Section 892 Controlled Commercial Entities: The USRPHC Trap

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By Kimberly S. Blanchard, Esq. Weil, Gotshal & Manges LLP, New York, NY

There are two types of tax traps for the unwary. The first type is a rule that no one expects or knows about and falls into inadvertently. The second type is a rule that the experienced advisor knows about, but falls into anyway, usually because the rule is so irrational that its contours can be fathomed only when one is presented with specific, unique facts. Regs. §1.892-5T(b)(1) is a paradigm of both types. Initiates to §892 would never expect the rule to be there in the first place; and even seasoned practitioners in the area can be tripped up by it. This regulation is particularly vicious because it creates a trap on top of another trap - the §892 rule applicable to “controlled commercial entities.”

Section 892 provides a limited exemption from U.S. tax for foreign governmental entities. That section divides the world of foreign governmental entities into two distinct types, the integral part of the foreign government itself, and a controlled entity. If an integral part of a foreign government engages in what the statute refers to as a “commercial activity,” the income (if any) from that activity will not qualify for exemption (normally it wouldn't anyway, since §892 covers only dividends, interest, and capital gains), but nothing more bad will happen to the foreign government. However, if a controlled entity engages in a commercial activity, the controlled entity is classified as a “controlled commercial entity” and is kicked out of §892 with respect to all of its income, not just the income from that activity. Therefore, no foreign government will want to hold through a controlled commercial entity investments that would otherwise generate exempt income. It follows that foreign governments have to monitor their controlled entities very carefully. This “all or nothing” rule is the underlying trap for the unwary.

Layered on top of this unfortunate rule is the rule of Regs. §1.892-5T(b)(1), which provides as follows:

U.S. real property holding corporations. A U.S. real property holding corporation, as defined in §897(c)(2), or a foreign corporation that would be a United States real property holding corporation if it was a United States corporation, shall be treated as engaged in commercial activity and, therefore, is a controlled commercial entity … .1

This regulation creates a “per se” rule that any controlled entity that is a U.S. real property holding company (a “USRPHC”) will always be a controlled commercial entity that is kicked out of §892.2 In general, a USRPHC is a corporation, 50% or more of the assets of which (by value) consist of U.S. real property interests (“USRPIs”). Not all assets are counted in the denominator of the 50% test; the denominator includes only USRPIs, non-U.S. real property, and assets used in a trade or business.

The per se rule of the regulation makes policy sense where the USRPIs in question consist of U.S. “dirt” (i.e., land, buildings) owned directly or through pass-through entities. Not only is there no §892 exemption for such investments, if 50% or more of the counted assets of a controlled entity consist of U.S. dirt, its inherent commerciality should probably be presumed. However, if the USRPIs owned by the controlled entity consist solely or largely of passive investments in shares of stock of noncontrolled, lower-tier USRPHCs (which are themselves subject to U.S. tax), which would also cause the controlled entity to be a USRPHC, the rule makes no sense viewed in the larger context of §892.

Section 892 exempts from U.S. tax dividends and gains from stock investments in noncontrolled corporations. The exemption trumps FIRPTA.3 If an integral part of a foreign sovereign invests in the stock of one or more noncontrolled USRPHCs, its dividends and gains thereon will be exempt from U.S. tax. The result should be no different if the integral part makes the same investments through a special purpose controlled entity.4

This unfortunate regulation forces foreign sovereigns into wasteful planning to avoid it (and they are the lucky ones - those who do not monitor their ownership structures carefully will fall into the trap). As noted, the trap can be avoided simply by owning noncontrolled USRPHCs directly and not through a controlled entity. However, this will often be impractical. One alternative is to load up the controlled entity with other assets that are not USRPIs. However, for several reasons this is difficult. A controlled entity cannot own non-USRPI business assets included in the denominator of the USRPHC fraction, because if it engages in any commercial activity at all, it will lose the benefit of §892 entirely. That leaves only non-U.S. real property, normally not within the investment profile of the entity in question.

One solution to avoid the trap of the per se rule is to seek to rely on a special rule for determining USRPHC status, found in the FIRPTA regulations. The rule recognizes the fact that, due to the denominator of the USRPHC fraction including only business assets and non-U.S. real property, purely passive investment companies could be treated as USRPHCs if they own only a dime's worth of USRPIs. To remedy this problem, an investment company “kick-out” rule permits a corporation to count its investment assets as “good” trade or business assets in the denominator of the fraction if 90% or more of its assets consist of passive investments in cash, stock, securities, and the like.5 While this sounds promising, the requirement that at least 90% of the corporation's assets consist of investment securities other than USRPIs makes reliance on the investment company kick-out rule difficult in many situations.

A controlled entity might also consider acquiring commercial activity assets (including foreign real estate, where desired) through a controlled (at least 50%) subsidiary. While this sounds counterintuitive, this technique relies upon the fact that the regulations under FIRPTA attribute assets upward from a controlled subsidiary to its parent,6 whereas under the §892 regulations there is no upward attribution from a subsidiary. Thus, the fact that the controlled subsidiary is not entitled to the benefits of §892 does not “taint” the entitlement of the entity that owns its stock.

A §892 investor can also avoid the application of the per se rule where there are other unrelated investors that wish to co-invest in one or more USRPHCs through a “blocker” structure. If the blocker is not itself controlled by the §892 investor, it will not be subject to the per se rule.7

A prior installment in this column mentioned the possibility that the peculiar FIRPTA withholding tax rules applicable to §892 investors might be explained by the presumption of the regulations' drafters that most §892 investors would be ineligible for relief from FIRPTA due to the application of the per se rule discussed herein.8 However, the per se rule can be planned around by well-informed investors. Both the per se rule and the FIRPTA withholding regulations should be amended to eliminate these unwarranted traps for the unwary.

This commentary also will appear in the July 2009 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Rubin and Hudson, 912 T.M., Federal Taxation of Foreign Investment in U.S. Real Estate, and Dick, 913 T.M., U.S. Income Taxation of Foreign Governments, International Organizations and Their Employees, and in Tax Practice Series, see ¶7120, Foreign Persons' U.S. Activities.

1 Emphasis supplied. The italicized language is surplusage, and reflects a basic misunderstanding of the USRPHC rules. A USRPHC can be either a domestic or a foreign corporation.

2 A government pension trust is treated as a controlled entity. However, if such a trust earns only income that would not be unrelated business income if it were a domestic pension trust, it will not be treated as a controlled commercial entity. Regs. §1.892-5T(b)(3). Typically, the FIRPTA assets of a §892 pension trust would not consist of “dirt,” but only of interests in noncontrolled USRPHCs. Such assets would not generate income that would be unrelated business income to a domestic pension fund. Accordingly, it seems that the special rule for pension trusts trumps the per se rule for USRPHCs.

3 Regs. §1.892-3T(b), Example (1)(ix).

4 Regs. §301.7701-2(b)(6) treats an unincorporated entity wholly owned by a foreign sovereign as a per se corporation, and thus, of course, as a controlled entity. To be entitled to rely on §892 at all, the controlled entity must be incorporated in the same country as its owner.

5 Regs. §1.897-1(f)(3)(ii).

6 Regs. §1.897-2(e)(3).

7 Of course, if stock of the blocker is the only asset that the §892 investor owns, we are back to square one. This technique works best where the §892 owner is an integral part of a foreign sovereign.

8 Blanchard, “FIRPTA in the 21st Century, Installment Six: FIRPTA Withholding Where a §892 Investor Is a Partner,” 38 Tax Mgmt. Int'l J. 291 (5/8/09).

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