In a generic legal advice memorandum (AM 2023-003 (pdf) or GLAM), the IRS Office of the Chief Counsel addressed the application of the regularly traded stock exception under IRC Section 897(c)(3) to stock of a United States real property holding corporation (USRPHC) held by a partnership. The IRS concluded that the 5% ownership test (10% for real estate investment trusts (REITs)) should apply at the partnership level (an entity approach). The GLAM clarifies the IRS's position on an issue of longstanding uncertainty. Foreign persons and the partnerships in which they invest should consider the GLAM's impact on their US taxation and reporting requirements.
Detailed discussion
Background
IRC Section 897
IRC Section 897(a)(1) was enacted as part of the Foreign Investment in Real Property Tax Act (FIRPTA) of 1980. FIRPTA takes into account any gain or loss of a nonresident alien individual or foreign corporation from the disposition of a United States real property interest (USRPI) as if the taxpayer were engaged in a US trade or business and the gain or loss were income effectively connected with that trade or business (ECI). The foreign owner must also file a US federal income tax return.
In addition to direct interests in US real property, the definition of USRPI includes an interest in a USRPHC. A USRPHC is a corporation for which the fair market value of its USRPIs equals or exceeds 50% of the total fair market value of the corporation's interests in real property (wherever located) and other trade or business assets.
IRC Section 897(c)(3)
Enacted as an exception to the general definition of USRPHC, IRC Section 897(c)(3) (the Regularly-Traded-Stock-Exception Test) only treats a class of stock that is regularly traded on an established securities market as a USRPI for a "person" who holds more than 5% of that stock at any time during the relevant holding period. In other words, the stock is not treated as a USRPI if a person's ownership of a regularly traded stock does not exceed 5%, and any gain or loss on its disposition is not treated as ECI for US federal income tax purposes.
The constructive ownership rules of IRC Section 318 (with certain modifications) apply in determining whether a person's ownership interest exceeds 5%. Thus, stock owned by a partnership is treated as owned proportionately by its partners, and a partnership is treated as owning the stock owned by its partners. IRC Section 897, its legislative history and associated regulations do not provide a definition of "person" specific to IRC Section 897 or the Regularly-Traded-Stock-Exception Test. However, IRC Section 7701(a)(1) defines the term "person" to include a partnership.
Fact pattern
The GLAM addresses two situations. In both, PRS is a partnership in which each partner is allocated a proportionate share of all items of the partnership's income and loss. NRA, a non-resident alien and partner of PRS, owns a 25% interest in the capital and profits of PRS. The partnership directly holds shares in CORP — a USRPHC — that are regularly traded on an established securities market. The GLAM addresses whether to treat gain on the disposition of CORP stock (by PRS in Situation 1 and by NRA in Situation 2) as ECI under IRC Section 897(a) and concludes in both situations that the 5% stock ownership threshold for a corporation was reached, causing the foreign individual to recognize ECI from the respective sales:
- In Situation 1, PRS directly owns 8% of the CORP stock, and NRA does not own any other CORP shares, aside from its indirect ownership through PRS. PRS disposes of all of its CORP stock, and the PRS gain is allocated proportionately to all partners, including NRA. Because PRS holds 8% of the CORP stock and, in the IRS's view, the Regularly-Traded-Stock-Exception Test applies at the partnership level, the GLAM concludes that the CORP stock is a USRPI and NRA's allocable share of the gain is ECI.
- In Situation 2, PRS directly owns 4% of the CORP stock and, separately, NRA directly owns 4.5% of the CORP stock. NRA disposes of the 4.5% of CORP stock it held directly. Due to IRC Section 318 attribution, NRA is treated as holding an additional 1% of CORP (i.e., 25% of PRS's 4% interest in CORP). Because NRA is treated as owning a total of 5.5% of CORP's stock, the stock is considered a USRPI and NRA's gain on the disposition of its directly held CORP shares is ECI.
IRS conclusions
After noting that the IRC Section 7701(a)(1) definition of "person" includes a partnership, the GLAM states that the Regularly-Traded-Stock-Exception Test "should apply at the partnership level, unless it is more appropriate for the partnership to be treated as an aggregate of its partners for this purpose." As neither IRC Section 897 nor its legislative history addresses whether to treat a partnership as an aggregate for this purpose, the GLAM states, the entity approach is more appropriate in carrying out the purposes of IRC Section 897(c)(3). The GLAM notes other contexts where a partner's share of partnership income is subject to US tax based on nexus, with nexus being determined at the partnership level, taking into account the partnership's activities:
- When a foreign person invests in a partnership engaging in a US trade or business, the trade or business is imputed to the foreign person, so the foreign person must file a US tax return, regardless of its ownership percentage in the partnership.
- For a partner investing through a partnership, the applicability of the IRC Section 864(b) safe harbor is tested at the partnership level.
- A permanent establishment of a partnership is attributed to the partner for treaty purposes.
- A tax-exempt entity may derive unrelated business taxable from a partnership regardless of the tax-exempt entity's ownership percentage.
The GLAM's entity approach to the Regularly-Traded-Stock-Exception Test clearly contrasts with the Treasury and the IRS's position on qualified investment entities (QIEs), which takes an aggregate approach in assessing a partnership's actual ownership interest under the domestically controlled test in IRC Section 897(h)(4)(B) for the purposes of applying the domestically controlled QIE exception (DC QIE Exception). Regarding the DC QIE Exception, an aggregate approach under Prop. Treas. Reg. Section 1.897-1(c)(3)(ii)(B) would be required to determine a QIE's foreign ownership. On its face, the DC QIE test appears to be comparable to the Regularly-Traded-Stock-Exception Test, given that a non-resident's interest is not subject to tax upon the disposition of a domestically controlled QIE, so long as it owns (directly or indirectly) less than 50% of the QIE's stock; therefore, any distributions from the QIE to a non-resident alien individual or foreign corporation ought not to be treated as ECI under IRC Section 897(a)(1). The GLAM does not elaborate on why it took a different approach for the Regularly Traded Stock Exception Test.
The GLAM's entity approach is also inconsistent with the aggregate approach taken in determining whether the portfolio interest exemption for owners of less than 10% of the borrower applies to interest payable to a partnership with non-US partners. For those purposes, Treas. Reg. Section 1.871-14(g)(3)(i) determines the 10% ownership threshold at the partner level rather than at the partnership level. The GLAM does not attempt to distinguish its position on the Regularly-Traded-Stock-Exception Test from these other areas where clear guidance exists, even though they are arguably more comparable to the Regularly Traded Stock Exception than the nexus issues discussed in the GLAM.
Implications
Before the GLAM, it was unclear whether the IRS viewed the Regularly-Traded-Stock-Exception Test to apply at the partner or partnership level. The GLAM addresses that question by concluding that the test applies at the partnership level.
A GLAM cannot be cited as precedent and merely reflects the position of IRS counsel. Nevertheless, taxpayers that invest in regularly traded USRPHCs through partnerships should consider this GLAM's impact on their current and past positions, especially those for which application of the Regularly-Traded-Stock-Exception Test at the partnership level would yield a different result than the taxpayer has historically taken.
Nonresident partners should also be mindful of partner-to-partnership attribution under IRC Section 318, which may cause the partnership's interest to exceed the 5% threshold under the Regularly-Traded-Stock-Exception Test. For example, although not addressed in the analysis of Situation 2 of the GLAM, PRS would own a total of 8.5% if NRA's direct 4.5% ownership of CORP stock were attributed to the partnership. Query whether the partnership-level approach endorsed by the GLAM would mean that PRS (if it sold the stock) would fail the Regularly-Traded-Stock-Exception Test, causing CORP to be treated as a USRPI for all-foreign partners in PRS, regardless of their ownership levels. Other open questions include, for practical purposes, how PRS and any one of its foreign partners are to determine the extent to which other foreign PRS partners in the USRPHC hold stock ownership interests separately from their interest in PRS. These downward attribution questions are not new, and the GLAM does not address them.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP (United States), International Tax and Transaction Services
- Craig Hillier, Boston, MA
- Colleen O’Neill, Washington, DC
- Julia Tonkovich, Washington, DC
- Arlene Fitzpatrick, Washington, DC
- Zach Pouga Tinhaga, New York, NY
- Jeshua Wright, Washington, DC
- Candice C James, Washington, DC
- Shivani Mehra, Washington, DC
Ernst & Young LLP (United States), Joint Venture & Partnership Tax Services
- Mark Opper, Washington, DC
Ernst & Young LLP (United States), Global Compliance & Reporting
- John Hauser, New York, NY
Ernst & Young LLP (United States), Business Tax Advisory, Real Estate and Partnerships
- Mark Kirshenbaum, Boston, MA
Published by NTD’s Tax Technical Knowledge Services group; Maureen Sanelli, legal editor
For a full listing of contacts and email addresses, please click on the Tax News Update: Global Edition (GTNU) version of this Alert.
