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Withholding Tax Issues for Foreign Investors in REIT’s
Under the Foreign Investment in Real Property Tax Act of 1981 (“FIRPTA”), gains realized by foreign persons in connection with the disposition of interests in U.S. real estate are taxable as effectively-connected income for U.S. federal income tax purposes. Included within the definition of interests in U.S. real estate are certain interests in U.S. corporations (including trusts taxable as corporations) whose assets consist principally of U.S. real estate. The taxation of gains under FIRPTA is enforced through a withholding system under which generally the last U.S. person to have custody of the proceeds of a disposition of U.S. real estate interests must withhold taxes due by the foreign person subject to taxation. While this system is necessary to prevent tax avoidance, it rarely results in the collection of the correct amount of tax due, which places an unwanted tax compliance burden on foreign investors. Some peculiar withholding tax rules that apply to REITs can exacerbate the burden on their foreign interest holders, as discussed below.
Interests in equity real estate investment trusts (“REITS”) are typically treated as U.S. real property interests under FIRPTA. There is an exception, however, for any class of stock of any corporation, including a REIT, that is regularly traded on an established securities market, if the transferor held 5 percent or less of that class of stock for the shorter of the 5-year period preceding the date of transfer or the period of time that the transferor actually held the interest. There is also an exception for sales of stock in “domestically-controlled” REITs, which are defined as REITs less than 50 of the value whose stock is held, directly or indirectly, by foreign persons. In addition, under FIRPTA, distributions by REITs to foreign persons are, to the extent attributable to gain from sales or exchanges by the REIT of interests in U.S. real property, treated as dispositions by the shareholders of interests in U.S. real property.
The FIRPTA withholding tax rules provide that a transferee of a U.S. real property interest must generally withhold a tax equal to 10-percent of the amount realized (the gross sales price) on the disposition. Since the transferee typically will not have any information regarding the amount of the transferor’s actual gain on the transaction, the 10-percent rate is designed to roughly approximate the relationship between the actual tax due and the sales price. If the withholding amount is too low, the taxpayer is obliged to pay the difference on its tax return for the year in which the transfer occurs and may be required to make estimated tax payments in order to avoid penalties. If the withholding amount is too high, the transferor can secure a reduction by obtaining a withholding certificate from the Internal Revenue Service or by furnishing the transferor (and the Internal Revenue Service) with a notice indicating that it is not required to recognize any gain on the transaction because of the application of a non-recognition provision of the Internal Revenue Code.
A foreign transferor that takes no steps to have the correct amount withheld at the time that the transfer actually takes place can obtain a refund of any excess withholding by applying for a withholding certificate before the close of the tax year in which the transfer occurs or filing a tax return thereafter. It is important to note that the government is not obligated to pay interest on any overwithholdings except for the period after the tax return is filed. As a result, obtaining a withholding certificate can result in a significant benefit in situations in which there is a large difference between the amount required to be withheld and the transferor’s actual tax liability.
Under the applicable rules, a withholding agent that does not comply with the appropriate procedures can be liable for any tax that should have been withheld. While there will be no such liability if the transferor ultimately pays any tax due, the withholding agent may still be liable for interest and penalties regardless of whether the underlying tax liability is paid.
The sale of stock of a REIT which is not domestically-controlled is normally subject to the 10-percent withholding requirement applicable to U.S. real estate interests generally. There is an exception, however, for transfers of interests in REITs if any class of stock of the REIT is publicly traded. This exemption from withholding applies even if the disposition is of an interest consisting of more than 5 percent of the class of publicly-traded stock or of nonpublicly-traded stock, both of which are subject to taxation under FIRPTA. However, the applicable regulations contain a provision that requires withholding in certain situations in which substantial amounts of nonpublicly-traded interests in publicly-traded REITs are acquired from a single or related transferor in a single or related transactions. If no withholding is required in a situation in which there is a substantive liability for tax, the transferor must file a tax return for the year in question and pay the tax due.
If an interest in a domestically-controlled REIT is transferred, no withholding is required because the interest is not a U.S. real property interest. There is no explicit procedure, however, for a purchaser to satisfy itself that no withholding is required in such a case. The closest analogue contained in the regulations is the procedure for establishing that a U.S. corporation is not a U.S. real property holding corporation. Under these rules, a transferor of shares of the corporation can request the corporation to provide it with a statement that it is not a U.S. real property holding corporation. If the corporation provides the statement to the transferee and the transferee does not have actual knowledge that the statement is false and doesn’t received notice that is false from its own agent or an agent of the transferor, the transferee can avoid any penalty for not withholding if it turns out that the corporation is a U.S. real property holding corporation. It would be prudent for a purchaser of an interest in a REIT to obtain such a statement from the REIT if the seller wants to make the transfer free of withholding taxes.
As noted above, capital gain distributions by REITs are subject to taxation under FIRPTA, and the applicable regulations require that the withholding agent withhold 35 percent of the amount of any distribution characterized by the REIT as a capital gain dividend. This rule applies regardless of whether the REIT is domestically-controlled. REITs do not typically make a determination of how much of a distribution is capital gain until after the year in which it is made. However, for withholding tax purposes only, a distribution by a REIT is deemed to be a capital gain distribution when made to the maximum extent that it could be so designated at the time. If someone other than the REIT itself is the withholding agent, it will not be in a position to comply with this rule, so the regulations provide that when a foreign person holds an interest in a REIT through a U.S. nominee, the nominee is not required to withhold under FIRPTA with respect to any distribution until an actual designation of the of the distribution as a capital gain is made. In such situations, the regulations permit the nominee to withhold from future distributions the amount that it should have withheld from the prior distributions. This means that foreign persons who hold their REIT interests directly will usually have taxes withheld before those who hold their interests through a U.S. nominee. Moreover, in situations in which distributions subsequent to the year in which capital gain distributions occur are not sufficient to enable the nominee to withhold the amount required, the foreign interest holder will have to file a tax return and pay the amount due.
Although nominees do not have to withhold with respect to REIT distributions until there has been a designation by the REIT of a prior year’s distribution as a capital gain distribution, the foreign interest holder is still subject to tax in the prior year under FIRPTA on the amount so designated. This discontinuity between the substantive tax regime and the withholding tax regime can conceivably cause the interest holder to have to pay the tax in full for the prior year and not be in a position to recover withholding that occurs in the first-succeeding year with respect to the distribution until the second-succeeding year. Presumably, the foreign interest holder could avoid withholding or obtain an early refund by obtaining a withholding certificate in such a situation.
Another aspect of the withholding rules that can operate to the detriment of a taxpayer is the specification in the regulations of a tax rate of 35 percent for individuals and corporations alike. Although the maximum rate of tax on corporations and individuals is 35 percent, individuals (including trusts) are subject to a maximum tax rate of 15 percent on most types of long-term capital gains (depreciation recapture is taxed at the rate of 25 percent). As a result, individuals and trusts will have more tax withheld from their REIT capital gain distributions than is actually due. This has been a problem for foreign pension funds, many of which are treated as trusts under the applicable U.S. entity classification rules. Although the Internal Revenue Service initially resisted granting prospective relief in such cases (i.e., the interest holder would have to file a tax return to recover the excess amount withheld), it has recently begun issuing withholding certificates to affected taxpayers with the result that REITs can safely withhold at the lower tax rates.
A final wrinkle in the FIRPTA withholding situation as it applies to REITs is that withholding agents often make mistakes in applying the rules. Thus, for a variety of reasons, the amount of tax withheld seldom correlates to the transferor’s true tax liability. Excess withholdings result in the loss of the time value of the money involved as well as the money itself if a timely claim for refund is not filed. In cases in which not enough is withheld, a penalty of up to 25 percent of the difference can apply if a taxpayer does not file a tax return, and a penalty of 20 percent of such amount can be imposed if the proper amount of tax is not reported on its return. As a result, foreign interest holders must actively monitor their tax position with respect to their REIT holdings and cannot assume that their custodians or nominees, or the REITs themselves, will protect their interests.