by William H. Newton III
A nonresident, nondomiciliary alien of the United States (NRNDA) may interpose a foreign corporate-related structure in connection with the acquisition of residential real property located in the United States.1 Afterward, the shareholder or members of the shareholder’s family may personally utilize the underlying premises. From the United States income tax perspective, their doing so presents considerations relating to the payment of arm’s length rent, structuring alternatives, and compliance requirements.
At least two basic corporate-related structures may be presented. The first is that in which the NRNDA is the shareholder of a foreign corporation that is itself the parent of an underlying domestic subsidiary. The subsidiary is in turn the direct owner of the realty. Alternatively, the foreign corporation may take title to the realty directly without regard to a domestic subsidiary. Potential U.S. income tax implications vary depending on the specific structure at issue.
The Tax Court decision in G.D. Parker, Inc. v. C.I.R., T.C. Memo. 2012-327 (2012), is illustrative. It addresses the resulting U.S. tax consequences in the foreign corporate parent-domestic corporate subsidiary context. There, two separate houses, one in Key Biscayne (Florida realty), and the other in Valdemossa, Spain (Spanish realty), were directly owned by the same Florida corporation. The ultimate parent of the collective corporate structure was a Panamanian corporation, which was itself wholly owned by Genero Delgado Parker, a citizen and resident of Peru. Parker and his family from time to time personally used both houses during each of the taxable years at issue.2 The Tax Court found that no rent had been paid to compensate the Florida corporation for its personal use of the respective premises.3 Deductions claimed by the Florida corporation, e.g., for repair, maintenance, and depreciation, were essentially disallowed by the court4 with the corresponding imposition of accuracy-related penalties.5
Based on these facts, the Tax Court concluded that the rent-free use of the houses was in substance a constructive dividend that was deemed to have been paid by the Florida corporation up through the corporate chain to Parker individually. As the dividend at inception was treated as having been paid by a domestic corporation and was considered correspondingly as having been received by a foreign person, the deemed payment was classified as U.S.-source fixed or determinable, annual or periodic income. Accordingly, the Florida corporation was held to have been a withholding agent and, as such, was required to have withheld on the deemed dividend at the flat Code rate of 30 percent.6 The collective amount of the dividend was based on the fair rental value of the premises7 during the respective periods of personal usage.
Notably, absent sufficient earnings and profits, it would not have been unexpected for the commissioner to impute rental income to the domestic corporate owner to compensate the corporation for the personal usage of the realty. In this event, the availability of deductions would nevertheless have remained a consideration, but in the computation of taxable income instead of earnings and profits as utilized in computing the amount of the constructive dividend to the foreign shareholder.8
If, in contrast with a domestic corporation, a direct foreign corporate owner had instead been involved, the result may have differed in a real and substantial sense. The distinction rests on the nature and extent that a foreign, as contrasted with a domestic, corporation is subject to U.S. income taxation. While a domestic corporation is subject to worldwide income taxation, a foreign corporation is not taxed on foreign-source rental income as derived from real property.9 More specifically, such income because of its foreign-source status cannot be treated as effectively connected.10 Accordingly, the issue of existence versus nonexistence of a U.S. trade or business is immaterial. For this purpose, the source of rental income from real property is tied to the location of the realty. If the realty is located in the U.S., the rental income is U.S.-source but, if located abroad, it is foreign source.11
These precepts may be illustrated by a structuring anomaly inherent in Parker. There, the collective real property at issue included the Spanish realty. If leased, because of its location in Spain, the realty would have given rise to foreign and not U.S.-source income. Accordingly, if owned by a foreign, instead of as in Parker a domestic, corporation, only foreign-source rental income in respect thereof would have been derived. Since existence of a U.S. trade or business would in such context have been immaterial, no second tier tax as based on distributions, whether actual or constructive, to the foreign shareholder would have arisen.12 Thus, under such a factual scenario, the amount of the constructive dividends as imputed from the Florida corporation and as based on the Key Biscayne property would have correspondingly been reduced.
Drawing on a further variation of the facts in Parker, if the Florida realty had been owned by a foreign corporation with U.S.-source rental income then being at issue, the existence versus nonexistence of a U.S. trade or business would have been material. Whether a U.S. trade or business exists is a factually intensive consideration. Resolution is tied to whether the activities of the foreign corporate owner with respect to the realty are regular and continuous, as opposed to isolated and sporadic, with the corporation, instead of the tenant, maintaining responsibility for paying the expenses associated with real property operations.13 The factual inquiry and the potential uncertainty regarding the existence of a United States trade or business may be and often is eliminated through the exercise of the Code net basis election.14
The election allows the foreign corporate owner of the realty to be treated as engaged in a U.S. trade or business irrespective of whether an actual trade or business exists in fact. Correspondingly, the rental income is thereby treated as effectively connected with the deemed trade or business, such that deductions, e.g., real property taxes, insurance, repairs, depreciation, etc., are automatically taken into account in the computation of taxable income. Otherwise, absent an actual or deemed U.S. trade or business, the rental income would be taxed on a gross basis at a flat 30 percent rate, as applicable to U.S.-source fixed or determinable annual or periodic income, without the benefit of deductions.15 Additionally, as depreciation adjustments are generally for depreciation allowed or allowable, a downward adjustment in the basis of the underlying realty may thereby also occur with no tax benefit for the depreciation itself.
The existence of a U.S. trade or business likewise activates the requirement that a foreign corporation file a true and accurate income tax return. Such a return if not filed within 18 months of the basic corporate return due date is typically not deemed to be true and accurate.16 The result, as in the case of the 30 percent flat tax, is the loss of deductions otherwise available and thus taxation on a gross rather than a net basis. Implicit in such context is that deductions will be lost irrespective of the existence of a U.S. trade or business.
It is emphasized that the matter of the loss of deductions relates only to foreign corporations as the owners of U.S. real property and not to foreign corporations in respect of foreign real property. Accordingly, if theoretically a foreign corporation had owned both the Spanish realty and the Florida realty, the foreign-source rental income would not have been subject to U.S. income taxation irrespective of the existence of an actual trade or business as conducted or as deemed to have been conducted with respect to the Florida realty. Correspondingly, in the domestic corporate context, considerations regarding the Code net basis election and the filing of a corporate return within 18 months of the basic return due date likewise all become immaterial.
The effect is to encourage the use of a domestic subsidiary of a foreign corporation coupled with the requirement that arm’s length rental be paid to such subsidiary in the context of residential real property located in the U.S. However, by contrast, for real property located abroad, the owner thereof should be a foreign and not a domestic corporation. In this latter scenario, the payment of rental, whether or not arm’s length, would then be unnecessary.
1 The principal rationale for the interposition of a foreign corporation is to ensure inapplicability of the federal estate tax with respect to U.S. situs real property. Treas. Reg. §20.2105-1(f) (shares of stock in foreign corporation are foreign situs property for estate taxation). See also I.R.C. §2104(a) (shares of stock in a domestic corporation have a U.S. situs).
2 The court found the absence of a corporate business purpose other than for the use of the ground floor by Parker’s administrative assistant. See Parker, T.C. Memo 2012-327 at 49, 53.
3 The alleged payment of rent through the reduction of a purported loan was rejected. See Parker, T.C. Memo 2012-327 at 54 and 55.
4 Only a percentage of the deductions for the Florida realty was allowed as attributable to the ground floor office. See Parker, T.C. Memo 2012-327 at 47.
5 The court in imposing accuracy-related penalties with respect to the real property deductions also found the absence of reasonable cause and good faith. See Parker, T.C. Memo 2012-327 at 64, 69-70.
6 I.R.C. §881(a)(1).
7 The testimony of expert witnesses was presented as to the fair rental value of the Florida realty. The court accepted the report of the commissioner’s expert in finding the fair rental value of the Florida realty to be $21,000, $23,000, and $23,000 per month for 2003, 2004, and 2005, respectively with a Rule 155 adjustment being necessary to take into account the usage of the ground floor by the administrative assistant. The amount of fair rental value of the Spanish realty was not contested by the commissioner. See Parker, T.C. Memo 2012-327 at 57-59. Though the petitioner reported rental income on its income tax returns for the years at issue, an inadequate level of income was, thus, reported for the Florida realty. Moreover, due to the disallowance of deductions, earnings and profits for dividend purposes were necessarily enhanced for both properties.
8 While taxable income is the starting point in the computation of earnings and profits, adjustments are then applied to eliminate items which were incorporated into the Code based on tax policy rather than economic considerations, e.g., deductions. To illustrate, earnings and profits are not affected by a loss sustained in a prior year, e.g., a net operating loss. Treas. Reg. §1.312-6(d). Likewise, the depreciation period for real property is also generally lengthened in the computation of earnings and profits. I.R.C. §§312(k)(3)(A) and 168(g)(2).
9 I.R.C. §881(a)(1).
10 I.R.C. §864(c)(4).
11 I.R.C. §861(a)(4) and §862(a)(4).
12 The branch profits tax under such a scenario would not have been activated. I.R.C. §884.
13 See, e.g., Schwarcz v. C.I.R., 24 T.C. 733 (1955), acq., 1956-2 C.B. 4.
14 I.R.C. §882(d).
15 I.R.C. §881(a)(1) and §882(c)(1).
16 I.R.C. §882(c)(2) and Treas. Reg. §1.882-4(a)(3)(i). See also Swallows Holding, Ltd. v. C.I.R., 515 F.3d 162 (3d Cir. 2008) (upholding validity of 18-month filing requirement as imposed by regulations).
William H. Newton III is author of the two-volume treatise International Income Tax and Estate Planning, published by Thompson-West, a practicing attorney in Miami, an adjunct professor of law in the master’s of tax and estate planning programs at the University of Miami of Law for over 25 years, author of numerous articles regarding international tax and international estate planning, and a graduate of the Massachusetts Institute of Technology and Southern Methodist University.
This column is submitted on behalf of the Tax Law Section, Joel David Maser, chair, and Michael D. Miller and Benjamin Jablow, editors.