Non-U.S. real estate investors, if not properly advised, may face unwanted U.S. tax return filing obligations and potentially significant U.S. tax liability from investing in U.S. real estate. We describe certain of these risks below and introduce a reasonably straightforward structure commonly deployed by non-U.S. real estate investors for investing in U.S. real estate assets, including hotels and resorts, to help reduce such risks, often referred to as a “leveraged blocker” structure.
The Problem: High U.S. Effective Tax Rates and Filing Obligations
Gain from the disposition of, and in general most or all of the income from, a direct investment in U.S. real estate by a non-U.S. investor is subject to U.S. federal income tax and required to be reported by the investor on a U.S. tax return regardless of the non-U.S. investor’s investment intent or how long the property has been held. Such income and gains are taxable under the U.S. tax rules relating to income that is “effectively connected” with a U.S. trade or business, including the Foreign Investment in Real Property Tax Act (FIRPTA).
Under current law, the effective U.S. federal income tax rate applicable to a direct investment by a non-U.S. investor in U.S. real estate can range from 20% for capital gains recognized by individuals, to 39.6% for operating income that is recognized by individuals, to up to 54.5% for income and capital gains recognized by non-U.S. entities classified as corporations for U.S. federal tax purposes. These taxes are collected through a combination of direct liability imposed on the non-U.S. investor and withholding taxes. Withholding taxes include gross basis U.S. withholding (i.e., taxes imposed with respect to the total proceeds received rather than the investor’s net income or gain), which can be imposed at rates of up to 30% for rental income and dividends and 15% on sale proceeds. In some cases, because they are calculated on a gross basis, these withholding taxes can raise the non-U.S. investor’s effective U.S. tax rate to over 100%, (but in most cases the non-U.S. investor is permitted to file a U.S. tax return to claim back the amount of U.S. taxes withheld that exceeds the non-U.S. investor’s actual liability for tax based on its net income or gain). In addition, state and local income and other taxes may apply to a non-U.S. investor’s investment in U.S. real estate.
Possible Solution: Leveraged Blocker Structure
Investing in U.S. real estate indirectly through one or more entities in many cases will not reduce these U.S. taxes or eliminate the requirement for the non-U.S. investor to file U.S. federal income tax returns. A “leveraged blocker” structure, however, may reduce (but not eliminate) the U.S. tax costs of investing in U.S. real estate and will generally alleviate the administrative burden associated with, or, in certain cases, even eliminate, the U.S. tax return filing requirement.
In a leveraged blocker structure, one or more non-U.S. investors acquire an interest in U.S. real estate by investing in an entity classified as a corporation for U.S. federal income tax purposes (a “blocker”). The blocker typically is organized as a U.S. entity, such as a Delaware corporation or a limited liability company that elects to be treated as a corporation for U.S. federal income tax purposes. The blocker then acquires an interest, directly or indirectly, in U.S. real estate.
Blocker Capitalization. A non-U.S. investor acquires, as a legal matter, two types of interests in a leveraged blocker: an equity interest (e.g., shares of corporate stock) and a debt investment (e.g., shareholder loans), which provide the “leverage.” The ratio of investor equity to debt and the commercial terms of the debt investment must reflect arms-length principles, which typically are determined in consultation with external tax and/or economic advisers. We commonly see blockers capitalized with 30% to 50% investor equity and 50% to 70% investor debt, with the investor debt having a term of 5-7 years and an interest rate ranging from 5% to 12%, depending on the circumstances. Interest accruing on the investor debt, subject to a number of limitations, may be partially or fully deductible by the blocker, and if properly structured may be eligible for a reduced or zero rate of withholding when paid to the non-U.S. investor, as discussed below.
U.S. Tax Implications to Blocker. A leveraged blocker generally shields non-U.S. investors from the U.S. tax consequences of investing directly in U.S. real estate, because the underlying rental or other income or gain from the sale of the U.S. real estate investment is recognized by the leveraged blocker, not the investor. The leveraged blocker must pay U.S. federal, state and local income taxes on its net taxable income, after taking any available deductions for interest on the investor debt and other expenses. The net available cash remaining in the leveraged blocker after paying its taxes and other expenses is used to pay interest and principal on the investor debt and then to make distributions on the investor equity.
U.S. Tax Implications to Non-U.S. Investor. From a non-U.S. investor’s perspective, the use of a leveraged blocker effectively transforms the income and gain from a U.S. real estate investment, as a legal matter, into interest income and distributions in respect of the blocker’s equity, which generally are taxable as follows.
Interest paid by the leveraged blocker with respect to investor debt will generally be subject to U.S. federal withholding taxes at rates of 0% to 30% depending on the eligibility of the non-U.S. investor for treaty benefits and whether the interest qualifies as “portfolio interest” for U.S. federal income tax purposes. Whether the non-U.S. investor is eligible for treaty benefits will depend on the country of residence of the investor and, in the case of an investor that is an entity, may depend on a number of other factors including the country of residence of the investor’s beneficial owners and the structure and legal classification of the investor. Qualifying for the portfolio interest exemption does not depend on the investor’s country of residence, but does involve a number of complex considerations which we do not discuss here. As a general matter, however, a non-U.S. investor must give up significant control rights over the underlying investment (e.g., including partnering with a dispersed number of additional investors in making the investment) in order to avail itself of the portfolio interest exemption.
Distributions made by a leveraged blocker with respect to investor equity may be characterized for U.S. federal income tax purposes as dividends, return of capital distributions or proceeds from a liquidation of the leveraged blocker. Dividends, and certain other distributions, paid by the leveraged blocker to non-U.S. investors will generally be subject to U.S. federal withholding taxes at rates of 0% to 30% depending on the type of payment and the eligibility of the non-U.S. investor for treaty benefits. Notably, if the leveraged blocker disposes of all of its interests in U.S. real property prior to liquidation it may make liquidating distributions that are not subject to U.S. withholding taxes.
Summary of Potential Benefits of Leveraged Blocker Structure
In summary, a properly structured leveraged blocker can provide non-U.S. investors with the following tax benefits as compared to a direct investment in U.S. real estate:
- Elimination of U.S. federal income tax filings at the non-U.S. investor level in most cases;
- Elimination of 15% gross basis FIRPTA withholding on a direct sale of the property by the blocker and 30% gross basis withholding, if otherwise applicable, on rental income; but, as discussed above, rental income that is effectively converted to interest or dividend distributions made by the blocker may still be subject to withholding of up to 30%;
- Reduction of U.S. tax liability as compared to a direct investment in U.S. real estate by non-U.S. corporate investors (and possibly for non-U.S. individuals); and
- Reduction of U.S. tax liability as compared to an unleveraged blocker structure.
While these benefits often will justify investing through a leveraged blocker structure, there can still be significant U.S. tax costs or “leakage” associated with the investment, due to the U.S. corporate income and withholding taxes paid by the blocker. The actual effective U.S. tax rate for a particular leveraged blocker structure will depend on the non-U.S. investor’s income and cash-flow projections for its investment, as well as a number of other factors and circumstances, but we typically see projected effective tax rates ranging from 20% to 35%. In addition, a non-U.S. investor will need to analyze the effects of the structure on its taxation in the investor’s home jurisdiction.
Also, it should be noted that the particular circumstances of the non-U.S. investors and applicable sponsors, if any, may affect the implementation of the leveraged blocker, and therefore not all of the benefits described may be achieved by any particular leveraged blocker structure.
A leveraged blocker may not be the ideal or even a desirable structure for certain types of non-U.S. investors, such as foreign sovereign entities that would hold a majority interest in the blocker or “qualified foreign pension funds.” Alternatives to the leveraged blocker that may be viable in light of a particular non-U.S. investor’s situation, include, but are not limited to, investing through a U.S. real estate investment trust, an unleveraged blocker corporation (U.S. or non-U.S.), a non-U.S. trust, an insurance separate account, or even an unblocked investment (e.g., an investment in an LLC that is not taxed as a corporation for U.S. federal income tax purposes, or a direct investment).
Non-U.S. investors should engage U.S. tax advisers with relevant expertise early in the investment process to determine if a leveraged blocker is the appropriate vehicle for the U.S. real estate investment and, if so, to determine the precise contours of the leveraged blocker structure that make the most sense for the non-U.S. investor under the particular circumstances.
For additional information or questions relating to leveraged blockers, or other structures for investing in U.S. real estate, please contact a member of the Goodwin tax group.