Final Regulations on Domestically Controlled Qualified Investment Entities Provide Limited Relief

On April 24, 2024, the Internal Revenue Service (IRS) and the Department of the Treasury issued final regulations (the Final Regulations) in connection with the determination of whether a “qualified investment entity” (QIE) is “domestically controlled.” The Final Regulations generally retain the framework of the regulations as initially proposed in December 2022 (the 2022 Proposed Regulations), with certain modifications discussed below. For a discussion of the 2022 Proposed Regulations, please see our prior Advisory.

As discussed in more detail below, the Final Regulations modify the “look-through” rule introduced in the 2022 Proposed Regulations by increasing the threshold of non-U.S. ownership required to “look through” a U.S. C corporation owning a QIE from at least 25% to more than 50%. The Final Regulations also establish a 10-year transition rule for the application of such look-through rule to existing QIE structures, subject to certain requirements.

Background

Under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), Section 897 of the U.S. Internal Revenue Code (the Code) imposes U.S. federal income tax on gain received on certain dispositions of “United States real property interests” (USRPIs) by non-U.S. persons. For these purposes, stock in a U.S. corporation that is a so-called “United States real property holding corporation” (USRPHC) is treated as a USRPI. A USRPHC generally is a U.S. corporation owning, directly or indirectly, a threshold amount of USRPIs. As an exception, Section 897(h)(2) of the Code generally provides that a USRPI does not include any interest in a 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 U.S. federal income taxation under Section 897(a) of the Code.

A QIE generally includes a “real estate investment trust” (REIT) or “regulated investment company” (RIC) that is a USRPHC.

Look-Through Rule

A QIE generally is “domestically controlled” if less than 50% of the value of its stock is held directly or indirectly by non-U.S. persons during the relevant testing period (generally, the five-year period ending on the date of the relevant disposition).

The Final Regulations generally follow the 2022 Proposed Regulations in adopting a limited look-through approach for purposes of determining whether a QIE is held directly or indirectly by non-U.S. persons, dividing owners of QIEs into “non-look-through persons” and “look-through persons.” Under the Final Regulations, only non-look-through persons are taken into account in determining whether a QIE is domestically controlled.

Non-look-through persons include, without limitation, individuals, U.S. C corporations (subject to the below special look-through rule for non-public “foreign-controlled” U.S. C corporations), certain U.S. tax-exempt organizations, non-U.S. corporations (including non-U.S. governments), publicly traded REITs, publicly traded RICs, estates, international organizations, publicly traded partnerships, so-called “qualified foreign pension funds” (QFPFs) or certain entities controlled by a QFPF.

Look-through persons are defined as any person other than a non-look-through person, including, without limitation, non-publicly traded REITs, non-publicly traded RICs, S corporations, non-publicly traded partnerships, or trusts.

A person holding less than 5% of the stock of a U.S. publicly traded QIE at all times during the specified testing period is treated as a U.S. person that is a “non-look-through person” with respect to that stock, unless the REIT has actual knowledge that such person is not a U.S. person or has actual knowledge that such person is a “foreign-controlled” U.S. C corporation, as discussed below.

Under this look-through 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.

Special Look-Through Rule for “Foreign-Controlled” U.S. C Corporation

Prior to the 2022 Proposed Regulations, based on a 2009 private letter ruling from the IRS, taxpayers often took the position that a U.S. C corporation was treated as a U.S. person for purposes of the DC-QIE determination, even if such C corporation had owners that were non-U.S. persons.

Contrary to such position, the 2022 Proposed Regulations included a special look-through rule for non-publicly traded U.S. C corporations. Under this rule, a non-public U.S. C corporation would be treated as a look-through person to the extent non-U.S. persons hold directly or indirectly at least 25% of the fair market value of such corporation’s outstanding stock (such a corporation under the 2022 Proposed Regulations exceeding such 25% threshold, a “foreign-owned domestic corporation”).

A substantial number of comments were submitted in opposition to this rule in the 2022 Proposed Regulation from both statutory interpretation and policy perspectives, but the IRS and the Department of the Treasury were not persuaded to remove the rule. However, the Final Regulations provide limited relief to the application of the look-through rule to a non-public U.S. C corporation by increasing the look-through threshold from at least 25% to more than 50% (such a corporation under the Final Regulations exceeding such 50% threshold, a “foreign-controlled domestic corporation”). In connection with this change, the preamble to the Final Regulations provide that “the scope of the rule should be narrowed to address compliance concerns and to ensure the rule is more appropriately limited to situations where significant indirect ownership by foreign persons indicative of foreign control is present.” As such, the new threshold in the Final Regulations limits the look-through to non-public U.S. C corporations controlled by non-U.S. persons, and is consistent with other provisions in Section 897 of the Code that are based on a more-than-50% threshold.

Look-Through Transition Rule

The 2022 Proposed Regulations did not contain any transition rules for QIEs that currently rely on a U.S. C corporation’s ownership of their stock for DC-QIE status, without regard to the non-U.S. ownership of such corporation. However, the Final Regulations provide a 10-year transition period that exempts existing structures from the final U.S. C corporation look-through rule. The continued application of the transition rule is contingent on such existing structures meeting certain requirements, including not acquiring a threshold amount of new USRPIs and not undergoing a threshold change in ownership. When the transition rule ends, the look-through rule is applied only prospectively.

More specifically, a QIE ceases to qualify under the transition rule after the QIE acquires (directly or indirectly) new USRPIs that exceed 20% of the USRPIs (by fair market value) held directly or indirectly by the QIE as of April 24, 2024 (or the most recent prior date under certain quarterly tests). The Final Regulations do not indicate whether acquisitions exclude tax-free or tax-deferred transactions, such as like-kind exchanges or property contributions to partnerships and subsidiary entities, although IRS employees have unofficially indicated that such transactions are expected to count as acquisitions.

A QIE also ceases to qualify under the transition rule after the QIE’s direct and indirect ownership by non-look-through persons (e.g., U.S. and non-U.S. individuals, non-U.S. corporations, publicly traded U.S. C corporations) has increased by more than 50%, in the aggregate by value, relative to the shares of such QIE held by such non-look-through persons as of April 24, 2024.

Additional Rules

The Final Regulations adopted the rule included in the 2022 Proposed Regulations that a QFPF is considered a non-U.S. person for purposes of determining DC-QIE status. There was uncertainty on this issue because Section 897(l) of the Code provides that a QFPF “shall not be treated as a nonresident alien individual or foreign corporation” for purposes of Section 897. The preamble to the Final Regulations explains that the term “nonresident alien individuals or foreign corporations” in Section 897(l) of the Code and the term “foreign persons” in Section 897(h)(4)(B) of the Code have different definitions and the two provisions serve different purposes. The preamble to the Final Regulations concludes that there is no evidence that Congress intended to confer U.S. person status on QFPFs for purposes of the DC-QIE rules.

The Final Regulations also establish that a QIE may voluntarily provide a statement as to its DC-QIE status to allow a transferor of interests in the QIE to certify to a transferee that no U.S. federal withholding tax under FIRPTA is required upon a transfer of such interests.

The Final Regulations are effective as of April 25, 2024. We recommend that real estate funds and investors review the impact of the Final Regulations with their tax counsel.

© Arnold & Porter Kaye Scholer LLP 2024 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.