US real estate miniseries #2 – direct foreign corporation ownershipJuly 3, 2015 - Phil HodgenFriday Edition
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Real estate investor mini-series, episode 2
Today is the second episode of a mini-series on real estate investment in the USA. The mini-series will cover federal estate tax and income tax on rent in four investment structures:
- Direct ownership by a nonresident alien individual;
- Direct ownership by a foreign corporation in a non-treaty country (today’s episode);
- A foreign corporation owns a U.S. corporation, which in turn owns the real estate; and
- Direct ownership by a foreign corporation in a treaty country.
This is the second episode. The next two episodes will roll out over the next two Fridays, but there might be an interruption for something Dreadfully Important). You will find heavy references to the Internal Revenue Code, because it is fun (for certain definitions of fun).
You are a nonresident of the United States, and you want to invest in U.S. real property. You will collect rent from the real estate, and (you hope) sell the property in a few years with a nice capital gain.
To keep this miniseries shorter than an encyclopedia, let’s make these assumptions:
- Federal tax only. The math gets much simpler and the ideas are easier to explain when we only think about Federal income tax. Ignore state and city income taxes.
- Rent paid by the tenants is $100,000 per month (before expenses), or $1,200,000 per year. We assume these numbers in order to force the tax rates up to the highest marginal levels, and eliminate weird rules about phase-outs of exemptions and deductions.
- Operating expenses. Assume $400,000 of operating expenses (maintenance, property tax, mortgage interest, etc) and $300,000 of depreciation every year.
- Property value. The value of the real property is $10,000,000. This makes estate tax math simple.
- Home country income tax. I am ignoring income tax in your home country, in order to highlight the U.S. tax planning you need to do. Obviously, your home country income tax must be considered.
Last week, we looked at a simple idea: you own the U.S. real property directly.
The worst problem with this idea was the estate tax. If you die, there will be an estate tax risk of 40% of the value of the property. On a $10,000,000 property, that is a $4,000,000 tax that your heirs must pay. Not good.
This week: direct ownership by a foreign corporation
This week we look at using a legal structure to eliminate the estate tax risk. Instead of owning the real estate directly, you will create a corporation in a country that is not your home country, and is not the United States.
I will call this a “foreign corporation” because, from the perspective of the U.S. tax system, that is what it is called. Yes, I know. It’s only foreign from the U.S.-centric point of view.
Also, we ignore the use of treaties (income tax or estate tax) between the United States and your home country. More often than not we see real estate investments coming from countries that do not have tax treaties with the United States. Ignoring treaties in this discussion is consistent with reality, and also makes this discussion simpler and shorter.
Estate tax results: good
The U.S. imposes a tax when people die. It is a tax based on wealth at the time of death, and is called the “estate tax”. IRC §§2101, 2103, 2106. For a nonresident, look at what the individual owned at the date of death. Was that asset a “U.S. situs asset”? “U.S. situs” means “located in the United States, from the perspective of U.S. tax law”.
Shares of a foreign corporation are not U.S. situs assets. IRC §2104(a). It does not matter what the foreign corporation owns (even U.S. real estate). The individual owned the shares of a foreign corporation at the time of death, and these shares were not “in the United States”. There is nothing for the U.S. to tax.
By owning U.S. real estate in the name of a foreign corporation (rather than in your own name), you remove a $4,000,000 estate tax risk if you die.
This is the main (only?) reason to own U.S. real estate in the name of a foreign corporation.
Income tax: meh
Rental income earned by a foreign corporation from U.S. real estate can be taxed in one of two ways:
- 30% of gross rent (no deductions for expenses), or
- graduated rates on net income after deductions for expenses.
IRC §882(d). This is just the same as the tax choices facing an individual owner.
Almost always you will want to choose to be taxed on your rental income minus your expenses. The simplest way to do this is by making a special election on your income tax return. There is nothing magic about this: just attach a statement to the tax return; the tax rules tell you what you need to say in the statement.
The foreign corporation will calculate its normal corporate income tax using the rules of I.R.C. §882. Here is how it works (remember, these numbers are assumed for the purposes of this example):
- Start with $1,200,000 of rent income for the year.
- Subtract $400,000 for your expenses.
- Subtract $300,000 for the allowable depreciation deduction.
- You are left with $500,000 of taxable income.
- Now it is a multiplication job: find the corporate income tax rate in I.R.C. §11 and multiply your taxable income by that percentage.
The corporate income rate quickly averages to 34%. Let’s therefore roughly compute a corporate income tax of $170,000.
This means that the income tax on a foreign corporation’s rental income is about the same as the income tax paid if you own the real estate directly. It’s a big “Meh!”
Branch profits tax: pain factory
But that’s not all. There is a second tax on the rental income, called the “branch profits tax”. This tax applies only to foreign corporations.
And (true confession time) the meta purpose of this week’s episode is to explain the branch profits tax in gruesome detail.
If you want to skip this section (and the brain damage that comes with it), here is the short answer that will get you to approximately the correct answer, most of the time (using the example’s numbers):
Take this year’s taxable income ($500,000). Deduct the amount of corporate income tax paid ($170,000). You are left with $330,000. Multiply that by 30%, which is the branch profits tax rate. Your branch profits tax rate payable is $99,000 — in addition to the corporate income tax of $170,000 that you paid.
Why the branch profits tax exists
Still with me? Good.
The branch profits tax exists to make you indifferent between the income tax results of owning the U.S. real estate in a foreign corporation or in a U.S. corporation. Either way you own the U.S. real estate, the after-tax income to you (the shareholder) should be the same. Or close to the same, anyway.
If you own the U.S. real estate in a U.S. corporation, then when the U.S. corporation earns income, it will pay corporate income tax.
Then, when the U.S. corporation distributes the after-tax cash to you (the shareholder), the U.S. will impose a 30% tax on the dividend you receive. IRC §871(a).
So, for example, if we match the earlier example and assume that your U.S. corporation distributed $330,000 to you in cash as a dividend, there would be a $99,000 tax imposed on the dividend, in addition to the $170,000 corporate income tax that is paid.
Foreign corporation, no branch profits tax
Without the branch profits tax, if you own U.S. rental property in a foreign corporation, here is what would happen.
The foreign corporation would collect rental income and pay its $170,000 of corporate income tax. But after that, the U.S. would be powerless to impose a tax on the dividend that the foreign corporation paid to you (the shareholder).
A foreign corporation paying a dividend to a nonresident shareholder — this is 100% outside the reach of the U.S. government’s tax boffins.
Less tax collected using one corporation method compared to another? Something Must Be Done.
The branch profits tax is that “Something”.
The big picture for calculating branch profits tax
The branch profits tax is 30% of the “dividend equivalent amount” of a foreign corporation. IRC §884(a).
We have to calculate a magic number called the “dividend equivalent amount”. Here is how:
- start with the current year’s “effectively connected earnings and profits”, then
- adjust that number up or down for “changes in U.S. net equity”.
It’s a messy job, full of tax icebergs (the amount of work and necessary knowledge buried between a simple phrase like “dividend equivalent amount” or “U.S. net equity” will curl your metaphorical hair). So let’s do it.
Start: this year’s effectively connected earnings and profits
Calculation of dividend equivalent amount starts with the current year’s effectively connected earnings and profits for the current year. IRC §884(b).
“Effectively connected earnings and profits” means:
- the foreign corporation’s “earnings and profits” that are
- derived from its “effectively connected income”.
IRC §884(d)(1) says it this way:
The term “effectively connected earnings and profits” means earnings and profits (without diminution by reason of any distributions made during the taxable year) which are attributable to income which is effectively connected (or treated as effectively connected) with the conduct of a trade or business within the United States.
Earnings and profits
“Earnings and profits” is a term that is critical to understanding corporate income tax, but curiously it has no official definition. (Heh. Who said that tax law should be logical?)
“Earnings and profits” is (roughly) a concept that represents a corporation’s ability to pay dividends to its shareholders. The concept applies to domestic corporations and foreign corporations alike.
It can be generally thought of as the corporation’s gross income minus anything that would reduce what the corporation can distribute out. The corporation’s deductible expenses and income tax paid will reduce the corporation’s ability to distribute cash to its shareholders.
In our highly simplified example, the foreign corporation had $500,000 of net income after expenses. It then paid $170,000 of normal corporate income tax. It is left with $330,000 of earnings and profits for the current year.
“Effectively connected” means that the foreign corporation was engaged in business in the United States, and earned income from the business activities.
The foreign corporation is engaged in business because it is renting real estate (and elected to be taxed as if it is engaged in business).
The entire $330,000 of after-tax income for the year will be effectively connected to business activities in the United States.
Put them together
Put those two things together, and you have effectively connected earnings and profits. The foreign corporation collected rent from its tenants and paid some expenses and income tax.
That is our starting point. The current year’s effectively connected earnings and profits = $330,000.
Adjustments (up and down)
Now that we know how what “effectively connected earnings and profits” means (at a kindergarten level), our next job is to adjust it up and down by changes in “U.S. net equity”. The result, after the adjustments, is the “dividend equivalent amount” needed to calculate the branch profits tax.
U.S. net equity and how it changes
“U.S. net equity” represents the amount that the corporation has invested in its U.S. business activities. It’s pretty simple: assets (or specifically, the adjusted tax basis of all of the assets) minus liabilities of the foreign corporation that are used in its U.S. business activities.
Take on more liabilities, and U.S. net equity goes down. Acquire more assets, and U.S. net equity goes up.
But for our discussion, let’s focus on the definition of “assets” as tied to the tax concept of adjusted basis. Highly simplified for the purposes of this explanation, if you do nothing but own and operate U.S. real estate, U.S. net equity goes down for depreciation allowed on your real estate, because the depreciation expense reduces the adjusted basis for your real estate asset.
You buy a $10,000,000 real estate asset. This year’s depreciation expense is $300,000. Your adjusted basis in the real estate is $9,700,000.
Dividend equivalent amount decreases when U.S. net equity increases
If U.S. net equity increases in a year, this means that the foreign corporation expanded its U.S. business. The dividend equivalent amount is reduced accordingly. IRC §884(b)(1).
Explanation: if the foreign corporation took some of its money and invested in its U.S. business, it has less money available to pay a dividend to the shareholders, so it makes sense that the branch profits tax should be lower.
Dividend equivalent amount increases when U.S. net equity decreases
If U.S. net equity decreases in a year (because of depreciation expense, for example), then the foreign corporation shrank its U.S. business operations.
In theory this means that more money is available for distribution to shareholders, so it means that the dividend equivalent amount should go up.
In the example we are using here, the real estate owned by the foreign corporation had a tax-deductible depreciation expense of $300,000. Since U.S. net equity is computed on the adjusted basis of the U.S. assets owned by the foreign corporation, we have a decrease in U.S. net equity of $300,000 because the amount of adjusted basis in the U.S. real estate decreased.
This in turn leads to an increase in the dividend equivalent amount. But this is tax, so it ain’t so simple . . . .
The limit on increases to the dividend equivalent amount
But the increase in the dividend equivalent amount (for a decrease in U.S. net equity due to, in our example, depreciation) has limits. And here is where things devolve to gibberish, even for me.
First let’s look at I.R.C. §884(b)(2)(B):
(i) In general. The increase under subparagraph (A) for any taxable year shall not exceed the accumulated effectively connected earnings and profits as of the close of the preceding taxable year.
(ii) Accumulated effectively connected earnings and profits. For purposes of clause (i), the term “accumulated effectively connected earnings and profits” means the excess of—
(I) the aggregate effectively connected earnings and profits for preceding taxable years beginning after December 31, 1986, over
(II) the aggregate dividend equivalent amounts determined for such preceding taxable years.
Let’s apply this to our example. That will help show what is happening here.
The current year effectively connected earnings and profits amount is $330,000. That is our starting point. IRC §884(b).
The U.S. net equity decreases by $300,000. This is because the U.S. net equity (assets minus liabilities) at the beginning of the year is $10,000,000 (the purchase price of the real estate) and at the end of the year it is $9,700,000 (purchase price minus allowable depreciation of $300,000). IRC §884(b)(2)(A).
Because U.S. net equity decreased, we are supposed to increase the current year’s effectively connected earnings and profits by the $300,000 decrease. IRC §884(b)(2)(A). This means we are at $330,000 (current year’s effectively connected earnings and profits) + $300,000 (the decrease in U.S. net equity) = $660,000 for a dividend equivalent amount.
But wait. Here comes the limit to save the day.
Look at the aggregate effectively connected earnings and profits for the preceding taxable years. IRC §884(b)(2)(B)(ii)(I). This is zero, because it is the first year of operations.
Subtract from zero the “aggregate dividend equivalent amounts” for the preceding taxable years. IRC §884(b)(2)(B)(ii)(II). There was no such “aggregate dividend equivalent amount” in prior years because this is the first year of operation. So zero minus zero equals zero.
As a result, even though U.S. net equity went down by $300,000 (and we should have seen a dividend equivalent amount increase by the same amount), the actual adjustment is zero due to the limit.
Your corporation had $500,000 of net income after expenses. It then paid $170,000 of normal corporate income tax. It is left with $330,000 of effectively connected earnings and profits.
You also have $330,000 of dividend equivalent amount for branch profits tax because effectively connected earnings and profits is your starting point for computing the dividend equivalent amount, and change in U.S. net equity was limited to zero.
Your corporation’s dividend equivalent amount is $330,000, the tax rate is 30%, and the branch profits tax is $99,000.
Cash position after tax
Here is how much cash you have on hand after the first year:
- You collected $1,200,000 of rent.
- Subtract $400,000 of out of pocket expenses.
- Subtract $170,000 of normal corporate income tax.
- Subtract $99,000 of branch profits tax.
- You are left with $531,000.
Contrast this with $625,000 if you held the property directly. You pay about $100,000 extra in U.S. taxes by using a foreign corporation to hold the property.
Summary: an expensive substitute for life insurance
By investing in U.S. real estate directly, you have an estate tax risk of about 40% of the value of the property – about $4,000,000 in this example.
If you use a foreign corporation to hold the property, and you own the shares of the corporation, then you avoid the estate tax, but it comes at the cost of higher taxes: Each year, you pay $100,000 extra in taxes for the protection against the estate tax – a very expensive way to buy protection from estate tax.
Next week’s episode will continue the brief overview of holding structures. We will discuss the tax consequences of having the foreign corporation own all of the stock of a U.S. corporation, which then owns the U.S. real property.
Why would you do this? Use the foreign corporation to prevent estate tax, and use the U.S. corporation to prevent the branch profits tax.
This post is not tax advice, etc. etc. Hire someone to help you with this stuff. It boggles the mind sometimes.