New U.S./France Estate Tax Treaty changes the landscape for real estate investments

On December 8, 2004, the governments of France and the United States amended the Estate Tax Treaty between the two countries. It appears to contain a major change in the way nonresident real estate investments are taxed. Lucky for us that the treaty is optional, not mandatory.Here's Conventional Wisdom -- up to now -- on how a resident of France would should buy and hold real estate in the United States in order to avoid U.S. estate tax. Form a non-U.S. corporation. Acquire real estate in that corporation. Die. Result: the heirs inherit stock of that non-U.S. corporation (which happens to own U.S. real estate). The stock is not deemed to be a U.S. asset, and therefore is not taxed for estate tax purposes. Bottom line: heir inherit U.S. real estate without paying U.S. estate tax.Quoting everyone's favorite jailbird, Martha Stewart, it's a Good Thing.Now here comes the new estate tax treaty. It says, in plain English, that if more than 50% of a corporation's assets consist of real estate, then treat the stock of that corporation as if it, too, is real estate. Specifically, Article IV, Section 3 of the treaty now (after amendment) reads:

(3) The term "real property" shall also include shares, participations and other rights in a company or legal person the assets of which consist, directly or through one or more other companies or legal entities, at least 50 percent of real property situated in one of the Contracting States or of rights pertaining to such property. These shares, participations and other rights shall be deemed to be situated in the Contracting State in which the real property is situated.

The first thing you notice is the stunningly obtuse treaty language. Welcome to my world, people.But when you interpret that paragraph into Normal-speak, it says two things. First, if the company's assets are at least 50% real estate, then treat the company's stock as if it is real estate. Second, treat the company's stock as if it is located in the country where the real estate is.Real world example.

French resident forms a Cayman Islands corporation, puts $1,000,000 cash into the corporation. The Cayman Islands corporation uses the cash to buy U.S. real estate for $1,000,000. It has no other assets. French resident dies (solely for the sake of this example).The new treaty says that the U.S. tax authorities can now tax the French resident's estate. The stock of the Cayman Islands corporation is deemed to be "real estate." And the stock-that-is-real-estate is treated as being located in the U.S. Therefore, the U.S. can impose estate tax on the French resident's assets owned at the time of death.

Compare that result to the old way of doing things. Pick up the story where the French resident dies. U.S. estate tax law says that the U.S. will only impose estate tax on a nonresident's U.S.-situs assets (that's tax jargon for "it's physically located in the United States"). Stock of a foreign corporation (like a Cayman Islands corporation) is considered to be located OUTSIDE the United States. Therefore the corporation's stock is not taxable, no matter what the corporation's assets are. Since the French resident's assets at death consisted of stock, his estate is outside the ambit of U.S. estate tax laws.Yes, I knew your recognized that logic. it's the contorted tax analog of the old favorite song, "Ankle bone connected to the . . . shin bone. Shin bone connected to the . . . knee bone. Knee bone connected to the . . . thigh bone." (Continue until satiated). Welcome to the world I live in.Back to reality. Here's the bottom line. If a French resident invokes the U.S./France tax treaty (you don't have to--it's optional with the taxpayer), U.S. real estate is going to be taxed in the U.S. no matter what. Under the treaty, our dead French resident will get a credit in France against French taxes for the U.S. taxes paid. But still . . . .Double bottom line. I wonder why anyone would do that? Why not just ignore the treaty and stand pat with standard U.S. tax law, which will maintain the Old Way of Doing Things, and eliminate U.S. estate tax?Note for people who go the other way (U.S. residents buying real estate in France) -- the treaty will apply in the same way. Your non-French corporation won't insulate your French real estate holdings from French estate tax.Memorandum from the Musing Department. Hmmm. This new treaty provision looks a lot like FIRPTA and its concept of a U.S. Real Property Holding Company (note for the uninitiated - for U.S. income tax if a nonresident holds real estate through a U.S. corporation, then the stock of that U.S. corporation is treated as if it, too, is actual real estate. For tax purposes of course.) I wonder if this is a long term trend for the IRS -- to pursue legislative or treaty efforts to disregard the existence of a corporation?