According to recent estimates, foreign investment in US oil and gas production rose to more than $3.8 billion in 2004. By comparison, foreign investment in US oil and gas production in 2003 was only $386 million.
From a US federal income tax perspective, the primary obstacle facing foreign persons who invest in US oil and gas interests is the Foreign Investment in Real Property Tax Act (FIRPTA). Under FIRPTA, any gain recognized by a foreign person on the disposition of a “United States real property interest” (USRPI) will be treated as if such gain were effectively connected to a US trade or business and, therefore, subject to US federal income tax at the graduated rates that apply to Americans.
Additionally, the purchaser of a USRPI typically is required to withhold and remit to the IRS 10% of the purchase price. For this purpose, a USRPI includes an interest in “mines, wells, and other natural deposits” which, according to the IRS, encompasses most forms of US oil and gas interests, such as royalty interests, net profits interest, and production payments that convey the right to share in the appreciation in value of the property.
One possible strategy to avoid FIRPTA, but still allow a non-US taxpayer to participate in the profits from the disposition of US oil and gas interests, involves the use of a shared appreciation loan (SAL). In a typical SAL arrangement, a lender provides an operator with a loan bearing a below-market fixed rate of interest, plus a share of the profit on a subsequent disposition of the property. As this article will illustrate, if the transaction is structured correctly, the taxpayers investing in US oil and gas interests who may have the most to gain from the use of SALs are non-US taxpayers.
US federal income taxation of non-US taxpayers, in general
Foreign persons typically are not subject to US federal income tax on US-source capital gains unless those gains are effectively connected to a US trade or business. As stated above, FIRPTA treats any gain recognized by a foreign person on the disposition of a USRPI as if it were effectively connected to a US trade or business.
A USRPI is broadly defined as (i) a direct interest in real property located in the US, and (ii) an interest (other than an interest solely as a creditor) in any domestic corporation that constitutes a US real property holding corporation (i.e., a corporation whose USRPIs make up at least 50% of the total value of the corporation’s real property interests and business assets). An interest in a partnership may also be considered a USRPI in certain situations.
The FIRPTA regulations elaborate on the phrase “an interest other than an interest solely as a creditor” by stating it includes “any direct or indirect right to share in the appreciation in the value, or in the gross or net proceeds or profits generated by, the real property.”
The regulation goes on to state that a “loan to an individual or entity under the terms of which a holder of the indebtedness has any direct or indirect right to share in the appreciation in value of, or the gross or net proceeds or profits generated by, an interest in real property of the debtor or of a related person is, in its entirety, an interest in real property other than solely as a creditor.” Accordingly, a SAL that is tied to US real estate is a USRPI for purposes of FIRPTA.
Simply owning a USRPI, however, does not necessarily trigger any adverse tax consequences to a non-US taxpayer under FIRPTA. Rather, a non-US taxpayer will be subject to tax under FIRPTA only when the USRPI is “disposed of.” For this purpose, the term disposition “means any transfer that would constitute a disposition by the transferor for any purpose of the Internal Revenue Code and regulations thereunder.”
Furthermore, the Internal Revenue Manual provides that a disposition may include sales, gifts where liabilities exceed adjusted basis, like-kind exchanges, changes in interests in a partnership, trust, or estate, and corporate reorganizations, mergers, or liquidations, even foreclosures or inventory conversions.
With respect to SALs, an example in the FIRPTA regulations illustrates a significant planning opportunity for non-US taxpayers investing in US real estate. In the example, a foreign corporation lends $1 million to a domestic individual, secured by a mortgage on residential real property purchased with the loan proceeds.
Under the loan agreement, the foreign corporate lender will receive fixed monthly payments from the domestic borrower, constituting repayment of principal plus interest at a fixed rate, and a percentage of the appreciation in the value of the real property at the time the loan is retired.
The example states that, because of the foreign lender’s right to share in the appreciation in the value of the real property, the debt obligation gives the foreign lender an interest in the real property “other than solely as a creditor.” Nevertheless, the example concludes that FIRPTA will not apply to the foreign lender on the receipt of either the monthly or the final payments, because these payments are considered to consist solely of principal and interest for US federal income tax purposes.
Thus, the example concludes the receipt of the final appreciation payment that is tied to the gain from the sale of the US real property does not result in a disposition of a USRPI for FIRPTA purposes, because the amount is considered to be interest rather than gain from the disposition of a USRPI. The example does note, however, that a sale of the debt obligation by the foreign corporate lender will result in gain that is taxable under FIRPTA.
Withholding on US source interest
By characterizing the contingent payment in a SAL as interest (and not a disposition of a USRPI) for tax purposes, the FIRPTA regulations potentially allow non-US taxpayers to avoid US federal income tax on gain arising from the sale of US oil and gas interests, if structured correctly. Specifically, non-US taxpayers are generally subject to a 30% withholding tax (unless reduced by treaty) on certain passive types of US source income, including interest.
An important exception to this rule exists for “portfolio interest,” which is exempt from withholding tax in the US. For this purpose, portfolio interest is defined as any interest that is paid on a note that is either (i) in registered form or (ii) that is not in registered form, if there are arrangements reasonably designed to ensure that the note will be sold only to non-US persons and certain other conditions are satisfied.
There are, however, a number of exceptions to portfolio interest, including certain “contingent interest.” For purposes of this provision, contingent interest is any interest that is determined by reference to, among other items: (i) any receipts, sales, or other cash flow of the debtor or related person; (ii) any income or profits of the debtor or a related person; or (iii) any change in value of any property of the debtor or a related person.
Therefore, a payment on a SAL that is otherwise treated for US federal income tax purposes as interest will not qualify for the portfolio interest exemption if the payment is contingent on the appreciation of the financed real property. Accordingly, unless a treaty applies to reduce the withholding tax, the contingent interest feature of a SAL would be subject to a 30% withholding tax in the US.
Currently, there are several jurisdictions that have concluded income tax treaties with the US that contain provisions that entirely eliminate US withholding tax on interest, including contingent interest, paid from the US to the respective treaty jurisdiction: Czech Republic, Hungary, Iceland, Norway, Poland, the Russian Federation, the Slovak Republic, and Ukraine. Accordingly, a payment of US source interest, including contingent interest, made to a resident of one of these treaty jurisdictions generally would not be subject to US withholding tax, assuming such person otherwise is eligible for treaty benefits.
For a non-US taxpayer to be eligible for treaty benefits, the taxpayer must be considered a resident of the particular treaty jurisdiction and must satisfy any limitation on benefits (LOB) provision in the treaty. Under most US income tax treaties, a foreign person will be considered a resident for treaty purposes if such person is “liable to tax therein by reason of its domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of a similar nature.”
Similarly, under most “modern” income tax treaties, a resident of a treaty country will satisfy the LOB provision if that resident is an individual, or a corporation that is at least 50% owned by citizens or residents of the US or by residents of the jurisdiction where the corporation is formed and not more than 50% of the gross income of the foreign corporation is paid or accrued in the form of deductible payments to persons who are neither citizens nor residents of the US or residents of the jurisdiction where the corporation is formed.
In order for a non-US taxpayer who is not resident in one of the treaty jurisdictions listed above to obtain a complete exemption from US withholding tax on the contingent interest payment, that taxpayer must rely on a treaty that has been concluded with the US that has no LOB provision.
Currently, two treaty jurisdictions provide an exemption from withholding on payments of US-source interest, including contingent interest, and do not have LOB provisions: Hungary and Poland. Therefore, a non-US taxpayer that is not resident in a favorable treaty jurisdiction can obtain a complete exemption from withholding on contingent interest by investing through a corporation formed in one of these two jurisdictions.
Using finance branch to reduce foreign tax
Of course, when organizing a corporation in a non-US jurisdiction, local income taxes need to be considered. Hungary currently has a 16% corporate income tax rate and Poland has a 19% corporate income tax rate. Given that an individual non-US taxpayer is eligible for the 15% long-term capital gains tax rate in the US for property that has been held for at least 12 months, it generally would not be practical from a tax perspective for a non-US taxpayer to invest in US oil and gas interests through a corporation formed in one of these jurisdictions, if a foreign tax of at least 15% would be incurred.
A finance branch located in a jurisdiction that has concluded a favorable income tax treaty with Hungary or Poland may be used to reduce the foreign income tax incurred in these two jurisdictions. In particular, both Hungary and Poland have concluded income tax treaties with jurisdictions, such as Switzerland and Luxembourg, under which income allocated to a Swiss or Luxembourg branch (otherwise known as a “permanent establishment” under the treaties) of a Polish or Hungarian company will not be subject to corporate income tax in Poland or Hungary. In addition, both Switzerland and Luxembourg have very favorable finance branch rules under which the interest income allocated to one of these branches only will be subject to income tax at a 2% to 4% rate.
Example: Residents of the UK wish to participate in a limited partnership that invests in US oil and gas royalty interests. A direct investment in the limited partnership would subject the UK investors to adverse US federal income tax consequences, both on the operating income of the partnership and on disposition of the partnership interest under FIRPTA. As a result, the investors organize a Hungarian corporation that has a branch office in Switzerland. The Hungarian corporation is capitalized 100% with equity. The Hungarian company lends money to the limited partnership, the terms of which provide for interest that is contingent on the profits of the limited partnership. The loans are allocated to the Swiss finance branch.
With this structure, no US withholding tax would be imposed on the SAL payments, including the contingent interest payment, under the US-Hungary income tax treaty. In addition, the interest on the loans that are allocated to the Swiss finance branch will not be taxed in Hungary and only will be subject to tax in Switzerland at approximately a 2% rate.
When the earnings subsequently are repatriated from the Swiss finance branch to the UK investors, it may be possible to route the income in a tax-efficient manner through Hungary without incurring any foreign taxes. This is because no withholding taxes will be incurred in Switzerland or Hungary when the profits are paid to the UK investors.
Possible challenges by the IRS
The IRS may attempt to challenge the use of a SAL to avoid FIRPTA by characterizing the relationship between the foreign lender and the US borrower as a partnership for tax purposes, resulting in treating the contingent interest payment as something other than interest for US federal income tax purposes.
The IRS was successful on this argument in Farley Realty Corp. v. Commissioner, in which the Tax Court bifurcated a purported debt instrument into both a loan and the acquisition of an equity interest in a corporation, and held that the appreciation payment was not deductible as interest. The Second Circuit Court affirmed the Tax Court’s holding, indicating that the lack of a fixed maturity date as well as the indefiniteness of the appreciation were both critical factors weighing against the finding of a debtor-creditor relationship with respect to the appreciation payment.
On the other hand, there are authorities that support the characterization of a contingent interest payment as interest for federal tax purposes and do not treat the lender and borrower as partners for tax purposes. For one, as noted earlier, an example in the FIRPTA regulations clearly indicates that the payment on a SAL that reflects equity participation rights in US real property is considered to be interest for US federal income tax purposes. Moreover, in Revenue Ruling 83-51, the IRS specifically ruled that the contingent interest feature of a SAL was treated as interest for federal income tax purposes.
It also is significant that no authorities have cited Farley for the proposition that a supposed debt instrument can be bifurcated into debt and equity components. In fact, Farley is often cited for the necessity of a fixed maturity date in a debt instrument.
In addition, commentators have noted that the terms of the SAL in Farley were “clearly distinguishable” from the typical SAL and, therefore, “the case should not cause any apprehension for a SAL lender.” For these reasons, and despite Farley, non-US taxpayers should feel comfortable that, if properly structured, the payment on a SAL that reflects the equity participation rights in US oil and gas interests should be treated as interest for US federal income tax purposes.
Conclusion
With foreign investment in US oil and gas production continuing to increase, minimizing the taxes imposed under FIRPTA will remain a critical objective for years to come. Although SALs raise a host of complex tax issues, the FIRPTA regulations illustrate that, if structured correctly, SALs can result in significant tax savings. In addition, with the use of the appropriate treaty jurisdictions, and proper planning, these tax savings may be enjoyed by any non-US taxpayer, regardless of residence.
About the author
Jeffrey L. Rubinger [[email protected]] is a tax attorney with Holland & Knight LLP in Fort Lauderdale, Fla., where his practice focuses on domestic and international tax matters.
