The impact of sec. 897 on an NRA or foreign corporation's sale of domestic stock.

• Author: Calianno, Joseph M.
• Position: Nonresident alien individuals

Foreign corporations and nonresident alien individuals (NRAs) frequently invest in the United States via the stock of domestic corporations. When they make such an investment, in addition to considering the U.S. international tax implications of distributions from such entities, they must also consider the U.S. federal tax implications of a subsequent disposition of their interest in a domestic corporation. (1) Subject to certain exceptions, an NRA or foreign corporation's taxable sale of its domestic corporation stock normally results in a foreign source gain or loss under Sec. 865(a) that is not subject to U.S. taxation. (2)

One of the notable exceptions to this general rule, however, occurs when the domestic corporation's stock is stock of a U.S. real property holding corporation (USRPHC). Sec. 897(a) generally provides that a foreign person's gain or loss from the disposition of a U.S. real property interest (USRPI) is treated as gain or loss that is effectively connected with a U.S. trade or business. Subject to certain exceptions, a USRPI includes an interest (other than solely as a creditor) in a USRPHC. Generally speaking, a USRPHC is a domestic corporation that primarily holds USRPIs. Secs. 882(a) and 871(b) subject foreign corporations and NRAs, respectively, to U.S. taxation on their income effectively connected with a U.S. wade or business. Thus, an NRA or foreign corporation's gain or loss on the sale of domestic stock may be treated as effectively connected income of a U.S. wade or business under Sec. 897. When it is, such gain or loss normally is brought within the U.S. tax system. (3)

In addition, Sec. 1445(a) generally requires the person acquiring a USRPI from a foreign person to deduct and withhold tax equal to 10% of the amount realized on the disposition (special rules apply under Sec. 1445(e) for certain distributions by certain entities). However, Sec. 1445(b) provides exemptions from this withholding requirement, some of which are discussed below.

This article highlights some of the important issues under Sec. 897 when an NRA or foreign corporation sells stock of a domestic corporation, focusing primarily on when a domestic corporation is treated as a USRPHC and the requirements needed to establish that such an entity is not a USRPHC. (4)

USRPI/USRPHC

Generally speaking, Regs. Sec. 1.897-1(c)(1) provides that a USRPI is an interest, other than an interest solely as a creditor, in real property (including an interest in a mine, well, or other natural deposit) located in the United States or the Virgin Islands. Some typical examples include certain noncreditor interests in land, improvements on land (e.g., a building), and certain personal property associated with the use of real property (e.g., movable walls and furnishings). The Code and regulations elaborate on other types of interests that may constitute a USRPI for purposes of Sec. 897. (5)

For interests in domestic corporations, Sec. 897(c) (1) (A) (ii) provides:

(ii) [USRPI means] any interest (other than an interest solely as a creditor) in any domestic corporation unless the taxpayer establishes (at such time and in such manner as the Secretary by regulations prescribes) that such corporation was at no time a United States real property holding corporation during the shorter of--

(I) the period after June 18,1980, during which the taxpayer held such interest, or

(II) the 5-year period ending on the date of the disposition of such interest.

Some important observations about Sec. 897(c)(1)(A)(ii) as it relates to interests in domestic corporations are worth noting. As a preliminary matter, an interest solely as a creditor in a domestic corporation is not a USRPI. (6) Also, a domestic corporation generally is presumed to be a USRPHC unless the taxpayer establishes that such corporation was at no time a USRPHC during the relevant period (i.e., the shorter of the period the taxpayer held such interest or the five-year period ending on the date of such interest's disposition). Failing to take this presumption into account when an NRA or foreign corporation sells stock in a domestic corporation can be a trap for the unwary.

A domestic corporation generally will be considered a USRPHC if the fair market value (FMV) of the USRPIs held by the domestic corporation on any applicable determination date equals or exceeds 50% of the sum of the FMV of its USRPIs, its interests in real property located outside the United States, and any other of its assets used or held for use in a trade or business. (7) Only these types of assets are taken into account in making the USRPHC determination. Moreover, in determining whether any domestic corporation is a USRPHC, certain special rules will need to be considered when it owns interests in other corporations or entities, including flowthrough entities. (8)

For instance, a...