US Treasury Releases Final And Proposed Regulations On Qualified Foreign Pension Funds And Other Issues Under FIRPTA

• Published date: 25 January 2023
• Subject Matter: Finance and Banking, Employment and HR, Tax, Financial Services, Fund Management/ REITs, Retirement, Superannuation & Pensions, Capital Gains Tax, Withholding Tax
• Law Firm: Mayer Brown
• Author: Ms Michelle M. Jewett, Jeffrey Bruns, Matthew McDonald, JoonBeom Pae, Michael Loquercio and Xiao Xiao

On December 28, 2022, the Treasury Department and the Internal Revenue Service ("IRS") released final regulations regarding the Section 897(l)¹ exception from the Foreign Investment in Real Property Tax Act ("FIRPTA") for qualified foreign pension funds ("QFPFs") ("Final Regulations").² On the same day, the Treasury Department and the IRS also proposed regulations clarifying the treatment of QFPFs under Section 892 and making certain changes to the rules surrounding domestically controlled qualified investment entities and related FIRPTA exceptions ("2022 Proposed Regulations").³

This Legal Update provides a review of certain rules provided in the Final Regulations and the 2022 Proposed Regulations, including comparisons to the prior proposed regulations.

QFPF Final Regulations

The PATH Act⁴ added Section 897(l) in 2015, which provides a complete exemption from taxation under Section 897 for gain or loss recognized by a QFPF attributable to the disposition of, and certain distributions with respect to, United States real property interests ("USRPIs"). On June 6, 2019, the Treasury Department and the IRS released proposed regulations under Section 897(l) ("2019 Proposed Regulations").⁵ The 2019 Proposed Regulations provided guidance regarding the scope of the Section 897(l) exemption, the requirements for an entity to qualify as a QFPF, and related withholding tax rules under Sections 1445 and 1446.

The Final Regulations retain the general approach and structure of the 2019 Proposed Regulations with certain revisions and clarifications that generally are favorable for trusts or other entities seeking QFPF status. In general, the Final Regulations are effective on December 29, 2022, although certain rules will apply with respect to dispositions and distributions occurring on or after June 6, 2019. In addition, an eligible fund may apply the Final Regulations to dispositions and distributions occurring on or after December 18, 2015, provided that the eligible fund and all other relevant persons consistently apply all applicable rules for all relevant years.

1. Scope of the Exception

Under Section 897(l), a QFPF, or an entity all the interests of which are held by a QFPF, is not treated as a nonresident alien individual or a foreign corporation for purposes of Section 897. As such, under the Code, QFPFs (and entities wholly owned by QFPFs) are exempt from FIRPTA with respect to gain attributable to the disposition of USRPIs. The 2019 Proposed Regulations introduced the concepts of "qualified holders," "qualified controlled entities" and "qualified segregated accounts." Under the 2019 Proposed Regulations, gain or loss of a "qualified holder" from the disposition of a USRPI (including a REIT capital gain dividend as described in Section 897(h)) is not subject to Section 897(a) to the extent the gain or loss is attributable to one or more "qualified segregated accounts" maintained by the qualified holder. As defined in the 2019 Proposed Regulations, a qualified holder is a QFPF or a "qualified controlled entity." The Final Regulations generally adopt the relevant concepts related to the scope of the exception as provided in the 2019 Proposed Regulations.

a. Qualified Controlled Entities ("QCEs")

The 2019 Proposed Regulations defined a QCE as a trust or corporation organized under the laws of a foreign country, all of the interests of which are held by one or more QFPFs directly or indirectly through one or more QCEs or partnerships. Commentators requested that a de minimis exception should be allowed for the ownership of a QCE by other persons, including the situation where a QCE inadvertently fails to qualify because one of its co-investors ceases to be a QFPF. The Final Regulations do not adopt these suggestions and reject other suggested approaches that would permit an entity to be a QCE despite limited non-QFPF ownership. The preamble to the Final Regulations states that permitting a person other than a QFPF or another QCE to own an interest in a QCE would impermissibly expand the scope of the Section 897(l) exception by allowing investors other than QFPFs to avoid tax under FIRPTA.

The 2019 Proposed Regulations clarified that an "interest" for purposes of determining whether an entity is a QCE is determined under Treasury Regulations Section 1.897-1(d)(5), which provides that an interest in an entity means an interest in such entity other than an interest solely as a creditor. The Final Regulations do not provide additional guidance regarding the type of ownership interest taken into account in determining the QCE status. The preamble to the Final Regulations references Treasury Regulations Section 1.897-1(d)(3), which further defines an interest in an entity other than solely as a creditor. The preamble also states that "whether an interest in an entity constitutes one of the interests listed under [Section] 1.897-1(d)(3) or is instead disregarded is determined based on the facts, taking into account general tax principles." So there is a risk that a non-economic interest held by a non-QFPF can disqualify an entity's status as a QCE.

b. Qualified Holders

The Final Regulations generally include the same qualified holder rule as provided in the 2019 Proposed Regulations, with certain modifications. The Final Regulations provide two alternative tests that a QFPF or a QCE must satisfy at the time of the disposition of the USRPI or the distribution attributable to gain from such disposition. Under the alternative tests, a QFPF or a QCE is a qualified holder if (1) it owned no USRPIs as of the earliest date during an uninterrupted period ending on the date of the disposition or distribution during which it qualified as a QFPF or a QCE, or (2) it satisfies the applicable testing period requirement.

The testing period is the shortest of (1) the period beginning on the effective date of Section 897(l) (i.e., December 18, 2015), and ending on the date of the disposition or distribution; (2) the ten-year period ending on the date of the disposition or distribution; or (3) the period during which the entity (or its predecessor) was in existence. In other words, the QFPF or QCE must not have held any USRPIs on the date that it most recently became a QFPF or QCE, or it must have continuously qualified as a QFPF or QCE for the ten-year period prior to the applicable disposition or distribution (or, if shorter, since December 18, 2015 or the entire period for which the QFPF or QCE has been in existence).

The Final Regulations include transition rules that provide limited exceptions to compliance with the qualified holder rule. While commentators suggested other approaches with respect to the qualified holder rule, such as a tolling period to remedy the loss of QFPF status, shorter maximum testing period, and mark-to-market or tracing alternatives to the testing period rule, the Final Regulations do not adopt these suggestions.

c. Qualified Segregated Accounts

The 2019 Proposed Regulations defined a "qualified segregated account" as "an identifiable pool of assets maintained for the sole purpose of funding qualified benefits to qualified recipients." The 2019 Proposed Regulations provided separate standards for assets held by eligible funds and assets held by QCEs. The Final Regulations adopt the same rules, but clarify that in the case of assets held by eligible funds a qualified segregated account is maintained so long as contributions to the plan are not more than what is reasonably necessary to fund the qualified benefits to be provided to qualified recipients, even though funds may revert back to the government or employer under the foreign law. This will be a welcome change for pension funds organized under foreign laws that permit a reversion of prior plan contributions in the case of overfunding. However, the Final Regulations do not adopt the recommendation that an eligible fund's interest in a corporation can be treated as a segregated account.

2. Requirements Applicable to a QFPF

a. Established to Provide Retirement and Pension Benefits

The 2019 Proposed Regulations generally provided that a pension fund is considered a QFPF if it is established by either (1) the foreign country in which it is created or organized to provide retirement or pension benefits to participants...