The end of 2015 brought with it a number of notable U.S. tax developments for the private equity community, including two significant changes in the areas of foreign investment in U.S. real property and partnership audits.1
Below is a brief discussion of these two noteworthy developments.2
Tax Break Makes U.S. Real Property Investment More Attractive for Foreign Pension Funds
What Happened. Since the enactment of the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”), non-U.S. investors have grappled with the U.S. federal income tax burden imposed on foreign investment in U.S. real property. Generally, under FIRPTA, non-U.S. investors that invest in U.S. real property interests, whether directly or indirectly through a partnership or other tax transparent vehicle, are subject to U.S. federal income tax (and, in certain cases, an additional branch profits tax) upon the sale or other disposition of such U.S. real property interests. For this purpose, “U.S. real property interests” include real property located in the United States as well as stock of domestic corporations that hold U.S. real property as a majority of their worldwide real property and business assets.
In December, the application of FIRPTA to non-U.S. pension fund investors changed dramatically when President Obama signed into law the Consolidated Appropriations Act, 2016 (the “CAA”). The CAA provides that certain qualified foreign pension funds are now exempt from the tax that would otherwise be imposed under FIRPTA on the sale or other disposition of U.S. real property interests. As a result, such qualified foreign pension funds generally may now dispose of U.S. real property interests without incurring any U.S. federal income tax (provided that such U.S. real property interests are not otherwise held in connection with a U.S. trade or business). Under the CAA, a “qualified foreign pension fund” is generally any trust, corporation or other organization or arrangement that (1) is organized under the laws of a country other than the United States, (2) is established to provide retirement or pension benefits to current or former employees, (3) does not have a single beneficiary entitled to more than 5% of its assets or income, (4) is subject to government regulation, including information reporting, and (5) is entitled to certain tax benefits under the laws of the country in which it is organized.
What That Means. This new FIRPTA exemption for qualified foreign pension funds is much broader than the exemption currently afforded to non-U.S. governments under Section 892 of the Internal Revenue Code. As a result of this expansive and straightforward exemption, real estate-focused funds and certain other funds with significant investment allocations to passive investment in U.S. real property interests may see increased interest from non-U.S. pension plan investors.
New Legislation Enhances IRS’s Ability to Audit Large Partnerships
What Happened. The U.S. Internal Revenue Service (the “IRS”) has for some time publicly discussed the challenges it has faced in effectively auditing, and assessing deficiencies against, large partnerships under the existing partnership tax audit rules. Under the existing rules, the IRS generally conducts an audit at the partnership level, but any adjustments arising in connection with such audit are required to be assessed and collected by the IRS on a partner-by-partner basis. Further complications arise where, as is the case with many investment partnerships such as private equity funds, the partners of the partnership under audit include other partnerships to which these same audit rules apply.
In November, President Obama signed into law the Bipartisan Budget Act of 2015 for partnership tax years beginning after 2017, that Act substantially changes the manner in which the IRS makes audit adjustments with respect to partnerships and limited liability companies that are treated as partnerships for U.S. tax purposes. Under the new rules, tax adjustments from IRS audits of partnerships generally will be determined and collected at the partnership level, notwithstanding the fact that partnerships are not otherwise subject to income taxes and the partners are the relevant taxpayers. A partnership may elect, under the new rules, to implement an alternative adjustment procedure pursuant to which the partnership would send an amended Schedule K-1 to each of the individuals and entities that was a partner during the year under audit (irrespective of whether those persons still hold an interest in the partnership). Each individual and entity receiving an amended Schedule K-1 would then be required to pay any additional tax, interest and penalties in the current tax year, rather than being required to amend tax returns for prior years. If the partnership does not elect this alternative procedure, then the cost of any tax adjustments generally will be borne, absent any provision to the contrary in the partnership agreement, by the individuals and entities that are partners of the partnership at the time of the audit.
The new rules provide an exception for partnerships with 100 or fewer partners. However, this exception does not currently apply to a partnership in which another partnership is a partner, which includes many investment partnerships.
Steps to Take. Prior to the effectiveness of the new rules, partnerships and limited liability companies that are treated as partnerships for U.S. tax purposes should review their partnership agreements or operating agreements, as the case may be, in light of the new rules and, in particular, review the ability under these agreements to (1) elect the alternative Schedule K-1 adjustment procedure should such election be desirable in connection with an audit, (2) specially allocate the cost of any tax adjustments at the partnership level among the partners and (3) clawback the cost of any audit adjustments at the partnership level from former partners. Buyers of partnership and limited liability company interests should also be mindful of the potential application of these new rules when acquiring an interest in a partnership or limited liability company.
1 For recent tax developments in the UK, see elsewhere in this issue.
2 For additional detail regarding these topics, as well as other notable legislative tax developments for private equity funds and their investors, see these Debevoise & Plimpton Client Updates: New Legislation Relating to the Taxation of REITs and Foreign Investment in U.S. Real Property (December 22, 2015) and Bipartisan Budget Act of 2015 Revamps Partnership Tax Audit and Collection Procedures (November 3, 2015).