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Blocker Alchemy

Posted on Aug. 31, 2020
[Editor's Note:

This article originally appeared in the August 31, 2020, issue of Tax Notes Federal.

]
David Mattingly
David Mattingly

David Mattingly is a partner with Torys LLP in New York. He thanks Scott Semer and Peter Keenan for their insightful comments on an earlier draft of this report, as well as Andrew Wong for assistance with the Canadian tax discussion. This report is based on a paper presented to the Tax Club of New York on April 22.

In this first installment of a two-part report, Mattingly explores cross-border tax aspects of blocker entities.

Copyright 2020 David Mattingly.
All rights reserved.

Magic can spring from the humblest origins. Consider the lowly blocker. Interposed between a taxpayer and something else — income, assets, activities — a blocker transforms the fundamental obligations to report information to the government and pay tax.

A complete taxonomy of blockers would include purely domestic transactions — for example, a tax-exempt organization’s use of blockers to avoid unrelated business taxable income. This report makes no attempt at completeness. Instead, it focuses on the cross-border use of blockers.

I. Blocker Basics

One good place to begin is with a below-the-fund blocker — an entity classified for federal tax purposes as a corporation and used by a private equity fund to shield a foreign investor from “bad” income. In this case, bad income means, among other things, income or gain treated as effectively connected with a trade or business within the United States (effectively connected income).1

Example 1

Before exploring the blocker’s benefits, it helps to recite a few pertinent inbound tax rules. Generally, a foreign investor engaged in a U.S. trade or business is subject to federal net income tax on its ECI. A corporate foreign investor may also be subject to a federal branch profits tax.2 The branch profits tax, imposed on repatriations of after-tax income, roughly simulates the 30 percent withholding tax on dividends paid by U.S. corporations to foreign shareholders. Both the net income tax and the branch profits may be reduced under an income tax treaty. Finally, if a nonresident alien individual or corporation realizes gain from the disposition of a U.S. real property interest (USRPI) — so-called FIRPTA gain3 — that individual or corporation generally is treated as if it were engaged in a U.S. trade or business and as if the gain were effectively connected with that trade or business.4

Blockers shield foreign investors from all of the above: ECI, the tax on FIRPTA gain,5 and branch profits tax. The obligation to file a federal income tax return also falls on the blocker, not the foreign investors. Foreign investors may therefore sit on their hands until the holdings partnership disposes of its interest in the U.S. portfolio company, following which the blocker often can be liquidated tax free.6

If the blocker structure seems straightforward, the rules that the structure is designed to counteract are less so. Among the more important rules relevant to blocker structures are the following:

  • Sections 871(b) and 882. These sections impose tax on ECI of NRAs and corporations engaged in a trade or business within the United States.

  • Section 875(1). This provision treats an NRA individual or foreign corporation as engaged in a U.S. trade or business if it is a partner of a partnership so engaged.7

  • Section 702(b). According to section 702(b), the character of a partner’s distributive share of income or gain is determined as if realized directly from the source from which realized by the partnership and incurred in the same manner as incurred by the partnership.8

  • Section 865(i)(5). According to section 865(i)(5), the source of income from the sale of personal property is determined at the partner level, except as provided in (nonexistent) regulations.

  • Section 6012(a). This provision generally imposes an income tax return filing obligation on all NRA individuals and foreign corporations engaged in a U.S. trade or business, such as partners of a partnership, regardless whether those persons recognize ECI.9

  • Donroy.10 In Donroy, the Ninth Circuit held that the general partner of a California limited partnership was a general agent of the limited partner within the meaning of the Canada-U.S. income tax treaty, and that the office of the limited partnership was therefore the permanent establishment of the limited partner within the United States. That is, in the absence of a treaty equivalent to section 875, Donroy applied an agency theory to impute a PE to a limited partner.11

  • Unger.12 In Unger, the D.C. Circuit held that as a result of an NRA individual’s interest in a domestic partnership, he had a U.S. PE and that his share of long-term capital gains from the real estate business of the limited partnership was therefore taxable in the United States as business profits attributable to that PE. As pointed out by Kimberly S. Blanchard, in the absence of a treaty equivalent to section 875, Unger applied an “attributional approach” — notwithstanding the court’s express references to the aggregate approach — “by reading section 875 as an attribution rule and then extending the ‘policy’ of section 875 to the treaty context.”13

  • Prop. reg. section 1.892-5(d) (the section 892 limited partner exception). This proposed regulation permits a foreign-government-controlled entity that qualifies for the section 892 exemption to take the position that it is not engaged in any commercial activity of a limited partnership (such as a private equity fund) of which it is a limited partner, subject to some conditions.14

  • Section 864(c)(8). This provision treats gain or loss from the sale by a foreign partner of an interest in a partnership that is engaged in a U.S. trade or business as effectively connected with that U.S. trade or business to the extent that the partner would have had effectively connected gain or loss had the partnership sold all its assets at their fair market value as of the date of that sale or exchange.15 Section 864(c)(8) does not change the source of that gain or loss.16

  • Section 897(g). This provision treats consideration received by an NRA individual or corporation from the sale of a partnership interest, “to the extent attributable” to USRPIs, as from the sale or exchange of those USRPIs.17

  • Section 1446. This section generally requires a partnership to withhold tax from a foreign partner’s allocable share of effectively connected taxable income (ECTI). This allocable share of ECTI excludes, however, income or gain exempt under the code or an income tax treaty.18

But for the below-the-fund blocker, a foreign investor in the fund in Example 1 would be:

  • treated as engaged in a U.S. trade or business;19

  • allocated ECI;20

  • prevented from claiming exemption under the business profits article of an income tax treaty;21

  • therefore required to recognize ECI;22

  • subject to U.S. withholding tax on distributions up the chain from the U.S. portfolio company;23

  • subject to U.S. net income tax upon the disposition of the U.S. portfolio company by the holdings partnership;24 and

  • required to file a federal income tax return annually, even for years in which no ECI is recognized.25

Assuming it is not recharacterized for tax purposes — as an agent of the foreign investor or otherwise26 — a blocker bears the burden of some or all of the foregoing consequences.

II. How to Turn Bad Income Into Good

Aside from bearing tax burdens that would otherwise fall on foreign investors, blockers — broadly construed to include fiscally transparent entities — can solve several tax problems. One such problem is turning bad income into good income.27

Even in the fund context described earlier, a domestic below-the-fund blocker has the incidental effect of turning ECI that might otherwise attract an additional branch profits tax into potentially exempt dividends. This is because dividends paid by a domestic blocker may well qualify for exemption from U.S. withholding tax under the code28 or an income tax treaty.29 A foreign blocker, in contrast, generally remains subject to at least some measure of branch profits tax, even if reduced by a treaty.30 Thus, a domestic below-the-fund blocker, unlike most corporate vehicles giving rise to two levels of tax, may function as a “half” conduit.

The realm of tax conduits is in fact where blockers routinely find full employment. Such conduits as regulated investment companies, real estate investment trusts, and publicly traded partnerships, among others, forfeit their status as tax conduits if they fail to earn sufficient good, “qualifying” income.31

A PTP, for example, generally avoids classification as a corporation only if at least 90 percent of its gross income is “qualifying income.”32 Generally, this means interest, dividends, real property rents, gain from the disposition of real property, some natural-resources-related income and gain, gain from the disposition of a capital asset giving rise to the foregoing types of income, and specified income and gain from commodities (including futures, forwards, and options).33 REITs and RICs endure comparable constraints.34

Based on the above definitions, a crude, if effective, way for a PTP to earn qualifying income is to own a business generating “bad” income through a corporate blocker. As with a below-the-fund blocker, a U.S. holding company (Holdco) capitalized by the PTP with debt therefore generates only dividends and interest — good, qualifying income. And, as with a below-the-fund blocker, the U.S. Holdco prevents ECI from being allocated to foreign investors in the PTP. See Example 2.35

Example 2

Most PTPs are indifferent to whether they generate ECI (or UBTI) for their unitholders. Indeed, the beauty of the PTP structure inheres in its long-term deferral of tax on a substantial share of income. For example, consider a U.S. individual who invests in a master limited partnership (MLP)36 owning a pipeline. Typically, depreciation attributable to the pipeline substantially reduces the U.S. unitholder’s taxable income from the MLP. For $100 of cash distributed by the MLP, the U.S. unitholder might owe tax on only $20 of net income, reducing outside basis in the MLP year after year until it reaches zero. A U.S. individual investor who passes away at this moment thus achieves for heirs the grail of permanent deferral.37

However, not all PTPs are indifferent to whether they generate ECI (or UBTI) for their investors. Some so-called investment PTPs encourage U.S. tax-exempt and foreign investment, in which case the simple blocker structure in Example 2 offers advantages. Here is a sample.

A. FIRPTA Gain

As with a below-the-fund blocker, the Holdcos in Example 2 generally prevent a foreign unitholder, solely by reason of investing in the PTP, from being treated as engaged in a U.S. trade or business. If debt is incurred at the Holdco level and not at the PTP or holdings partnership (Holdings Partnership) level, a U.S. tax-exempt investor should not recognize UBTI as a result of its investment in PTP units. The more interesting aspects relate to FIRPTA.

Under FIRPTA, if the U.S. Holdco in the PTP structure is a “United States real property holding corporation” (USRPHC), an equity interest in the U.S. Holdco is a USRPI. Gain realized from the sale of a USRPI by an NRA individual or foreign corporation generally is taxable under FIRPTA as if it were ECI.38 That is, FIRPTA overrides the general rule that gain from the sale of a capital asset by a foreign person is treated as foreign-source39 and therefore not subject to U.S. tax.40

Thus, if U.S. Holdco is a USRPHC, under the general aggregate rule of section 897(g) described above, gain from the sale of PTP units by a foreign investor, to the extent attributable to the interest in U.S. Holdco (through Holdings Partnership), would be taxed under FIRPTA. FIRPTA provides an exception for persons owning 5 percent or less of a class of stock regularly traded on an established securities market (the 5 percent exception).41 But because stock of U.S. Holdco is not traded, the 5 percent exception does not apply to that stock.

1. PTP as blocker.

This is not the end of the story. In view of the similarity between a PTP and a publicly traded corporation, a special rule in the FIRPTA regulations treats publicly traded PTP units like publicly traded stock of a corporation.42 This has the effect of extending the 5 percent exception to foreign unitholders of PTPs. As a result, only a greater than 5 percent interest in PTP units can be a USRPI. Gain from the sale of PTP units by a foreign unitholder is therefore subject to FIRPTA tax only if (1) the investor owns more than 5 percent of the publicly traded PTP units and (2) the PTP would be a USRPHC if it were a corporation.43 The regulations shift the FIRPTA focus from whether U.S. Holdco is a USRPHC to whether the PTP is a USRPHC (or would be if it were a corporation). In other words, the FIRPTA regulations apply the entity approach to the sale of PTP units, instead of the aggregate approach generally applicable under FIRPTA to the sale of a partnership interest.

The following scenarios illustrate some implications of these rules.

Example 3

a. Scenario 1.

Facts: U.S. Holdco is a USRPHC. PTP is a USRPHC.44 Foreign Investor sells its 1 percent interest in PTP.45

Comment: Assuming PTP’s units are regularly traded on an established securities market, a foreign investor selling its 1 percent interest in PTP would not be subject to FIRPTA tax.46 The PTP blocker structure therefore shields the foreign investor from FIRPTA tax attributable to the disposition of an interest in nonpublic U.S. Holdco that is a USRPHC.

b. Scenario 2.

Facts: U.S. Holdco is a USRPHC. PTP is not a USRPHC. Foreign Investor sells its 9 percent interest in PTP.

Comment: Although the foreign investor’s interest in both PTP and U.S. Holdco exceeds 5 percent, and U.S. Holdco is a USRPHC, the result is the same as in Scenario 1 — no FIRPTA tax.47

2. Intermediate partnership as blocker.

In the above scenarios, the 5 percent exception eliminates FIRPTA tax (and a U.S. tax return filing obligation) for small unitholders. What about large investors in a PTP treated as a USRPHC? Consider the following.

Example 4

Facts: Both U.S. Holdco and PTP are USRPHCs. Foreign Investor owns Holdings Partnership units exchangeable for 9 percent of the PTP units.

Comment: By investing in Holdings Partnership instead of the PTP, the foreign investor potentially bypasses the rules treating PTPs like public corporations for purposes of the 5 percent exception, depending on the circumstances.

In Example 4, the PTP blocker structure potentially facilitates a large foreign investment without triggering the adverse FIRPTA consequences of directly owning PTP units, but this is far from certain. Because the PTP would be a USRPHC if it were a corporation,48 a greater than 5 percent interest in the PTP would constitute a USRPI.49 If the foreign investor were to sell a direct 9 percent interest in the PTP, its gain would be taxable under FIRPTA, based on the special rule applying the entity approach to the disposition of PTP units that are regularly traded on an established securities market.50

The question is how the foreign investor is taxed upon the disposition or some or all of its 9 percent interest in Holdings Partnership in this UP-PTP structure.51 Gain from the foreign investor’s direct sale of exchangeable units clearly could be subject to FIRPTA tax under the aggregation rule of section 897(g) because U.S. Holdco is a USRPHC. This would be favorable. Why? By reason of the exchange right, the foreign investor has benefited from economic exposure to the entire PTP group. But under section 897(g), FIRPTA tax applies only to the portion of the gain attributable to U.S. Holdco. Gain attributable to the interest in the foreign Holdco cannot be subject to tax under section 897(g), because shares of a foreign corporation, even if it is a USRPHC, cannot be a USRPI.52

Had the investor exchanged its Holdings Partnership units for PTP units before selling, the entire gain realized by selling a 9 percent interest in the PTP would have been subject to tax as a result of the PTP’s classification as a USRPHC. Thus, interposed Holdings Partnership acts to block some, but not all, FIRPTA gain attributable to a 9 percent economic interest in a PTP treated as a USRPHC.

Is this the end of the analysis? It is not. The exchange right complicates things. Under FIRPTA, a USRPI includes “any interest” in real property or a domestic USRPHC, other than solely as a creditor.53 An interest in an entity other than solely as a creditor includes:

(A) Stock of a corporation;

(B) An interest in a partnership as a partner within the meaning of section 761(b) and the regulations thereunder;

* * *

(D) 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 described in [(A) or (B)] 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; or

(E) A right (whether or not presently exercisable) directly or indirectly to acquire, by purchase, conversion, exchange, or in any other manner, an interest described in [(A), (B), or (D)].54 [Emphasis added.]

Based on this broad definition, the exchangeable units themselves conceivably are USRPIs, at least in part, because the exchange feature is a right attributable to a USRPI — a greater than 5 percent interest in the PTP. That is, the foreign investor’s sale of its 9 percent interest in Holdings Partnership could be taxable under FIRPTA as the disposition of (1) a direct or indirect right to share in the appreciation in value of a (greater than 5 percent) interest in the PTP; or (2) a right directly or indirectly to acquire, by exchange, a (greater than 5 percent) interest in the PTP.55 Presumably, the aggregate approach of section 897(g) would therefore not apply to the sale of an interest in Holdings Partnership.

This is also not clearly the right answer. One can imagine a particular set of circumstances swaying a foreign investor to assert the aggregate approach. For example, assume that all the gain realized from the sale of exchangeable units is attributable to the foreign Holdco shares.56 Could the foreign investor simply sell the exchangeable units and rely on the aggregate approach of section 897(g) to avoid FIRPTA tax?57 This does seem consistent with the facts. All the appreciation in PTP units would have been attributable to a non-USRPI (shares of the foreign Holdco). None of the appreciation would have been attributable to a USRPI (shares of U.S. Holdco).

Yet another way to see the problem is to suppose the foreign investor had first exercised the exchange right58 and then sold a 9 percent interest in the PTP. In that case, the entire amount of gain realized would, perversely, become taxable under FIRPTA, even though no portion of the gain would have been attributable to USRPIs.

The exercise of the exchange right itself poses questions that border on the mystical. The threshold question is whether the exchange of exchangeable units for PTP units qualifies for nonrecognition under section 721. Under FIRPTA, nonrecognition generally applies only if a “hot for hot” requirement is met. A foreign investor’s exchange of a USRPI for a non-USRPI in an otherwise tax-free transaction therefore triggers FIRPTA tax.59

What, then, is the result if the foreign investor exercises the exchange right for half its interest, so that it owns 4.5 percent of the PTP units (and Holdings Partnership units exchangeable for 4.5 percent of the PTP units)? Would the sale of that 4.5 percent interest in the PTP qualify for the 5 percent exception as a non-USRPI? If it would, the hot-for-hot requirement presumably would not be met. That is, a potential USRPI in the form of exchangeable units would have been exchanged for a non-USRPI in the form of PTP units. The exercise of the exchange right would therefore trigger FIRPTA tax.

But should the ongoing ownership of half the exchangeable units be aggregated with the 4.5 percent interest in the PTP for purposes of the hot-for-hot requirement? And even if the hot-for-hot requirement is not satisfied, how should FIRPTA tax be calculated? Should section 897(g) apply? Or should an entity approach apply, based on the treatment of exchangeable units themselves as USRPIs (that is, as interests other than solely as a creditor in PTP units)? And in assessing whether the 5 percent exception applies to a sale of 4.5 percent of the PTP, how should the five-year lookback rule for classifying an interest in a domestic USRPHC as a USRPI be taken into account — does the lingering interest in half the exchangeable units matter?60

3. A tax unicorn as blocker.

The upshot is that the PTP blocker structure presents several ways to finesse FIRPTA tax — to turn bad gain taxable under FIRPTA into good gain not subject to federal income tax, depending on a foreign investor’s appetite for risk. Even though — or perhaps because — “nothing in FIRPTA is clear,”61 opportunities to avoid FIRPTA tax by using a blocker structure abound. Consider another variation of the simple PTP structure, whereby U.S. Holdco is replaced by a U.S. REIT.

Example 5

In Example 5, because of its ownership of USRPIs, U.S. REIT is treated as a domestic USRPHC. This implicates the FIRPTA tax on gain, as above. Perhaps more interesting, however, are the FIRPTA consequences of U.S. REIT’s status as a conduit. Unlike U.S. Holdco, U.S. REIT passes through the character of gain it recognizes from the disposition of a USRPI. This means that a dividend paid by U.S. REIT to Holdings Partnership, to the extent attributable to the disposition of a USRPI, generally would be subject to FIRPTA tax upon allocation to an NRA individual or foreign corporate investor in the PTP.62

Unlike the U.S. Holdco scenario — in which FIRPTA tax generally arises only upon the disposition of PTP units — FIRPTA tax in the U.S. REIT scenario arises as the result of ongoing ownership of PTP units.63 Much more important, a foreign unitholder who is allocated those dividends is required to file a federal income tax return — solely because of a passive investment in a PTP that is not otherwise engaged in a U.S. trade or business. For many foreign investors, this is sufficient reason not to invest.

The tax efficiency of replacing a U.S. Holdco with a U.S. REIT is therefore undercut by FIRPTA. Nonetheless, there are still a few means to mitigate the effect of FIRPTA while obtaining the benefits of a U.S. REIT in the above PTP structure. The easiest fix, circumstances permitting, is for the U.S. REIT to simply refrain from making distributions attributable to the sale of USRPIs. In this case, a foreign unitholder would not be required to file a federal income tax return by reason of its investment in the PTP.64

Another easy fix is available, but only if the U.S. REIT is a public company. Under section 897, if interests in a U.S. REIT are regularly traded on an established securities market located in the United States, those dividends do not trigger a U.S. tax return filing obligation for foreign persons owning no more than 10 percent of the traded interests.65 In that case, the dividends are treated simply as ordinary dividends potentially eligible for treaty-reduced withholding, or, for investors such as qualified foreign pension funds, complete exemption.66 The PTP can therefore own an interest in a public REIT without triggering a U.S. tax return filing obligation for its foreign unitholders.67

A more interesting solution is available to a tax “unicorn.” Under section 897(k)(2), a U.S. REIT may remain private and still pay the dividends without triggering a U.S. tax return filing obligation for foreign investors in the PTP if the PTP satisfies all the following conditions:

  1. the PTP is created or organized under foreign law as a limited partnership in a jurisdiction that has an agreement for the exchange of tax-related information with the United States;

  2. the PTP has a class of limited partnership units that is regularly traded on the New York Stock Exchange or Nasdaq Stock Market (and the value of that class of units is greater than 50 percent of the value of all partnership units);

  3. the PTP is a “publicly traded partnership” as defined in section 7704(b) that is not classified as a corporation under section 7704(a);

  4. the PTP is a withholding foreign partnership for purposes of chapters 3, 4, and 61 of the code;

  5. the PTP, if it were a domestic corporation, would be a USRPHC;68 and

  6. the PTP maintains records on the identity of each person who, at any time during the foreign person’s tax year, directly holds 5 percent or more of that traded class of PTP units.69

Perhaps the most peculiar of the above requirements is that the PTP be created or organized under foreign law. Based on this requirement, a PTP organized under Delaware law that wishes to attract foreign retail investors cannot directly own an interest in a private U.S. REIT that is paying dividends attributable to the disposition of USRPIs, because the allocation of those dividends would trigger a U.S. tax return filing obligation for the foreign investors. But a PTP organized under foreign law can own an interest in a private U.S. REIT without that adverse effect on foreign investors.

Assuming that such a foreign PTP makes business sense, one issue is how to form the entity without triggering an inversion. For purposes of the inversion rules of section 7874, a foreign PTP is treated as a foreign corporation.70 Absent careful planning (and wondrous facts), the formation of such a foreign PTP by transferring enough U.S. real property to cause it to become a USRPHC might well cause the foreign PTP to be a “surrogate foreign corporation” treated as a domestic corporation under section 7874(b).71 This seems adverse. Peculiarly enough, it is not (always).72

4. PTP as corporate blocker.

Based on the Tax Cuts and Jobs Act’s reduction of the marginal federal corporate tax rate to 21 percent,73 an obvious choice for a PTP is to consider electing to be classified as a corporation or otherwise converting to a corporation. This may make less sense for an MLP, based on the depreciation “shield” discussed earlier,74 but it has made sense for many investment PTPs, as confirmed by the recent corporate conversions of KKR & Co. LP and the Blackstone Group LP, among others.75 Even before the TCJA, some shipping PTPs elected to be classified as corporations.76

One meaningful distinction between PTPs and corporate issuers relates not to tax, but to control. Most large public corporations issue to the public common shares with full voting rights. PTPs typically issue units with minimal or no voting rights. PTPs recently converting to corporations have in many cases preserved their limited voting structure despite corporate tax treatment (or organization).77 This mimics other recent U.S. capital market developments78 and is hardly surprising, given the private equity origin of those public vehicles.

B. Income From PFICs and CFCs

Aside from offering benefits to foreign investors, the simple PTP Holdco structure also benefits U.S. investors. In particular, it can help mitigate some adverse consequences under the passive foreign investment company and controlled foreign corporation anti-deferral regimes. If bad income under these regimes cannot be turned into good income, at least it can be managed through interposed partnerships.

1. PFIC basics.

A foreign corporation is a PFIC for federal income tax purposes for any tax year in which, after applying look-through rules, either (1) at least 75 percent of its gross income for that year consists of specified types of passive income; or (2) at least 50 percent of the value of its assets (determined on the basis of a quarterly average) during that year produces or is held for the production of passive income.79 Passive income generally includes dividends, interest, royalties, rents, annuities, net gains from the sale or exchange of property producing that income, and net foreign currency gains.

If a foreign corporation is a PFIC for any tax year during a U.S. shareholder’s holding period, gain recognized by the shareholder upon the sale of shares generally is allocated ratably over the shareholder’s holding period. Amounts allocated to the tax year of the sale and to any year before the corporation became a PFIC are taxed as ordinary income. The amount allocated to each other tax year is taxed at the highest applicable ordinary income rate, together with an interest charge to eliminate the value of deferral.80

In lieu of the foregoing adverse consequences, a U.S. shareholder may make a qualified electing fund election to be taxed currently on that shareholder’s pro rata share of the PFIC’s ordinary earnings and net capital gain, whether or not distributed.81 That is, as a reward for making the QEF election to eliminate deferral, the more adverse consequences of the PFIC tax regime are eliminated.

2. CFC basics.

A foreign corporation is a CFC if more than 50 percent of (1) the total combined voting power of all classes of stock entitled to vote or (2) the total value of all classes of stock is owned by “United States shareholders.”82 Generally, a U.S. shareholder is a U.S. person (including a domestic partnership) treated as owning 10 percent or more of the total combined voting power or total value of all classes of stock of the foreign corporation.83 U.S. shareholders generally must include as ordinary income their allocable shares of the CFC’s subpart F income and global intangible low-taxed income.84 A U.S. shareholder generally must include gain from the sale of CFC stock as a dividend to the extent of the CFC’s post-1962 earnings and profits during the portion of the shareholder’s holding period that the foreign corporation was a CFC, subject to limitations and exceptions.85

Consider the following two examples.

Example 6

Facts: PTP and Holdings Partnership are foreign. Fco, Fco Sub 1, and Fco Sub 2 all satisfy the PFIC income and asset tests to be classified as PFICs. PTP is widely held.

Based on the TCJA’s repeal of former section 958(b)(4), Fco and Fco Sub 2 technically are CFCs, because USco constructively owns 100 percent of each.86 But no U.S. holder of PTP units is a U.S. shareholder of Fco or Fco Sub 2.87 As a result, all the foreign subsidiaries remain PFICs for PTP’s U.S. unitholders: Fco, Fco Sub 1, and Fco Sub 2.88 To mitigate the adverse effects of the PFIC regime, each U.S. unitholder may make a QEF election for each of the three PFICs.89 But the PTP cannot make QEF elections on the unitholders’ behalf. For a U.S. unitholder, the task of making QEF elections and monitoring PFIC status is a significant disincentive to invest in the PTP.

Example 7

Facts: As above, PTP is foreign, but Holdings Partnership is domestic. As above, each of the three foreign subsidiaries satisfies the income and asset tests to be classified as a PFIC. PTP is widely held.

As in Example 6, Fco Sub 1 remains a PFIC for U.S. unitholders. But in Example 7, domestic Holdings Partnership, as the first U.S. person in the chain above the PFIC, is permitted to make a QEF election on behalf of all U.S. unitholders.90 By organizing Holdings Partnership as a domestic partnership, PTP therefore lightens the tax compliance burden of its U.S. unitholders under the outbound anti-deferral regimes. But for the choice to form Holdings Partnership under domestic law, PTP’s U.S. unitholders would be required to actively monitor and mitigate the more severe PFIC consequences on an entity-by-entity basis. In contrast, by making Holdings Partnership domestic, PTP can assume this burden on their behalf. If PTP makes the QEF election for Fco Sub 1, a U.S. unitholder is relieved of its entire compliance burden under the PFIC regime.

Can QEF elections be made by domestic Holdings Partnership for Fco and Fco Sub 2? This depends on whether these subsidiaries are PFICs or CFCs with respect to U.S. unitholders. Based on the IRS’s position before the TCJA, each subsidiary would have been treated as a CFC based on 100 percent ownership by domestic Holdings Partnership. A QEF election would not have been available.91 Holdings Partnership would have been a U.S. shareholder, and each U.S. unitholder would therefore have been required to include its pro rata share of subpart F income of Fco and Fco Sub 2.92

Under current law, the tax consequences regarding Fco and Fco Sub 2 are somewhat unsettled:

  1. As for section 951A, it is clear under final regulations that the U.S. unitholders have no GILTI inclusions.93

  2. As for section 951, under current law, the U.S. unitholders might be required to include subpart F income. Under proposed regulations, however, the PTP is permitted to not allocate subpart F income to its U.S. unitholders.94

  3. Aside from sections 951A and 951, the IRS has made clear that section 1248 gain might remain taxable to U.S. unitholders, solely by reason of the treatment of domestic Holdings Partnership as a U.S. shareholder.95

Stated differently, when a foreign corporation is a CFC solely as the result of ownership by a domestic partnership, the IRS mandates the aggregate approach for GILTI purposes and seems likely to eventually adopt the aggregate approach for subpart F purposes, but for now, the IRS appears committed to the entity approach for section 1248 purposes.

What are the implications for Fco and Fco Sub 2? These foreign subsidiaries are treated as CFCs (and not PFICs) with respect to a U.S. unitholder only if (1) the subsidiaries are CFCs and (2) the U.S. unitholder is a U.S. shareholder as defined in section 951(b).96 Based on the bifurcated approach to section 951(b) ownership taken in the final and proposed regulations, should the PTP’s U.S. unitholders be taxed solely under the CFC regime? If yes, U.S. unitholders would have no GILTI inclusions and no subpart F income (under proposed regulations) but would potentially have section 1248 gain upon exit. If no, Fco and Fco Sub 2 would remain PFICs with respect to U.S. unitholders. In that case, domestic Holdings Partnership would be permitted to make QEF elections on behalf of all U.S. unitholders.97

Based on the IRS’s acknowledgment of the uncertainty,98 perhaps this is a case in which the PTP may elect which of the two regimes to apply, as long as it takes a consistent approach, and in the absence of further guidance. Either way, the approach illustrated by Example 7 allows the PTP to shoulder the entire compliance burden of the relevant anti-deferral regime, whether PFIC or CFC, and to report the relevant items on a U.S. unitholder’s Schedule K-1. That is, domestic Holdings Partnership acts as a blocker that eliminates some information reporting otherwise required of a U.S. investor in a PTP.

III. How to Alter a Tax Threshold

In an example furnished earlier, using a blocker — a domestic holdings partnership — potentially changed the tax status of an underlying asset from PFIC to CFC. It is fairly obvious that interposing a corporate or partnership blocker can alter the tax treatment of an underlying asset or income. Less obvious, and less certain, is whether a blocker conceivably changes the tax treatment of an underlying activity.

In the inbound context, for example, can the use of a corporate blocker alter the tax treatment of an underlying activity? In particular, is the threshold of activity constituting a U.S. trade or business lower for a corporation than for a noncorporate taxpayer? (And does it matter?)

A. Business Profits Under a Treaty

To explore this question, consider the application of the business profits article of an income tax treaty to a foreign investor’s income from a U.S. investment. Almost invariably, foreign investors are indifferent to the business profits article, which deals with income from carrying on a business through a PE (in the United States):

1. Profits of an enterprise of a Contracting State shall be taxable only in that Contracting State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits that are attributable to the permanent establishment in accordance with the provisions of paragraph 2 of this Article may be taxed in that other Contracting State.

2. For the purposes of this Article, the profits that are attributable in each Contracting State to the permanent establishment referred to in paragraph 1 of this Article are the profits it might be expected to make, in particular in its dealings with other parts of the enterprise, if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed by the enterprise through the permanent establishment and through the other parts of the enterprise.99

Most foreign investors roughly equate the treaty concept of “business profits” from carrying on a business in the United States with ECI. Foreign investors are mostly indifferent to the potential for ECI to qualify as business profits not attributable to a U.S. PE, because they generally do not earn ECI in the first place. Under the trading safe harbor of section 864(b)(2), a foreign person is not treated as engaged in a U.S. trade or business — that is, generating ECI — if its activities in the United States consist solely of trading in stocks and securities for its own account.100

As discussed in detail later, activity within the trading safe harbor does not necessarily fail to constitute “carrying on a business” for purposes of the business profits article. It simply is not a “trade or business within the United States” for purposes of some limited inbound provisions of the code.101 Somewhat counterintuitively, this means that under the business profits article of a treaty, U.S.-source fixed or determinable annual or periodical income derived by a foreign investor may be exempt from the 30 percent withholding tax on gross income102 — even if that income is not ECI.103

But for foreign investors, the distinction generally is irrelevant, because the business profits article expressly does not address such typical U.S.-source investment income as dividends and interest:

3. Where profits include items of income that are dealt with separately in other Articles of this Convention, then the provisions of those Articles shall not be affected by the provisions of this Article [regarding business profits].104

This means that U.S. withholding tax on dividends and interest generally is reduced under the dividends or interest articles of a treaty, assuming no code exemption applies. Nor is gain realized by a foreign investor from the sale of U.S. stocks or securities generally subject to federal income tax.105 For good reason, foreign investors therefore generally give no thought to the business profits article — virtually all categories of investment income they derive are either not subject to U.S. tax or are subject to reduced rates of tax under articles of the treaty other than the business profits article.

There are, however, limited categories of ancillary investment income for which treaty benefits might be welcome. Consider borrow fees, for example. As compensation for lending securities to a U.S. borrower, a foreign securities lender might receive — in the case of a securities lending agreement that provides for the transfer of noncash collateral to the lender — a borrow fee. The amount of the borrow fee can vary, depending on the demand for the transferred securities — that is, how hot the transferred securities are.106

There is no formal guidance on the source or character of borrow fees, thus the tax treatment of borrow fees is uncertain. The IRS ordinarily will not rule on whether borrow fees are “from sources within or without the United States; the character of such amounts; and whether the amounts constitute a particular kind of income for purposes of any United States income tax treaty.”107

Do borrow fees qualify for treaty benefits? Consider the following example, based on a 1988 letter ruling.108

Example 8

In LTR 8822061, the IRS ruled that borrow fees received by a foreign insurance company for lending securities to a U.S. borrower constituted “industrial or commercial profits” (that is, business profits) for purposes of an income tax treaty. The IRS concluded that the borrow fees were exempt under the treaty because they were not attributable to a PE of the insurance company in the United States. The ruling did not address the source of the borrow fee income.

The ruling is confined to securities lenders whose investment activity of securities lending is treated as business activity for U.S. tax purposes:

Generally, insurance companies earn two types of income, underwriting income and investment income. While the activity of loaning securities described above may not constitute the active conduct of a trade or business for many businesses, for purposes of the Treaty such activity does constitute the active conduct of a life insurance business. The nature of a life insurance business is such that underwriting income alone does not cover a life insurance company’s cost of its business. Rather, a life insurance company must also generate investment income to enable it to cover anticipated future claims. Loaning securities is one way for Y [(the insurance company)] to maximize its return on its investment portfolio. Therefore, we find that generating [borrow fees] through security loans pursuant to the Agreement is part of an active trade or business for a life insurance company under the Treaty and, hence, the Fees constitute industrial or commercial profits for purposes of Article [redacted] of the Treaty.109 [Emphasis added.]

Thus, the 1988 ruling supports the treatment of borrow fees as business profits for treaty purposes, even though the investment activity giving rise to those business profits ordinarily would not constitute carrying on a business within the meaning of the business profits article.

This invites a question: May a non-insurance company engaged solely in investment activity claim the business profits exemption for borrow fees?110 Stated differently, can mere investment activity constitute carrying on a business for treaty purposes?

B. Trade or Business Under the Code

1. Trading as a trade or business.

Because U.S. income tax treaties do not define the term “carrying on a business” for purposes of the business profits article, it must be construed under U.S. law.111 The treaty term “carrying on a business” generally has been interpreted to have the same meaning as “trade or business” for federal income tax purposes.112 The term “trade or business” is not defined in the code, but under common law. For investment activity, including securities lending, the most relevant cases are those that distinguish mere “investing” in stocks and securities from “trading” that constitutes a trade or business.

Among the factors relevant to trading are the following:

  • whether the taxpayer engages in hedging, the purchase of securities on margin, selling short, or the purchase of puts and calls;113

  • whether the activities are extensive instead of “infrequent or inconsequential”;114 and

  • whether “securities are bought and sold with reasonable frequency in an endeavor to catch the swings in the daily market movements and profit thereby on a short-term basis.”115

A U.S. taxpayer whose activities are described above is engaged in a trade or business. But a foreign taxpayer engaged in the same activities is not engaged in a U.S. trade or business. Why? Those activities fall within the section 864(b)(2) trading safe harbor for foreign taxpayers.116 Does this mean that activity within the trading safe harbor does not constitute carrying on a business for purposes of the business profits article? It should not.

When Congress defined the scope of the trading safe harbor by enacting the Foreign Investors Tax Act of 1966 (FITA), it made clear that the purpose of the trading safe harbor was to encourage foreign investment in the United States. FITA amended the code to allow a foreign investor to grant discretionary authority to a U.S. broker or agent to trade in stocks and securities for the investor’s own account without causing the foreign investor to be engaged in a U.S. trade or business.117 At the time, a grant of discretionary authority was thought to create some risk of subjecting foreign taxpayers to U.S. net income tax (by excluding them from the predecessor to the current trading safe harbor).118

In view of this legislative history, it makes little sense to treat trading activity (within the meaning of the trading safe harbor) as failing to qualify as carrying on a business (within the meaning of the business profits article). If this were the law, tax treaty benefits under the business profits article would be denied for trading that barely falls within the trading safe harbor. Those tax treaty benefits would, perversely, be permitted for trading falling slightly outside the trading safe harbor. That interpretation hardly seems correct.119

What was the original question? This discussion began by asking whether a non-insurance company could claim the treaty exemption for business profits not attributable to a U.S. PE for specified income from investment activity. The above discussion only shows that if investment or trading activity falls within the trading safe harbor, this should not disqualify it from treatment as carrying on a business for treaty purposes. It remains to be shown that mere investment activity can constitute a trade or business for federal income tax purposes — and therefore constitute carrying on a business for treaty purposes.

2. Investing as a trade or business.

Taken together, the “trading” cases cited earlier appear to establish a relatively high threshold for trade or business. That is, the cases stand for the proposition that a trading business arises only if the taxpayer trades in stocks and securities with the purpose of profiting from short-term swings in market movements. However, although these cases remain pertinent for taxpayers who are individuals, case law and legislative history indicate that the trade-or-business threshold for corporate investors is different.

Significantly, all the trading cases that might undercut a business-profits-based claim appear to concern trading by individuals.120 For example, in the paradigmatic trading case, Higgins, the Supreme Court affirmed the Second Circuit’s opinion that an individual resident in Paris was not “carrying on a business” so as to generate deductible expenses, even though the individual “devoted a considerable portion of his time to the oversight of his [large investments in securities] and hired others to assist him in offices [including a New York office] rented for that purpose.”121 On these facts, Eugene Higgins’s activities were found to be those of an investor rather than a trader.

Does Higgins apply to corporate investors? Consider legislative history. Only a year after Higgins was decided, Congress legislatively reversed the Supreme Court’s decision by enacting section 23(a)(2) of the 1942 code, allowing individuals such as Higgins to deduct investment expenses:

In the case of an individual, all the ordinary and necessary expenses paid or incurred during the taxable year for the production or collection of income, or for the management, conservation, or maintenance of property held for the production of income.122 [Emphasis added.]

According to the Supreme Court, Higgins was directly responsible for section 23(a)(2) of the 1942 code.123 Had Congress believed that similar relief were necessary for corporate investors, there would have been little need to clarify that the new law applied “in the case of an individual.” This is because a related rule, section 23(a)(1) of the 1942 code, already allowed a deduction for all the ordinary and necessary expenses incurred “in carrying on any trade or business.” The clear inference is that investing by a corporation was already understood to constitute a trade or business under section 23(a)(1). There would have been no need to legislatively overturn the result in Higgins for corporate investors.124

Case law addressing foreign entities organized for investment purposes is consistent with this interpretation. For example, in Scottish American Investment, the Supreme Court implicitly treated foreign investment trusts as engaged in a trade or business when the trusts sought to be taxed as resident foreign corporations under the revenue acts of 1936 and 1938 by reason of an office or fixed place of business in the United States.125 Congress also recognized this distinction when it enacted FITA in 1966. According to the legislative history, “individuals who trade in U.S. stocks and commodities are not treated as thereby being engaged in the business of buying and selling stocks and commodities, whether or not the volume of their activity is large.”126

Nor is the point lost on the IRS, which affirmed this interpretation of Higgins in the preamble to the recently proposed regulations on the separate calculation of UBTI for each trade or business:

Some commenters cited Higgins v. Commissioner . . . to support the position that an exempt organization’s investment of its own assets is not a trade or business. However, Higgins is not relevant under sections 511 through 514 because it applies to individuals, not corporations or trusts. For the taxable years involved in Higgins, a deduction was allowed for all ordinary and necessary expenses of carrying on a trade or business, but a deduction was not allowed for personal, living, or family expenses. Congress responded to Higgins by enacting what is now section 212(1) to allow individuals to deduct all ordinary and necessary expenses incurred in the production or collection of income.127

How does this relate to blockers?

The theory is that the interposition of a corporate blocker (and treaty resident) might lower the trade or business threshold — and thus the “carrying on a business” threshold for purposes of the business profits article — thereby obtaining, for some ancillary categories of investment income, such as borrow fees, treaty benefits that would not otherwise be available.128

Code provisions concerning U.S. mutual funds are consistent with this theory. For example, an investment company is regarded as engaged in an “investment business” for purposes of the continuity of business enterprise requirement for tax-free reorganizations.129 And there is little question that the expenses of a U.S. mutual fund are deductible as trade or business expenses,130 because U.S. mutual funds “are generally in business to enhance the market value of a pool of securities and the value of their shareholders’ interests in that pool [and] the expenses a RIC incurs to accomplish these objectives are collectively borne and relate to the production of collectively shared income.”131

In the narrow context of borrow fees, it bears mention that some rules regarding securities lending are consistent with this theory. For example, payments received by exempt organizations from securities lending are not treated as UBTI.132 Comparable carveouts exist in the mutual fund context133 and for income from commercial activity for purposes of the section 892 exemption for foreign governments.134 The absence of these carveouts would tend to indicate that securities lending does not constitute trade or business activity. Thus, the presence of the carveouts supports the treatment of securities lending as trade or business activity.

Is this reading of Higgins a reed too fragile to support a tax position in any circumstance that matters? An answer seems unlikely to arrive soon. For now, this aspect of blockers appears to be a solution in search of a problem.

FOOTNOTES

1 See sections 871(b) and 882; see also section 897(a). Example 1 assumes the U.S. portfolio company is engaged in a trade or business through a U.S. permanent establishment. Aside from shielding foreign investors from ECI, the below-the-fund blocker shields U.S. tax-exempt investors from UBTI. See section 513.

2 Section 884.

3 “FIRPTA” refers to the 1980 Foreign Investment in Real Property Tax Act, codified as section 897.

4 Section 897(a).

5 If, however, the below-the-fund blocker is a domestic U.S. real property holding corporation under section 897, an exit by sale of the interests in the blocker generally is taxable to the foreign investor (id.), unless the investor qualifies for an exemption under the code. Qualified foreign pension funds, for example, qualify for a blanket exemption from FIRPTA tax. See section 897(l).

6 This assumes that a separate blocker owns each underlying U.S. portfolio company. Advisers to funds and their investors will recognize that this brief summary oversimplifies blocker structures. For insightful discussion of blockers, see Andrew W. Needham, “Avoiding UBTI/ECI With a Blocker,” BNA Tax Mgmt. Portfolio No. 735-3rd, at VIII.D (2020); and Neil Marcovitz and Christian M. McBurney, “Canadian Private Equity Fund Investors and Choice of Entity for a U.S. Blocker,” 113 J. Tax’n 214 (2010).

7 A trade or business is also imputed through multiple partnership tiers. Johnston v. Commissioner, 24 T.C. 920 (1955). Under section 875(2), an NRA individual or foreign corporation that is a beneficiary of an estate or trust that is engaged in a U.S. trade or business is also treated as so engaged.

8 See, e.g., reg. section 1.702-1(a)(8)(ii), illustrating this point: “Thus, if any partner is a controlled foreign corporation, as defined in section 957, items of income that would be gross subpart F income if separately taken into account by the controlled foreign corporation must be separately stated for all partners.” (Emphasis added.)

9 See, e.g., reg. section 1.6012-2(g)(1)(ii): “Thus, for example, a foreign corporation which is engaged in trade or business in the United States at any time during the taxable year is required to file a return on Form 1120-F even though (a) it has no income which is effectively connected with the conduct of a trade or business in the United States, (b) it has no income from sources within the United States, or (c) its income is exempt from income tax by reason of an income tax convention or any section of the code.”

10 Donroy Ltd. v. Commissioner, 301 F.2d 200 (9th Cir. 1962).

11 Although Donroy emphasized agency, the court also considered aggregate principles: “Under this concept of partnership as an association of individuals, it follows that each partner, whether general or limited has an interest as such in the assets and the profits of the partnership, including the physical plant or offices at which the partnership conducts its business, so that the office or permanent establishment of the partnership is in law, the office of each of the partners — whether general or limited.” Id. at 207.

12 Unger v. Commissioner, 936 F.2d 1316 (D.C. Cir. 1991), aff’g T.C. Memo. 1990-15.

14 A foreign government “controlled entity” may qualify for the section 892 exemption only if does not engage in commercial activity anywhere in the world. Joint Committee on Taxation, “Economic and U.S. Income Tax Issues Raised by Sovereign Wealth Fund Investment in the United States,” JCX-49-08, at 75 (June 17, 2008).

15 As discussed in more detail later, section 864(c)(8) reversed the result in Grecian Magnesite Mining, Industrial & Shipping Co. SA v. Commissioner, 149 T.C. 63 (2017), aff’d, 926 F.3d 819 (D.C. Cir. 2019).

16 Preamble to REG-113604-18, 83 F.R. 66647, 66649 (Dec. 27, 2018) (“Neither section 864(c)(8) nor the proposed regulations address the source of gain or loss from the transfer of a partnership interest.”).

17 The IRS takes the position that section 897(g) is self-executing. Notice 88-72, 1988-2 C.B. 383.

18 Reg. section 1.1446-2(b)(2)(iii).

19 See section 875(1).

20 See section 702(b).

21 See Donroy, 301 F.2d 200; and Unger, 936 F.2d 1316.

22 See sections 871(b) and 882.

23 See section 1446.

24 See sections 864(c)(8) and 897(g).

25 See section 6012.

26 See Needham, supra note 6, at VIII.D.2.a (addressing the potential for a blocker to be treated as an agent).

27 “Bad” means problematic — for example, income taxed at higher rates, income that fails to qualify for treaty benefits, income that generates a tax return filing obligation for a foreign investor, or income that disqualifies an entity from treatment as a tax conduit, as discussed later.

28 See, e.g., section 892(a)(1)(A)(i) (generally exempting income of foreign government investors from investments in the United States in stocks, bonds, or other domestic securities). The section 892 exemption for foreign governments does not, however, apply to income received by or (directly or indirectly) from a “controlled commercial entity.” Section 892(a)(2)(A)(ii). This means that a section 892 investor generally may claim 0 percent withholding on dividends received from the below-the-fund blocker, provided that it does not control the blocker.

29 See, e.g., Canada-U.S. Income Tax Convention, Art. XXI. The domestic blocker capitalized with debt may further reduce its taxable income, subject to code limitations on the deduction of interest expense. See, e.g., sections 59A, 163(j), and 267A; and reg. section 1.385-3.

30 See, e.g., Luxembourg-U.S. Income Tax Convention, art. 11 (reducing the branch profits tax to 5 percent of the “dividend equivalent amount” of the business profits of the company that are attributable to a U.S. PE).

31 Sections 851(b), 856(c)(2), and 7704(c). Some might take issue with this characterization of a REIT as a tax conduit. For purposes of this discussion, a conduit is any entity (other than a partnership or other fiscally transparent entity) taxed more favorably than a C corporation as the result of a special code regime.

32 See section 7704(c)(2).

33 Section 7704(d)(1).

34 These qualifying income provisions often piggyback on one another. For example, income good enough for a RIC or REIT is also good enough for a PTP. Section 7704(d)(4) (defining qualifying income for PTP purposes to include income that would qualify under section 851(b)(2)(A) or 856(c)(2)).

35 The Holdcos also prevent U.S. tax-exempt investors in the PTP from being allocated UBTI. This assumes that neither the holdings partnership nor the PTP incurs debt to fund its investment in the Holdcos, which could give rise to unrelated debt-financed income taxable as UBTI under section 514.

36 “Master limited partnership” is a business term for a PTP whose assets mainly give rise to qualifying income from natural resources, including transportation of oil and gas, as defined in section 7704(d)(1)(E).

37 See sections 1014, 754, and 743(b) (assuming a section 754 election is in effect).

38 Section 897(a) and (c).

39 Section 865(a)(2). FIRPTA also treats gain from the disposition of a USRPI by a foreign person as U.S.-source. See section 861(a)(5).

40 This assumes the foreign person is not otherwise treated as engaged in a U.S. trade or business. See section 864(c).

41 See section 897(c)(3).

42 See reg. section 1.897-1(c)(2)(iv):

If any class of interests in a partnership or trust is, within the meaning of section 1.897-1(m) and (n), regularly traded on an established securities market, then for purposes of sections 897(g) and 1445 and section 1.897-2(d) and (e) an interest in the entity shall not be treated as an interest in a partnership or trust. Instead, such an interest shall be subject to the rules applicable to interests in publicly traded corporations pursuant to paragraph (c)(2)(iii) of this section. Such interests can be real property interests in the hands of a person that holds a greater than 5 percent interest.

43 If the PTP is organized outside the United States, it is unclear how these regulations apply. See Blanchard, “FIRPTA in the 21st Century, Installment Three: FIRPTA and Foreign PTPs,” 37 Tax Mgmt. Int’l J. 176 (2008). This is because an interest in a USRPHC that is organized outside the United States (and not otherwise treated as a domestic corporation) is not a USRPI. An interest in a USRPHC is only a USRPI if the USRPHC is domestic. Section 897(c)(1)(A)(ii).

44 “PTP is a USPRHC” means, of course, that the PTP would be a USRPHC if it were classified as a corporation.

45 For simplicity, further assume that the foreign investor is not otherwise engaged in a U.S. trade or business and is not an NRA individual present in the United States for 183 days or more during the tax year, as described in section 871(a)(2). Also assume, by reason of the blocker structure, that the PTP is not engaged in a U.S. trade or business.

46 See section 897(c)(3) and reg. section 1.897-1(c)(2)(iv).

47 See reg. section 1.897-1(c)(2)(iv) and (iii).

48 To determine whether it is a USRPHC, the PTP must look through its controlling interests in subsidiary corporations, including foreign corporations. See section 897(c)(5) and reg. section 1.897-2(a) (“for purposes of determining whether another corporation is a U.S. real property holding corporation, an interest in a foreign corporation is a U.S. real property interest unless it is established that the foreign corporation is not a U.S. real property holding corporation.”).

49 See reg. section 1.897-1(c)(2)(iv). This assumes the PTP is organized in the United States. The answer is less clear for PTPs organized outside the United States. See supra note 43.

50 Reg. section 1.897-1(c)(2)(iv).

51 See generally John C. Hart and Andrew B. Purcell, “The Umbrellas of Subchapter K,” in 10 The Partnership Tax Practice Series: Planning for Domestic and Foreign Partnerships, LLCs, Joint Ventures and Other Strategic Alliances (2019).

52 Section 897(c)(1)(A)(ii). This assumes that foreign Holdco has not made the election under section 897(i) to be treated as a domestic corporation for FIRPTA purposes.

53 Reg. section 1.897-1(c)(1).

54 Reg. section 1.897-1(d)(e)(i).

55 If the PTP is organized outside the United States, there might be a position that a greater than 5 percent interest in the PTP is not a USRPHC because an interest in a foreign USRPHC is not a USRPI. As Blanchard notes in her article cited supra note 43, this is almost too good to be true.

56 That is, assume that both the PTP and U.S. Holdco are USRPHCs but there is no appreciation in the U.S. Holdco shares.

57 Despite the IRS’s position that section 897(g) is self-executing (see Notice 88-72), there is no clear guidance for determining the amount of gain realized that is “attributable to” USRPIs. Possibly a partnership-level deemed sale is appropriate, by analogy to the mechanic set forth in the proposed regulations under section 864(c)(8).

58 For simplicity, assume that the exchange qualifies for nonrecognition under section 721, subject to the discussion below.

59 See reg. section 1.897-6T(a)(1) (generally providing that “any nonrecognition provision shall apply to a transfer by a foreign person of a U.S. real property interest on which gain is realized only to the extent that the transferred U.S. real property interest is exchanged for a U.S. real property interest which, immediately following the exchange, would be subject to U.S. taxation upon its disposition”); and reg. section 1.897-6T(a)(2) (identifying section 721 among the pertinent nonrecognition provisions). See generally David F. Levy, “Nonrecognition Transactions Involving FIRPTA Companies,” Tax Notes, June 2, 2008, p. 933.

60 See section 897(c)(3) and (c)(1)(A)(ii)(II).

61 Levy, supra note 59.

62 See section 897(h)(1). For thoughtful discussions of the tax treatment of REIT dividends attributable to the disposition of USRPIs, see, e.g., Scott L. Semer and Michele J. Alexander, “Section 897(h)(1),” BNA Tax Mgmt. Portfolio No. 743-2nd, at V.2.b (2020); and Blanchard, “Is There a FIRPTA Tax on REIT Distributions?” Tax Notes, Sept. 18, 2006, p. 1071.

63 This assumes that the U.S. REIT pays such dividends. If it does not, part of the FIRPTA problem goes away.

64 This assumes that the PTP is not otherwise engaged in a U.S. trade or business.

65 Section 897(h)(1) and (k)(1)(B).

66 See section 897(l).

67 Nor would the foreign investor owning 9 percent of Holdings Partnership in the UP-PTP structure have a U.S. tax return filing obligation solely because of dividends paid by the U.S. REIT. Moreover, by reason of owning less than 10 percent of the public U.S. REIT, the foreign investor might not be subject to FIRPTA tax under section 897(g) upon the sale of exchangeable units of Holdings Partnership.

68 This reference to “domestic” in section 897(k)(3)(B)(ii)(III) does not make sense. Classification as a USRPHC does not depend on whether a corporation is foreign or domestic.

69 See section 897(k)(3)(A)(i)(II), (B)(ii), and (A)(iii).

70 Reg. section 1.7874-2(g).

71 See reg. section 1.7874-2(g)(3).

72 For example, at least two publicly traded Canadian REITs owning U.S. real property have undertaken deliberate inversions under section 7874. See Milestone Apartments Real Estate Investment Trust, Prospectus (Feb. 27, 2013); and WPT Industrial Real Estate Investment Trust, Prospectus (Apr. 18, 2013). Both prospectuses are available on the SEDAR website.

73 TCJA section 13001(a).

74 But see Kinder Morgan Inc., Registration Statement on Form S-4 (Oct. 1, 2014) (filed with the SEC) (regarding the merger whereby Kinder Morgan Inc. acquired all the outstanding PTP units of Kinder Morgan Energy Partners LP not already owned); and Amy S. Elliott, “Kinder Morgan Consolidates, Converting 2 PTPs,” Tax Notes, Aug. 18, 2014, p. 770.

75 See, e.g., The Blackstone Group Inc., Form 8-K (July 1, 2019) (filed with the SEC) (regarding the conversion of the Blackstone Group LP to a corporation); and KKR & Co. LP, Form 10-Q (May 8, 2018) (filed with the SEC) (regarding the conversion of KKR & Co. LP to a corporation).

76 See, e.g., Teekay Offshore Partners LP, Registration Statement, Form F-3, at 28 (May 10, 2013) (filed with the SEC) (“We have elected to be taxed as a corporation for U.S. federal income tax purposes.”).

77 See, e.g., section 5.01 of the certificate of incorporation for Blackstone. The Blackstone Group Inc., supra note 75, at Exhibit 3.2.

78 See Maureen Farrell, “Tech Founders Want IPO Riches Without Those Pesky Shareholders,” The Wall Street Journal, Apr. 3, 2017 (updated).

79 Section 1297(a).

80 Section 1291.

81 Section 1293(a).

82 Section 957(a).

83 Section 951(b).

84 Sections 951 and 951A.

85 Section 1248. Section 1248 gain is treated as an unrealized receivable for purposes of section 751. Section 751(c) (flush language).

86 See sections 958(b) and 318(a)(3)(C).

87 See section 958(a)(2). This assumes, of course, that no U.S. holder of PTP units constructively owns at least 10 percent of the PTP units.

88 See section 1298(a)(3) and (5) (regarding the attribution of ownership of Fcos generally to U.S. unitholders), section 1298(a)(2)(B) (regarding ownership by attribution of Fco Sub 1), section 1298(a)(2)(A) (regarding ownership by attribution of Fco Sub 2), and section 1297(d) (the general rule that the CFC regime trumps the PFIC regime, but only for U.S. shareholders within the meaning of section 951(b)).

89 If stock of a foreign corporation is marketable stock, a mark-to-market election for current taxation may be made in lieu of a QEF election. See section 1296(a). Stock of a wholly owned foreign subsidiary would not qualify as marketable stock.

90 See reg. section 1.1295-1(d)(1) (last sentence).

91 See section 1297(d).

92 See, e.g., reg. section 1.701-2(f), Example 3; and LTR 201106003.

93 See reg. section 1.951A-1(e)(1) and (e)(3), Example 1. Because GILTI inclusions, unlike subpart F inclusions, are measured by aggregating all of a U.S. shareholder’s interests in CFCs, the IRS, as a practical matter, essentially is forced into this approach.

94 See prop. reg. section 1.951-1(a)(4) and (d)(1). These regulations permit current reliance. Preamble to REG-101828-19, 84 F.R. 29114, 29119 (June 21, 2019).

95 See preamble to REG-101828-19, 84 F.R. at 29119 (“This aggregate treatment does not apply for any other purposes of the code, including for purposes of section 1248.”); and preamble to T.D. 9866, 84 F.R. 29288, 29316 (June 21, 2019) (“The treatment of domestic partnerships as foreign partnerships in the final regulations is solely for purposes of section 951A. . . . The rule does not affect the determination of ownership under section 958(a) for any other provision of the code (such as section 1248(a)).”).

96 See section 1297(d).

97 The cost of QEF elections is, of course, the loss of deferral, compared with taxation under section 1248.

98 See, e.g., preamble to REG-101828-19, 84 F.R. at 29120:

The Treasury Department and the IRS are considering the operation of the PFIC regime where U.S. persons are partners of a domestic partnership that owns stock of a foreign corporation that is a PFIC, some of those partners might themselves be U.S. shareholders of the foreign corporation, and the foreign corporation might not be treated as a PFIC with respect to such U.S. shareholders under section 1297(d) if the foreign corporation is also a CFC.

99 U.S. Model Income Tax Convention, art. 7 (2016).

100 The trading safe harbor does not apply to dealers. Section 864(b)(2)(A)(ii). Stated differently, if all of a foreign investor’s activities fall within the trading safe harbor, that investor’s income from investing or trading in stocks and securities is not subject to net income tax (on ECI). This excludes, of course, the possibility of FIRPTA tax.

101 See section 864(b) (limiting the trading safe harbor to parts I and II of subchapter N and chapter 3 of the code). Nor can non-ECI be attributed to a U.S. PE for tax treaty purposes. Section 894(b).

102 U.S.-source passive income derived by a foreign investor, although not taxable as ECI, generally is subject to the gross income tax on U.S.-source FDAP. That income generally includes U.S.-source dividends and interest. Sections 871(a) and 881. The tax on U.S.-source FDAP is collected by withholding. Sections 1441 and 1442 (imposing U.S. withholding tax on U.S.-source FDAP).

103 See, e.g., Rev. Rul. 86-156, 1986-2 C.B. 297 (exempting U.S.-source equipment rental income derived by a foreign corporation not engaged in a U.S. trade or business as “industrial or commercial profits” not attributable to a U.S. PE for purposes of Article III of the Netherlands-U.S. Income Tax Convention of 1950, as amended by the 1965 protocol); see also FSA 200031005.

104 U.S. Model Income Tax Convention, art. 7 (2016).

105 Generally, that gain is treated as foreign-source (see section 865(a)(2)), assuming it is not ECI (and not FIRPTA gain, which is treated as U.S.-source). Although that gain is FDAP, it is not U.S.-source FDAP, and therefore not subject to federal income tax. See sections 871(a) and 881. Income and gain realized by a foreign investor is therefore either (1) taxable as ECI, (2) taxable as U.S.-source FDAP, or (3) not subject to federal income tax. Mercifully, these three categories are mutually exclusive.

106 If cash collateral is transferred, the borrow fee may be referred to as a “negative rebate fee,” because the fee takes the form of income retained by the foreign investor from its investment of the cash collateral, in contradistinction to the portion of that investment income that is paid to the securities borrower as a “rebate fee.”

107 Rev. Proc. 2020-7, 2019-1 IRB 268, section 4.01(25). The revenue procedure addresses securities loan payments made in connection with a transfer of securities described in section 1058. A securities loan described in section 1058, although a realization event, is accorded nonrecognition. See also preamble to T.D. 8735, 62 F.R. 53498, 53499 (Oct. 14, 1997) (promulgating final regulations regarding substitute dividends and expressly refraining from characterizing the source or character of fees).

109 Id.

110 Note that borrow fees might well qualify for exemption under the “other income” article of the relevant treaty. For discussion purposes, borrow fees are assumed not to qualify for that exemption, nor to be addressed separately in any other treaty article.

111 See, e.g., U.S. Model Income Tax Convention, art. 3(2) (2016).

112 See, e.g., Herbert v. Commissioner, 30 T.C. 26, 33 (1958); see also Joseph Isenbergh, 2 International Taxation, at para. 103.6 (2020) (“Thus when provisions in U.S. treaties governing business profits are applied to foreign taxpayers, the notion of ‘business’ draws its meaning from the U.S. tax laws. This term . . . is widely understood to have the same meaning as the Code’s notion of a ‘trade or business’ as it applies to foreign taxpayers. Indeed a number of the cases on the contours of a ‘trade or business’ were decided under treaties rather than the Code.”) (citing Herbert).

113 Liang v. Commissioner, 23 T.C. 1040, 1043 (1955).

114 Adda v. Commissioner, 10 T.C. 273, 277 (1948).

115 Liang, 23 T.C. at 1043.

116 See supra the discussion accompanying note 100.

117 See H.R. Rep. No. 89-1450, at 12-13 (1966).

118 Id. at 12.

119 Such an interpretation is also inconsistent with the long line of U.S. tax cases that regard trading in stocks and securities as a trade or business. See, e.g., Liang, 23 T.C. 1040; and Adda, 10 T.C. 273.

120 E.g., Higgins v. Commissioner, 312 U.S. 212 (1941); Liang, 23 T.C. 1040; and see also Moller v. United States, 721 F.2d 810 (Fed. Cir. 1983) (home office deduction).

121 Higgins, 312 U.S. at 213, 217-218.

122 Revenue Act of 1942, ch. 619, section 121 (current version codified as amended at section 212).

123 McDonald v. Commissioner, 323 U.S. 57, 61 (1944).

124 This view finds support among some tax commentators. See, e.g., Boris I. Bittker and Lawrence Lokken, Federal Taxation of Income, Estates, and Gifts, at para. 20.1.2 (1999) (“Congress’s failure to include corporations in section 212 [as successor to section 23(a)(2) of the 1942 code] suggests that the term ‘trade or business’ as used by section 162 [as successor to section 23(a)(1) of the 1942 code] was thought to be broad enough to embrace a corporation’s management of its own investments.”). (Emphasis added.)

125 See Commissioner v. Scottish American Investment Co. Ltd., 323 U.S. 119, 120 (1944).

126 H.R. Rep. No. 89-1450, at 13 (1966) (emphasis added).

127 Preamble to REG-106864-18, 85 F.R. 23172, 23179 (Apr. 24, 2020) (citations omitted).

128 This assumes those business profits are not attributable to a U.S. PE. As noted earlier, borrow fees might be exempt under the “other income” provision of a treaty. See, e.g., U.S. Model Income Tax Convention, art. 21(1) (2016). But this is not always the case. See, e.g., Canada-U.S. Income Tax Convention, Art. XXII(1). Borrow fees might also be exempt as foreign-source income that is not ECI, by analogy to the residence-based source rule for “qualified fails charges.” See reg. section 1.863-10(a).

129 See Rev. Rul. 87-76, 1987-2 C.B. 84 (emphasis added).

130 See section 162 (the successor to section 23(a)(1) of the 1942 code).

131 Susan A. Johnston, Taxation of Regulated Investment Companies and Their Shareholders, at para. 6.05[1] (2019). As noted earlier in the discussion of the 1988 ruling, the IRS has on at least one occasion explicitly treated investing (by an insurance company) as a trade or business.

132 Section 512(b)(1) and (a)(5)(A) (specifically excluding from UBTI “payments with respect to securities loans” described in section 1058).

133 Section 851(b)(2).

134 Reg. section 1.892-3T(a)(2).

END FOOTNOTES

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