Background on FIRPTA and DCQIE Exception

Section 897(a)(1) provides that gain or loss of a nonresident alien individual or foreign corporation from the disposition of a United States real property interest (USRPI) is treated as if the nonresident alien individual or foreign corporation were engaged in a trade or business within the United States. Section 897(h)(1) generally provides that any distribution by a qualified investment entity (QIE) to a nonresident alien individual, a foreign corporation, or other QIE, to the extent attributable to gain from sales or exchanges by the QIE of USRPIs, is treated as gain recognized by such nonresident alien individual, foreign corporation, or other QIE from the sale or exchange of a USRPI. For this purpose, Section 897(h)(4)(A) defines a QIE as any (i) real estate investment trust (REIT), and (ii) regulated investment company (RIC) which is a United States real property holding corporation (USRPHC) or which would be a USRPHC if certain exceptions did not apply to interests in any REIT or RIC.

Section 897(h)(2) provides that a USRPI does not include an interest in a DCQIE (“DCQIE Exception”). A QIE is "domestically controlled" (i.e., a DCQIE) if less than 50% of the value of its stock is held "directly or indirectly" by foreign persons at all times during the testing period prescribed in section 897(h)(4) (generally, the five-year period ending on the date of the disposition). In PLR 200923001 (the "2009 PLR"), the IRS ruled that QIE stock held by US C corporations would be treated as "domestically owned" for purposes of the DCQIE determination, even if the US C corporations were owned primarily by foreign investors.

The Look-Through Rule

The Proposed Regulations interpret the term "directly or indirectly" in section 897(h)(4)(B) by using a "look through" approach in determining QIE ownership. The term "look-through persons" means any person other than a "non-look-through person." The term "non-look-through person" means, among others, an individual, a US C corporation (other than a foreign-owned domestic corporation), a nontaxable holder, a publicly traded partnership (domestic or foreign), or an estate (domestic or foreign). The upward attribution process required by Prop. Treas. Reg. § 1.897-1(c)(3)(ii)-(iii) continues until all QIE stock is treated as owned by one or more non-look-through persons. If a US C corporation is non-public and foreign persons hold directly or indirectly 25% or more of the corporation's stock (by value), then such corporation is a "foreign-owned domestic corporation" and is therefore a look-through-person.

In sum, for purposes of determining whether a QIE qualifies as a DCQIE, the Look-Through Rule provides that partnerships, trusts, and non-public US C corporations with foreign ownership of 25% or greater are all treated as look-through persons, such that any QIE stock owned by such an entity, whether directly or by attribution from a lower-tier entity, is attributed upstream through successive look-through entities until all QIE stock is treated as held exclusively by non-look through persons. The preamble to the Proposed Regulations suggests the Look-Through Rule is aimed at the use of intermediary US C corporations by foreign investors to create DCQIEs. 

The most troubling aspect of the Proposed Regulations is the treatment of US C corporations. Although US C corporations are generally treated as non-look-through persons, Prop. Treas. Reg. § 1.897-1(c)(3)(iii)(B) provides that a limited look-through approach should apply to non-public US C corporations in which foreign persons hold a 25% or more interest. In effect, the Look-Through Rule mandates that a foreign-owned US C corporation must be looked through to determine whether a QIE is domestically controlled.  The Proposed Regulations provide no grandfathering of existing structures. 

Analysis and conclusion

Taxpayers and tax advisors are perplexed by the Look-Through Rule as it flip-flopped the long-standing position of the 2009 PLR.  Given that, when enacting the PATH Act, Congress considered the 2009 PLR to be an appropriate description of the status quo with respect to DCQIE determinations (see Joint Committee on Taxation Report, JCX-144-15, at 184), the bewilderment of the tax community is understandable. Also, many believe that the Look-Through Rule is inconsistent with the statute.  Neither section 897(h)(4)(B), nor any other section of the Code, defines the term "directly or indirectly," nor does any portion of section 897 provide for the application of constructive ownership rules to the determination of DCQIE status. If Congress intended for the term "directly or indirectly" in section 897(h)(4)(B) to already incorporate a look-through concept in the case of QIE stock held by a US C corporation, the special ownership rules in section 897(h)(4)(E) would not be needed, as the upstream attribution would already have resulted from such a look-through concept. Further, the Look-Through Rule effectively equates "direct or indirect" ownership with "constructive" ownership.  These two concepts are not the same and courts have consistently held that constructive ownership can be imputed only when specifically authorized by the Code.

Readers should note that, because of the five-year look-back period for determining DCQIE status, the Look-Through Rule will impact existing US real estate investment structures as well. Thus, foreign investors and investment sponsors will need to closely scrutinize their existing US real estate investment structures in light of the Look-Through Rule. For example, did the sponsor already rely on the existing DCQIE rules (including the 2009 PLR) and contractually commit to such structures with its foreign investors (e.g., via a side letter)?  Given that the Proposed Regulations would apply only to transactions occurring on or after they are finalized (although taxpayers can rely on them in the interim) should the sponsor exit those DCQIE investments? Going forward, do sponsors need to restrict ownership by foreign investors and/or conduct detailed diligence to determine the ownership of any US C corporation investors? These are some of the many questions coming out of Treasury's Pandora’s Box, with which taxpayers and tax advisors are coping. 

Although some believe that the validity of the Look-Through Rule will be challenged under the two-prong test provided by Chevron USA., Inc. v. Natural Resources Defense Council, Inc., 467 US 837, 863-64 (1984), if finalized in its current form, the Look-Through Rule will cause many foreign investors and investment sponsors of US real estate to reevaluate their expectations and consider alternative structuring ideas. More to come as the Look-Through Rule undergoes the notice-and-comment process.