The Real Estate Board of New York to The Internal Revenue Service re: Proposed Regulations Relating to the Taxation of the Income of Foreign Governments from Investments in the United States

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The Real Estate Board of New York (REBNY) is the City’s leading real estate trade association. Founded in 1896, REBNY represents commercial, residential, and institutional property owners, builders, managers, investors, brokers, salespeople and other organizations and individuals active in New York City real estate. REBNY appreciates the opportunity to comment on proposed rules that impact when a foreign government may be determined to have effective control of an entity under Section 892 of the Internal Revenue Code.

To support investment in the United States, Section 892 generally exempts foreign governments from U.S. federal income tax on income earned from certain qualifying investments. However, income from commercial activity conducted by a foreign government, including from commercial entities controlled by a foreign government, is generally not considered to be exempt from U.S. federal income tax.

These new proposed rules create uncertainty as to when a sovereign investor1 is considered to exercise effective control over a commercial entity, upsetting longstanding market practice which has evolved over time to comply with the proposed rules issued previously that provided guidance in this area. In doing so, the proposal would have a significant impact on existing U.S. real estate investments that involve sovereign investors. Unfortunately, if not amended, the rule could deter future potential investments into the U.S. and disrupt existing investments in ways that would harm the U.S. economy.

U.S. real estate sponsors, including members of REBNY, frequently raise funds from sovereign investors and use those funds to invest in all types of U.S. real estate investments. Typically, when a sovereign investor invests in such investments, the sovereign investor does not have a majority ownership interest (by vote or by value) in the investment and does not exercise day-to-day management of the real estate (e.g., does not act as the sponsor, general partner, leasing agent, property manager, asset manager etc.).

Additionally, it is typical in these investments that when a sovereign investor invests in these deals their investment is protected through various governance provisions that give the sovereign investor veto rights over certain decisions. This is standard practice given the significant size of investment (which can be in hundreds of millions or billions of dollars) and the desire of the sovereign investor to have basic safeguards in place to protect its equity investment. Importantly, these safeguards do not enable the sovereign investor to force any particular action. Rather, they are designed to allow the sovereign investor to prevent or raise concerns about certain actions outside of day-to-day operations.

The proposed rule establishes a facts and circumstances test to determine whether veto rights are evidence that a sovereign investor has effective control and provides several examples of situations where effective control could be found, in particular examples 5 and 8. These examples appear to indicate that the veto rights found in common governance arrangements could result in a sovereign investor being found to have effective control.

Absent further clarification, these proposed rules do not consider the role veto rights play in typical commercial arrangements. Veto rights are in place to protect the sovereign investor and not give that sovereign investor the right to take any action nor make day-to-day decisions regarding the operations of the commercial entity. Furthermore, simply because an investor has veto rights does not mean that the investor can unilaterally cause an action to occur or a decision to be made and instead any such action or decision requires the consent of the U.S. sponsor.

Consequently, the proposed rule should be clarified in several ways.

First, a safe harbor should be established for minority sovereign investors that allows them to maintain certain veto rights. The safe harbor could, for example, apply in situations where (1) another investor unrelated to the sovereign investor either holds more than a 50% equity interest, is the sole managing partner or member, or directs the day-to-day conduct on all matters and (2) the veto rights given the sovereign investor are shared by other investors (including the U.S. sponsor) or apply only to certain actions other than day-to-day conduct.

Second, the rule should provide greater detail as to the facts and circumstances test and how it will consider the existence of veto rights. The regulations should clarify that the types of facts outlined in the proposed safe harbor above could be taken into account when evaluating whether veto rights are evidence of effective control.

Third, the rule should grandfather existing governance arrangements to avoid causing significant disruption in the market. As stated above, since veto rights are commonly used in existing governance arrangements, the proposed rule would cause significant harm to current governance structures. This could be avoided if existing arrangements could be grandfathered, provided that any material changes in such governance that increase a sovereign investor’s consent rights would require compliance with any new standards.

Finally, given the complexity and fact-specific nature of the analysis required to determine if a sovereign investor is exempt from U.S. income tax, U.S. sponsors and other third-party withholding agents should be allowed to rely on the representations made on IRS Form W-8EXP provided by the sovereign investor without having to independently analyze whether the sovereign investor has effective control. Such clarification will help to ensure that market transactions can move forward without undertaking additional costly and complex analysis and place the burden on the sovereign investor who would be privy to facts the withholding agent may not.
Thank you for considering these views.