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By Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP, New York, NY
This is the seventh in a series of commentaries intended to highlight some of the questions that arise in modern practice under the Foreign Investment in Real Property Tax Act (FIRPTA) where the answers are unclear, and where the Treasury Department and the IRS could usefully provide guidance addressing a host of questions that has existed for many years. This commentary will focus on the application of FIRPTA to participating or convertible debt issued by a partnership owning U.S. real property, including the relationship of the FIRPTA rules to the regulatory scheme employed under the §892 regulations.
The statutory language of FIRPTA, at §897(c)(1)(A), defines two distinct types of "United States real property interests" (USRPIs). The first, set forth in clause (i), is an "interest" in real property located in the United States. While this type of USRPI is colloquially referred to as an interest in "dirt," for reasons that will become clear, I will use the more technical term "Type (A)(i) property." The second, set forth in clause (ii), is any interest, other than an interest solely as a creditor, in a domestic corporation, unless it is established that the corporation is not a "United States real property holding corporation" (USRPHC). I will refer to this as "Type (A)(ii) property."
The FIRPTA regulations expand upon the first statutory category by defining a USRPI to include any interest, other than an interest solely as a creditor, in Type (A)(i) property.1 That is, the regulations apply the "other than solely as a creditor" concept to define what constitutes an "interest" in Type (A)(i) property, creating a new type of USRPI which I'll call "Type P [for participating] property." Type P property would include, for example, a shared appreciation loan or other loan secured by property where the loan gives the lender the right to participate in the profits generated by the property.
The statute does not refer to any type of interest in a partnership. This is presumably because partnerships are tax transparent for FIRPTA purposes, and Congress expected that a partner of a partnership would be treated as owning his share of the partnership's USRPIs.2 But what if a person is not a partner, but instead simply a creditor of a partnership? The normal rules of the Code would not treat a creditor as owning any portion of the partnership's assets, and nothing on the face of FIRPTA does so. However, the regulations just mentioned expressly treat an interest, other than solely as a creditor, in a partnership owning Type (A)(i) or Type (A)(ii) property as, itself, a USRPI, that is, as Type P property.3 Thus, if a foreign person lends money to a partnership and takes back an instrument that entitles him to participate in the profits on sale of a USRPI owned by the partnership, the loan itself is a USRPI in its entirety; it is, in my nomenclature, Type P property.
The regulations go to some length to describe what is meant by the italicized phrase "other than an interest solely as a creditor."4 Essentially, it means any interest entitling its holder to share, directly or indirectly, in the appreciation in value of, or the gross or net proceeds generated by, an underlying USRPI. In the context of Type (A)(ii) property, it has long been clear that an interest in a corporation that takes the form of debt, but that entitles the holder to participate in corporate profits, can be a USRPI. In addition, the legislative history of FIRPTA suggests that even a plain vanilla convertible loan to a USRPHC would be Type (A)(ii) property. The FIRPTA regulations confirm this by providing that any conversion or similar right is an interest other than solely as a creditor.5
Because the FIRPTA regulations treat participating or convertible debt of an entity holding USRPIs as itself a USRPI, the regulations had to address the circumstances in which FIRPTA would apply to tax the holder's gain. The statutory scheme of both §§897 and 1445 does not provide any guidance as to how to treat a participating debt interest in Type (A)(i) property. The regulations plug the gap by providing that when the lender sells its participating interest, the gain on the sale is subject to FIRPTA tax, and to withholding. However, the regulations also state that if the participating debt is paid in accordance with its terms, no amount, not even the "equity kicker" portion, is subject to tax or withholding under FIRPTA.6
This construct gives rise to the rather odd conclusion that if a lender holds convertible debt of a partnership, it will have no incentive to exercise the conversion feature, but will instead wait until the underlying property is sold to be paid in cash. If the lender were to exercise its conversion privilege, its interest would be converted into an actual USRPI that would be subject to tax, not only upon a sale of the partnership interest,7 but also upon a sale by the partnership of the underlying USRPI. The cause of this dissonance may be that the FIRPTA rules were designed to deal with only two types of USRPIs - Type (A)(i) and Type (A)(ii) property - and are not easily reconciled to treating participating debt of a partnership (or of an individual) as a USRPI.
All of this is sort of interesting, but fairly easily planned around. But the dissonance just mentioned leads to an unresolved inconsistency where the holder of the debt is a foreign government entitled to the benefits of §892. That section of the Code exempts from U.S. tax any gain from the sale of stocks, bonds, or other securities. So the basic question is whether a participating or convertible partnership debt attributable to partnership USRPIs can be sold free of tax under §892, or remains subject to tax under FIRPTA.
The §892 regulations were clearly written by a person who read the statutory language of FIRPTA and concluded that there were only two types of USRPIs - Type (A)(i) and Type (A)(ii) property. The drafter apparently never read the portion of the FIRPTA regulations that treats a participating debt instrument issued by a partnership (or even by an individual) owning one or more USRPIs as itself a USRPI.8 The §892 regulations define a "security" (the interest on which is exempt under that section) in a straightforward way. The term includes "any note or other evidence of indebtedness. Thus, an annuity contract, a mortgage, a banker's acceptance or a loan are securities for purposes of this section."9 Clearly, a Type P interest in a partnership is a security within the meaning of §892, the interest on which is exempt and the sale of which would be exempt from U.S. tax.
The §892 regulations are equally clear that gain from the sale of Type (A)(ii) property, e.g., stock of a USRPHC, is exempt under §892 as long as the interest is not an interest in a controlled entity.10 On the other hand, the §892 regulations also clearly state that §892 does not exempt from tax any gain on the sale of Type (A)(i) property.11 The obvious intention was to allow §892 to exempt gain on the sale of stock of a noncontrolled USRPHC, but not gain on the sale of dirt. It clearly never occurred to the author of these regulations that a participating loan to a partnership, which is quite clearly a security within the meaning of §892, could be Type (A)(i) property.
The result is a clear inconsistency in the §892 regulations. If a participating debt of a partnership is treated as a security, which it clearly is, then §892 exempts any gain on its sale from tax under FIRPTA, just as gain on the sale of an interest in a noncontrolled USRPHC is exempt from tax. But if a participating debt of a partnership is treated as Type (A)(i) property, the §892 regulations would allow it to be taxed under FIRPTA. It appears to this writer that the better answer to this conundrum is that participating or convertible debt of a partnership is a security, the sale of which is exempt under §892. The language of §892 is clear on its face, while the FIRPTA rule is not contained in the statute, but only in the FIRPTA regulations.
This commentary also will appear in the April 2012 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Caballero, Feese, and Plowgian, 912 T.M., U.S. Taxation of Foreign Investment in U.S. Real Estate, and Dick, Nikravesh, and Maloney, 913 T.M., U.S. Income Taxation of Foreign Governments, International Organizations, Central Banks, and Their Employees, and in Tax Practice Series, see ¶7140, Foreign Persons - FIRPTA.
1 Regs. §1.897-1(c)(1).
2 See §897(g); Regs. §1.897-1(e)(2).
3 Regs. §1.897-1(d)(1), (3)(D).
4 Regs. §1.897-1(d).
5 Regs. §1.897-1(d)(3)(E). See also Regs. §1.897-1(d)(2)(B) for a rule treating any option to acquire a USRPI as a USRPI. Convertible debt could be viewed as having an embedded option.
6 Regs. §1.897-1(h), Ex. (2).
7 Under current regulations, however, some sales of partnership interests are not subject to tax. See Regs. §§1.897-7T and 1.1445-11T.
8 The §892 regulations state the obvious, which is that a partnership interest is not a "security," but that statement seems clearly to refer only to traditional partnership equity interests. Regs. §1.892-3T(a)(3).
9 Regs. §1.892-3T(a)(3).
10 Regs. §1.892-3T(b), Ex. (1), part (ix).
11 Regs. §1.892-3T(a)(1) (flush language).
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