While some activities are limited when working from home during a global lockdown, there are still a variety of tax-efficient options available to sell foreign real property. This article discusses the U.S. Federal income tax consequences of several options available to a U.S. individual disposing of foreign real property.
LAYING DOWN THE BASICS
The facts that drive this article are as follows:
- Mr. A is a U.S. tax resident (i.e., an individual who is either a U.S. citizen, a lawful permanent resident of the U.S. for immigration purposes, or a U.S. resident for income tax purposes under the Substantial Presence Test).
- He resides in the U.S. and is gainfully employed in the U.S.
- He owns the stock of a Spanish corporation ("F Co."), which in turn owns a parcel of undeveloped real property in Spain.
- Mr. A is a nonresident for Spanish tax purposes.
- Mr. A invested in the property in 2010 with a goal of long-term appreciation.
- The property has substantially increased in value, and Mr. A is now proposing to sell it at a significant gain.
- F Co. is a controlled foreign corporation ("C.F.C.").
Very simply, a foreign corporation is a C.F.C. if more than 50% of its voting rights or value is owned by one or more U.S. Shareholders.1 A U.S. Shareholder, inter alia, includes an individual who is a U.S. citizen who owns at least 10% of the voting rights or value of a foreign corporation.2 Since, Mr. A owns all of the voting rights and value of F Co., he meets the definition of U.S. Shareholder, and F Co. is a C.F.C.
ALTERNATE TAX STRUCTURES3
Option 1: F Co. Sells the Property and Distributes Dividends to Mr. A
One of the easiest ways to dispose of the real property is a direct sale of the property by F Co.
First Level of Tax: Spanish Corporate Income Tax on F Co. on Capital Gains
Spain will treat the excess of the sale proceeds over the adjusted basis of the real property as a capital gain, which will be subject to tax in the hands of F Co. at the corporate rate of 25%.
Second Level of Tax: Spanish Personal Income Tax on Mr. A on Dividends Distributed by F Co.
Mr. A will be subject to Spanish personal income tax on the dividends distributed by F Co. F Co. will be responsible for withholding tax at the time the payment is made to Mr. A. As a result, he will be eligible to claim the benefit of a lower tax rate on Spanish-source dividends. Article 10 of the Spain-U.S. Income Tax Treaty provides for a 15% withholding tax on dividends paid by a Spanish company to an individual.
Third Level of Tax: U.S. Federal Income Tax on Subpart F Income
For U.S. Federal income tax purposes, F Co. is a C.F.C. and Mr. A is a U.S. Shareholder. The capital gain in the hands of F Co. will be treated as Subpart F4 Income in the hands of Mr. A, who will be taxed on the Spanish company's Foreign Personal Holding Company Income even if it is not distributed by F Co. Subpart F Income is treated as ordinary income, and therefore, Mr. A will be subject to U.S. Federal income tax at a rate of up to 37%. Mr. A will not be subject to additional U.S. tax when F Co. makes an actual distribution of the dividends.5
Eligibility of Mr A to Claim Credit for Income Taxes Paid in Spain
When computing the U.S. tax liability of a U.S. individual for income tax purposes, the Code allows a taxpayer to claim a foreign tax credit for the foreign income taxes paid or accrued with regard to the foreign income that is taxed. In broad terms, this allows the U.S. tax to be reduced by the foreign taxes paid. However, the foreign tax credit reduces only the portion of U.S. tax imposed on foreign-source income.6 Broadly, an individual is allowed to claim a credit of the taxes paid to a foreign country only if, inter alia, the following conditions are satisfied:
- The individual is the person on whom the foreign jurisdiction imposes the legal liability to pay the income tax ("Technical Taxpayer Rule").7
- The foreign levy is an income tax in the U.S. sense.8
- The income is foreign-source income.9
Typically, a foreign income tax paid by a foreign entity treated as a corporation under U.S. income tax rules for characterizing entities,10 is not considered to be the legal liability of its shareholder. Therefore, Spanish taxes paid by F Co. on its capital gain arising from the sale of the real property is not treated as being imposed on Mr. A. The legal liability test is not met. Thus, Mr. A fails the Technical Taxpayer condition and, accordingly, is not eligible to claim a credit for the Spanish foreign taxes (25%) paid by F Co. on the gain.
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Footnotes
1. Code §957(a).
2. Code §951(b).
3. The article briefly discusses the basic Spanish capital gain tax and personal income tax regime for purposes of background only.
4. Code §954(c)(1)(B)(iii). In particular, the gain will be treated as a Foreign Holding Personal Company Income, which is one category of Subpart F Income.
5. Code §959(a).
6. Code §904(a).
7. Treas. Reg. §1.901-2(f)
8. Treas. Reg. §§1.901-2(a)(1)(ii), 1.901-2(a)(3)(i).
9. Code §904(a).
10. Treas. Reg. §§301.7701-2 and 301.7701-3.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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