The following article discusses session three in the IR Global Virtual Series on 'Preferential Portfolios: Tax efficiency in international real estate investments'
USA – RB The typical structure for non-US investment in US real estate is through a US corporation owned by a non-US entity, organised either in the investor’s domicile or a tax advantaged jurisdiction.
The recent reduction in US corporate income tax from 35 per cent to 21 per cent renders this structure even more favourable. As discussed earlier, the US corporation is commonly referred to as a ‘blocker’ as it blocks the real property from being treated as owned by a foreign person and the attendant disadvantages of a foreign person directly owning real property in the US.
The non-US investor generally acquires two types of interest in the blocker corporation: equity shares of stock) and debt (a registered promissory note). The ratio of debt to equity and debt terms vary, but in general should be commercially reasonable, which is driven by the type of underlying real estate investment being considered.
The minimum equity is typically 20 per cent to 50 per cent of total capitalisation, depending on the financial strength and leverage of the underlying investment. Subject to certain limitations, applicable to very large transactions, the interest is generally deductible to the blocker corporation and, if structured properly, can be exempt from US withholding tax when paid to the non-US investor, as is repayment of the principal.
This structure can be successful in sheltering the operating income from the real property from US tax. On sale of the real property, the blocker corporation will pay US tax on any gain realised, but liquidated distributions back to the non-US investor after sale of all real property are not subject to US withholding tax. As a cautionary note, the US has tax treaties with many countries and the terms of the treaty may vary these tax principles.
Canada – JS When considering the cross-border investment structure, it is important to consider, among other items, where the non-resident of Canada (NRC) is resident for tax, whether the NRC is entitled to treaty benefits, how income is taxed in the home jurisdiction, possible repatriation strategies and the exit strategy.
Capitalisation is an issue if the corporation is claiming a deduction for interest paid to a specified NRC. The Income Tax Act of Canada restricts a deduction for interest paid or payable by a corporation resident in Canada, in a taxation year, on debts owing to specified NRCs, if the ratio of these debts to the corporation’s equity exceeds 1.5 to 1. A specified non-resident is basically any NRC that owns more than 25 per cent of a Canadian corporation. Therefore, it is tough to be a lender and an owner.
It is worth considering the utilisation of hybrid or convertible shares as a means of financing Canadian real estate initiatives by NRCs. If an investment is made directly and the shares are created as special or preference shares, drafting may provide a means of reducing the tax impact and strengthening an NRC position.
Germany – DL There are no advantages in using equity as a source of funding in Germany. Shareholder loans made under arm’s length conditions are possible, but may trigger limited tax liability in Germany for the creditor.
Hybrid financing and preference shares are relevant to German-based corporations and payment has to be qualified as either debt or equity. Equity does not allow this structure to reduce taxable income.
Where a German-based corporation is being used, dividends trigger withholding tax of 25 per cent, plus a solidarity surcharge. Any deductions based on double taxation treaties or the EU’s parent subsidiary directive are potentially subject to national treaty override regulations.
With regard to deductions based on debt interest payments, losses can be carried back for the previous year and carried forward. Deductible losses are limited to one million euros, plus 60 per cent of the remaining taxable income.
New Zealand – RA New Zealand is a signatory to both base-erosion and profit shifting (BEPS) and Automatic Exchange of Information (AEOI) initiatives and consequently any non-resident investor considering NZ as an attractive opportunity, must factor this point into their decision matrix.
With both initiatives, we have seen recent legislative amendments to facilitate both the increased automatic sharing of information with other taxing jurisdictions, and the implementation of various rules to counter the BEPS strategies non-residents use to lower their exposures to NZ taxation.
As a consequence, there are rules (although they were in existence well before BEPS came on the scene) that act to restrict interest deductions on debt, where the non-resident investor fails to satisfy requisite debt/asset thresholds (thin capitalisation).
There are also laws that re-characterise hybrid financial arrangements to ensure uniformity of tax treatments between the lender/borrower jurisdictions, and the requirement of the borrower to deduct non-resident withholding tax on interest on payments to the non-resident lender. New Zealand also has a transfer pricing regime, with Inland Revenue active in reviewing interest rate pricing between associated cross-border parties, to ensure an arms-length market rate is being used in the financing transaction.
For example, the (possible) impact of the insurance premium on the price, and the applicable law (the same law should apply to the insurance policy and the sale and purchase agreement).
Other questions include the legal subrogation right of the insurer and the tax treatment of any insurance payment received by the purchaser and the related possible impact on tax gross-up clauses.