Using shared application mortgages to avoid FIRPTA.

The combination of a weak U.S. dollar and low interest rates has resulted in an enormous increase in foreign investment in U.S. real estate. (1) While investment is not expected to continue at the same pace, the U.S. is expected to remain the number one overall real estate market for non-U.S, investors. (2)

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), more specifically [section] 897. Under this provision, any gain recognized by a foreign person on the disposition of a "United States real property interest" (USRPI) will be treated as if such gain were effectively connected to a U.S. trade or business and, therefore, subject to U.S. federal income tax at the graduated rates that apply to U.S. persons. Additionally, when [section] 97 applies, the purchaser of a USRPI typically is required to withhold and remit to the IRS 10 percent of the purchase price in accordance with [section] 1445.

One possible strategy to avoid FIRPTA involves the use of a shared appreciation mortgage (SAM). In a typical SAM arrangement, a lender provides a developer with a loan bearing a below-market fixed rate of interest, plus a share of the profit on a subsequent disposition of the property. SAMs were popular in the 1970s and 1980s when interest rates were in the double digits, but became less attractive as interest rates declined. Fueled by rising housing prices and mortgage rates, however, SAMs are staging a comeback, particularly with real estate projects that are perceived to be risky investments. As this article will illustrate, if the transaction is structured correctly, the taxpayers investing in U.S. real estate who may have the most to gain from the use of SAMs are non-U.S. taxpayers.

Section 897

Foreign persons typically are not subject to U.S. federal income tax on U.S. sourced capital gains unless those gains are effectively connected to a U.S. trade or business. (3) As stated above, [section] 897 treats any gain recognized by a foreign person on the disposition of a USRPI as if it were effectively connected to a U.S. trade or business.

A USRPI is broadly defined under [section] 897(c)(1)(A) 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 percent of the total value of the corporation's real property interests and business assets). An interest in a partnership may also be considered a USRPI in certain situations. (4)

Regulation 1.897-1(d)(2)(i) elaborates on the phrase "an interest other than an interest solely as a creditor" by stating it 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." The regulation goes on to state that a "loan to an individual or entity under the terms of which a holder of the indebtedness has any direct or indirect right to share in the appreciation in value of, or the gross or net proceeds or profits generated by, an interest in real property of the debtor or of a related person is, in its entirety, an interest in real property other than solely as a creditor." Accordingly, a SAM that is tied to U.S. real estate is a USRPI for purposes of [section] 897.

Simply owning a USRPI, however, does not necessarily trigger any adverse tax consequences under [section] 897. Rather, a non-U.S, taxpayer will be subject to tax under that provision only when the USRPI is "disposed of." Reg. 1.897-1(g) provides that disposition "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. (5)

With respect to SAMs, Reg. [section] 1.897-1(h), Example 2, illustrates a significant planning opportunity for non-U.S, taxpayers investing in U.S. real estate. 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, because these payments are considered to consist solely of principal and interest for U.S. federal income tax purposes. Thus, the example concludes the receipt of the final appreciation payment that is tied to the gain from the sale of the U.S. real property does not result in a disposition of a USRPI for purposes of [section] 897, because the amount is considered to be interest rather than gain under [section] 1001. The example does note, however, that a sale of the debt obligation by the foreign corporate lender will result in gain that is taxable under [section] 897. The Internal Revenue Manual also acknowledges that U.S. tax savings can be achieved by non-U.S, taxpayers who invest in U.S. real estate through SAMs:

Taxpayers may attempt to use debt instruments with contingent interest features to avoid IRC section 897. This scheme takes advantage of the fact that IRC section 897 only applies to dispositions. IRC section 897 does not apply to collections of principal and interest. Under this scheme, a foreign taxpayer obtains a shared appreciation loan. It does so rather than obtain a direct interest in a USRPI. The USRPI is owned by a related domestic corporation. The related domestic corporation is the debtor with respect to the shared appreciation loan. The domestic corporation realizes a gain on the sale of the property. Part of the gain is transferred to the foreign taxpayer as contingent interest. The contingent interest received by the foreign taxpayer is generally subject to 30 percent withholding tax. However, the withholding tax is often eliminated or reduced by treaty. Therefore, this scheme allows a foreign taxpayer to convert IRC section 897 taxable gain into tax-free or tax-reduced interest income. (6)

Withholding on U.S. Source Interest

By characterizing the contingent payment in a SAM as interest (and not a disposition of a USRPI) for tax purposes, the [section] 897 regulations potentially allow non-U.S, taxpayers to avoid U.S. federal income tax on gain arising from the sale of U.S. real estate, if structured correctly. Specifically, non-U.S, taxpayers are generally subject to a 30 percent withholding tax (unless reduced by treaty) on certain passive types of U.S. source income, including interest. (7) An important exception to this rule exists for "portfolio interest," which is exempt from withholding tax in the U.S. For this purpose, portfolio interest is defined as any interest (including OID) that is paid on a note that is either 1) in registered form or 2) that is not in registered form, if there are arrangements reasonably designed to ensure that the note will be sold only to non-U.S. persons and certain other conditions are satisfied. (8)

There are, however, a number of exceptions to portfolio interest, including certain "contingent interest." For purposes of this provision, [section] 871(h)(4)(A) provides that contingent interest is determined by reference to, among other items: 1) any receipts, sales, or other cash flow of the debtor or related person; 2) any income or profits of the debtor or a related person; or 3) any change in value of any property of the debtor or a related person.

Therefore, a payment on a SAM that is otherwise treated for U.S. federal income tax purposes as interest will not qualify for the portfolio interest exemption if the payment is contingent on the appreciation of the financed real property. Accordingly, unless a treaty applies to reduce the withholding tax, the contingent interest feature of a SAM would be subject to a 30 percent withholding tax in the U.S.

Currently, there are at least 11 jurisdictions that have concluded income tax treaties with the U.S. that contain provisions that entirely eliminate U.S. withholding tax on interest, including contingent interest, paid from the U.S. to the respective treaty jurisdiction: Czech Republic, Finland, Germany, Hungary, Iceland, Norway, Poland, the Russian Federation, the Slovak Republic, Sweden, and Ukraine. Accordingly, a payment of U.S. source interest, including contingent interest, made to a resident of one of these treaty jurisdictions generally would not be subject to U.S. withholding tax, assuming such person otherwise is eligible for treaty benefits.

For a non-U.S, taxpayer to be eligible for treaty benefits, the taxpayer must be considered a resident of the particular treaty jurisdiction and must satisfy any limitation on benefits (LOB) provision in the treaty. Under most U.S. income tax treaties, a foreign person will be considered a resident for treaty purposes if such person is "liable to tax therein by reason of its domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of a similar nature."

Similarly, under most "modern" income tax treaties, a resident of a treaty country will satisfy the LOB provision if that resident is an individual, or a corporation that is at least 50 percent owned by citizens or residents of the U.S. or by residents of the jurisdiction where the corporation is formed and not more than 50 percent of the gross income of the foreign corporation is paid or accrued in the form of deductible payments to persons who are neither citizens nor residents of the U.S. or residents of the jurisdiction where the corporation is formed.

In order for a non-U.S, taxpayer who is not resident in one of the treaty jurisdictions listed above to obtain a complete exemption from U.S. withholding tax on the contingent interest payment, that taxpayer must rely on a treaty that has been concluded with the U.S. which has no LOB provision. Currently, four treaty jurisdictions provide an exemption from withholding on payments of U.S.-source interest, including contingent interest, and do not have LOB provisions: Hungary, Iceland, Norway, and Poland. Therefore, a non-U.S, taxpayer that is not resident in a favorable treaty jurisdiction can obtain a complete exemption from withholding on contingent interest by investing through a corporation formed in one of these four jurisdictions.

Using Hybrid Entities to Reduce Foreign Tax

Of course, when organizing a corporation in a non-U.S, jurisdiction, local income taxes need to be considered. Hungary currently has a 16 percent corporate income tax rate, Iceland 18 percent, and Norway and Poland both 28 percent. Given that an individual non-U.S. taxpayer is eligible for the 15 percent long-term capital gains tax rate in the U.S. for property that has been held for at least 12 months, it generally would not be practical from a tax perspective for a non-U.S, taxpayer to invest in U.S. real estate through a corporation formed in one of these jurisdictions, if a foreign tax of at least 15 percent would be incurred.

A back-to-back loan arrangement using a hybrid entity may lower the effective foreign corporate income tax burden. Of the four treaty jurisdictions that do not have LOB provisions, two--Hungary and Norway--do not impose withholding taxes under their local laws on interest paid to nonresidents. Accordingly, by lending money from a low-tax jurisdiction to a corporation formed in Hungary or Norway and then re-lending that money from Hungary or Norway to the U.S. pursuant to a SAM, it may be possible to avoid U.S. federal income tax on the SAM payments and incur very little foreign tax. Furthermore, depending on the jurisdiction, it then may be possible to repatriate the profits to the jurisdiction where the ultimate non-U.S, investors are resident, in a tax-efficient manner.

Example: A U.K. resident (but non-domiciliary) wishes to participate in the appreciation, if any, of a real estate development project located in the U.S. To do so, the investor organizes a Norwegian corporation that owns 100 percent of the stock of a U.S. limited liability company (LLC) that defaults into a disregarded entity for federal income tax purposes. The U.S. LLC loans money to its Norwegian parent, which then re-lends the money to the U.S., taking back a SAM tied to the U.S. real estate venture.

With this structure, no U.S. withholding tax would be imposed on the SAM payments, including the contingent interest payment, under Article 11 (the interest provision) of the U.S.-Norway income tax treaty. Also, the interest paid from Norway to the U.S. LLC would not be subject to withholding tax in Norway and would give rise to a deduction in Norway (leaving a small interest rate spread in Norway). Many foreign jurisdictions, including Norway, treat a U.S. single-member LLC as a separate company for foreign tax purposes, regardless of whether the LLC is disregarded for U.S. tax purposes. Because the LLC would be disregarded for U.S. tax purposes, the interest paid from Norway to such LLC should also be disregarded for U.S. tax purposes.

The earnings eventually could be paid from the LLC to the ultimate non-U.S. investors of the Norwegian corporation in a tax-efficient manner. Norway recently amended its participation exemption regime and, as a result, not only exempts from corporate income tax dividends received from within the European Economic Area (EEA) (EU, Norway, Iceland, and Liechtenstein), but also exempts dividends received from outside of the EEA, so long as the jurisdiction is not considered a low tax jurisdiction (i.e., a jurisdiction where the corporate tax rate is less than 18.67 percent or two-thirds of Norway's corporate tax rate of 28 percent). The U.S. would not appear to be a low tax jurisdiction for this purpose. Also, Norway does not impose withholding taxes on dividends paid to residents of the EEA, which includes the U.K.

Possible Challenges by the IRS

The Service has several potential arguments to use in denying treaty benefits to a non-U.S, taxpayer investing in U.S. real estate pursuant to a SAM.

* Is There a Partnership?--The most likely IRS argument would be an attempt to characterize the relationship between the foreign lender and the U.S. borrower as a partnership for tax purposes, resulting in treating the contingent interest payment as something other than interest for U.S. federal income tax purposes. The IRS was successful on this argument in Farley Realty Corp. v. Commissioner, 279 F.2d 701 (2d Cir. 1960), aff'g TC Memo 1959-93, in which the Tax Court bifurcated a purported debt instrument into both a loan and the acquisition of an equity interest in a corporation, and held that the appreciation payment was not deductible as interest. The Second Circuit affirmed the Tax Court's holding, indicating that the lack of a fixed maturity date as well as the indefiniteness of the appreciation were both critical factors weighing against the finding of a debtor-creditor relationship with respect to the appreciation payment. See also, GCM 36702 (4/12/1976), in which the IRS recharactered an apparent loan evidenced by a 40-year promissory note as an equity interest in a limited partnership.

On the other hand, there are authorities that support the characterization of a contingent interest payment as interest for federal tax purposes and do not treat the lender and borrower as partners for tax purposes. For one, as noted earlier, Reg. 1.897-1(h), Example 2, clearly indicates that the payment on a SAM that reflects equity participation rights in U.S. real property is considered to be interest for U.S. federal income tax purposes. Moreover, in Rev. Rul. 83-51, 1983-1 CB 48, the Service specifically ruled that the contingent interest feature of a SAM was treated as interest for purposes of [section] 163.

It also is significant that no authorities have cited Farley for the proposition that a supposed debt instrument can be bifurcated into debt and equity components. In fact, Farley is often cited for the necessity of a fixed maturity date in a debt instrument. In addition, commentators have noted that the terms of the SAM in Farley were "clearly distinguishable" from the typical SAM and, therefore, "the case should not cause any apprehension for a SAM lender." (9) For these reasons, and despite Farley (and the other decisions that recharacterize a purported debt instrument into an equity investment), non-U.S. taxpayers should feel comfortable that, if properly structured, the payment on a SAM that reflects the equity participation rights in U.S. real property should be treated as interest for U.S. federal income tax purposes. (10)

* Treaty Benefits--If a back-to-back loan arrangement is used, the IRS also may attempt to deny treaty benefits under Aiken Industries, Inc. v. Commissioner, 56 T.C. 925 (T.C. 1971), and the conduit financing rules (Reg. [section] 1.881-3). In Aiken, the IRS successfully argued that interest payments made by a U.S. corporation to a Honduran corporation (which collected the interest on behalf of a Bahamian corporation) were not exempt from U.S. withholding tax under the U.S.-Honduras income tax treaty then in effect. The Tax Court agreed with the IRS and reasoned that the Honduran corporation, while a valid resident under the U.S.-Honduras treaty, had no "dominion and control" over the funds and was a mere collection agent or "conduit for the passage of interest payments" from the U.S. entity to the Bahamian entity.

Similarly, under the conduit financing regulations, the IRS has the authority to disregard, for purposes of [section] 881, the participation of one or more intermediate entities in a "financing arrangement" where the entities are acting as conduit entities. If the intermediate entity is disregarded under those regulations, the financing arrangement is recharacterized as a transaction directly between the remaining participants to the transaction. A financing arrangement would include back-to-back loans. Therefore, under the conduit financing regulations, the Service would have the ability to disregard the existence of the Norwegian entity, if those provisions are otherwise satisfied.

The weakness in applying the rationale of Aiken or the conduit financing regulations, however, is that the entity making the first loan (i.e., the hybrid entity) is disregarded for U.S. federal income tax purposes and treated as a branch of the Norwegian. As a result, there are no back-to-back interest payments for U.S. federal income tax purposes. Thus, the IRS would have a much more difficult time contending that the Norwegian company is acting as a mere conduit for payments between the U.S. and the hybrid entity.

Finally, the IRS may argue that the regulations under [section] 894(c)(2) should apply to deny treaty benefits. Reg. 1.894-1(d)(1) provides that "an item of income received by an entity [which includes disregarded entities, under Reg. 1.894-1(d)(3)(i)], wherever organized, that is fiscally transparent under the laws of the United States and/or any other jurisdiction with respect to an item of income shall be eligible for reduction under the terms of an income tax treaty to which the United States is a party only if the item of income is derived by a resident of the applicable treaty jurisdiction."

Admittedly, the provision would deny treaty benefits if the interest were paid directly to the hybrid entity, rather than through the Norwegian company to the hybrid entity. That follows because the income would not be considered to be derived by a resident of the treaty jurisdiction. For example, a payment of interest from the U.S. to a disregarded U.S. LLC owned by a Norwegian corporation would not be considered derived by the Norwegian corporation for purposes of obtaining treaty benefits, because the U.S. LLC would not be treated as fiscally transparent under the laws of Norway. The regulations under [section] 894(c)(2) should not be applicable, however, because the interest payments are not being made from the U.S. directly to the hybrid entity but instead are being made to a nonfiscally transparent entity organized in a treaty jurisdiction. The Service would be facing an uphill battle if it attempted to deny treaty benefits in that situation.

Conclusion

With foreign investment in U.S. real estate reaching an all-time high, minimizing the taxes imposed under [section] 897 will remain a critical objective for years to come. Although SAMs raise a host of debt-equity issues, the [section] 897 regulations illustrate that, if structured correctly, SAMs can result in significant tax savings. In addition, with the use of the appropriate treaty jurisdictions, and proper planning, these tax savings may be enjoyed by any non-U.S. taxpayer, regardless of residence.

(1) Foreign Investment in US. Real Estate Continues to Rise, NATIONAL REAL ESTATE INVESTOR, May 1, 2005.

(2) "Foreign Investors Will Reduce U.S. Real Estate Portfolio Allocations," 2004 Association of Foreign Investors in Real Estate Annual Survey.

(3) A nonresident alien individual also will be subject to U.S. federal income tax on U.S. source capital gains if that individual is present in the U.S. for 183 days or more during the tax year and certain other conditions are satisfied. Section 871(a)(2).

(4) See [section] 897(g)and Temp. Reg. 1.897-7T. I.R.M. 4233, [section] 5(13)1(8).

(6) I.R.M. 4.61.12.11(2) (1/1/02).

(7) Sections 871 (a) and 881(a), and [subsection] 1441 and 1442. In general, interest is sourced according to the residence of the debtor. Section 861 (a)(1). Sections 871(h) and 881(c).

(9) Friend, Shared Appreciation Mortgages, 34 HASTINGS L.J. 331 (November 1982), fn. 287. See also Drankoski, Revenue Ruling 83-51: Tax Treatment of Shared Appreciation Payment Mortgages, 4 VA. TAX REV. 409 (Winter 1985).

(10) For example: 1) The terms of the loan should contain a definite maturity date as well as a cap on interest participation; 2) The loan should not be convertible into an equity interest in the borrower, particularly if the economic return to the lender before and after the conversion to equity is substantially the same; 3) The lender should not have effective control over the borrower or the borrower's assets (i.e., the real estate) exceeding that which a lender ordinarily would have; 4) There should be sufficient security for the debt; 5) The loan should be recourse in nature, rather than nonrecourse; 6) There should not be a provision in the loan under which the purported lender is obligated to subordinate to some or all of the borrower's future creditors; and 7) The contingent interest should be based on the borrower's gross receipts rather than on its net income. If the terms of a SAM contain these provisions, it is more likely to withstand I.R.S. scrutiny.

Jeffrey L. Rubinger is an attorney in Holland & Knight's Ft. Lauderdale office. He received his J.D. from the University of Florida and an LL.M. from New York University School of Law. Mr. Rubinger is admitted to the Florida and New York bars and is a certified public accountant.

This column is submitted on behalf of the Tax Section, Mitchell I. Horowitz, chair, and Michael D. Miller, Benjamin A. Jablow, and Normarie Segurola, editors.