US Treasury Releases Final Regulations Addressing Domestic Control Determinations Under FIRPTA

On April 24, 2024, the Treasury Department and the IRS released final regulations under Section 897 that change the rules for determining whether qualified investment entities (QIEs) are domestically controlled under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA). The changes also affect the treatment of qualified foreign pension funds (QFPFs). The final regulations generally follow the proposed regulations issued in January 2023, with certain changes discussed below. The final regulations are of interest to taxpayers who sponsor or participate in investment structures that rely on the preferential FIRPTA treatment given to investments in domestically controlled real estate investment trusts (REITs) and regulated investment companies (RICs) that are treated as QIEs.

Foreign Ownership Threshold for Nonpublic C Corporation Look-Through Is Increased to 50%

The proposed regulations provided that if foreign persons own 25% or more of the fair market value of a non-publicly traded domestic C corporation’s outstanding stock, domestic control is determined by looking through the C corporation to its direct and indirect foreign owners. The final regulations increase the ownership threshold to 50% before the look-through rules apply to non-publicly traded domestic C corporations. The 50% threshold is determined by fair market value (not vote), and it is not entirely clear how the fair market value of stock in a non-publicly traded C corporation is determined for this purpose—especially if there are multiple classes of equity. Nonetheless, the expansion of the ownership requirement to more than 50% provides some relief for taxpayers. As described below, the final regulations raise important questions regarding how a QIE should determine its indirect foreign ownership.

QFPFs Are Foreign Persons for Purposes of Determining Domestic Control

The proposed regulations addressed uncertainty as to the appropriate treatment of QFPFs when determining domestic control by clarifying that QFPFs are treated as foreign persons for this purpose. The final regulations confirm the treatment expressed in the proposed regulations. Specifically, the Treasury Department and the IRS noted that the QFPF exception is not intended to give non-QFPF investors the ability to benefit from the domestically controlled QIE exception. Consequently, a QFPF (including any part of a QFPF) or a qualified controlled entity is treated as a foreign person, irrespective of whether the fund or entity qualifies for the exception from FIRPTA provided in Code Section 897(l). The transition rules do not apply to structures currently taking a position contrary to this aspect of the final regulations.

Certain Public Entities Are Look-Through Persons If the QIE Has Actual Knowledge of Foreign Control

The proposed regulations provided that a person holding less than 5% of a class of QIE stock that is publicly traded on a US securities market is treated as a US person that is not subject to look-through treatment unless the QIE has actual knowledge that the person is not a US person. The final regulations further provide that a QIE is also not able to treat the person as a US person if the QIE has actual knowledge that the person is foreign controlled. The final regulations also require look-through treatment for publicly traded domestic corporations and publicly traded partnerships if the QIE has actual knowledge that the entity is foreign controlled.

It is unclear how a QIE would know if its publicly traded shareholders are foreign controlled and how much diligence (if any) is required. Even if a QIE does know that a publicly traded domestic corporation or publicly traded partnership is treated as a look-through person, it may be impossible for the QIE to determine the foreign ownership percentage of the entity. In the context of private funds with QIE subsidiaries, it may be possible to obtain the relevant information in the subscription documentation, but for a publicly traded QIE, it may be significantly more challenging to conduct any diligence. Moreover, in light of the “actual knowledge” standard, there is arguably a disincentive for a QIE to conduct any diligence with respect to the foreign ownership of its shareholders.

Public RICs Are Non-Look-Through Persons

The proposed regulations provided that publicly traded corporations, publicly traded partnerships and publicly traded QIEs are treated as non-look-through persons. However, under the proposed regulations, a publicly traded RIC is treated as a look-through person if the RIC is not a QIE. Although all REITs are QIEs, a RIC is a QIE only if the majority of its assets consist of real estate or interests in certain real estate companies. The final regulations extend non-look-through treatment to publicly traded RICs that are not QIEs. For this purpose, a RIC is treated as publicly traded if it has any class of stock that is regularly traded on an established securities market or has common stock that is continuously offered pursuant to a public offering and held by no fewer than 500 persons. However, as with publicly traded domestic corporations and publicly traded partnerships, look-through treatment is required if the QIE has actual knowledge that a publicly traded RIC is foreign controlled.

No Guidance, Certifications, or Procedures Are Given for Determining Domestic Control

The final regulations do not provide any guidance, sample certifications, or other procedures taxpayers should follow for determining whether a domestic C corporation is foreign controlled, nor do they provide procedures generally for a QIE to identify which of its shareholders are non-look-through persons for purposes of determining whether the QIE is domestically controlled. The preamble to the final regulations states that a QIE must take “appropriate measures” to identify the status of its direct and indirect shareholders and notes that future guidance may be considered. QIEs and private funds that utilize QIEs in their structures would be well-advised to revisit their investor onboarding procedures and information requests in light of the final regulations.

Transition Rules May Benefit Existing Structures

The proposed regulations were proposed to be prospective in application from the date of the final regulations but in application could have caused existing structures to fail because existing structures within the scope of the regulations could no longer claim domestically controlled status. This particular aspect of the proposed regulations generated much concern in the industry with regard to existing structures and was the focus of several comments.

The final regulations grant relief in the form of a 10-year transition rule for existing QIEs, with certain caveats. This means that, for an existing QIE that would fail domestically controlled status solely due to the non-publicly traded domestic corporation look-through rule of the final regulations, domestically controlled status can nevertheless be maintained for the duration of the transition period. The transition rule has two major requirements:

• First, the grandfathered QIE may not acquire additional US real property interests (USRPIs) with an aggregate fair market value that is 20% or more of the fair market value of the USRPIs held as of the date of the final regulations. (Certain allowances are made to use valuations as of the immediately prior quarterly testing date for purposes of simplicity.)
• Second, the ownership (direct and indirect, as determined under the final regulations) of the QIE by one or more non-look-through persons cannot increase by more than 50 percentage points (tested against these persons’ ownership as of the date of the final regulations). Note that this change in ownership test can be triggered even if the QIE’s overall foreign ownership does not change at all. For example, if two foreign persons each transfer a 26% indirect interest in the QIE to another foreign person, that is treated as a 52% increase in a foreign person’s (the transferee’s) ownership in the QIE even though the transferors were also foreign persons. For publicly traded QIEs, transfers by less-than-5% owners are ignored unless (similar to the standard discussed above) there is actual knowledge of foreign ownership.

The transition rule should provide relief to many existing structures. For existing structures that are still acquiring assets, additional structuring to hold new USRPI investments outside of the existing QIE may be necessary so that transition relief can be maintained, given the limited scope of the 20% fair market value acquisition requirement. For open-ended fund structures or other situations where transfers or capital structure changes may occur during the transition period, sponsors will need to determine when to permit transfers or other changes such as non-pro rata redemptions or issuances, given the 50% limitation on increases in ownership by one or more foreign persons, which includes changes in the ownership of existing owners for this purpose. Usefully, the transition rule clarifies that if at the time of failing to qualify for transition relief the structure has become compliant with the final regulations, the QIE is considered to be domestically controlled for all periods, i.e., by “tacking” the transition relief period for a QIE with the full qualification period thereafter.