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Section 897 final regulations address domestically controlled qualified investment entities
April 2024
In brief
What happened?
Treasury and the IRS on April 24, 2024, released final regulations (TD 9992) regarding the definition of a domestically controlled qualified investment entity (DC QIE) under Section 897. The final regulations finalize the proposed regulations published on December 29, 2022, other than the portions of the proposed regulations addressing the Section 892 exemption (which will be addressed in a separate rulemaking).
The final regulations primarily affect foreign persons that own stock in a QIE that would be a United States real property interest (USRPI) if the QIE were not domestically controlled. The final regulations generally maintain the approach of the proposed regulations but do provide a few modifications, including a transition rule.
Why is it relevant?
Gain realized by a foreign person on the disposition of an interest in a ‘domestically controlled QIE’ (generally referring to real estate investment trusts (REITs) and certain regulated investment companies (RICs) that primarily holds US real property) is excluded from taxation under the Foreign Investment in Real Property Tax Act (FIRPTA). A QIE is domestically controlled if, during a testing period, less than 50% of the value of the shares is held, directly or indirectly, by foreign persons. For purposes of determining the foreign ownership percentage in a QIE, the final regulations increase the threshold for look-through treatment with respect to the domestic corporation look-through rule from 25% to 50%. While certain approaches suggested by commentators in response to the proposed regulations are not adopted in the final regulations, the change to the threshold for look-through treatment with respect to the domestic corporation is a welcome one for widely-held structures, particularly in the capital markets space.
The final regulations also adopt a transition rule that exempts existing structures from the final domestic corporation look-through rule for a ten-year period, provided they meet certain requirements. The transition rule may help alleviate the effect of the final regulations. However, the requirements of the grandfather rules will likely limit their applicability to entities that are not looking to acquire material assets prior to the sale of the REIT stock.
The final regulations are effective April 25, 2024.
Actions to consider
Taxpayers that conducted a DC QIE analysis treating a US corporation as a ‘non-look-through' person should revisit their analysis to determine the impact of the updated look-through threshold per the final regulations.
REITs that hold assets that may not constitute USRPIs should consider undertaking a US real property holding corporation (USRPHC) analysis to the extent the final regulations cause the REIT to no longer be domestically controlled.
In detail
Background
Income (or loss) derived from the disposition of a USRPI by a nonresident alien individual or a foreign corporation generally is treated as effectively connected income with a US trade or business. In general, a USRPI includes any interest (other than solely as a creditor) in any US corporation unless the taxpayer establishes that the US corporation is not and was not a USRPHC during the shorter of (1) the ownership period or (2) the five-year period ending on the date of disposition.
A USRPHC is generally any corporation if the fair market value of its USRPIs is 50% or more of the total fair market value of its USRPIs, foreign real property, and assets held for use in its trade or business.
A QIE includes any REIT and certain RICs. A QIE may or may not be a USRPHC. However, even if the QIE is a USRPHC, the stock of such QIE is not a USRPI if the QIE is domestically controlled. Thus, income from the sale or exchange of a DC QIE is not treated as income from the sale or exchange of a USRPI even if the DC QIE is a USRPHC.
A QIE is treated under Section 897(h)(4) as a DC QIE if non-US persons, directly or indirectly, own less than 50% of the value of the QIE during the shortest of (1) the period starting on June 19, 1980 and ending on the date of the disposition; (2) the five-year period ending on the date of disposition; or (3) the period during which the QIE existed (the Testing Period).
Limited ‘look-through’ regime for domestic control
For purposes of determining domestic control status when interests in a QIE are held through other entities, the final regulations adopt the general approach provided by the proposed regulations of dividing QIE owners into two categories, ‘look-through persons’ and ’non-look-through persons.’ In general, for purposes of determining domestic control, a REIT treats a non-look-through person as the owner but does not treat a look-through person as the owner. Instead, the owners of the look-through person are treated as the owner. For purposes of determining the foreign ownership percentage in a QIE, the proposed regulations treated a non-public domestic C-corporation that was 25% held, directly or indirectly, by foreign persons (a ‘foreign-owned domestic corporation’) as a look-through person. The final regulations increase that threshold to 50% and changed the relevant term to a ‘foreign-controlled domestic corporation.’
Observation: Increasing the threshold from 25% or more to more than 50% will continue to impact closely held structures. However, this might be impactful for more widely held corporations, particularly in the capital markets space.
Transition rule
The final regulations include a transition rule that exempts existing structures from the final domestic corporation look-through rule for a ten-year period, provided they meet certain requirements. The requirements are intended to ensure that the final domestic corporation look-through rule does not apply to preexisting business arrangements, but only to the extent the QIE does not acquire a significant amount of new USRPIs and does not undergo a significant change in its ownership.
A QIE is considered to have acquired a significant amount of new USRPIs if the total fair market value of the USRPIs it acquires directly and indirectly exceeds 20% of the fair market value of the USRPIs held directly and indirectly by the QIE as of April 25, 2024. A significant change in the ownership of a QIE occurs if the direct or indirect ownership of the QIE by non-look-through persons (determined by applying the final domestic corporation look-through rule) has increased by more than 50 percentage points in the aggregate relative to the QIE stock owned by such non-look-through persons on April 25, 2024. The final regulations disregard transfers by any person (regardless of whether they are a non-look-through person) that owns a less than 5% interest in the publicly-traded stock of the QIE, unless the QIE has actual knowledge of that person’s ownership.
The transition rule applies until April 24, 2034, or earlier, if the requirements precluding significant acquisitions of USRPIs and changes in ownership are not met, at which time the final domestic corporation look-through rule applies in determining whether a QIE is domestically controlled. However, even after the transition rule no longer applies, the final domestic corporation look-through rule is prospective only and thus does not apply to any portion of a testing period during which the transition rule applied to a QIE.
Observation: Historic structures appear to remain unimpacted as long as there is no material change. The preamble clarifies the final regulations are prospective only.
Observation: While the preamble to the proposed regulations noted that Treasury and the IRS may challenge positions contrary to the proposed regulations’ definition of a domestically controlled QIE and the foreign ownership percentage before final regulations were issued, the final regulations do not appear to contain similar language. The transition rule eliminates the concern around the proposed regulations retroactive applicability date for determining whether a QIE is domestically controlled.
Treatment of qualified foreign pension funds for purposes of the domestic control test
Entities that are qualified foreign pension funds (QFPFs) or qualified controlled entities (QCEs) are not treated as nonresident alien individuals or foreign corporations for purposes of Section 897, which includes the domestically controlled REIT rules. Some taxpayers may have interpreted the statutory provision as indicating that a QFPF is not treated as a foreign person for purposes of determining domestic control.
The final regulations adopt the proposed regulations’ guidance that QFPFs and QCEs are treated as foreign persons for purposes of determining a DC QIE.
The preamble notes that that DC QIE exception is a separate provision with underlying policies that focus on foreign control rather than taxability of controlling persons, and these policies are inconsistent with treating a QFPF as a United States person for purposes of the DC QIE exception.
Certain registered investment vehicles
The final regulations align the treatment of certain RICs that are not QIEs with the treatment of other publicly held entities that are not QIEs. The final regulations provide that a public RIC, generally defined as a RIC that is not a QIE and whose shares are (i) regularly traded on an established securities market or (ii) common stock that is continuously offered pursuant to a public offering and held by at least 500 shareholders, is generally treated as a non-look-through person. A RIC will not be a public RIC, and will be a look-through person, if the QIE being tested for domestically controlled status has actual knowledge that the RIC is foreign controlled, which results in treating the RIC as a non-public domestic C corporation.
Ownership of US publicly traded QIE stock
The proposed regulations provided that a person holding less than 5% of US publicly traded stock of a QIE is treated as a US person that is a non-look-through person with respect to that stock unless the QIE has actual knowledge that such person is not a US person. The final regulations modify the rule to provide that it will also not apply if the QIE has actual knowledge that such person is foreign controlled.
The final regulations also modify the proposed regulations non-look-through treatment for public domestic C corporations and publicly traded partnerships to exclude domestic entities that are known to be foreign controlled. In such case, the domestic C corporation or domestic partnership will be a look-through person.
Observation: It is uncertain how a QIE may know if its owner is foreign controlled, and this may be practically difficult to determine. The final regulations do not provide guidance regarding the procedures for determining whether a domestic C corporation is a foreign-controlled domestic corporation, nor do they provide any procedures generally for a QIE to identify its non-look-through person owners for purposes of determining whether the QIE is domestically controlled. The final regulations note that guidance may be considered in a separate guidance project.
Section 1445 withholding on dispositions of USRPI
The final regulations clarify the procedures available to a transferor to certify to a transferee that no withholding is required because the DC QIE exception applies. The final regulations confirm that a domestic corporation may voluntarily provide a statement in response to a request from a transferor certifying that an interest in the corporation is not a USRPI because the corporation is a DC QIE, which the transferor may furnish to the transferee, provided the statement issued by the corporation otherwise complies with the regulatory requirements.
See also
- Tax Insight: Section 897 guidance addresses REITs, RICs, foreign government tax exemption (Jan 2023)
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