| ||Wither FIRPTA?|
Fred B. Brown*
*Associate Professor of Law and Director of the Graduate Tax Program, University of Baltimore School of Law; Rutgers University, B.S. 1982; Georgetown University Law Center, J.D. 1985; New York University, LL.M. 1986. I am grateful to Jing Xu for her excellent research assistance. I thank Michael Lloyd for all of the excellent work that he performed in editing and commenting on this article. I also thank Cynthia Blum, Chuck Borek, Wendy Gerzog, Jonathan Lipson, Frank McCrystle, Larry Lokken and Walter Schwidetzky for reviewing and providing very helpful comments on earlier drafts of this article. Any errors are solely the responsibility of the author.
It is commonly understood that the tax law is composed of a complicated and interrelated set of statutory provisions. This raises the possibility that changes to one area of the law may necessitate revisions to other areas. While statutory change sometimes means that other provisions need to be added or amended, there is also the possibility that the enactment of a new provision allows for the repeal of another rule because it is either deadwood or simply no longer sensible in light of the rule's intended purpose as well as fundamental tax policies.
A simplification study released by the Joint Committee on Taxation in 2001 indicates the prevalence of this deadwood (and the like) phenomenon. This study recommends the repeal of 105 provisions identified as pure deadwood. The study also proposes the elimination of other provisions that no longer serve sound policy objectives as a result of tax law changes since their enactment. Given the tax law's interrelated statutory scheme and frequent changes, the extent of the deadwood phenomenon should come as no surprise.
An area that is ripe for such a deadwood analysis is the Foreign Investment in Real Property Tax Act ("FIRPTA"), and in particular section 897. Indeed, FIRPTA has been ripe for such an analysis since the changes effected by the Tax Reform Act of 1986. This Article suggests that the repeal of portions of FIRPTA may be in order and sets forth an analysis of the various considerations in arriving at this conclusion.
A. FIRPTA's Legislative Background
FIRPTA was enacted in 1980 in order to remove the perceived competitive advantage experienced by foreign persons under the tax law in purchasing U.S. real estate. Prior to FIRPTA, foreign persons had used several techniques to avoid federal income tax upon the disposition of U.S. real estate, while obtaining net basis taxation during the operation of the real property. For example, a foreign person could operate U.S. realty as a trade or business and then dispose of the realty in an installment sale so that gain was recognized after the foreign person was no longer engaged in a U.S. business. This technique allowed the taxpayer to achieve net basis taxation during the operations phase, which often meant no federal tax liability during this phase because deductions for depreciation, taxes and interest could offset gross income from operations. If the foreign person did not maintain a U.S. business when the gain from the disposition was recognized on the installment method, the realty gain would not be taxable under the effectively connected regime, nor would it be taxable under the fixed or determinable, annual or periodic ("FDAP") regime as that regime exempts most types of gain. In a variation on this technique, the foreign person disposed of the U.S. real estate by exchanging it for foreign real property in a qualifying nonrecognition transaction under the like-kind rule, and subsequently disposed of the foreign realty in a sale that would be beyond U.S. tax jurisdiction. The like-kind exchange strategy would permit an ultimate disposition of the foreign realty that was free of U.S. tax even if the taxpayer were actually engaged in a U.S. business for the year of the sale (or had made a Code election to be so treated). Another technique employed to obtain little or no U.S. taxation on the operation and disposition of U.S. real property was to take advantage of certain treaties that allowed taxpayers to make an annual election to treat U.S. real estate activities as a U.S. trade or business.
Foreign persons were also able to achieve this desired tax avoidance treatment by using corporations to conduct their U.S. real estate activities. Under this technique, a foreign person would conduct U.S. realty activities as a business through either a U.S. or foreign corporation, and thus obtain U.S. net basis taxation on these operations. The foreign person could then dispose of the U.S. real property by first having the corporation sell the U.S. real property after adopting a plan of liquidation, and then having the corporation distribute the proceeds of the sale to the shareholder in exchange for her stock. Under the former General Utilities doctrine, the liquidating corporation would not have recognized any gain on the sale, and any gain to the foreign shareholder on the liquidation would generally be free of U.S. tax under the effectively connected and FDAP regimes. Alternatively, the foreign investor could have sold stock in the corporation to the purchaser, with any gain on the sale generally not being subject to U.S. tax. The purchaser of the stock, even if a U.S. person, could then liquidate the corporation free of U.S. tax, because the former General Utilities doctrine would result in nonrecognition treatment at the corporate level, and there would be no realized gain at the shareholder level given that the shareholder's basis should equal the appreciated value of the real property.
In contrast to the ability of foreign persons to avoid U.S. taxation on the disposition of U.S. real estate, U.S. persons enjoyed no such treatment. Consequently, the existing rules as applied to the taxation of U.S. realty arguably violated notions of horizontal equity by subjecting U.S. taxpayers to more onerous U.S. tax treatment on U.S. real estate activities than foreign taxpayers. This in turn arguably resulted in foreign persons having a competitive advantage over their U.S. counterparts in acquiring U.S. real estate.
FIRPTA was enacted to ensure that dispositions of U.S. real property by foreign persons would not escape federal income tax, which resulted in the removal of the U.S. tax advantage experienced by foreign taxpayers. Specifically, section 897, FIRPTA's principal provision, subjects foreign persons to U.S. taxation on dispositions of U.S. real property as if the gains were effectively connected with a U.S. business, whether or not the taxpayer was actually engaged in such a business when the gain was recognized. Thus, the FIRPTA rule for taxing dispositions of directly held U.S. realty prevents foreign persons from avoiding federal income taxation on the disposition of U.S. real property by employing the installment sale technique. Section 897 also contains special nonrecognition rules that prevent attempts to circumvent FIRPTA by engaging in nonrecognition transactions (such as like-kind exchanges) in which property subject to FIRPTA is exchanged for property whose disposition would be free of U.S. tax. FIRPTA also deals with the ability to use tax treaties to avoid federal tax on dispositions of U.S. real property by overriding any conflicting treaty obligations that remain in effect four years after FIRPTA's enactment.
Section 897 tackles the corporate avoidance strategy in two different ways depending on whether a U.S. or foreign corporation is employed. For situations involving U.S. corporations, the provision generally taxes foreign persons on dispositions of stock in U.S. corporations whose assets significantly consist of U.S. real property. Consequently, the statute can reach gain realized by a foreign person on the disposition of stock pursuant to the liquidation of a U.S. realty holding corporation, as well as on the sale of the stock to another person. Where a foreign corporation is employed to hold U.S. real property, the statute brings on a mini-repeal of the General Utilities doctrine by generally causing a foreign corporation to recognize gain on the distribution of the realty or sale in connection with a liquidation. As a result, a disposition of U.S. real property via the sale followed by liquidating distribution route is taxable under section 897. And while the sale of stock in a foreign corporation holding U.S. realty is not taxable under FIRPTA, the foreign seller can be expected to bear an indirect tax due to the receipt of a reduced sales price reflecting the corporation's future tax liability.
B. Subsequent Tax Law Changes
Since the enactment of FIRPTA, there have been several changes in the tax law that would have eliminated the ability to avoid U.S. tax on the disposition of U.S. real property through the use of the pre-FIRPTA techniques. Section 864(c)(6), added in 1986, provides that the effectively connected status of deferred gain or income is to be determined as if the gain or income were taken into account in the year in which the underlying sale or other transaction occurred, and without regard to whether the taxpayer is engaged in a U.S. business for the year in which the gain or income is taken into account. Consequently, even without FIRPTA, taxpayers would not be able to avoid U.S. tax on dispositions of U.S. real property used in business by engaging in installment sales of U.S. realty. Furthermore, the repeal of the General Utilities doctrine ("GU Repeal"), which also occurred in 1986, would have frustrated the pre-FIRPTA avoidance strategy of selling U.S. realty after adopting a plan of liquidation, followed by a liquidating distribution of the proceeds to the foreign shareholder. Following GU Repeal, a liquidating corporation is required to recognize gain on a sale or distribution (as if the distributed property had been sold for its fair market value), thus defeating this technique for avoiding federal tax on the disposition of U.S. real property. Finally, the like-kind exchange rule was amended in 1989 to provide that U.S. and foreign real property are not like-kind property. As a result, regardless of FIRPTA, a foreign person cannot avoid U.S. tax on a disposition of U.S. business real estate, by swapping the U.S. realty for foreign realty and then selling the foreign real estate.
C. Method for Analyzing the Continuing Need for FIRPTA
The effect of these legislative changes on the efficacy of the pre-FIRPTA avoidance techniques raises the issue of whether the existence of FIRPTA continues to make sense as a policy matter. To this end, this Article examines two key features of FIRPTA: (i) the rules applying to dispositions of directly held U.S. real estate, (ii) and the rules applying to dispositions of stock in U.S. corporations whose assets significantly consist of U.S. real estate. For each of these features, this Article examines whether Congress's original purposes in enacting FIRPTA continue to justify the need for the particular feature. In doing so, this Article assumes that the original purposes are valid: the objective is to eliminate deadwood and the like, not to question Congress's original purposes for adopting the provisions. Consequently, if it is determined that the original purposes continue to justify the feature, this Article recommends retention of the rule.
On the other hand, if it is determined that the feature is no longer necessary in light of its original purposes, then it still needs to be decided whether other policy objectives support the rule. There may be sound policy reasons for retaining the feature even though Congress's original reasons for the rule have been mooted because of subsequent changes in the tax law. In this regard, this Article considers the following fundamental policy concerns in the taxation of cross-border business and investment activities: equity, efficiency, administrability, treaty override, and harmonizing different countries' tax laws. For this purpose, equity refers to the type of horizontal equity concerns that underlie FIRPTA, that is, similarly taxing U.S. and foreign persons with respect to income that bears a sufficient economic connection to the United States; and efficiency refers to concerns of competitive neutrality, also underlying FIRPTA, that aim to remove competitive advantages created by the tax law for foreign persons verses their U.S. counterparts. This Article also addresses these recognized policy objectives in evaluating the need for a particular feature where there is uncertainty as to whether Congress's original purposes continue to justify the rule-that is, in situations where some but not all of Congress's objectives are served without the particular feature as a result of subsequent legislative changes.
As explained below, this analysis leads to the following conclusions. While it is somewhat unclear as to whether Congress's original reasons continue to justify the rule for directly held U.S. real estate, fundamental policy considerations call for the retention of this rule. On the other hand, serious consideration should be given to eliminating the rules that apply to dispositions of stock in certain U.S. real property holding corporations: an original purpose analysis of these rules is inconclusive, and a revised policy analysis suggests that the equity and efficiency benefits of the rules may not warrant the significant administrative costs involved.