the amount of any benefits paid by a QFPF. In response to comments received, the IRS and Treasury determined that certain types of such withdrawals should not be taken into account in determining the 85 Percent Threshold or the 100 Percent Threshold, or the limitation on non-ancillary benefits. Under the Final Regulations, three categories of distributions are excluded from such determinations: loans to qualified recipients pursuant to terms set by the eligible fund, distributions permitted under the laws of the non-US jurisdiction in which the eligible fund is established or operates that are made before the participant or beneficiary reaches retirement age under the relevant non-US laws (but only if the distribution is to a qualified holder or other retirement or pension arrangement subject to similar distribution or tax rules under the laws of the non-US jurisdiction), and withdrawals prior to retirement age that are taken to satisfy financial need under principles similar to US hardship distributions rules permitted under the laws of the relevant non-US jurisdiction in which the fund is established or operates, provided that the distribution (or at least the portion thereof exceeding basis) is subject to tax and penalty in such jurisdiction.
Under the 2019 Proposed Regulations, eligible funds were required to provide benefits only to “qualified recipients.” For a Government Established Fund, qualified recipients were defined to be any persons eligible to be treated as participants or beneficiaries of such eligible fund and persons designated by such persons to receive qualified benefits. As a result, the determination of qualified recipient status for Government Established Funds was made without regard to status as a current or former employee. However, Employer Funds defined qualified recipients as only current or former employees or persons designated by such current or former employee to receive qualified benefits. In response to comments received regarding the possible participation of neither current nor former employees in an Employer Fund, as allowed in some jurisdictions, the IRS and Treasury broadened this rule in the Final Regulations to allow for up to five percent of participants in Employer Funds to be individuals who were never employees and to allow for spouses of current or former employees to be included in the definition of qualified recipients.
Preferential Tax Treatment
A QFPF is required to be subject to preferential tax treatment under the laws of the country in which it is established or operates. The 2019 Proposed Regulations provided that, for this purpose, an eligible fund satisfies this requirement if, under the tax laws of the non-US jurisdiction in which the eligible fund is established or operates either (i) at least 85 percent of the contributions to the fund are deductible or excluded from the gross income of the eligible fund or taxed at a reduced rate or (ii) at least 85 percent of the investment income of the eligible fund is deferred or excluded from the gross income of the eligible fund or is taxed at a reduced rate.
The 2019 Proposed Regulations provided, however, that for purposes of determining whether this requirement is satisfied, no states, provinces, or political subdivisions of a non-US jurisdiction were included. The preamble to the 2019 Proposed Regulations indicated that this is because such subnational taxes generally constitute only a minor component of an entity’s overall tax burden. On reconsideration, the IRS and Treasury have indicated that to the extent any such subnational tax law is covered under an income tax treaty with the United States, it should be considered as a component of the determination. As a result, the Final Regulations provide that any such taxes covered under an income tax treaty between the relevant non-US jurisdiction and the United States can satisfy this requirement.
Under the Final Regulations, the information reporting requirement imposed on a QFPF is satisfied if the eligible fund annually provides information about the qualified benefits provided to qualified recipients to relevant tax authorities or other governmental units, if such information is otherwise available to such parties. An eligible fund will not fail to satisfy such requirement if it is not required to provide such information to such authorities in a year in which no qualified benefits are provided to qualified recipients.
In response to requests for clarification received in comments, the IRS and Treasury have clarified in the Final Regulations that a non-US partnership that is wholly owned by qualified holders should not be subject to withholding tax under Section 1445 of the Code, because the ultimate owners of such entities should qualify in full for the exemption under Section 897(l) of the Code. Thus, under the Final Regulations, a qualified holder and a non-US partnership, all of the interests of which are held by qualified holders (including through one or more partnerships), may certify its status as a “withholding qualified holder” that is not treated as a non-US person for purposes of withholding under Sections 1445 and 1446 of the Code, as relevant. Any qualified holder holding interests in USRPIs through such partnerships that do not constitute withholding qualified holders still may be eligible for the exemption available under Section 897(l) of the Code with respect to their distributive share of any FIRPTA gains.
With respect to coordination with Section 1441 of the Code, the Final Regulations also clarify that, although the coordination rules under Section 1.1441-3(c)(4) of the Treasury regulations do apply to qualified holders, such regulations have been amended to provide that withholding qualified holders are not subject to Section 1445 of the Code on distributions from USRPHCs that are not treated as dividends or on distributions from REITs or other QIEs that are capital gain dividends treated as gain attributable to the sale or exchange of USRPIs. Dividends from USRPHCs, as well as dividends from REITs or other QIEs that are not capital gain dividends, continue to be subject to withholding under Section 1441 of the Code. In addition, withholding under Section 1441 of the Code will also apply to the extent a capital gain dividend from a REIT or other QIE is excluded from withholding under Section 1445 of the Code because it is made with respect to stock that is regularly traded on an established securities market in the United States and is made to an individual or corporation that did not own more than five percent of the stock.
Under the Final Regulations, a withholding qualified holder may submit certification of non-foreign status to avoid FIRPTA withholding, subject to certain modifications. Because the Final Regulations require that a qualified holder must state it is not treated as a foreign person because it is a withholding qualified holder (a term that did not exist under the 2019 Proposed Regulations) and that a withholding qualified holder may provide a non-US taxpayer identification number if it doesn’t have a US taxpayer identification number, use of an IRS Form W-9 is not permissible for this purpose. The IRS intends to release a revised IRS Form W-8EXP, but, until that point, the preamble to the Final Regulations indicate that a certification of non-foreign status under Section 1.1445-2(b)(2)(i) of the Treasury regulations should be used to establish status as a withholding qualified holder. Once revised, IRS Form W-8EXP may be used in the alternative.
The Final Regulations generally apply with respect to dispositions of USRPIs and distributions described in Code Section 897(h) occurring on or after December 29, 2022. However, certain of the rules will apply with respect to dispositions of USRPIs and distributions occurring on or after June 6, 2019 (including the qualified holder rule and definition of QCE). In addition, an eligible fund may elect to apply the Final Regulations with respect to dispositions and distributions occurring on or after December 18, 2015 and before the applicability date of the Final Regulations if such eligible fund and all relevant related persons consistently apply the rules in the Final Regulations for all relevant years.
The 2022 Proposed Regulations
Controlled Commercial Entity
The exemption from US federal income taxation afforded to non-US governments by Section 892 of the Code (the 892 Exemption) does not apply to income derived from the conduct of a commercial activity or to income received by or from (directly or indirectly) a “controlled commercial entity” (a CCE). Under Section 1.892-5T(b)(1) of the existing Treasury regulations, a USRPHC is treated as engaged in commercial activity and is therefore a CCE if controlled by a non-US government. As such, a QFPF would be a CCE for purposes of Section 892 of the Code if it qualified as a USRPHC and if it were controlled by a non-US government. In such a case, no income received by a non-US government from such QFPF would be eligible for the 892 Exemption.
The IRS and Treasury have indicated that the rule referenced above under Section 1.892-5T(b)(1) of the Treasury regulations should not apply to a QFPF or QCE. As a result, the 2022 Proposed Regulations are intended to correct this result. In addition, the 2022 Proposed Regulations also exclude certain other USRPHCs from the application of Section 1.892-5T(b)(1) of the Treasury regulations, such as a corporation that is a USRPHC solely by reason of its direct or indirect ownership interest in other corporations that are not controlled by the non-US government.
QFPFs and the Domestically Controlled QIE Exception
Under Section 897(h)(2) of the Code, a USRPI does not include any interest in a REIT or other QIE that is “domestically controlled” (a DC-QIE). Therefore, gain or loss on the disposition of stock in a DC-QIE is not subject to US federal income taxation under Section 897(a) of the Code. A QIE is domestically controlled if less than 50 percent of the value of its stock is held directly or indirectly by non-US persons during the relevant testing period (generally, the five year period ending on the date of the relevant disposition). This rule looks to the non-US ownership percentage at the time during the relevant testing period during which such ownership was greatest. In the case of any class of stock of a QIE that is regularly traded on an established securities market in the United States, a person holding less than five percent of such class of stock at all times during the testing period is treated as a US person (unless the QIE has actual knowledge to the contrary).
Although the 897(l) Exemption provides that a QFPF is not treated as a nonresident alien individual or a foreign corporation for purposes of Section 897 of the Code, it does not expressly address whether a QFPF or QCE is treated as a non-US person for purposes of the ownership test with respect to DC-QIEs. The preamble to the 2022 Proposed Regulations explains that there is no indication that Congress intended for Section 897(l) of the Code to provide that QFPFs and QCEs are not treated as non-US persons for purposes of applying the DC-QIE exception to other persons that are neither QFPFs nor QCEs. As such, the 2022 Proposed Regulations provide that a QFPF (or any part thereof) or a QCE is a non-US person for purposes of determining whether a QIE is a DC-QIE.
Look Through Rules
The 2022 Proposed Regulations provide new guidance for determining whether stock of a REIT or other QIE is considered to be “held directly or indirectly” by non-US persons in connection with the determination of whether the QIE is a DC-QIE. Under this new guidance, stock held “indirectly” under Section 89(h)(4)(B) of the Code includes that of the QIE held through certain entities under a “limited look-through approach.”
The 2022 Proposed Regulations introduce the concept of a “non-look-through person” and a “look-through person” for purposes of determining whether a QIE is a DC-QIE. Non-look through persons include, without limitation, individuals, domestic C corporations (subject to the below special look through rule for foreign-owned domestic corporations), foreign corporations (including foreign governments), estates, international organizations, publicly traded partnerships, QFPFs, or QCEs. Look-through persons are defined as any person other than a non-look-through person, including, without limitation, REITs, RICs, S corporations, non-publicly traded partnerships, or trusts. Under this approach, in determining DC-QIE status, only a “non-look-through person” is treated as holding stock of a QIE, and any stock of a QIE held through intervening “look-through persons” is treated as held proportionately by the look-through person’s ultimate owners that are non-look-through persons. In addition, parallel rules apply to those above with respect to publicly traded exceptions. A person holding less than five percent of US publicly traded QIE stock that would be deemed to be a US person (as described above) is treated as a non-look-through person with respect to that stock. Stock of a QIE held by a public QIE that is treated as held by a non-US or US person based on whether the public QIE is a DC-QIE is similarly treated as held by a non-look-through person (despite the fact that the general definition of non-look-through persons excludes QIEs).
There is also a special look-through rule under the 2022 Proposed Regulations for foreign-owned domestic corporations (i.e., non-publicly traded domestic C corporations in which non-US persons hold a meaningful ownership interest). Under this rule, a domestic C corporation whose stock is not regularly traded on an established securities market is a look-through person, but only if non-US persons hold directly or indirectly at least 25 percent of the fair market value of the corporation’s outstanding stock. This new special look-through rule for foreign-owned domestic corporations has the potential to upend a large number of existing structures in which foreign investors have relied on a REIT or other QIE qualifying as domestically controlled.
The 2022 Proposed Regulations under Section 892 of the Code are proposed to apply to tax years ending on or after December 29, 2022. Taxpayers may rely on these rules until the date on which the regulations are adopted as final by the Treasury and published in the Federal Register.
The 2022 Proposed Regulations under Section 897 of the Code are proposed to apply to transactions occurring on or after the date the regulations are published as final in the Federal Register. However, the IRS and Treasury have indicated that rules for determining whether a QIE is domestically controlled may be relevant for determining QIE ownership during periods prior to finalization, and that the IRS may challenge positions contrary to the regulations as proposed before the regulations have been finalized.
© Arnold & Porter Kaye Scholer LLP 2023 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.