IRS Rules Total Return Swap Tied to Real Estate Index Is Not Subject to FIRPTA
In a significant taxpayer-friendly ruling (Rev. Rul. 2008-31), the IRS ruled that a total return swap, the return of which was calculated by reference to a broadly based real estate index, does not give rise to a United States real property interest (USRPI) for purposes of §897. The ruling is noteworthy for non-U.S. persons investing synthetically in U.S. real estate-related assets for at least two reasons. First, because of the broad definition of what constitutes a USRPI under the §897 regulations, it would not have been much of a stretch for the IRS to contend that a foreign person’s long position in a swap that is tied to U.S. real property is a USRPI for U.S. federal income tax purposes. Second, given all of the recent press dealing with the use of derivatives by foreign persons (primarily offshore hedge funds) to convert what would otherwise be U.S. source income into foreign source income, it is somewhat surprising that the IRS issued a positive ruling in this regard to begin with.
This article will examine the ruling and discuss its broader implications to non-U.S. persons investing in U.S.-real estate related assets through total return swaps.
Total Return Swaps in General
A total return swap is a cash-settled bilateral contract, in which each party agrees to make certain payments to the other depending on the value and distribution performance of the underlying asset. An investor may enter into a total return swap either 1) to simulate an investment in the underlying asset without actually acquiring the underlying equity (i.e., a synthetic long position), or 2) to divest oneself of the economic exposure to a particular asset without actually disposing of the underlying asset (i.e., a synthetic short position).
With respect to a synthetic long position, the following example illustrates how a total return swap over the shares of a publicly traded stock generally would operate. Assume a foreign investor believes that ABC, Inc., stock will appreciate and generate high yields over the next several years. For tax and other considerations, instead of investing directly in the shares of ABC, Inc., the foreign investor enters into a five-year total return equity swap with an investment bank with respect to 1,000 shares of ABC, Inc., stock. At the end of each year, 1) the bank pays the investor an amount equal to the sum of a) any distributions paid with respect to the ABC, Inc., shares during the year and b) the increase, if any, in the fair market value of the ABC, Inc., shares over the course of the year; and 2) the investor pays to the bank an amount equal to the sum of a) an interest rate (e.g., the London Interbank Offered Rate or LIBOR) multiplied by the value of the ABC, Inc., shares at the beginning of the year and b) the decrease, if any, in the fair market value of the ABC, Inc., shares over the course of the year. Although it is not required to do so, the bank will purchase a certain number of shares of ABC, Inc., stock to hedge its position under the swap.
The total return swap qualifies as a notional principal contract (NPC) for U.S. federal income tax purposes. For this purpose, an NPC is defined as a financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts. The specified index would be the ABC, Inc., stock and the notional principal amount would be the value of 1,000 shares of ABC, Inc., stock.
For U.S. federal income tax purposes, the swap payments received by the foreign investor would be exempt from U.S. withholding tax. The reason is that payments made pursuant to an NPC typically are sourced according to the residence of the recipient, and, therefore, would generate foreign source income in the example described above. This is a much better after-tax result than the foreign investor would achieve if it invested directly in the shares of ABC, Inc., stock because any U.S. source dividend payments generally would be subject to a 30 percent U.S. withholding tax unless reduced by an applicable income tax treaty.
FIRPTA in General
Foreign persons are subject to U.S. federal income taxation on a limited basis. Unlike U.S. persons, who are subject to U.S. federal income tax on their worldwide income, foreign persons generally are subject to U.S. taxation on two categories of income:
· Certain passive types of U.S. source income (e.g., interest, dividends, rents, annuities, and other types of “fixed or determinable annual or periodical income,” collectively known as FDAP).
· Income that is effectively connected to a U.S. trade or business (ECI).
FDAP income is subject to a 30 percent withholding tax that is imposed on a foreign person’s gross income (subject to reduction or elimination by an applicable income tax treaty) and ECI is subject to tax on a net basis at the graduated tax rates generally applicable to U.S. persons.
From a U.S. federal income tax perspective, the primary obstacle facing foreign persons who invest in U.S. real estate is the Foreign Investment in Real Property Tax Act (FIRPTA), or more specifically Section 897. Under this provision, any gain recognized by a foreign person on the disposition of a USRPI will be treated as if such gain were ECI and, therefore, subject to U.S. federal income tax at the graduated rates that apply to U.S. persons. The source of such gain automatically will be treated as U.S. source income. Additionally, when §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 §1445.
Section 897 represents a major departure from the U.S. federal income tax rules generally applicable to foreign persons’ gain from the disposition of U.S. source capital assets. Foreign persons typically are not subject to U.S. federal income tax on U.S. source capital gains unless those gains are ECI. As stated above, §897 treats any gain recognized by a foreign person on the disposition of a USRPI as if it were U.S. source ECI.
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).Treasury Regulation §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.”
Which Source Rules Apply?
Before the issuance of the ruling, there was no guidance on how the NPC rules work in conjunction with the FIRPTA provisions. In fact, the only mention of these two provisions in the same sentence was in a 1993 statement in the preamble to the NPC regulations indicating that “[t]he IRS is considering whether notional principal contracts involving … [certain] specified indices (e.g., United States real property) are subject to Section 897.” This statement led some practitioners to believe that payments and gains with respect to total return swaps on USRPIs are not subject to the FIRPTA provisions. In that case, the NPC residence-based source rules (which result in nontaxable foreign source income for a foreign taxpayer) would trump the general source rules under FIRPTA (which automatically provide for U.S. source effectively connected income). The ruling, albeit with somewhat restrictive facts, provides support for this position.
At issue in the ruling is whether an interest in a total return swap, the return on which is calculated by reference to a broadly based real estate index, is a USRPI for purposes of §897. In the ruling, a foreign corporation (FC) enters into a swap (which qualifies as an NPC for U.S. federal income tax purposes) with an unrelated counterparty, a domestic corporation (DC). The swap is tied to the performance of an index maintained and widely published by Taxpayer X. Neither FC nor DC is related to X.
The index seeks to measure the appreciation and depreciation of residential or commercial real estate values within a metropolitan statistical area (MSA), a combined statistical area (CSA) (both as defined by the U.S. Office of Management and Budget), or a similarly large geographic area within the United States. The MSA, CSA, or similarly large geographic area has a population exceeding one million people. The index is calculated by reference to 1) sales prices (obtained from various public records), 2) appraisals and reported income, or 3) similar objective financial information, each with respect to a broad range of real property holdings of unrelated owners within the relevant geographic area during a relevant testing period. Using proprietary methods, this information is weighted, aggregated, and mathematically translated into the index. Because of the broad-based nature of the index, an investor cannot, as a practical matter, directly or indirectly own or lease a material percentage of the real estate, the values of which are reflected by the index.
Pursuant to the swap, FC profits if the index appreciates (i.e., to the extent the underlying United States real property in the particular geographic region appreciates in value) over certain levels. Conversely, FC suffers a loss if the index depreciates (or fails to appreciate more than at a specified rate). During the term of the swap, DC does not, directly or indirectly own or lease a material percentage of the real property, the values of which are reflected by the index.
Without much analysis, the IRS concludes that, because of the broad-based nature of the index, the NPC does not represent a “direct or indirect right to share in the appreciation in the value. .. [of] the real property” within the meaning of Treasury Regulation §1.897-1(d)(2). Accordingly, FC’s interest in the NPC calculated by reference to the index is not a USRPI for purposes of §897.
Significance of the Ruling
While there are undoubtedly a number of critical factors in the ruling that limit its application to a broader setting, including the fact that 1) neither party to the swap are related to Taxpayer X, 2) because of the broad-based nature of the index, an investor cannot, as a practical matter, directly or indirectly own or lease a material percentage of the real estate, the values of which are reflected by the index, and 3) during the term of the swap, DC does not directly or indirectly own or lease a material percentage of the real property, the values of which are reflected by the index, the ruling itself is still significant. As noted earlier, the §897 regulations broadly define a USRPI to include “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.” Clearly, under the facts of the ruling the terms of the swap allow the foreign counterparty, FC, to share in the appreciation in the value of U.S. real property by profiting under the contract if the index appreciates over certain levels. Therefore, it is somewhat surprising that the IRS ruled that the swap did not give rise to a USRPI.
It is evident that the most important factor in the ruling is, because of the broad-based nature of the index, FC’s inability to, directly or indirectly, own or lease a material percentage of the real estate, the values of which are reflected by the index. The question, however, is how broadly based does the index need to be in order for a swap, the performance of which is tied to that index, not to constitute a USRPI for purposes of §897? Based on the facts of the ruling, it would seem to be sufficient if the index not only measured the appreciation or depreciation of commercial or residential real estate in major metropolitan areas, such as New York, Chicago, or San Francisco, but also smaller cities, such as Ocala, Florida, so long as the population in that area exceeds one million people. A similar issue that is not addressed is what constitutes the direct or indirect ownership or lease of a “material” percentage of the real estate in a particular area for purposes of the ruling? In an unrelated context, at least one court has held that 73 percent constitutes a “material” percentage for purposes of determining whether an acquisition of assets for stock and cash constitutes a tax-free reorganization.
Furthermore, another important concern that is not clearly addressed in the ruling is whether a total return swap could be tied to the performance of something other than a broadly based real estate index (such as shares in a REIT) in order not to constitute a USRPI, so long as the foreign investor could not, as a practical matter directly or indirectly own or lease a material percentage of the real estate owned by the REIT.Foreign taxpayers generally need to be concerned about two types of REITs for U.S. federal income tax purposes: 1) domestically controlled REITs, and 2) publicly traded REITs.
The significance of an REIT being domestically controlled for this purpose is that shares in such REIT will not constitute a USRPI for purposes of §897. As a result, gain realized by a foreign taxpayer from the disposition of the shares in a domestically controlled REIT will not be subject to U.S. federal income tax. Distributions, however, by a domestically-controlled REIT to a foreign taxpayer to the extent attributable to gain from the sale or exchange of USRPIs will be taxable under §897(h) and subject to withholding tax under §1445(e)(6). Accordingly, from a U.S. federal income tax perspective, it would appear to be more beneficial for a foreign taxpayer to gain economic exposure to shares in a domestically controlled REIT by means of a total return swap, rather than acquire the REIT shares directly. This results from the fact that any swap payments tied to distributions from the REIT to the extent attributable to gain from the sale or exchange of USRPIs will be exempt from U.S. withholding tax under the NPC rules, as opposed to being taxed under the general §897(h) and §1445(e)(6) rules.
The question, however, is whether in this scenario the interest in the swap would be excluded from USRPI treatment under the ruling. It would seem that where the underlying asset itself (i.e., shares in a domestically controlled REIT) is not a USRPI under §897, that a long position in a swap, the performance of which is tied to the value and distribution performance of the REIT shares, would not constitute a USRPI as well. Assuming this is the result, the IRS would only have the ability to tax the foreign investor under §§897(h) and 1445(e)(6) if the swap caused the foreign investor to be treated as the actual owner of the REIT shares under common law principles. Given the differences between actual share ownership and a long position in a swap with respect to shares in a domestically controlled REIT, the IRS likely would be facing an uphill battle in this regard. This would seem to be the case, regardless of whether the foreign investor could, as a practical matter, directly or indirectly, own or lease a “material” percentage of the real estate owned by the domestically controlled REIT.
A similar issue may arise with respect to shares in a publicly traded REIT, depending on the level of ownership held by the foreign taxpayer in such REIT. Foreign taxpayers who do not own more than five percent of any class of stock in a publicly traded REIT will not be taxed under §897 on either a disposition of the REIT shares or on the receipt of a distribution from the REIT, regardless of whether the distribution is attributable to gain from the sale or exchange of USRPIs. A foreign taxpayer, however, who owns more than five percent of a publicly traded REIT will be subject to U.S. federal income tax under Section 897 on any gain realized from the disposition of the REIT shares (assuming the REIT is not domestically controlled and constitutes a U.S. real property holding corporation) and on any distributions from the REIT to the extent attributable to gain from the sale or exchange of USRPIs.
Because of the adverse U.S. federal income tax consequences that would result to a foreign taxpayer who directly owns more than five percent of a publicly traded REIT, it would appear that an investment in a swap with respect to a greater than five percent interest in a publicly traded REIT would yield a much higher after tax return than would a direct investment in the REIT shares. As previously indicated, this is because the swap payments would be exempt from U.S. withholding tax. The ruling, however, does not appear to address the issue of whether the swap in this scenario would be excluded from USRPI treatment under §897, if the foreign investor could not, as a practical matter, directly or indirectly own or lease a “material” percentage of the real estate owned by the REIT.
Whether the Maturity of a Swap Constitutes a “Disposition” Under §897
A final (and much more difficult) issue that the ruling does not address, assuming the interest in the swap does constitute a USRPI for purposes of §897, is whether the maturity of the swap gives rise to a taxable “disposition” of such USRPI. As noted earlier, §897 is triggered only when a foreign taxpayer disposes of a USRPI. Although §897 does not define the term “disposition,” the §897 regulations provide that the term 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 a total return swap, a disposition could possibly result on either the maturity of the swap or upon a termination or assignment of the swap, depending on the characterization of the swap payments. Three types of payments are made in connection with a total return swap: 1) periodic payments, 2) nonperiodic payments, and 3) termination payments. A periodic payment is defined as a payment made or received pursuant to an NPC that is payable at intervals of one year or less during the entire term of the contract, that is based on a specified index, and that is based on a single notional principal amount. A nonperiodic payment, on the other hand, is a payment made or received with respect to an NPC other than a periodic payment or termination payment.
Finally, a termination payment is defined as a payment made or received to extinguish or assign all or a proportionate part of the remaining rights and obligations of any party under a NPC. Of these three categories of payments, the only one that likely gives rise to a disposition for purposes of §897 is a “termination payment.”
This conclusion is based on the effect of §1234A, which provides that “gain or loss attributable to the cancellation, lapse, expiration, or other termination of a right or obligation with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer shall be treated as capital gain or loss from the sale of a capital asset.” Proposed regulations under §1234A specifically confirm that any gain or loss arising from the termination of a swap is subject to §1234A. Assuming a position in a swap constitutes a capital asset in the hands of the taxpayer (which generally should be the case unless the taxpayer is a swaps dealer), a payment made or received to terminate the swap should constitute a sale of that position for purposes of §1234A. As noted above, because the term “disposition” includes a sale, a termination payment clearly should give rise to a disposition for purposes of §897.
On the other hand, the IRS apparently believes that the receipt of periodic and nonperiodic payments do not constitute a “cancellation, lapse, expiration or other termination” with respect to a capital asset. The IRS has ruled that the receipt of periodic payments (including the final periodic payment) does not result in a §1234A “sale” because such payments are simply made according to the original terms of the contract. Similarly, the IRS has ruled that the receipt of nonperiodic payments does not give rise to a §1234A “sale” because such payments do not terminate an NPC. Proposed regulations issued under §1234A confirm these results.
Furthermore, the §897 regulations appear to indicate by way of example that the receipt of the final periodic and nonperiodic payments on the maturity of the swap should not result in a §897 disposition. 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 §897 will not apply to the foreign lender on the receipt of either the monthly or the final payments since these payments are considered to consist solely of principal and interest for U.S. federal income tax purposes. In other words, the example concludes the receipt of the final payments did not result in a disposition of the debt obligation for purposes of §897. The example did note, however, that a sale of the debt obligation by the foreign corporate lender would result in gain that is taxable under §897.
Although this example deals with payments received pursuant to a shared appreciation mortgage rather than a total return swap, in both situations the foreign investor’s rights to participate in the appreciation of the underlying real estate are contractually based. Accordingly, even if an interest in a swap constitutes a USRPI for purposes of §897, it seems that, unless the swap is terminated or assigned prior to its stated maturity, §897 should not apply to treat the final periodic and nonperiodic payments as a “disposition.”
Since the preamble to the final NPC regulations was issued in 1993, no guidance has existed relating to how the NPC rules work in conjunction with the FIRPTA provisions. Given the broad definition of what constitutes a USPRI under the §897 regulations, the ruling certainly comes as a welcome surprise to many practitioners in this area. It will be interesting to see whether banks and other financial institutions attempt to take advantage of the ruling by creating their own real estate indices in a manner that would allow foreign investors to share in the appreciation of U.S. real property without triggering tax under §897.
1 2008-26 I.R.B. 1180.
2 All references to “section” refer to sections of the Internal Revenue Code of 1986, as amended, and the Treasury Regulations promulgated thereunder.
3 See Anita Raghavan, IRS Probes Tax Goal of Derivatives, Wall Street J. (July 19, 2007); Anita Raghavan, Happy Returns: How Lehman Sold Plan to Sidestep Tax Man — Hedge Funds Use Swaps to Avoid Dividend Hit (September 17, 2007); Anita Raghavan, Hedge Funds Could Lose Offshore Shelter — Senate Panel Weighs Targeting Derivatives by Change in Tax Rules (October 1, 2007); Floyd Norris, Lies, Damn Lies, and Swaps, New York Times (January 15, 2008).
4 Treas. Reg. §1.446-3(c).
5 Treas. Reg. §1.1441-4(a)(3).
6 Treas. Reg. §1.863-7(b)(1).
7 I.R.C. §§871(a)(1) and 881(a)(1).
8 I.R.C. §§871(a) and 881(a).
9 I.R.C. §§871(b) and 882.
10 I.R.C. §861(a)(5).
11 I.R.C. §897(c)(2).
12 For a more in depth discussion of this issue, see Jeffrey L. Rubinger, Can a Total Return Equity Swap Avoid FIRPTA?, J. of Taxation of Financial Products (Spring 2003).
13 T.D. 8491, 1993-2 C.B. 215.
14 See generally Gregory May, Flying on Instruments: Synthetic Investment and the Avoidance of Withholding Tax, 13 Tax Notes Int’l 1625 (November 11, 1996).
15 Ocala, Florida, is listed as one of the 363 MSAs in the United States according to a report issued by the U.S. Office of Management and Budget in November 2007.
16 Britt v. Commissioner, 40 B.T.A. 790 (1939) (court held that a reorganization occurred, when pursuant to a plan, a corporation transferred over 90 percent of its assets to another corporation in exchange for stock and cash, since the stock received represented a (i.e., 73 percent) of the value of the assets transferred).
17 An argument can be made that the ownership of the REIT shares constitutes an indirect ownership of the underlying real estate.
18 A domestically controlled REIT means a REIT in which at all times during the five-year period ending on the date of the disposition or of the distribution, as the case may be (or the shorter period if the REIT was in existence for less than five years), less than 50 percent in value of the stock was held directly or indirectly by foreign persons. I.R.C. §897(h)(4)(B).
20 This assumes that the gain is not ECI.
21 The IRS has recently made it clear that liquidating distributions from a REIT also will be subject to this rule. See Notice 2007-55, 2007-27 I.R.B. 13. See also AM 2008-003 (Feb. 15, 2008) for a further discussion of this issue.
22 For this purpose, the actual owner of stock in a REIT is the person who is required to include in gross income in his or her return the dividend received on the stock. Treas. Reg. §1.857-8(b).
23 Unlike the direct ownership interest in the underlying shares, the swap does not give the foreign investor the right to receive or sell the shares, the right to receive dividends on the shares, or the right to vote the shares. Furthermore, the swap only results in the foreign investor having a creditor interest and a short limited economic exposure to the shares through the swap.
24 This would be especially true if, similar to the facts in the ruling, the counterparty to the swap did not own the asset underlying the swap.
25 I.R.C. §897(h)(1).
26 Treas. Reg. §1.897-1(g).
27 Treas. Reg. §1.446-3(e)(1).
28 Treas. Reg. §1.446-3(f)(1).
29 Treas. Reg. §1.446-3(h).
30 Prop. Treas. Reg. §§1.1234A-1(a) and (b).
31 Section 1221(a).
32 See TAM 9730007 (April 10, 1997).
33 See PLR 9824026 (March 12, 1998) (the ruling involves a fixed nonperiodic payment). Based on the language in TAM 9730007, an argument can be made that all nonperiodic payments (i.e., fixed and contingent) should be exempt from §1234A since they are simply payments made pursuant to original terms of the contract.
34 See Prop. Treas. Reg. §1.1234A-1(b) (the regulations indicate that none of the following payments are subject to §1234A since they do not terminate or cancel a right or obligation: 1) a periodic payment; 2) a fixed nonperiodic payment; and 3) a contingent nonperiodic payment. These regulations also indicate that these payments give rise to ordinary income or expense).
35 See Treas. Reg. §1.897-1(h), Example 2.
Jeffrey L. Rubinger is a tax partner in Holland & Knight’s Ft. Lauderdale office and is head of its South Florida tax practice. He received his J.D. from the University of Florida School of Law and an LL.M. in taxation from New York University School of Law. Mr. Rubinger is admitted to the Florida and New York bars and is a certified public accountant.
This column is submitted on behalf of the Tax Section, Frank M. Bedell, chair, and Michael D. Miller and Benjamin A. Jablow, editors.