Three Ways The U.S. Tax System Offers A Beacon Of Stability For Cross-border Investment
As investors around the world face an uneven investing environment, the United States offers opportunities. Many of these are made possible by tax policies that are especially welcoming to foreign investors—and in some cases, Canadian foreign investors. Three U.S. investment opportunities stand out: 1) "bring your own treaty" investments; 2) private REITs; and 3) a federal corporate income tax rate that remains low and could represent a new normal.
1) "Bring your own treaty" investments
As interest rates rise, investments in loans have become an increasingly attractive alternative to equity investments. Many funds and money managers typically offer structures designed to allow an investor in a treaty jurisdiction to avoid net U.S. income tax on interest income.
These structures are often known as "bring your own treaty" funds, but they can also be offered as separate managed accounts and other investment platforms. They work by allowing a foreign investor to invest in loans without creating, or being attributed to, a "permanent establishment" in the United States. This is typically achieved by having the loans originated by an investment manager who qualifies as an "independent agent" under a tax treaty between the U.S. and another country. If structured properly, the activities and U.S. presence of the independent agent should not be attributed to the foreign investors.
Many funds and money managers typically offer structures designed to allow an investor in a treaty jurisdiction to benefit from the treaty's exemption from U.S. income withholding tax on interest income from investments in loans.
Where a treaty otherwise provides a complete exemption from U.S. withholding tax on interest income, these and similar structures allow for non-U.S. investors to invest in loans tax efficiently, which continues to fuel the strong appetite for debt capital by U.S. borrowers.
2) Private REITs
Rent-producing U.S. real estate continues to be an attractive asset class in categories that are either more resilient to fallout from the global pandemic or are even seeing increased demand as living patterns adjust to the "new normal" of post-pandemic life. Investing in these assets through private REITs continues to be an effective means to invest in U.S. real estate on a tax-efficient basis.
When the REIT is domestically controlled (generally meaning majority owned by U.S. investors), or the foreign investor is a qualified foreign pension plan or government investor who owns a non-controlling interest in the REIT, gains from a sale of REIT shares are exempt from the U.S. FIRPTA tax that otherwise applies to investment in U.S. real estate. When the foreign investor is a qualified foreign pension plan, gains are exempt from FIRPTA—and even property level sales can be exempt from U.S. income tax. Given the increased popularity of private REITs, it has become easier to find a buyer willing to buy REIT shares so that a non-U.S. investor can dispose of their investment in a tax-efficient manner.
Investing in U.S. real estate assets through private REITs continues to be an effective means for certain categories of foreign investors to invest in U.S. real estate on a tax-efficient basis.
Tax treatment for dividends is also beneficial. For pension plans in a treaty jurisdiction, such as Canada, the treaty can exempt dividends from unrelated U.S. corporations, which includes REITs. For foreign government investors who make a non-controlling investment in a U.S. REIT, dividends can also be exempt from the 30% U.S. withholding tax that would otherwise apply.
As a result, for U.S. real estate that is eligible to be held in a REIT (which includes virtually any real estate asset class that can be structured to produce rental income), private REITs continue to be a major planning tool for foreign investors who wish to obtain exposure to the stable cash flow and potential upside of U.S. real estate investments.
3) Lower corporate income tax rate is the new normal
Despite a new administration entering the White House in 2020, there has been no significant push to change the corporate income tax rate from its "new" 21% rate introduced in late 2017. This keeps the United States in line with other similar investment jurisdictions, particularly compared to the punitive 35% rate that had previously persisted for decades.
Moreover, for foreign investors in a jurisdiction that has a treaty that exempts interest income, such as investors residing in Canada, U.S. corporate entities can often be funded with shareholder debt. Although interest deductions are subject to various limits under the U.S. Internal Revenue Code, interest deductions can still help manage the effective corporate income tax rate, while the U.S.-Canada Income Tax Treaty provides an exemption from withholding tax for interest paid on the shareholder debt.
For equity investments in entities that are treated as corporations for U.S. tax purposes, or where a foreign investor needs to establish a taxable U.S. "blocker" that can be "leveraged" by capitalizing it with shareholder debt, the stable U.S. corporate income tax rate continues to allow for a manageable and reasonable tax cost that compares favourably with other investment opportunities.
Conclusion
As the world changes and political and tax systems struggle to adjust to, and define, the "new normal", investors in the United States are able to continue to rely on a stable arsenal of tax-planning opportunities created by the U.S. tax system to attract foreign capital. Some of these strategies leverage the country's historical position as a destination for cross-border investment; others present new investment opportunities created by recent economic and social developments. As always, the close relationship between Canada and the United States provides particular benefits to investors north of the border.