Coming to America

Whether they are acquiring an interest in U.S. real property or in a U.S. operating company, foreigners seek to structure their U.S. investments in a tax-efficient manner, so as to reduce their U.S. income tax liability with respect to both the current profits generated by the investment and the gain realized on the disposition of the investment, thereby increasing the return on their investment.

A recent decision by the U.S. Tax Court may mark a significant development in the taxation of the gain realized by a foreigner on the sale of its interest in a U.S. partnership.

Investment in Partnership

Taxpayer was a privately-owned foreign corporation that owned a minority membership interest in LLC, a U.S. limited liability company that was treated as a partnership for U.S. income tax purposes. Taxpayer had no office, employees, or business operation in the U.S.

Redemption

In 2008, LLC agreed to redeem Taxpayer’s membership interest; as a matter of state law, the redemption was to be effective as of December 31, 2008. LLC made two payments to Taxpayer – the first in 2008 and the second in 2009. Taxpayer realized gain on the redemption of its interest.

Tax returns

With its 2008 Form 1065, “U.S. Return of Partnership Income,” LLC included a Schedule K-1 for Taxpayer that reported Taxpayer’s share of LLC’s income, gain, loss, and deductions for 2008. Consistent with that Schedule K-1, Taxpayer filed a Form 1120-F, “U.S. Income Tax Return of a Foreign Corporation,” for 2008, on which it reported its distributive share of LLC’s income, gain, loss, and deductions. However, LLC did not report on that 2008 return any of the gain it had realized that year on the redemption of its interest in LLC.

With its 2009 Form 1065, LLC included a Schedule K-1 for Taxpayer that – consistent with the agreement between Taxpayer and LLC that the redemption of Taxpayer’s entire membership interest was effective as of December 31, 2008 – did not allocate to Taxpayer any income, gain, loss, or deductions for 2009. As in 2008, Taxpayer took the position that the gain realized was not subject to U.S. tax; thus, Taxpayer did not file a U.S. tax return for 2009.

IRS Audit

The IRS audited Taxpayer’s 2008 and 2009 tax years, and determined that Taxpayer should have recognized U.S.-source capital gain for those years from the redemption of its interest in LLC. This determination was based upon the IRS’s conclusion that, as a result of Taxpayer’s membership interest in LLC, its capital gain was effectively connected with a U.S. trade or business (“USTB”).

Taxpayer petitioned the U.S. Tax Court, where the issue for decision was whether the gain from the redemption of Taxpayer’s interest in LLC was U.S.-source income that was effectively connected with a USTB and, therefore, subject to U.S. taxation.

U.S. Taxation of Foreigners

Before reviewing the Court’s opinion, a brief description of how the U.S. taxes foreigners may be in order.

The income of a foreign corporation may be subject to U.S. income tax if: (1) the income is received from sources within the U.S. (“U.S.-source income”), and it is one of several kinds of income enumerated by the Code (including, for example, dividends, interest, and other “fixed or determinable annual or periodic” (“FDAP”) income); or (2) the income is “effectively connected with the conduct of” a trade or business conducted by the foreign corporation within the U.S. (“effectively connected income”).

In general, the gross amount of a foreigner’s FDAP income is subject to U.S. income tax (and withholding) at a flat 30% rate; no deductions are allowed in determining the tax base to which this rate is applied.

With some exceptions, the Code does not explicitly address the taxation of the capital gain realized by a foreigner on the sale of an equity interest in a U.S. business entity; rather, it is by virtue of addressing these exceptions that the general rule – that capital gain is not subject to U.S. tax – arises. Thus, the gain realized by a foreigner from the sale of a capital asset that is sourced in the U.S. is not subject to U.S. tax unless the asset is related to the foreigner’s USTB or the asset is “an interest in U.S. real property,” the sale of which is treated as effectively connected with a USTB.

In contrast to FDAP income, the foreigner is allowed to deduct the expenses incurred in generating its effectively connected income, and that net income is taxed at graduated rates.

Whether a foreigner is engaged in a USTB depends upon the nature and extent of the foreigner’s activities within the U.S. Generally speaking, the foreigner’s U.S. business activities must be “regular, substantial and continuous” in order for the foreigner to be treated as engaged in a USTB. In determining whether a foreigner’s U.S. activities rise to the level of a trade or business, all of the facts and circumstances need to be considered, including whether the foreigner has an office or other place of business in the U.S.

However, a special rule applies in the case of a foreigner that is a partner in a partnership that is, itself, engaged in a USTB; specifically, the foreigner shall be treated as being engaged in a USTB if the partnership of which such foreigner is a member is so engaged.

In that case, provided it is effectively connected with the conduct of a USTB, the foreigner partner must include its distributive share of the partnership’s taxable income in determining its own U.S. income tax liability.

Generally speaking, all income, gain, or loss from sources within the U.S., other than FDAP income, is treated as effectively connected with the conduct of a USTB.

Points of Agreement

Taxpayer conceded that it was engaged in a USTB by virtue of its membership interest in LLC. In fact, Taxpayer reported on Form 1120-F, and paid U.S. income tax on, its distributive share of LLC’s operating income for every tax year that it was a member of LLC, including the year in which its membership interest was redeemed.

In addition, both Taxpayer and the IRS agreed that no part of the redemption payments made to Taxpayer should be treated as a distributive share of partnership income.

The IRS also agreed with the Taxpayer that the payment made by LLC in redemption of Taxpayer’s membership interest should be treated as having been made in exchange for Taxpayer’s interest in LLC’s property. As such, the Taxpayer would recognize gain as a result of the redemption only to the extent that the amount of money distributed exceeded Taxpayer’s adjusted basis for its interest in LLC immediately before the distribution. This gain would be considered as gain from the sale or exchange of the Taxpayer’s membership interest.

Major Disagreement

In general, the gain realized on the sale of a partnership interest is treated as gain from the sale or exchange of “a capital asset.” According to Taxpayer, because the gain realized on the redemption of its membership interest was equivalent to the sale of a capital asset that was not used by Taxpayer in a USTB, it could not be subject to U.S. tax.

The IRS, however, viewed the issue differently. According to the IRS, Taxpayer’s gain did not arise from the sale of a single, indivisible asset – Taxpayer’s interest in LLC – but rather from the sale of Taxpayer’s interest in the assets that made up LLC’s business, in which Taxpayer was treated as having been engaged.

Aggregate vs. Entity

The IRS argued that the Court should employ the so-called “aggregate theory,” under which a partner’s sale of a partnership interest would be treated as the sale by the partner of its separate interest in each asset owned by the partnership.

The Court, however, rejected the IRS’s argument. It noted that the Code generally applies the “entity theory” to sales and liquidating distributions of partnership interests – it treats the sale of a partnership interest as the sale of “a capital asset” – i.e., one asset (a partnership interest) – rather than as the sale of an interest in the multiple underlying assets of the partnership.

The Court then pointed out that the Code explicitly carves out certain exceptions to this general rule that, when applicable, require that one look through the partnership to the underlying assets and deem the sale of the partnership interest as the sale of separate interests in each asset owned by the partnership; for example, where the partnership holds “hot assets,” or where it holds substantial interests in U.S. real property, in which case an aggregate approach is employed in determining the tax consequences of a sale.

Accordingly, the Court determined that Taxpayer’s gain from the redemption of its membership interest was gain from the sale or exchange of an indivisible capital asset: Taxpayer’s interest in LLC.

Effectively Connected?

The Court then considered whether the gain realized on the redemption was taxable in the U.S., which depended upon whether that gain was effectively connected with the conduct of a USTB — specifically, whether that gain was effectively connected with the trade or business of LLC, which trade or business was attributed to Taxpayer by virtue of its being a member of LLC.

The IRS argued that the gain was “effectively connected,” pointing to one of its own published rulings, in which it held that the gain realized by a foreigner upon the disposition of a U.S. partnership interest should be analyzed asset by asset, and that, to the extent the assets of the partnership would give rise to effectively connected income if sold by the entity, the departing partner’s pro rata share of such gain should be treated as effectively connected income.

The Court, however, did not find the ruling persuasive, and declined to follow it. Instead, the Court undertook its own analysis of the issue.

It considered whether the gain from the sale of the membership interest was U.S.-source. Unfortunately, the Code does not specifically address the source of a foreigner’s income from the sale or liquidation of its interest in a partnership.

However, under a default rule for sourcing gain realized on the sale of personal property (such as a partnership interest), gain from the sale of personal property by a foreigner is generally sourced outside the U.S. In accordance with this rule, the gain from Taxpayer’s sale of its LLC interest would be sourced outside the U.S.

The IRS countered, however, that this gain fell under an exception to the default rule: the “U.S. office rule.” Under this exception, if a foreigner maintains a fixed place of business in the U.S., any income from the sale of personal property attributable to such “fixed place of business” is treated as U.S.-source.

Taxpayer’s gain would be taxable under this exception, the Court stated, if it was attributable to LLC’s office, which the Court assumed – solely for purposes of its analysis – would be deemed to have been Taxpayer’s U.S. office.

In order for gain from a sale to be “attributable to” a U.S. office or fixed place of business, the U.S. office must have been a “material factor in the production” of the gain, and the U.S. office must have “regularly” carried on – i.e., “in the ordinary course of business” – activities of the type from which such gain was derived.

The IRS contended: that the redemption of Taxpayer’s interest in LLC was equivalent to LLC’s selling its underlying assets and distributing to each member its pro rata share of the proceeds; that LLC’s office was material to the deemed sale of Taxpayer’s portion of LLC’s assets; and that LLC’s office was material to the increased value of LLC’s underlying assets that Taxpayer realized in the redemption.

The Court responded that the actual “sale” that occurred here was Taxpayer’s redemption of its partnership interest, not a sale of LLC’s underlying assets. In order for LLC’s U.S. office to be a “material factor,” that office must have been material to the redemption transaction and to the gain realized.

The Court noted that Taxpayer’s redemption gain was not realized from LLC’s trade or business, that is, from activities at the partnership level; rather, Taxpayer realized gain at the partner-member level from the distinct sale of its membership interest. Increasing the value of LLC’s business as a going concern, it explained, is a distinct function from being a material factor in the realization of income in a specific transaction. Moreover, the redemption of Taxpayer’s interest was a one-time, extraordinary event, and was not undertaken in the ordinary course of LLC’s business – LLC was not in the business of buying and selling membership interests.

Therefore, Taxpayer’s gain from the redemption of its interest in LLC was not realized in the ordinary course of the trade or business carried on through LLC’s U.S. office, it was not attributable to a U.S. fixed place of business and, therefore, it was not U.S.-source.

Consequently, the gain was not taxable as effectively connected income.

It Isn’t Over ‘til the Weight-Challenged Person Sings

The Tax Court’s decision represents a victory for foreigners who invest in U.S. businesses through a pass-through entity such as a partnership or limited liability company – how significant a victory remains to be seen.

First, the IRS has ninety days after the Court’s decision is entered in which to file an appeal to a U.S. Court of Appeals. Query whether that Court would be more deferential to the IRS’s published ruling, describe above.

Second – don’t laugh – Congress may act to overturn the Tax Court’s decision by legislation. “Why?” you may ask. Foreigners who rely upon the decision will not report the gain from the sale of a partnership interest. If the partnership has in effect an election under section 754 of the Code, the partnership’s basis in its assets will be increased as a result of the sale (as opposed to the liquidation/redemption) of the foreigner’s partnership interest. This will prevent that underlying gain from being taxed to any partner in the future.

Third, the decision did not address how it would apply to “hot assets” — for example, depreciation recapture. As noted above, the Code normally looks through the sale of a partnership interest to determine whether any of the underlying assets are hot assets. Where the foreign partner has enjoyed the benefit of depreciation deductions from the operation of the partnership’s USTB – thereby reducing the foreigner’s effectively connected income – shouldn’t that benefit be captured upon the later sale of the foreigner’s partnership interest?

Finally, there is a practical issue: how many foreigners will invest through a pass-through entity rather than through a U.S. corporation? Although a corporate subsidiary will be taxable, its dividend distributions to the foreign parent will be treated as FDAP and may be subject to a reduced rate of U.S. tax under a treaty. The foreigner’s gain on the liquidation of the subsidiary will not be subject to U.S. tax. Moreover, the foreigner will not have to file U.S. returns.

Stay tuned. In the meantime, if a foreigner has paid U.S. tax in connection with the redemption of a partnership interest – on the basis of the IRS ruling rejected by the Tax Court – it may be a good idea to file a protective refund claim.

Catching up? Start with Part I here.

Sale of USRP – FIRPTA

Aside from planning for the taxation of U.S.-sourced rental income, the foreigner must plan for the disposition of the USRP pursuant to a sale.

The taxation of gain realized by a foreigner on the sale of an interest in USRP is governed by FIRPTA (the “Foreign Investment in Real Property Tax Act of 1980”).

Because FIRPTA treats such gain as income that is effectively connected with the conduct of a USTB, the tax rate that is applied to the gain will depend upon whether the foreign seller is an individual or a corporation.

Assuming the property is a capital asset in the hands of a foreign individual (not inventory or otherwise used in a USTB – the sale of either of which would have been taxable as effectively connected income anyway), and has been held by the foreign individual for more than twelve months, the gain from the sale will be taxed as capital gain at a rate of 20%.

If the seller is a FC, the gain will be taxed at the applicable corporate rate, up to 35%.

FIRPTA – Withholding

Upon the foreigner’s sale of USRP, the buyer is required to withhold 15% of the gross purchase price, which amount must be remitted to the IRS. The purchase price includes the amount of any liability assumed or taken subject to. The remaining tax, if any, must be paid by the foreign seller when it files its U.S. income tax return. If the tax withheld exceeds the amount of tax owed as a result of the sale, the foreigner may use the filing of the tax return to claim a refund.

Because the 15% withholding does not necessarily bear any relationship to the amount of tax actually owed – indeed, the sale may have generated a loss – IRS regulations allow a foreign seller to request a certificate from the IRS that directs the buyer to withhold a lesser amount, based upon the information submitted by the foreigner to establish its actual tax liability.

For example, one may apply for a withholding certificate based on a claim that the transfer is entitled to nonrecognition treatment (as in the case of a like-kind exchange for other USRP), or based on a calculation of the foreigner’s maximum tax liability.

There are also other exceptions to FIRPTA withholding, where a USC, the stock of which is sold by a foreigner, certifies that it is not a USRPHC, and has not been one in the last five years.

Withholding as to Corporate Distributions

Note that special withholding rules apply to certain dispositions by corporations.

If a FC distributes USRP to its shareholders, it must withhold tax at a rate equal to 35% of the gain that is recognized by the FC on the distribution. (The distribution of appreciated property by a corporation to its shareholders in respect of their stock is treated as a sale of such property by the corporation.)

In the case of a USRPHC, it must withhold 15% of the amount distributed if the distribution is made in redemption of a foreigner’s shares or in liquidation of the corporation.

U.S. Real Property

The foregoing has assumed that the property being sold by the foreign person is a direct interest in USRP.

FIRPTA, however, covers not only direct interests in USRP, but also certain indirect interests.

Specifically, if the FMV of a USC’s USRP equals or exceeds 50% of the sum of (i) the FMV of all of its real property plus (ii) the FMV of its trade or business assets, then the corporation will be treated as a USRP Holding Corporation (“USRPHC”), and any gain realized on the disposition of any amount of stock in that USRPHC will be subject to tax under FIRPTA (so long as the disposition is treated as a sale or exchange for tax purposes).

What’s more, if a USC was a USRPHC at any time during the five-year period ending with the date of the sale of stock therein by a foreigner, the gain realized will remain subject to FIRPTA even if less than 50% of the value of the corporation is attributable to USRP at the time of the sale.

Fortunately, there is an exception to this five-year rule: under the so-called “cleansing” rule, if the USC disposes of all of its interests in USRP in taxable sales or exchanges, such that the entire gain thereon has been recognized, and the corporation owns no USRP at the time of the stock sale by the foreign person, then the stock sale shall not be taxable under FIRPTA (or at all for that matter).

Election to be treated as a USRPHC 

As you may have gathered, a FC cannot be a USRPHC. Seems straightforward enough, except that there is a special election that allows a FC to elect to be treated as a USRPHC exclusively for purposes of FIRPTA.

Why would a FC make such an election? One reason is to avoid gain recognition upon the transfer of USRP to the FC. Among the requirements that must be satisfied in order for an election to be effective, the FC must satisfy the above “50% of value” test for USRPHCs.

Exceptions to FIRPTA

Not every disposition of USRP by a foreign person is taxable and subject to withholding under FIRPTA.

For example, a foreigner may sell USRP and roll over the net proceeds therefrom as part of a deferred like-kind exchange without incurring a tax liability (provided that the replacement property is also USRP, the subsequent disposition of which would be taxable to the foreign seller).

This principle underlies other exceptions to gain recognition; specifically, if a foreign person exchanges one interest in USRP for another interest in USRP, the gain realized on the exchange may not be taxable if certain regulatory requirements are satisfied.

For example, a foreigner may contribute USRP to a USC (or to a FC that has elected to be treated as a USC under FIRPTA) in exchange for shares of stock in that corporation without incurring a tax liability, provided the foreign person “controls” the USC immediately after the exchange, and provided the transferee USC is a USRPHC after the contribution. (A narrower exception applies for certain transfers by foreigners to a non-electing FC, which is somewhat inconsistent with the above principle.)

Varieties of Dispositions

A sale of USRP is the most common type of disposition that triggers FIRPTA. However, there are many other transactions of which a foreigner needs to be aware.

For example, if a USRPHC redeems some (but not all) of the shares of a foreign shareholder, the redemption may not be subject to FIRPTA, and may instead be treated as a dividend, if the foreigner’s stock ownership is not sufficiently reduced.

If a USRPHC makes a cash dividend distribution to its shareholders in an amount that exceeds its earnings and profits, the distribution may result in taxable gain that will be subject to FIRPTA.

The partnership rules may generate similar results as to both distributions by, and contributions to, partnerships. The disguised sale rules, for example, may convert what appears to be a tax-free contribution of USRP by a foreigner to a partnership in exchange for a partnership interest into a partially taxable sale that is subject to FIRPTA.

What’s Next

Our next post will review the U.S. gift and estate tax consequences of which a foreign investor in USRP must be aware and must consider in structuring the acquisition, operation, and disposition of such property.

Over the last few years, we have received an ever-increasing number of inquiries from “foreigners” who are interested in acquiring U.S. real property (“USRP”).

Some of these foreigners – meaning closely-held business organizations formed outside the U.S., and individuals who are neither U.S. citizens nor U.S. permanent residents – were acquiring USRP to be used in their U.S. business operations (a “U.S. trade or business,” or “USTB”). Others were acquiring USRP for investment purposes, whether for the production of rental income or for appreciation.

Know the Client

Where the foreign client is acquiring USRP for business or investment use, we have to ascertain the client’s goals and, in the case of a client that is a business entity, the personal goals of its owners.

For example, are they looking to generate rental income, will they remit the net income out of the U.S., how important is limited liability protection, what about U.S. tax and other filing requirements?

In all cases, we need to understand whether the foreigner plans to dispose of the USRP in the relatively short-term, or whether the acquisition represents a longer-term investment.

Once we have determined these personal and business/investment goals, preferences, and concerns, we can turn to the related tax considerations.

U.S. Taxes – In General

There are a number of U.S. federal income tax consequences that may arise from a foreigner’s ownership, operation, and disposition of USRP. (There are state and local tax considerations, as well, of which the foreign person must be made aware, including, for example, the N.Y. Real Estate Transfer Tax and the N.Y.C. Real Property Transfer Tax.)

As in the case of any other business or investment transaction, taxes will have a significant impact upon the net economic benefit or cost realized by the foreigner. The more that a taxpayer pays in taxes in respect of the income or gain realized from a property, or the more slowly the taxpayer recovers the taxpayer’s investment in the property, the more expensive the investment becomes.

Where taxes are not considered early on, the acquisition and ownership of a USRP may not be properly structured to minimize taxes and expenses. Thus, it is critical to plan for taxes prior to the acquisition of the USRP. It may be very difficult, and very expensive, to “correct” the structure later, once the property has appreciated in value.

The Adviser’s Goal

The tax adviser’s job is to educate the foreign investor as to these basic U.S. tax considerations – before the USRP is acquired – and, then, to see how to accommodate the foreigner’s business, investment, and other goals within a tax-efficient structure.

I should note that, although we are focusing on a U.S.-tax-efficient structure, it is also imperative that the U.S. adviser confer with the foreigner’s non-U.S. tax advisers. The client’s U.S. and foreign plans must be coordinated, lest one undermine a purpose of the other. Thus, each of the transactions described below should be examined for the its consequences under the law of the foreign person’s home country.

For this reason, and for other reasons that will vary from taxpayer to taxpayer, I can say with some certainty that there is no single structure that satisfies all of a taxpayer’s goals.

U.S. Income Tax 

We begin with a brief summary of the principles that govern the U.S. income taxation of foreign persons as it relates to USRP.

Income Taxes – Source 

In general, the U.S. will tax foreigners only as to their U.S.-sourced real property income.

Rental income from a USRP, dividends paid by a U.S. corporation (“USC”) that owns USRP, an allocable share of income from a partnership that owns USRP, interest from loans made to U.S. persons to acquire or improve USRP, and gains from the sale of URSP are all treated as U.S.-sourced income that will generally be subject to U.S. income tax.

Income Tax – Nature of the Income

Next, we need to determine the nature of the US-sourced income. Specifically, is it “portfolio” investment income, or is it effectively connected to the foreigner’s conduct of a USTB?

Nature of the Income – FDAP

If it is “portfolio” income – i.e., not effectively connected to a USTB of the foreigner – the rental income, the dividend income, and the interest income will be characterized as so-called “fixed and determinable annual and periodic” (“FDAP”) income.

Notably, the gain from the sale of stock of a USC is not treated as FDAP. Indeed, it is generally not taxable by the U.S. at all, provided the stock is a capital asset in the hands of the foreign seller, it is not used in a USTB, and the corporation is not a U.S. real property holding corporation (“USRPHC”).

The U.S. taxes the gross amount of a foreigner’s FDAP income. Thus, in the case of “portfolio” rental income from USRP, no deduction is allowed for property taxes, maintenance, depreciation, etc.

In addition, the tax on such gross income is imposed at a default rate of 30%, though it may be reduced under a U.S. tax treaty if the foreigner is a bona fide resident of the other treaty country. This rate applies regardless of whether the foreigner is an individual or a corporation, and regardless of the assets held by the U.S. payor.

Thus, if a USC, the principal asset of which is USRP, pays a dividend to a foreign shareholder, the dividend will be treated as U.S.-sourced income and will be taxable at a 30% (or lower treaty) rate. If a U.S. borrower pays interest to a foreign lender, the interest will be taxable at a 30% (or lower treaty) rate.

By comparison, if the dividend is paid by a foreign corporation (“FC”), there generally is no U.S.-sourced income because the payor is not a USC; this is the case even if the FC’s only asset is USRP.

That being said, if a FC is treated as being engaged in a USRP trade or business, it may be subject to the so-called “branch profits tax” (“BPT”). This tax, which is basically a “deemed dividend tax,” is imposed at the rate of 30% on the FC’s accumulated net profits that were not reinvested in its USTB. It purports to be a tax on the FC’s undistributed U.S. income. Because it is applied after application of the U.S. corporate income tax, the BPT can result in a total federal corporate tax rate in excess of 54%.

FDAP Withholding

The tax on a foreigner’s FDAP is collected, or withheld, at the source, by the U.S. payor of the income, which then remits the tax to the IRS.

Assuming the withholding fully satisfies the foreigner’s U.S. income tax liability, the foreigner need not file a U.S. income tax return.

That being said, the foreigner may nevertheless choose to file a return so as to start the running of the limitations period for the assessment of any additional U.S. income tax; for example, just in case the IRS later determines that its USRP activities rise to the level of a USTB.

U.S. Trade or Business

Speaking of a USTB, what level of activity is required before the IRS will treat the foreigner’s USRP activity as a trade or business?

If a foreigner is developing property in the U.S., it is safe to say that the foreigner is engaged in a USTB, and that the net taxable income generated therefrom is effectively connected with such business and will be taxable as ordinary income at the graduated rates applicable to U.S. persons, up to a top marginal rate of 39.6% for individuals, and up to 35% for corporations.

It is equally safe to say, as one would imagine, that a triple net lease does not constitute a trade or business. The rental income therefrom is FDAP that is taxable on a gross basis.

In between, there can be a lot of uncertainty.

Thus, the management of a multi-unit building may rise to the level of a trade or business if the foreigner is involved (directly or through agents) in paying expenses, maintaining the property, making repairs, hiring contractors, interviewing tenants, handling tenant complaints, dealing with local government, etc., with some continuity and regularity, and the foreigner does not substantially rely upon a local management company. In the latter situation, the foreigner’s activities may be difficult to distinguish from those of a prudent investor.

Assuming the activity rises to the level of a trade or business, then the foreigner may deduct the expenses associated with the rental activity in determining taxable income. Thus, depreciation, property taxes, interest on a mortgage, contractor fees, insurance, etc., will be deducted from the gross income in determining the foreigner’s U.S. taxable income.

Partnership

Note that if a foreigner is a partner in a partnership that is itself engaged in a USRP trade or business, then the foreigner will be treated as being engaged in a USTB as to the foreigner’s distributive share of the partnership’s income, even if the foreigner is not itself actually so engaged.

USTB Election

Based on the foregoing, one would guess that being taxed on a net basis is usually better, economically speaking, than being taxed at a flat rate on a gross basis, and that is generally the case.

However, as we noted earlier, a foreigner whose USRP income is treated as FDAP is generally not required to file a U.S. income tax return, while a foreigner who is engaged in a USRP trade or business must file such a return. This is often an important consideration for some foreign investors.

Assuming that reporting is not an issue, the Code recognizes that it may be difficult to determine whether a USRP investment rises to the level of a USTB. Thus, a special election is provided.

If this election is filed timely – by the due date, with extensions, for the first year that the election is to apply – the foreigner who has rental income from USRP for the filing year may treat that income as being effectively connected with the conduct of a USTB. Thus, the foreigner will be able to claim the related expenses (including depreciation) as deductions for purposes of calculating its U.S. income tax liability. Once made, this election is irrevocable, and will apply for all subsequent years.

The IRS has taken this election a step further by allowing foreign taxpayers to make a protective election, such that if the IRS were to determine on audit that the rental income should have been taxed on a gross basis (as FDAP), the protective election would be triggered to preserve the tax treatment as a USTB reflected on the filed return.

Stay tuned for Part II, tomorrow.