FIRPTA and the return of capital distributions.

• Author: Smith, Annette B.
• Position: Foreign Investment in Real Property Tax Act

At first glance, the Foreign Investment in Real Property Tax Act, RL. 96-499 (FIRPTA), appears relatively straightforward. By application of Sec. 897(a), gain or loss of a foreign person from the disposition of a U.S. real property interest (USRPI) is subject to a substantive U.S. federal income tax liability, and the purchaser must withhold 10% of the amount realized under Sec. 1445. However, FIRPTA is quite complex, as Sees. 897 and 1445 can be ambiguous and filled with traps for the unwary. One such area of complexity involves return of capital distributions.

Withholding Requirements

A key distinction between Sec. 897 and Sec. 1445 is that the former treats gain or loss from the disposition of a USRPI as income effectively connected with a U.S. trade or business, thereby creating a tax liability under Sec. 871(b) or 882(a) on the gain recognized, while the latter may impose withholding on the amount realized. Thus, because a return of capital does not result in gain or loss, Sec. 897 would not apply. However, for purposes of Sec. 1445, the amount of withholding is based on the total fair market value of the distribution without regard to whether there is gain on the transaction; accordingly, withholding is required on both the portion of the distribution that is a return of capital and the portion that is gain (i.e., the amount in excess of the property's basis). However, withholding is not required to the extent the distributing domestic corporation obtains a withholding certificate from the IRS reducing or eliminating the withholding tax.

Under Sec. 1445(e)(3), if a domestic corporation that is a U.S. real property holding corporation (USRPHC) as defined in Sec. 897(c)(2) or that has been a USRPHC during the shorter of the time the taxpayer owned the interest or the five-year period ending on the date of disposition (a former USRPHC) distributes property to a foreign person in a distribution to which Sec. 301 applies and that is not made out of earnings and profits, the domestic corporation is required to withhold 10% of the amount realized on the distribution. Consequently, because only a distribution made out of earnings and profits is a dividend, both a return of capital and a distribution in excess of capital (basis) are within the scope of Sec. 1445(e)(3). The regulations potentially expand the withholding requirements to all domestic corporations (i.e., not just USRPHCs or former USRPHCs) by requiring the corporation to withhold...