IRS rules total return swap tied to real estate index is not subject to FIRPTA.

AuthorRubinger, Jeffrey L.
PositionForeign Investment in Real Property Tax Act

In a significant taxpayer-friendly ruling (Rev. Rul. 2008-31), (1) the IRS ruled that a total return swap, the return of which was calculated by reference to a broadly based real estate index, does not give rise to a United States real property interest (USRPI) for purposes of [section]897. (2) The ruling is noteworthy for non-U.S. persons investing synthetically in U.S. real estate-related assets for at least two reasons. First, because of the broad definition of what constitutes a USRPI under the [section]897 regulations, it would not have been much of a stretch for the IRS to contend that a foreign person's long position in a swap that is tied to U.S. real property is a USRPI for U.S. federal income tax purposes. Second, given all of the recent press dealing with the use of derivatives by foreign persons (primarily offshore hedge funds) to convert what would otherwise be U.S. source income into foreign source income, it is somewhat surprising that the IRS issued a positive ruling in this regard to begin with. (3)

This article will examine the ruling and discuss its broader implications to non-U.S. persons investing in U.S.--real estate related assets through total return swaps.

Total Return Swaps in General

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

With respect to a synthetic long position, the following example illustrates how a total return swap over the shares of a publicly traded stock generally would operate. Assume a foreign investor believes that ABC, Inc., stock will appreciate and generate high yields over the next several years. For tax and other considerations, instead of investing directly in the shares of ABC, Inc., the foreign investor enters into a five-year total return equity swap with an investment bank with respect to 1,000 shares of ABC, Inc., stock. 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 the ABC, Inc., shares during the year and b) the increase, if any, in the fair market value of the ABC, Inc., shares 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 (e.g., the London Interbank Offered Rate or LIBOR) multiplied by the value of the ABC, Inc., shares at the beginning of the year and b) the decrease, if any, in the fair market value of the ABC, Inc., shares over the course of the year. Although it is not required to do so, the bank will purchase a certain number of shares of ABC, Inc., stock to hedge its position under the swap.

The total return swap qualifies as a notional principal contract (NPC) for U.S. federal income tax purposes. For this purpose, an NPC is defined as a financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts. (4) The specified index would be the ABC, Inc., stock and the notional principal amount would be the value of 1,000 shares of ABC, Inc., stock.

For U.S. federal income tax purposes, the swap payments received by the foreign investor would be exempt from U.S. withholding tax. (5) The reason is that payments made pursuant to an NPC typically are sourced according to the residence of the recipient, and, therefore, would generate foreign source income in the example described above. (6) This is a much better after-tax result than the foreign investor would achieve if it invested directly in the shares of ABC, Inc., stock because any U.S. source dividend payments generally would be subject to a 30 percent U.S. withholding tax unless reduced by an applicable income tax treaty. (7)

FIRPTA in General

Foreign persons are subject to U.S. federal income taxation on a limited basis. Unlike U.S. persons, who are subject to U.S. federal income tax on their worldwide income, foreign persons generally are subject to U.S. taxation on two categories of income:

* Certain passive types of U.S. source income (e.g., interest, dividends, rents, annuities, and other types of "fixed or determinable annual or periodical income," collectively known as FDAP). (8)

* Income that is effectively connected to a U.S. trade or business (ECI). (9)

FDAP income is subject to a 30 percent withholding tax that is imposed on a foreign person's gross income (subject to reduction or elimination by an applicable income tax treaty) and ECI is subject to tax on a net basis at the graduated tax rates generally applicable to U.S. persons.

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 Section 897. Under this provision, any gain recognized by a foreign person on the disposition of a USRPI will be treated as if such gain were ECI and, therefore, subject to U.S. federal income tax at the graduated rates that apply to U.S. persons. The source of such gain automatically will be treated as U.S. source income. (10) Additionally, when [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 [section]1445.

Section 897 represents a major departure from the U.S. federal income tax rules generally applicable to foreign persons' gain from the disposition of U.S. source capital assets. Foreign persons typically are not subject to U.S. federal income tax on U.S. source capital gains unless those gains are ECI. As stated above, [section]897...

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