- IRS Rules That Derivative Contract Tied to U.S. Real Property Index Is Not Subject to FIRPTA
- September 8, 2008
- Law Firm: Holland & Knight LLP - Tampa Office
In a significant, taxpayer-friendly pronouncement, the IRS ruled that a total return swap, the return of which is calculated by reference to a broadly based real estate index, does not give rise to a U.S. real property interest (USRPI) for purposes of Section 897. Rev. Rul. 2008-31 is noteworthy for non-U.S. persons investing synthetically in U.S. real estate related assets for at least two reasons.
First, because of the broad definition of what constitutes a USRPI under the Section 897 Regulations, it would not have been much of a stretch for the Service to contend that a foreign person’s long position in a swap that is tied to U.S. real property is a USRPI for U.S. federal income tax purposes. Second, given all of the recent press dealing with the use of derivatives by foreign persons (primarily offshore hedge funds) to convert what otherwise would be U.S. source income into foreign source income, it is somewhat surprising that the IRS issued a Ruling in this regard to begin with.
Total Return Swaps, Generally
A total return swap is a cash-settled bilateral contract in which each party agrees to make certain payments to the other depending on the value and distribution performance of the underlying asset. An investor may enter into a total return swap either (1) to simulate an investment in the underlying asset without actually acquiring the underlying equity (i.e., a synthetic long position), or (2) to divest oneself of the economic exposure to a particular asset without actually disposing of the underlying asset (i.e., a synthetic short position).
With respect to a synthetic long position, the following illustrates how a total return swap over the shares of a publicly traded stock generally would operate.
Example: A foreign investor believes that ABC Inc. stock will appreciate and generate high yields over the next several years. For tax and other considerations, instead of investing directly in the shares of ABC Inc., the foreign investor enters into a five-year total return equity swap with an investment bank with respect to 1,000 shares of ABC Inc. stock. At the end of each year, (1) the bank pays the investor an amount equal to the sum of (a) any distributions paid with respect to the ABC Inc. shares during the year and (b) the increase, if any, in the FMV of the ABC Inc. shares over the course of the year; and (2) the investor pays the bank an amount equal to the sum of (a) an interest rate (e.g., LIBOR) multiplied by the value of the ABC Inc. shares at the beginning of the year and (b) the decrease, if any, in the FMV of the ABC Inc. shares over the course of the year. Although it is not required to do so, the bank will purchase a certain number of shares of ABC Inc. stock to hedge its position under the swap.
The total return swap qualifies as a notional principal contract (NPC) for U.S. federal income tax purposes. For this purpose, Reg. 1.446-3(c) defines an NPC as a financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index on a notional principal amount in exchange for specified consideration or a promise to pay similar amounts. The specified index would be the ABC Inc. stock and the notional principal amount would be the value of 1,000 shares of ABC Inc. stock.
For U.S. federal income tax purposes, the swap payments received by the foreign investor would be exempt from U.S. withholding tax. The reason is that payments made pursuant to an NPC typically are sourced according to the residence of the recipient, and therefore would generate foreign source income in the example above. This is a much better after-tax result than the foreign investor would achieve if it invested directly in the shares of ABC Inc. stock because any U.S. source dividend payments generally would be subject to a 30% U.S. withholding tax, unless reduced by an applicable income tax treaty.
Foreign persons are subject to U.S. federal income taxation on a limited basis. Unlike U.S. persons, who are subject to U.S. federal income tax on their worldwide income, foreign persons generally are subject to U.S. taxation on two categories of income:
- Certain passive types of U.S. source income, e.g., interest, dividends, rents, annuities, and other types of “fixed or determinable annual or periodical income” (collectively known as FDAP income).
- Income that is effectively connected to a U.S. trade or business (ECI).
FDAP income is subject to a 30% withholding tax that is imposed on a foreign person’s gross income (subject to reduction or elimination by an applicable income tax treaty) and ECI is subject to tax on a net basis at the graduated tax rates generally applicable to U.S. persons.
From a U.S. federal income tax perspective, the primary obstacle facing foreign persons who invest in U.S. real estate is the Foreign Investment in Real Property Tax Act (FIRPTA), or more specifically Section 897. Under this provision, any gain recognized by a foreign person on the disposition of a USRPI will be treated as if such gain were ECI, and therefore subject to U.S. federal income tax at the graduated rates that apply to U.S. persons. The source of such gain automatically will be treated as U.S. source income. Additionally, when Section 897 applies, the purchaser of a USRPI typically is required to withhold and remit to the IRS 10% of the purchase price in accordance with Section 1445.
Section 897 represents a major departure from the U.S. federal income tax rules generally applicable to foreign persons’ gain from the disposition of U.S. source capital assets. Foreign persons typically are not subject to U.S. federal income tax on U.S. source capital gains unless those gains are ECI. As stated above, Section 897 treats any gain recognized by a foreign person on the disposition of a USRPI as if it were U.S. source ECI.
A USRPI is broadly defined in Section 897(c)(2) as (1) a direct interest in real property located in the U.S., and (2) an interest (other than an interest solely as a creditor) in any domestic corporation that constitutes a U.S. real property holding corporation (i.e., a corporation whose USRPIs make up at least 50% of the total value of the corporation’s real property interests and business assets). Reg. 1.897-1(d)(2)(i) elaborates on the phrase “an interest other than an interest solely as a creditor” by stating that such an interest includes “any direct or indirect right to share in the appreciation in the value, or in the gross or net proceeds or profits generated by, the real property.”
Which Source Rules Apply?
Before the issuance of Rev. Rul. 2008-31, there was no guidance on how the NPC rules interacted with the FIRPTA provisions. In fact, the only mention of these two provisions in the same sentence was in a 1993 statement in the Preamble to the NPC Regulations indicating that “[t]he IRS is considering whether notional principal contracts involving [certain] specified indices (e.g., United States real property) are subject to Section 897.”
This statement led some practitioners to believe that payments and gains with respect to total return swaps on USRPIs are not subject to the FIRPTA provisions. In that event, the NPC residence-based source rules (which result in nontaxable foreign source income for a foreign taxpayer) would trump the general source rules under FIRPTA (which automatically provide for U.S. source ECI). The Ruling, albeit with somewhat restrictive facts, provides support for this position.
At issue in the Ruling is whether an interest in a total return swap, the return on which is calculated by reference to a broadly based real estate index, is a USRPI for purposes of Section 897.
Facts. A foreign corporation (FC) enters into a swap (which qualifies as an NPC for U.S. federal income tax purposes) with an unrelated counterparty that is a domestic corporation (DC). The swap is tied to the performance of the “Index,” which is maintained and widely published by taxpayer X. Neither FC nor DC is related to X.
The Index seeks to measure the appreciation and depreciation of residential or commercial real estate values within a metropolitan statistical area (MSA), a combined statistical area (CSA) (both as defined by the U.S. Office of Management and Budget (OMB)), or a similarly large geographic area within the U.S. The MSA, CSA, or similarly large geographic area has a population exceeding one million people.
The Index is calculated by reference to (1) sales prices (obtained from various public records), (2) appraisals and reported income, or (3) similar objective financial information, each with respect to a broad range of real property holdings of unrelated owners within the relevant geographic area during a relevant testing period. Using proprietary methods, this information is weighted, aggregated, and mathematically translated into the Index. Because of the broad-based nature of the Index, an investor cannot, as a practical matter, directly or indirectly, own or lease a material percentage of the real estate, the values of which are reflected by the Index.
Pursuant to the swap, FC profits if the Index appreciates (i.e., to the extent the underlying U.S. real property in the particular geographic region appreciates in value) over certain levels. Conversely, FC suffers a loss if the Index depreciates (or fails to appreciate more than at a specified rate). During the term of the swap, DC does not, directly or indirectly, own or lease a material percentage of the real property, the values of which are reflected by the Index.
Holding. Without much analysis, the IRS concludes that, because of the broad-based nature of the Index, the NPC does not represent a “direct or indirect right to share in the appreciation in the value ... [of] the real property” within the meaning of Reg. 1.897-1(d)(2). Accordingly, FC’s interest in the NPC calculated by reference to the Index is not a USRPI for purposes of Section 897.
Significance of the Ruling
There undoubtedly are some critical factors in Rev. Rul. 2008-31 that limit its application to a broader setting, including:
- Neither party to the swap is related to taxpayer X.
- Because of the broad-based nature of the Index, an investor cannot, as a practical matter, directly or indirectly, own or lease a material percentage of the real estate, the values of which are reflected by the Index.
- During the term of the swap, DC does not, directly or indirectly, own or lease a material percentage of the real property, the values of which are reflected by the Index.
Nevertheless, the Ruling itself is still significant. As noted earlier, the Section 897 Regulations broadly define a USRPI to include “any direct or indirect right to share in the appreciation in the value, or in the gross or net proceeds or profits generated by, the real property.” Clearly, under the facts of the Ruling the terms of the swap allow foreign counterparty FC to share in the appreciation in the value of U.S. real property by profiting under the contract if the Index appreciates over certain levels. Therefore, it is somewhat surprising that the Service ruled that the swap did not give rise to a USRPI.
It is evident that the most important factor in the Ruling is, because of the broad-based nature of the Index, FC’s inability to, directly or indirectly, own or lease a material percentage of the real estate, the values of which are reflected by the Index. The question, however, is how broadly based does the index need to be in order for a swap, the performance of which is tied to that index, not to constitute a USRPI for purposes of Section 897? Based on the facts of the Ruling, it would seem to be sufficient if the index not only measured the appreciation or depreciation of commercial or residential real estate in major metropolitan areas, such as New York, Chicago, or San Francisco, but also smaller cities, such as Ocala, Florida, so long as the population in that area exceeds one million people. A similar issue that is not addressed is what constitutes the direct or indirect ownership or lease of a “material” percentage of the real estate in a particular area for purposes of the Ruling?
Another important concern that is not clearly addressed in the Ruling is whether a total return swap could be tied to the performance of something other than a broadly based real estate index (such as shares in a REIT) in order not to constitute a USRPI, so long as the foreign investor could not, as a practical matter, directly or indirectly own or lease a material percentage of the real estate owned by the REIT. Foreign taxpayers generally have to be concerned about two types of REITs for U.S. federal income tax purposes:
- Domestically controlled REITs.1
- Publicly traded REITs.
Domestically controlled. The significance of a REIT being domestically controlled for this purpose is that shares in such REIT will not constitute a USRPI for purposes of Section 897. As a result, gain realized by a foreign taxpayer from the disposition of the shares in a domestically controlled REIT will not be subject to U.S. federal income tax. Distributions, however, by a domestically controlled REIT to a foreign taxpayer to the extent attributable to gain from the sale or exchange of USRPIs will be taxable under Section 897(h) and subject to withholding tax under Section 1445(e)(6). Accordingly, from a U.S. federal income tax perspective, it would appear to be more beneficial for a foreign taxpayer to obtain economic exposure to shares in a domestically controlled REIT by means of a total return swap, rather than acquire the REIT shares directly. This is because any swap payments tied to distributions from the REIT, to the extent attributable to gain from the sale or exchange of USRPIs, will be exempt from U.S. withholding tax under the NPC rules, as opposed to being taxed under the general Section 897(h) and Section 1445(e)(6) rules.
The question, however, is whether in this scenario the interest in the swap would be excluded from USRPI treatment under the Ruling. It would seem that where the underlying asset itself (i.e., shares in a domestically controlled REIT) is not a USRPI under Section 897, that a long position in a swap, the performance of which is tied to the value and distribution performance of the REIT shares, similarly would not constitute a USRPI.
Assuming this is the result, the IRS would have the ability to tax the foreign investor under Sections 897(h) and 1445(e)(6) only if the swap caused the foreign investor to be treated as the actual owner of the REIT shares under common law principles. Given the differences between actual share ownership and a long position in a swap with respect to shares in a domestically controlled REIT, the Service likely would be facing an uphill battle if it attempted to make this argument. This would appear to be the case, regardless of whether the foreign investor could, as a practical matter, directly or indirectly, own or lease a “material” percentage of the real estate owned by the domestically controlled REIT.
Publicly traded. A similar issue may arise with respect to shares in a publicly traded REIT, depending on the level of ownership held by the foreign taxpayer in such REIT. Foreign taxpayers that do not own more than 5% of any class of stock in a publicly traded REIT will not be taxed under Section 897 on either a disposition of the REIT shares or on the receipt of a distribution from the REIT, regardless of whether the distribution is attributable to gain from the sale or exchange of USRPIs.
A foreign taxpayer that owns more than 5% of a publicly traded REIT, however, will be subject to U.S. federal income tax under Section 897 on any gain realized from the disposition of the REIT shares (assuming the REIT is not domestically controlled and constitutes a U.S. real property holding corporation), and on any distributions from the REIT to the extent attributable to gain from the sale or exchange of USRPIs.
Because of the adverse U.S. federal income tax consequences that would result to a foreign taxpayer that directly owns more than 5% of a publicly traded REIT, an investment in a swap with respect to a greater-than-5% interest in a publicly traded REIT would yield a much higher after-tax return than would a direct investment in the REIT shares. As previously indicated, this is because the swap payments would be exempt from U.S. withholding tax. The Ruling, however, does not clearly address the issue of whether the swap in this scenario would be excluded from USRPI treatment under Section 897. For example, it is not clear whether a foreign investor’s ability to acquire a greater-than-5% interest in the shares of a publicly traded REIT prohibits such investor from relying on the Ruling, if the foreign investor could not, as a practical matter, directly or indirectly, own or lease a “material” percentage of the underlying real estate owned by the REIT.
Is the Maturity of a Swap a “Disposition”?
A final (and much more difficult) issue that the Ruling does not address, assuming the interest in the swap does constitute a USRPI for purposes of Section 897, is whether the maturity of the swap gives rise to a taxable “disposition” of such USRPI.
As noted earlier, Section 897 is triggered only when a foreign taxpayer disposes of a USRPI. Although the statute itself does not define “disposition,” Reg. 1.897-1(g) provides that the term “means any transfer that would constitute a disposition by the transferor for any purpose of the Internal Revenue Code and regulations thereunder.” Furthermore, the Internal Revenue Manual provides that a disposition may include “sales, gifts where liabilities exceed adjusted basis, like-kind exchanges, changes in interests in a partnership, trust, or estate, and corporate reorganizations, mergers, or liquidations; even foreclosures or inventory conversions.” A disposition also can include a distribution and a contribution to capital. Thus, “disposition” encompasses a broad range of transactions.
With respect to a total return swap, a disposition could possibly result on either the maturity of the swap or on a termination or assignment of the swap, depending on the characterization of the swap payments. Three types of payments are made in connection with a total return swap:
- Periodic payments, which are made or received pursuant to an NPC, are payable at intervals of one year or less during the entire term of the contract, are based on a specified index, and are based on a single notional principal amount.
- Non-periodic payments, which are payments made or received with respect to an NPC and are other than a periodic payment or termination payment.
- Termination payments, which are made or received to extinguish or assign all or a proportionate part of the remaining rights and obligations of any party under an NPC.
Of these three categories of payments, the only one that likely gives rise to a disposition for purposes of Section 897 is a “termination payment.” This conclusion is based on the effect of Section 1234A, which provides that “[g]ain or loss attributable to the cancellation, lapse, expiration, or other termination of ... a right or obligation ... with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer ... shall be treated as capital gain or loss from the sale of a capital asset.” (Emphasis added.) Prop. Regs. 1.1234A-1(a) and (b) specifically confirm that any gain or loss arising from the termination of a swap is subject to Section 1234A.
Thus, assuming a position in a swap constitutes a capital asset in the hands of the taxpayer (which generally should be the case unless the taxpayer is a swaps dealer), a payment made or received to terminate the swap should constitute a sale of that position for purposes of Section 1234A. As noted above, because “disposition” includes a sale, a termination payment clearly should give rise to a disposition for purposes of Section 897.
By contrast, the IRS apparently believes that the receipt of periodic and non-periodic payments do not constitute a “cancellation, lapse, expiration, or other termination” with respect to a capital asset. The IRS has ruled that the receipt of periodic payments (including the final periodic payment) does not result in a Section 1234A “sale” because such payments are simply made according to the original terms of the contract. Similarly, the Service has ruled that the receipt of non-periodic payments does not give rise to a Section 1234A “sale” because such payments do not terminate an NPC. Proposed Regulations under Section 1234A confirm these results.
The courts, however, have construed “disposition” more broadly than “sale.” Thus, it is possible that, despite not giving rise to a sale for purposes of Section 1234A, the final periodic and non-periodic payments pursuant to a total return swap may result in a Section 897 disposition. One court in particular applied the plain meaning of “disposition” (i.e., “the getting rid, or making over, of anything; relinquishment”) to find that a satisfaction of a claim resulted in a disposition (but not a sale) of the claim since it was “rid of or relinquished upon payment.”
Notwithstanding the potentially broader judicial construction of “disposition,” however, the Section 897 Regulations appear to indicate by way of example that the receipt of the final periodic and non-periodic payments on the maturity of the swap should not result in a Section 897 disposition. In the example, a foreign corporation lends $1 million to a domestic individual, secured by a mortgage on residential real property purchased with the loan proceeds. Under the loan agreement, the foreign corporate lender will receive fixed monthly payments from the domestic borrower, constituting repayment of principal plus interest at a fixed rate, and a percentage of the appreciation in the value of the real property at the time the loan is retired. The example states that, because of the foreign lender’s right to share in the appreciation in the value of the real property, the debt obligation gives the foreign lender an interest in the real property “other than solely as a creditor.”
Nevertheless, the example concludes that Section 897 will not apply to the foreign lender on the receipt of either the monthly or the final payments since these payments are considered to consist solely of principal and interest for U.S. federal income tax purposes. In other words, the example concludes the receipt of the final payments did not result in a disposition of the debt obligation for purposes of Section 897. The example notes, however, that a sale of the debt obligation by the foreign corporate lender would result in gain that is taxable under Section 897.
Although this example deals with payments received pursuant to a shared appreciation mortgage rather than a total return swap, in both situations the foreign investor’s rights to participate in the appreciation of the underlying real estate are contractually based. Accordingly, even if an interest in a swap constitutes a USRPI for purposes of Section 897, it seems that, unless the swap is terminated or assigned prior to its stated maturity, Section 897 should not apply to treat the final periodic and non-periodic payments as a “disposition.”
Following the issuance of the Preamble to the final NPC Regulations in 1993, there has been no guidance relating to how the NPC rules work in conjunction with the FIRPTA provisions. Given the broad definition of what constitutes a USRPI under the Section 897 Regulations, the Ruling certainly comes as a welcome surprise to many practitioners in this area. It will be interesting to see whether banks and other financial institutions attempt to take advantage of the Ruling by creating their own real estate indices in a manner that would allow foreign investors to share in the appreciation of U.S. real property without triggering tax under Section 897.
1 A domestically controlled REIT means a REIT in which at all times during the five-year period ending on the date of the disposition or of the distribution, as the case may be (or the shorter period if the REIT was in existence for less than five years), less than 50% in value of the stock was held directly or indirectly by foreign persons.