Notice 2007-55

The Treasury Department (Treasury) and Internal Revenue Service (IRS) are aware of a type of transaction, described below, in which a foreign government inappropriately claims that certain distributions from a real estate investment trust (REIT) or other qualified investment entity to the foreign government are not subject to section 897(h)(1) of the Internal Revenue Code (Code) or are exempt from taxation under section 892 of the Code. This notice alerts taxpayers and their representatives that the IRS intends to challenge such claims under the relevant current statutory and regulatory provisions. In addition, Treasury and the IRS intend to issue regulations that will clarify the correct interpretation of these provisions. These regulations will apply to distributions occurring on or after June 13, 2007.

In a typical transaction, a foreign government purchases a non-controlling interest in a privately held (and domestically controlled) REIT, with a view to receiving dividends from the REIT over the course of the remaining life of the REIT (for example, five to seven years). At the end of the REIT’s life, the REIT typically sells all or a portion of its assets and distributes the sales proceeds (and any remaining assets) to its shareholders in complete liquidation. In some cases, the liquidation may take place over more than one year.

Notwithstanding section 897(h)(1), the foreign government (or withholding agent) asserts that distributions from the REIT (including distributions in liquidation) that are attributable to gain from the sale or exchange of a United States real property interest (USRPI) described in section 897(c)(1)(A)(i) are exempt from taxation (and withholding) under section 892. The foreign government (or withholding agent) may also assert that section 897(h)(1) does not apply to liquidating distributions from the REIT.

Section 892 addresses the taxation of income of foreign governments. Section 892(a)(1) excludes from gross income and exempts from U.S. federal income tax certain categories of income earned by foreign governments, including dividends from and capital gains with respect to investments in the United States in stocks, bonds, or other domestic securities. Section 892(a)(2)(A) provides that the exclusion under section 892(a)(1) does not apply to income derived from the conduct of any commercial activity (whether within or without the United States), income received by a controlled commercial entity or received (directly or indirectly) from a controlled commercial entity, or income derived from the disposition of any interest in a controlled commercial entity. In addition, income derived from sources other than described in section 892(a)(1) is not excluded from gross income and is not exempt from tax under section 892. See the flush language following Treas. Reg. § 1.892-3T(a)(1)(iii). Under section 892(a)(3), a foreign government is treated as a corporate resident of its country for purposes of the Code.

Section 897 provides special rules for the disposition of an investment in U.S. real property. Section 897(a)(1) provides, in part, that gain or loss of a nonresident alien individual or a foreign corporation from the disposition of a USRPI is taken into account under section 871(b)(1) or 882(a)(1) as if the nonresident alien individual or foreign corporation, respectively, were engaged in a trade or business in the United States during the taxable year and as if such gain or loss were effectively connected with such trade or business. Section 897(c)(1)(A) defines a USRPI to mean (i) an interest in real property located in the United States or the Virgin Islands and (ii) any interest (other than solely as a creditor) in a domestic corporation that is a United States real property holding corporation (USRPHC). As defined in section 897(c)(2), a USRPHC means any corporation if the fair market value of its USRPIs equals or exceeds 50 percent of the total fair market value of its USRPIs, its interests in real property located outside the United States, and any other assets which are used or held for use in a trade or business.

Section 897(h)(1) provides that any distribution by a qualified investment entity to a nonresident alien individual, foreign corporation, or other qualified investment entity shall, to the extent attributable to gain from the sale or exchange by the qualified investment entity of a USRPI, be treated as gain recognized by such nonresident alien individual, foreign corporation, or other qualified investment entity from the sale or exchange of a USRPI. Thus, such distributions are taxable to such nonresident alien individual or foreign corporation under section 897(a)(1). For purposes of section 897(h)(1), a qualified investment entity means any REIT and any regulated investment company (RIC) described in section 897(h)(4)(A)(i)(II).

A foreign government is treated under Treas. Reg. § 1.897-9T(e) as a foreign person with respect to USRPIs. Further, Treas. Reg. §§ 1.897-9T(e) and 1.1445-10T(b) provide that a foreign government is subject to taxation under sections 897 and 1445 on the disposition of a USRPI “except to the extent specifically otherwise provided in the regulations issued under section 892.”

The regulations issued under section 892 do not specifically exempt foreign governments from taxation under sections 897 and 1445. The flush language following Treas. Reg. § 1.892-3T(a)(1)(iii) provides that:

This language makes it clear that gain from the disposition of a USRPI described in section 897(c)(1)(A)(i) is not exempt from taxation under section 892. Gain derived by a foreign government from the disposition of a USRPI defined in section 897(c)(1)(A)(ii) (i.e., an interest in a USRPHC), however, is exempt from tax under Treas. Reg. § 1.892-3T if the USRPHC does not constitute a controlled commercial entity under section 892(a)(2)(B). See Example (1) of Treas. Reg. § 1.892-3T(b).

Regulations incorporating the guidance in this notice will apply to distributions occurring on or after June 13, 2007.

The principal authors of this notice are David A. Juster and Margaret A. Hogan of the Office of the Associate Chief Counsel (International). However, other personnel from Treasury and the IRS participated in its development. For further information regarding section 892 issues in this notice, contact Mr. Juster at (202) 622-3850 (not a toll-free call). For further information regarding section 897 issues in this notice, contact Ms. Hogan at (202) 622-3860 (not a toll-free call).