What is FIRPTA?
The Foreign Investment in Real Property Tax Act (FIRPTA) is a tax law that enables the IRS to tax non-US persons on their dispositions of U.S. Real Property Interests (USRPI). Understanding the application of FIRPTA is critical in conducting tax due diligence of Target companies, as the application of FIRPTA can have a significant impact on the after-tax IRR of a potential acquirer’s bid model, as well as create additional complications when structuring the transaction. It is essential that your M&A tax advisor understands FIRPTA and its impact on your transaction.
A USRPI is defined broadly for US tax purposes and can include: (1) interests in real property, such as land, buildings, improvements, leaseholds and natural deposits; (2) interests in partnerships that hold USRPIs; and (3) some intangibles, including goodwill, that is inherently tied to USRPIs. For certain industries such as infrastructure, determining what is a USRPI and the application of FIRPTA can be tricky, as the USRPI definitions can be quite broad.
FIRPTA also applies to mergers and acquisitions involving U.S. Real Property Holding Corporations (USRPHCs). A U.S. corporation that owns a certain amount of USRPI assets may be considered a USRPHC. Specifically, the IRS determines whether a company is a USRPHC based on whether the fair market values of its USRPI holdings equal or exceed 50% of the sum of its:
- Interests in real property held outside of the U.S., and
- Business assets (other than #1 and #2 above) that are used in the company’s trade or business.
Note that once a corporation is treated as a USRPHC in any given year, it will be automatically treated as a USRPHC for the next five years (aka the 5-year FIRPTA taint). Given the definition above, it should come as no surprise FIRPTA can quickly complicate a M&A deal’s tax profile, and understanding a Target’s assets is critical during tax due diligence. For example, note that in certain greenfield developments for US tax purposes a corporation technically won’t have any business assets during its construction phase. Therefore, many greenfield projects are initially considered to be USRPHCs since they likely have at least some USRPI assets, but won’t have business assets and therefore their USPRI holdings will exceed 50%. Because of the 5-year FIRPTA taint, greenfield projects are therefore typically USRPHCs for their first 5 years of operations. Therefore even if certain infrastructure, or renewable energy projects may ultimately not be considered a FIRPTA project, they may in fact be treated as a USRPHC for its first 5 years of operations. Financial models for greenfield infrastructure projects should keep these rules in mind when modelling their cash taxes.
FIRPTA for sellers
Non-US persons generally may dispose of shares of a corporation without being subject to tax in the US, unless the corporation is a USRPHC. If the corporation is a USRPHC, then non-US persons will be subject to tax in two situations. First, when they dispose of their shares in the USRPHC. Second, non-US persons will be subject to tax if they are taking out distributions in excess of their basis in the shares of the USRPHC. Generally, this is thought of as distributions in excess of the paid-in capital, but note that computations of basis and paid-in capital may differ. For example, in order calculate the amount of distributions that are in excess of basis, it will be important to determine the amount of the distributions that should be treated as a dividend for US tax purposes. This will require modelling out the amount of the corporation’s earnings and profits.
FIRPTA for buyers
Buyers involved in asset deals or stock deals involving Targets that own real property interests should always find out whether FIRPTA applies. If a buyer acquires a USRPI from a foreign person, they will be required to withhold 15% of the total consideration and remit it directly to the IRS within 20 days after the close of the transaction. Withholding tax may be reduced or potentially eliminated if an application for a withholding certificate is filed with the IRS on Form 8288-B.
Buyers should make sure that they do not need to withhold or that they withhold the correct amount. If the buyer fails to withhold the correct portion of their payment to the seller or if they fail to withhold at all, the buyer is on the hook for that portion of the seller’s taxes to the IRS.
To prove that FIRPTA does not apply, the seller is required to provide the buyer with the correct forms or affidavits. Unfortunately, the seller sometimes fails to supply the correct forms, and the buyer is ultimately liable for the amount they otherwise would have withheld from their payment to the seller. This ultimately has a negative impact on the IRR in the aftermath of the deal.
Why Should Buyers and Sellers be Concerned about FIRPTA?
It’s important for both buyers and sellers to understand the scope of FIRPTA because understanding the scope of what is considered a USRPI is tricky and there are various exemptions available that may apply depending upon the profile of the investors.
The seller may be able to use exemptions to avoid FIRPTA if their investors are qualified foreign pension funds within the meaning of Section 897(l) or foreign governmental entities that qualify for benefits under Section 892.
Buyers will want to know about these exemptions to FIRPTA so that taxes are not taken out unnecessarily and so that superfluous penalties are not incurred by either party involved. Sellers will want to be sure that they understand whether any exemptions cover their potential tax liabilities. Any exemptions could affect the ultimate purchase price of the transaction and could make the transaction less burdensome from a tax standpoint.
Unwary professionals on either side of the deal may fall into any number of traps that the uninitiated often make when it comes to FIRPTA. Consider the following scenario:
A U.S. person considers buying an entity that owns an operating wind farm in the United States from a Canadian owner. The U.S. corporation should find out whether the blades on the turbines are removable from the rest of the wind apparatus. If so, then the blades may be considered more in the nature of machinery rather than a fixture to the land, and therefore may not be considered USRPI. The U.S. corporation may also buy a license required to operate the wind farm from the Canadian company. Since the license is considered an intangible, it may or may not be considered a USRPI. Therefore, depending upon the value of the blades and the intangibles, the operating wind firm may or may not be subject to FIRPTA and withholding tax may or may not apply.
The above example illustrates one trap that unwary buyers often fall into. A lack of or poor tax planning can cause the parties involved to pay more in taxes to the IRS. Determining what constitutes real property is one of the many traps that FIRPTA creates. If it is determined that FIRPTA applies to the blades and the intangibles, then the buyer is likely required to withhold 15% of the total proceeds paid to the Canadian corporation, unless an application for reduced withholding tax is filed.
Advance cross-border M&A tax planning can help buyers mitigate or eliminate the need to withhold taxes. Since FIRPTA and the relevant IRS tax filings often appear convoluted to non-U.S. sellers, the buyer should ensure that both tax compliance and reporting requirements are met to avoid paying the seller’s taxes. Certain certificates, such as the “FIRPTA certificate” can greatly reduce or entirely do away with the need to withhold taxes. Furthermore, not all investors and sellers are subject to FIRPTA. Since certain qualified foreign pension funds and sovereign wealth funds are exempt from the FIRPTA, deal professionals should always consult with a knowledgeable M&A tax adviser to determine whether FIRPTA applies. At Leo Berwick, our trusted tax professionals are well equipped to help deal professionals navigate FIRPTA’s murky waters.
 26 CFR § 1.897-2(b).