New Russian CFC Rules Will Impact Inbound U.S. Tax Planning
According to recent estimates, the number of wealthy Russians investing in the United States ballooned in 2014 as a result of political turmoil and a disintegrating ruble causing Russians to seek a safe haven for their wealth abroad. The amount of private net capital flowing out of Russia hit $120 billion by the end of 2014, according to a recent report. That projection would nearly double the $61 billion in outflows Russia saw in 2013, according to data from the Russian Central Bank.
The primary investment sought by wealthy Russians typically has been U.S. real estate in cities such as New York and Miami. From a U.S. federal income tax perspective, the main 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 897 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.
Typical Structure for U.S. Real Estate Investment
A recent New York Times article indicates that many of the real estate investments are structured through “shell” companies, such as LLCs and partnerships. Historically, this would allow the Russian investor to hide their cash in real estate without needing to disclose their ownership to the Russian tax authorities.
For example, a typical inbound real estate structure by a Russian investor may involve establishing a U.S. LLC to acquire the property (the LLC likely will be treated as a corporation for U.S. tax purposes and serve as a “blocker” corporation) and a company established in a low-tax jurisdiction, such as the British Virgin Islands (BVI), that would lend money to the U.S. LLC in an attempt to strip out a large portion of the income or gain from the sale of the property in the form of deductible interest (subject to the Section 163(j) “interest stripping” provisions that seek to minimize the amount of deductible related party interest that is allowed where no U.S. tax is imposed on such interest). This structure allows the Russian investor to minimize the U.S. federal income tax consequences of an investment in U.S. real estate, which in many cases could be as high as 54.5 percent when taking into account the U.S. corporate income tax rate of 35 percent plus the 30 percent branch profits tax) while at the same time avoid having to file a U.S. income tax return. As discussed below, however, the recent enactment of Russian controlled foreign corporation (CFC) rules certainly will have an impact on the type of structures used by Russians to invest in U.S. real estate.
Russian CFC Rules
The Russian CFC rules, which are effective January 1, 2015, will require Russian tax residents (individuals and companies) to disclose their foreign ownership and to pay tax on profits generated by CFCs (even before such profits are distributed to Russia). The tax rate will be 20 percent for Russian corporations and 13 percent for Russian individual residents. Russia will allow, however, a foreign tax credit for withholding taxes incurred in the jurisdiction of the CFC. Beginning in 2018, penalties also will be imposed in Russia for failure to disclose the ownership of a CFC and failure to report the income attributable from the CFC.
A foreign company will be considered a CFC for Russian tax purposes if: (i) the foreign company (which includes a fund/foundation, partnership, trust or other form of collective investment or trust management that is entitled to conduct profit generating activities) is not a Russian tax resident; (ii) and the Russian tax resident owns more than 25 percent of the company (in 2015, more than 50 percent), or more than 10 percent if the aggregate ownership of all Russian tax residents in the CFC exceed 50 percent. Russian tax residents also will be considered as controlling persons (regardless of the level of their ownership) if they have the ability to control or influence decisions regarding the distribution of profits of the CFC.
Certain profits of a CFC, however, will be exempt from Russian taxation, including (i) profits derived by a CFC established in member countries of the Eurasian Economic Union (which includes Russia, Belarus, Kazakhstan, and Armenia); (ii) profits of a CFC that is resident in a jurisdiction that has a tax treaty with Russia (it is not clear whether this is limited to income tax treaties or also includes exchange of information treaties) and the effective tax rate in the jurisdiction where the CFC is resident is at least 75 percent of the average Russian weighted tax rate; and (iii) profits of a CFC that is resident in a double tax treaty country if the passive income of the CFC does not exceed 20 percent of its total income.
Implications and Alternative Planning
With the enactment of the new CFC rules in Russia, the use of a leveraged U.S. blocker entity along with a BVI company to strip out a large portion of the U.S. source income in a tax-free manner no longer will be the most tax efficient strategy. Under the CFC rules, the Russian investor will be required to report the ownership of the BVI company and will be required to pay tax currently on the income of such entity whether or not that income is distributed. Given that the effective U.S. income tax rate at the blocker level will be somewhere close to 17 percent and these taxes will not be creditable against the Russian tax incurred under the CFC rules, other structures certainly would seem to be more tax efficient.
One such structure may be for the Russian investor to simply lend money to the U.S. real estate venture and take back a “shared appreciation mortgage” (SAM) (i.e., a loan that contains an equity kicker feature). 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, however, SAMs would appear to be an attractive option, especially with their tax treatment under FIRPTA and certain provisions of the U.S.-Russia income tax treaty (the “Treaty”).
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 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). Regulation Section 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 appreciation in value of, or in the gross or net proceeds or profits generated by, an interest in real property of the debtor is, in its entirety, an interest in real property other than solely as a creditor.”
This principle is illustrated by example in Regulation Section 1.897-1(d)(2)(i):
A non-U.S. taxpayer lends money to a U.S. resident to use in purchasing a condominium. The nonresident lender is entitled to receive 13 percent annual interest for the first ten years of the loan and 35 percent of any appreciation in the FMV of the condominium at the end of the ten-year period. The example concludes that, because the lender has a right to share in the appreciation of the value of the condominium, he has an interest other than solely as a creditor in the condominium (i.e., a USRPI). 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.” Although Section 897 does not define “disposition,” Regulation Section 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.”
With respect to SAMs, Regulation 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.
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. Non-U.S. taxpayers generally are subject to a 30 percent withholding tax (unless reduced by treaty) on certain passive types of U.S. source income, including interest. An important exception to this rule exists for “portfolio interest,” which is exempt from withholding tax in the U.S. Portfolio interest, however, does not include certain “contingent interest.” For this purpose, contingent interest is defined as interest that is determined by reference to any of the following: (i) any receipts, sales, or other cash flow of the debtor or related person; (ii) any income or profits of the debtor or a related person; (iii) any change in value of any property of the debtor or a related person; (iv) any dividend, partnership distribution, or similar payments made by the debtor or a related person; and (v) any other type of contingent interest that is identified in Regulations, where a denial of the portfolio interest exemption is necessary or appropriate to prevent avoidance of federal income tax. 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.
This is where the Treaty comes into play. Under Articles 10 and 11 of the Treaty, all interest, including contingent interest, is exempt from U.S. withholding tax, so long as the interest is not rechacterized as a dividend under U.S. tax law. As noted above, the FIRPTA regulations clearly indicate that contingent interest on a SAM will be respected as interest and will not be characterized as a dividend simply because of the contingent nature of the payment. As a result, so long as the other requirements of the Treaty (including the “Residence” and “Limitations on Benefits” provisions) are satisfied, a Russian investor lending money to a U.S. real estate venture should be able to participate in the upside of the venture without being subject to the FIRPTA provisions and also avoid the Russian CFC rules. (Of course, the Russian investor will have to report the income generated from the U.S. real estate project in Russia (but not necessarily repatriate such income to a Russian bank account) but with individual tax rates in Russia only being 13 percent at the present time, such an arrangement certainly will be more tax efficient than most other structures. In addition, U.S. estate tax also will need to be considered if this structured is utilized by an individual Russian resident because a debt instrument with a contingent interest feature will be treated as a U.S.-situs asset and therefore subject to U.S. estate tax unless further planning were done).