• Untitled Document
    Untitled Document

    Why FIRPTA should be repealed

    Increased access to global capital will strengthen our economy

    Deborah Byers and Greg Matlock, EY, Houston

    The late 1970s and early 1980s were difficult years for the US economy. The Arab oil embargo, which began in late 1973, quadrupled the price of oil seemingly overnight and eventually led to an inevitable increase in the cost of most goods and services. By 1980, annual inflation had reached an astonishing 13.5%.

    Unemployment was high, as well. Nationwide, the unemployment rate almost doubled from 1974 to 1975, and by 1982 it was close to 11%, a level not seen since the Great Depression. The recession that began in 1981 hit key industries such as steel production and automobile manufacturing especially hard, and in some parts of the industrial Midwest, unemployment soared past 20%. By the spring of 1983, 30 states had unemployment rates in double digits.

    Amid high inflation and high unemployment, the stock market plunged. From January 1973 to December 1974, the Dow Jones Industrial Average lost more than 45% of its value. Between high inflation, high unemployment, high interest rates, and a floundering stock market, it appeared that the country's best days were gone forever.

    In the minds of many Americans, those challenging months and years created concerns that went beyond simple finances. Was recovery even possible? One major issue was the fear that foreign investors were benefiting from our misfortune and buying up our most precious asset, real estate. Politicians, the news media and many ordinary citizens viewed this trend with anxiousness as companies from nations such as Japan made significant purchases of property, from rural farmland to well-known commercial real estate developments. America was for sale at bargain-basement prices, and the Japanese and others were buying.

    This anxiety over "losing America" led Congress to pass the Foreign Investment in Real Property Tax Act of 1980, also known as FIRPTA. The law attempted to put the brakes on the supposed widespread takeover of American assets by requiring foreign persons or organizations to pay income tax on the realized gains from the sale of domestic real property interests.

    At the time, FIRPTA appeared to be a smart, strategic maneuver to protect American icons from falling into outside hands. Over the years, however, it has stifled foreign investment in the US, and made it difficult for sovereign equity funds and foreign private equity investors to provide much-needed capital for domestic infrastructure improvements. In short, FIRPTA has done far more harm than good.

    Competing for capital

    As we head into yet another year of recession, we face a challenge similar to the one in the late 1970s. How do we get our economy moving again? Obviously there isn't complete consensus on how to accomplish this objective, but one idea that almost everyone agrees on is the need for long-term investments in the foundation of our nation's social and economic systems – from new housing, schools, healthcare facilities and accessible, affordable energy to roads, bridges, ports, waste and water treatment facilities and more.

    Energy, in particular, holds significant value. The emergence of domestic shale gas and oil as major components of our overall energy mix means jobs, royalties and new sources of tax revenue. We are seeing tremendous growth in states such as North Dakota, Texas, Louisiana, and Pennsylvania where the rush to develop shale plays is driving economic development and reducing unemployment. Investing in these resources – and in associated pipelines, processing plants, and refineries – can provide us with numerous benefits in the years to come.

    Yet much of the capital burden for these types of investments will fall on the private sector. And any proposed project must compete for capital with many others – both in the US and elsewhere – on the basis of the best return. In this regard, FIRPTA adds an additional hurdle, and makes US-based oil and gas projects less competitive than those in other parts of the world.

    With one simple move, the US could increase the attractiveness of a wide range of necessary energy and infrastructure projects, improve access to affordable capital and accelerate many much-needed developments that are languishing on the drawing board. How? Repeal FIRPTA.

    Complexity discourages investment

    FIRPTA is one of the leading deterrents to foreign investment in US infrastructure projects. Although the law does not prohibit foreign ownership, its complexity makes it prohibitive for many foreign investors. And the taxes it requires upon sale of certain assets further hinder the free flow of capital by adding to the costs of borrowing – a project's rate of return must be substantially higher under FIRPTA to cover the cost of tax upon disposal.

    Private/public partnerships, like those involved in major public works projects such as toll roads, are also impacted. Foreign investors are drawn to those types of projects because of their long-term nature and stability, but their involvement in US-based partnerships is somewhat deterred due to FIRPTA.

    Just as important, FIRPTA encourages foreign companies to hold on to their existing US assets longer than might be anticipated to avoid the tax implications of selling, which of course is the exact opposite of the law's intention.

    So what exactly is this little known rule – primarily of interest only to tax lawyers and accountants – that has created such a roadblock?

    To first fully understand why FIRPTA is a unique tax roadblock, we need to understand that, in general, taxation of foreign residents on capital gains earned on investments in US stocks and securities is exempt from tax since this income is subject to tax by the country in which the investor is resident. Which sovereign jurisdiction has the right to tax foreign earnings is often governed and limited by bi-lateral tax treaties and domestic tax laws.

    The US has 58 bi-lateral tax treaties in place that dictate these matters. As stated above, Congress enacted FIRPTA as an exception to such general rule so that non-US investors would generally be subject to US taxation on income from the (actual or deemed) disposition of US real property interests (USRPIs). FIRPTA is generally enforced through a withholding regime that requires certain amounts to be withheld in connection with the disposition of certain USRPIs.

    In addition to the sale of interests in land and buildings, FIRPTA applies to sales of mineral interests (including oil, gas and coal), interests in partnerships and stock of US corporations that are classified as US real property holding corporations (USRPHCs). A US corporation is considered a USRPHC if the fair market value of such corporation's USRPIs equals or exceeds 50% of the fair market value of:

    • its USRPIs
    • its interest in real property located outside of the United States, plus
    • any other of its assets that are used or held for use in a trade or business.

    In general, FIRPTA treats the gain from the sale of a USRPI as if the taxpayer is engaged in a trade or business in the United States, and as if the gain is income effectively connected with such US trade or business. Certain exceptions exist for publicly traded interests, interests solely as a creditor and specific other interests.

    In the Senate Finance Committee's report accompanying the enactment of FIRPTA, the committee stated that "[t]he committee does not intend by the provisions of this bill to impose a penalty on foreign investors or to discourage foreign investors from investing in the United States."1 The practical effect of FIRPTA, however, has done just that. An excerpt from an article written in 1983 noted that:

    The supposedly horrific inequity of foreign versus domestic taxation actually remains unchanged, except for the special case of real estate dispositions. The clear intention of this statute, therefore, is not to eradicate inequities, but rather to discourage foreign investment in [US] real estate, a goal for which FIRPTA is singularly unsuited. In any case, the goal itself manifests a disturbing xenophobia that lacks any economic rationale or common sense foundation. The new statute quite clearly is flawed beyond amendatory repair and should be repealed in its entirety at the earliest opportunity.2

    Nearly 30 years after that sentiment was expressed, its reasoning still resonates – FIRPTA represents an underlying policy that reflects an out-of-date fear of a global economy. This complex set of rules – designed for the express purpose of limiting outside investment – is antiquated in today's interconnected economy, where capital moves freely around the globe. In 1980, the US was the heart of the global economy; today, financial centers are located around the world, and financiers are just as likely to invest in China, Qatar, or Brazil as they are New York or Nebraska.

    In fact, having non-US investors as owners or partners in a toll road, a mineral deposit or a gas processing plant hardly puts those assets at risk. After all, no one can walk off with the Empire State Building or a mineral deposit thousands of feet below the ground just because they own it. Without FIRPTA, global investors could get a competitive, acceptable rate of return in the US, and our economy would reap the benefits of those dollars being put to work to develop needed infrastructure.

    Repeal, not amend

    Despite our economic difficulties, the US remains an attractive place to make investments. We have solid rule of law, stable government and open capital markets. We offer the widest possible range of opportunities for investors in any number of business sectors. At the local and state levels, there are almost unlimited prospects for partnerships and joint investment.

    In addition, we need as many forms of capital as possible to help rebuild infrastructure and smooth our recovery. Capital constraints force credible, beneficial projects to the sidelines – projects that could help spur economic development. The biggest projects – those with the highest risk and the highest long-term return – would benefit the most from foreign investment. Restricting that capital via FIRPTA is simply holding us back.

    In recent years, there has been some movement to amend FIRPTA. Congress now is looking at a number of changes that would primarily benefit the real estate industry; for example, allowing foreign investment in real estate investment trusts (REITs). But the need for outside investment extends to a wide range of US business sectors beyond real estate. Even with these proposed changes, FIRPTA would remain a significant barrier for other industries.

    In the 1980s, when the Japanese were buying American real estate assets, the concerns over those investments extended beyond US shores. The New York Times reported then that "… many Japanese officials … are increasingly fearful that their country's huge increase in American investments is creating a perception of Japan as less a partner than a rival."

    Today, China alone is sitting on approximately $3.2 trillion in foreign currency reserves – money that could be put to use helping build the next generation of American energy assets, transportation systems or municipal facilities. The US government has made overtures to the Chinese to encourage this investment, but FIRPTA remains a stumbling block. In the oil and gas industry, for example, many investments in the upstream, midstream and downstream sectors could be considered real property for purposes of FIRPTA, requiring significant planning by accountants and tax lawyers to minimize application. Those types of obstacles are damaging to our long-term interests.

    In other words, we can be a partner with countries such as China and others who have expressed an interest in investing in US assets, or we can continue with an antiquated tax rule that was designed with the view that they were rivals. One approach ensures a quicker recovery and maximizes our benefits in terms of economic development, jobs, and enhanced infrastructure. The other continues to push us further and further away from global capital and damages our reputation as "market of choice" for investment. Which road will we take?

    About the authors

    Deborah Byers is the office managing partner for EY's Houston office and also serves as the energy markets leader for EY's Southwest region. Deborah has represented investors and companies in various types of domestic and cross-border oil and gas transactions.

    Greg Matlock

    Greg Matlock is a senior manager in EY's transaction advisory service – transaction tax practice, and he has also served as the tax sector resident for EY's Global Oil and Gas Center. His practice is focused on US federal income tax planning and structuring for business transactions, with particular emphasis on oil and gas investments.

    1S. Rep. No. 504, 96th Cong., 1st Sess. 6 (1979).

    2Kaplan, Creeping Xenophobia and the Taxation of Foreign-Owned Real Estate, 71 Geo. LJ 1091 (1983).

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