Hi, it’s Phil Hodgen again. Welcome again to the Friday Edition
This episode is written from seat 3E on American Airlines flight 126 — LAX to Chicago. Wifi in the sky for the win, right? (Also: Bose noise-cancelling earbuds are essential for flying sanity and preventing the post-flight head-buzz from all of the engine noise. Just spend the money. Totally worth it.)
Thursday night I will attend a party at Dan Sullivan
‘s house, then Friday (while you are reading this) is an all-day Strategic Coach 10X workshop in an office building right across the way from O’Hare.
My daughter is with me, and will attend the Strategic Coach special one-day program for 18-24 year olds on Saturday. She starts UCLA in the fall, looking at an economics/business major. Dinner is planned with my nephew and his wife (he works for the Cubs but sadly no baseball games are on tap for us on this trip).
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Real estate investor mini-series, episode 4
Today is the fourth episode of a mini-series on real estate investment in the USA. The mini-series covers federal estate tax on your real estate investment and income tax on rent in four investment structures:
Note that this mini-series does not cover the capital gains tax treatment of sale of real estate by a nonresident investor. That will be covered in a future mini-series.
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.
In the first episode, 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.
The second episode looked at a legal structure that protects against estate tax: you own a non-U.S. corporation, and the corporation owns the U.S. real estate. This protects your heirs from the estate tax risk, but creates a horrible mess with the branch profits tax on the rental income.
The third episode looked at a slightly more complicated holding structure: you own the stock of a non-U.S. corporation, which in turn owns all of the stock of a U.S. corporation, which in turn owns the U.S. real estate.
This week: foreign corporation with treaty benefits
Today we look at the final example in the mini-series. What if you use a corporation formed in your home country, and want to avail yourself of the benefits of the income tax treaty between your home country and the United States?
For this week’s episode, I will assume that you are a citizen and resident of China, so we can use the China/USA income tax treaty as an example of how things work.
Instead of creating a corporation in a tax haven like the British Virgin Islands, you will create a limited liability company in your home country of China, which has an income tax treaty with the USA. The Chinese LLC will own the U.S. real estate directly.
Chinese LLC: taxed in the USA as a corporation
There is a set of rules that is used to figure out how a foreign entity is treated for U.S. tax purposes. These rules have a set of defaults, with the possibiity of making an election to override the defaults in some cases.
A Chinese LLC is taxed as a corporation in the U.S. by default. Reg. §301.7701-2, -3.
We will not change the default classification by making a special election using Form 8832.
From now on, I will refer to the Chinese LLC as a Chinese corporation so we are using the language of the Internal Revenue Code.
But this highlights an important point. Limited liabilities companies in the United States are not
treated like corporations for tax purposes (though they can be, if you force that result). Do not be lulled into complacency because you see a foreign entity that has the letters “LLC” in its name. It is probable that it is the equivalent (for business and U.S. tax purposes) to a corporation as you understand corporations.
Estate tax: good
The U.S. imposes an estate tax on the transfer of a nonresident alien’s assets when he dies. IRC §§2101, 2103, 2106. This estate tax is limited to U.S. situs assets. IRC §2103.
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.
Since a Chinese LLC owns the U.S. real estate and the Chinese LLC is treated as a corporation for U.S. tax purposes, your ownership of the Chinese LLC is treated as if you own shares of a foreign corporation, and shares of a foreign corporation are not U.S. situs assets. If you die while holding this U.S. real estate investment, there will be no U.S. estate tax imposed: you do not own a U.S. situs asset.
By owning U.S. real estate in the name of a Chinese LLC, you remove a $4,000,000 estate tax risk if you die.
Note that this is the same result as if you had used a foreign corporation in any other country as a holding structure mechanism for your U.S. real estate investment. The existence (or not) of an income tax treaty is irrelevant, since the estate tax protection comes directly from your careful accomodation of the quirks of the Internal Revenue Code.
Treaties do exist for estate tax purposes, but there is no such treaty between the USA and China. There is a simple reason for that: China does not impose an estate tax.
Income tax: “Meh!” by default
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!”
Income tax: the treaty does not help
The income tax treaty between U.S. and China specifically says the U.S. can apply its normal tax rules on the income from real property. The US-China income tax treaty says:
Income derived by a resident of a Contracting State from real property situated in the other Contracting State may be taxed in that other Contracting State.
Income Tax Convention, U.S.-China, art. 6(1).
Just to emphasize that this applies to rental income, the treaty continues:
The provisions of paragraph 1 shall apply to income derived from the direct use, letting or use in any other form of real property.
Income Tax Convention, U.S.-China, art. 6(1).
The rule makes sense: real estate is immovable property physically located in a country. That country should have the right to tax rental income in the way it wants. This is how it works in every income tax treaty that I have looked at.
Branch profits tax: none (that’s good)
Recall that a foreign corporation with U.S. source income from business activities will pay 30% branch profits tax on the “dividend equivalent amount”. It works (extremely) roughly like this:
- Calculate the foreign corporation’s taxable income from business operations in the United States;
- Pay the normal corporate income tax;
- Subtract the normal corporate income tax that the foreign corporation paid from its taxable income, and pay 30% of that as the branch profits tax.
Warning: there is no scientific precision in this explanation at all! 🙂
Some foreign corporations do not pay branch profits tax. Your Chinese LLC is (in the eyes of the U.S. tax system) a foreign corporation. Is your Chinese LLC exempt from the branch profits tax?
Branch profits tax exemption
The Treasury Regulations list certain exceptions to the normal branch profit rules:
The branch profits tax shall not be imposed on the portion of the dividend equivalent amount with respect to which a foreign corporation satisfies the requirements of paragraphs (g)(1) and (2) of this section for a country listed below, so long as the income tax treaty between the United States and that country, as in effect on January 1, 1987, remains in effect, except to the extent the treaty is modified on or after January 1, 1987, to expressly provide for the imposition of the branch profits tax:
- People’s Republic of China <– [Look at that! Ed.]
- Netherlands Antilles
- United Kingdom
The last modification to the U.S.-China income tax treaty was modified happened in May, 1986. The treaty and protocol were effective as of January 1, 1987. Therefore the U.S.-China income tax treaty will provide branch profits tax relief.
Why there is no branch profits tax
Section 884(e) gives the rules for how to coordinate the Internal Revenue Code with income tax treaties. The magic language we are looking for is here: relief from the branch profits tax is available if a treaty says so. IRC §884(e)(2)(B). The part of the treaty we use, specifically, as an antidote to the branch profits tax is the so-called “nondiscrimination” provisions.
When the branch profits tax was imposed in 1986, the Joint Committee on Taxation made the following comment:
Although Congress generally believed that a branch profits tax does not unfairly discriminate against foreign corporations because it treats foreign corporations and their shareholders together no worse than U.S. corporations and their shareholders, it understood that most treaty nondiscrimination articles relating to permanent establishments arguably operate to consider corporations and their shareholders separately in determining whether discriminatory tax rules exist. Congress generally did not intend to override U.S. income tax treaty obligations that arguably prohibit imposition of the branch profits tax even though as later-enacted legislation the Act’s branch tax provisions normally would do so. JCS-10-87, 1038 (1987).
Like many treaties, the U.S-China treaty has a nondiscrimination clause for permanent establishments, which provides that a treaty country may not treat the permanent establishment of a corporation resident in the other treaty country in a worse manner than it treats domestic corporations. U.S.-China income tax treaty, art. 23.2.
It is consistent with Congressional intent to exempt Chinese corporations from the branch profits tax until the treaty was re-negotiated. Accordingly, the Treasury Department listed Chinese corporations among the corporations exempt from the branch profits tax.
Treaty shopping: not possible
“Treaty shopping” is the somewhat pejorative term used to describe a situation where a resident of Country A seeks to use the income tax treaty between the USA and Country B for tax advantage.
There are rules in the Internal Revenue Code that specifically prevent treaty shopping as a way around the branch profits tax. In addition, the income tax treaty between the United States and China contains a “limitation of benefits” clause that achieves the same thing.
Suppose you are a resident of Hong Kong. Can you drive across the SAR border to Shenzhen to form a Chinese LLC, and use it to avoid the branch profits tax? The answer is no.
For a corporation to benefit from an income tax treaty, it must be a qualified resident of the treaty country. IRC §884(e)(1)(B). A qualified resident is defined as follows:
Except as otherwise provided in this paragraph, the term “qualified resident” means, with respect to any foreign country, any foreign corporation which is a resident of such foreign country unless–
(i) 50 percent or more (by value) of the stock of such foreign corporation is owned (within the meaning of section 883(c)(4)) by individuals who are not residents of such foreign country and who are not United States citizens or resident aliens, or
(ii) 50 percent or more of its income is used (directly or indirectly) to meet liabilities to persons who are not residents of such foreign country or citizens or residents of the United States.
Your Chinese LLC (treated as a foreign corporation for U.S. tax purposes) is a resident corporation of China, but you own 100% of the stock of the corporation, and a Hong Kong resident is not a resident of China, a U.S. citizen, or U.S. resident. Therefore, your Chinese LLC is not a “”qualified resident””. It does not benefit from the China-U.S. income tax treaty. It is subject to 30% branch profits tax.
Cash position after tax
Let’s do the numbers. Your Chinese LLC (taxable as a foreign corporation, but exempt from branch profits tax) has the following cash position on its rental income, after tax:
- You collected $1,200,000 of rent.
- Subtract $400,000 of out of pocket expenses.
- Subtract $170,000 of normal corporate income tax.
- You are left with $630,000.
Contrast this with $625,000 cash in your pocket if you held the property directly. Holding the real estate directly in a foreign corporation that does not have a treaty protection against the branch profits tax would cost you an additional $99,000 of branch profits tax.
Summary: don’t get too clever
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, you avoid the estate tax. If you live in a treaty country, you can avoid most or all of the branch profits tax that normally makes a corporate holding structure undesirable.
Unless you have some other reason to form the corporation in a tax haven country, using a corporation formed in your home country (assuming there is a treaty with the United States) is a decent strategy to consider.
As usual, this is not tax advice, and it is certainly only one tiny facet of what you need to consider in making a decision on holding structures for real estate investment. And who knows — I might be wrong. Heh.
I’m just telling you this so you do your own due diligence before you make a decision on what to do.
See you next week,