Can FIRPTA be avoided with financial instruments?

• Author: Rubinger, Jeffrey L.
• Position: Foreign Investment in Real Property Tax Act

With the continuing uncertainty in the stock markets, both in the United States and abroad, many investors are looking for safer places to invest their money, such as real estate. Nowhere is this more evident than in the case of foreign persons investing in U.S. real estate, where recent estimates indicate that the number of dollars invested in the U.S. real estate market by foreign investors rose from $38.9 billion in 1997 to $44.2 billion at the beginning of 2002, an increase of approximately 16 percent over this five-year period. (1)

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, Internal Revenue Code (the "Code") [section] 897. Under this provision, any gain recognized by a foreign person on the disposition of a "United States real property interest" (USRPI) will be treated as if such gain were effectively connected to a U.S. trade or business and, therefore, subject to tax at the graduated tax rates that apply to U.S. persons. Additionally, when Code [section] 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 Code [section] 1445. While gains recognized under Code [section] 897 may be eligible for the favorable 20 percent capital gains tax rate, when compared to the tax-free return that generally is afforded to foreign persons on the sale of other U.S.-situs capital assets, (2) this does not seem like much of a bargain.

In order to avoid the application of Code [section] 897 but still participate in the U.S. real estate market, some foreign persons have attempted to use certain derivative products or financial instruments to create a synthetic long position in the U.S. real estate market. Although the use of options or forward contracts clearly would not accomplish this result, (3) a total return equity swap may achieve this objective. This article examines whether Code [section] 897 applies to a long position in an equity swap with respect to the stock of a U.S. real property holding corporation (USRPHC), (4) and if so, when such position is considered to be "disposed" of for Code [section] 897 purposes.

Total Return Equity Swaps in General

A total return equity swap is a cash-settled bilateral contract, in which each party agrees to make certain payments to the other depending on the value and dividend performance of the underlying asset. An investor may enter into an equity swap either 1) to simulate an investment in the underlying equity without actually acquiring the underlying equity (i.e., a synthetic long position), 2) to divest oneself of the economic exposure to a particular equity without actually disposing of the underlying equity (i.e., a synthetic short position).

With respect to a synthetic long position, the following example illustrates how an equity swap with respect to the stock of USRPHC (5) generally would operate: Assume a foreign investor, who believes that the value of hotels in the South Florida area will appreciate over the next several years, would like to invest in the stock of South Beach, Inc. ("South Beach"), a USRPHC whose underlying assets consist of hotels in the Miami Beach area. South Beach is neither a publicly traded corporation nor a "domestically controlled REIT," (6) both of which are exempt from Code [section] 897. (7) Investors in South Beach are given the option to convert their South Beach shares into shares of a publicly traded South Beach on a quarterly basis beginning on the third anniversary date of their initial investment in South Beach.

Unfortunately, certain legal restrictions prohibit the investor from owning a direct interest in South Beach. Therefore, the investor enters into a five-year equity swap with an investment bank whereby 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 an interest in South Beach during the year and b) the increase, if any, in the fair market value of an interest in South Beach 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 (typically LIBOR) multiplied by the value of an interest in South Beach at the beginning of the year and b) the decrease, if any, in the fair market value of an interest in South Beach over the course of the year. The equity swap qualifies as a notional principal contract ("NPC") under Treas. Reg. [section] 1.446-3. (8) To hedge its position under the swap, the bank will purchase an interest in the underlying asset (i.e., the stock of South Beach).

Given that the investor's long position in the swap is equivalent economically to a leveraged purchase of the underlying stock in the USRPHC, the issue arises whether Code [section] 897 applies to the investor when such position is disposed of 2 The IRS could assert two alternative arguments in attempting to apply Code [section] 897 to the investor's long position in the swap 1) the investor's position in the swap is itself a USRPI, or 2) that the investor should be treated as owning the underlying USRPHC stock under common law principles.

Is a Long Position in an Equity Swap a USRPI?

Foreign persons typically are not subject to U.S. federal income tax on U.S. source capital gains unless these gains are effectively connected to a U.S. trade or business. (10) As stated above, however, Code [section] 897 treats any gain recognized by a foreign person on the disposition of a USRPI as if it were effectively connected to a U.S. trade or business. A USRPI is broadly defined as 1) a direct interest in real property located in the United States, and 2) an interest (other than an interest solely as a creditor) in any domestic corporation that constitutes a United States 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). (11)

The regulations promulgated under Code [section] 897 elaborate on the phrase "an interest other than an interest solely as a creditor" by stating it includes "an interest which is, in whole or in part, a direct or indirect right to share in the appreciation in value of an interest in an entity or a direct or indirect right to share in the appreciation in value of assets of, or gross or net proceeds or profits derived by, the entity." (12) Unfortunately, these regulations provide little guidance on what it means to have "a right to share in the appreciation of an interest in an entity."

Despite its rather broad language, however, an...