How non-resident Chinese investors can structure companies to be tax smart
Learn what key factors to consider before investing in the U.S. real estate market.
By Barry Wen and Lu Zhang
Investing in a real estate market in another country can be challenging. However, with the strength of the U.S. economy, the devaluation of the yuan and a relatively low interest rate in the United States, Chinese investment in the U.S. real estate market has been growing despite China's economic slowdown and increased foreign exchange controls.
Chinese investment in the American real estate market has surpassed $300 billion, according to 2016 numbers. Between 2010 and 2015, Chinese buyers bought $93 billion in residential real estate, nearly $208 billion of mortgage-backed securities and roughly $17 billion of commercial real estate, including office towers and hotels, according to the report by the Rosen Consulting Group and the Asia Society. In 2015, 35 percent of Chinese house purchases were in California, followed by 8 percent in Washington and 7 percent in New York. When investing in the U.S. real estate market, there are tax considerations and certain investment structures non-resident Chinese investors should consider.
Also, there are key non-tax factors that a foreign investor should consider before making a real estate purchase, including if the use of the property is personal, business or investment; if the investment is short or long term; how many investors are involved; if its funded through an equity or loan; what the holding structure is like: direct investment, an entity or a multiple entity structure; if the expected income will come from rent, interest or capital gains; the legal consequences of liability protection and confidentiality; and what exit method and timing is planned.
OVERVIEW OF U.S. TAX CONSIDERATIONS
Generally, foreign investors are subject to U.S. income tax under one of two regimes: effectively connected income or passive income. ECI is generally taxed on a net basis at regular rates applicable to U.S. individuals and entities. U.S. source income that is not ECI is taxed on a gross basis at a 30 percent withholding rate but is subject to potential reduction by income tax treaty. This category of income includes dividends, rent, interest and royalties.
U.S. FEDERAL INCOME TAX ON GAINS
Under Foreign Investment in the U.S. Real Property Tax Act, if a foreign person benefits from a United States real property interest, it will be treated as if it was ECI and, therefore, falls under U.S. federal income tax at the graduated rates that apply to U.S. residents. Additionally, when FIRPTA applies, the purchaser of a USRPI typically is required to withhold and remit 15 percent of the purchase price to the IRS. The tax act includes direct interests in U.S. real property and interest in a U.S. corporation that is a U.S. Real Property Holding Corporation.
In general, that corporation is where the sum of the fair market values of the property interest equals or exceeds 50 percent of the sum of the fair market value of USRPI, the non-US real property interest and other trade or business assets. For example, when a Chinese investor sold a U.S. property, the U.S. income tax imposed on it would be the lesser of the tax paid via the FIRPTA withholding and the tax paid if a tax return is filed.
"...HIGH NET WORTH CHINESE INDIVIDUAL INVESTORS ARE GENERALLY SUBJECT TO ESTATE AND GIFT TAXES ON PROPERTY LOCATED IN THE United States..."
U.S. FEDERAL INCOME TAX ON OPERATING INCOME
Based on the rules discussed above, if the operating income is ECI, tax is imposed on the Chinese investor at regular U.S. rates. The tax base is the gross income net of allocable deductions, including operating costs, management fees and interest expense. Passive income such as dividend and interest income, not considered as ECI, are generally taxed at 10 percent of the gross amount under the US/China income tax treaty.
Foreign corporations investing directly to the United States are normally subject to a U.S. branch profits tax, which is intended to replicate the second level U.S. withholding tax that would apply when a dividend is paid by a U.S. corporation to its foreign corporate parent. The situation is different for Chinese corporate investors, however, as the U.S./China treaty is provided with a complete exemption from the branch profits tax.
ESTATE AND GIFT TAXES
With certain exemption and exceptions, high net worth Chinese individual investors are generally subject to estate and gift taxes on property located in the United States including real property and tangible personal property located. The transfer by a Chinese investor of an intangible asset, such as stock in a U.S. or foreign corporation, is not subject to U.S. gift tax. However, a transfer of stock in a U.S. corporation triggers U.S. estate tax.
COMMONLY USED INVESTMENT STRUCTURES:
DIRECT INVESTMENT STRUCTURE
Without any specific tax planning, a Chinese investor may choose to invest in U.S. real estate directly or through the use a single member U.S. limited liability company. Under this structure, since a U.S. LLC is transparent for U.S. tax purposes, the Chinese investor must file U.S. income tax returns. Upon a tax audit, U.S. tax authorities may examine the investor’s worldwide transactions, for example to prove legal and accounting expenses billed to the U.S. real properties. In addition, direct ownership of U.S. real property is subject to both U.S. estate and gift tax, if the investor is a Chinese national.
U.S. CORPORATE STRUCTURE
An investment can also be made through a U.S. corporation. When there are multiple purchases, the real estate can be directly purchased by a U.S. LLC. In such cases, U.S. Blocker then invests in that U.S. LLC. The benefits under this structure are that the Chinese investor is not required to file U.S. income tax returns and transfers of the stock in a U.S. Blocker are not subject to U.S. gift tax. The downside of this approach is that dividends from a U.S. Blocker to the Chinese investor are generally subject to a 10 percent U.S. withholding tax.
TWO-TIER CORPORATE STRUCTURE
Under a two-tier corporate structure, the Chinese investor owns a non-U.S. corporation – a foreign blocker - which in turn owns a U.S. corporation - a U.S. blocker - that purchases the interests in the U.S. real estate. It is also common that the real estate is purchased by a U.S. LLC which is owned by the U.S. blocker. The benefits under this structure are that the foreign blocker is not required to file U.S. income tax returns, transfers of stock in the foreign blocker is not subject to U.S. estate or gift taxes and gain from sales of the real estate investments by the U.S. blocker is not subject to FIRPTA tax.
However, dividends from the U.S. blocker to the foreign blocker are generally subject to a 30 percent U.S. withholding tax. U.S. income tax treaties typically reduce the withholding rate from 5 percent to 15 percent. In the case where a foreign blocker is a Chinese corporation, the treaty withholding rate is 10 percent.
OTHER MORE COMPLEX STRUCTURES
In addition to the above commonly used structures, more complex structures such as a two-tier partnership structure or a structure involving a U.S. or foreign trust may offer higher U.S. tax savings. Regardless of the structure chosen, Chinese tax advisors should be consulted for any deal breaker under the Chinese tax rules.
As illustrated, there is no perfect structure. Pros and cons under each structure should be evaluated based on specific situations of the Chinse investor. For example, an investor with a plan to repatriate most of the profits back to China may use a structure different from an investor who plans to reinvest in the U.S. Chinese investors who work with their U.S. and Chinese tax advisors through careful planning and structuring will pay substantially lower effective tax rates worldwide.