Optimising the tax profiles of real estate investment transactions abroad

One of the most interesting issues for investors looking at the US market as an investor (see our free course on the US market), and in particular the real estate market, is undoubtedly the optimisation of the tax profiles linked to the investment.

Although the US tax system is very lean and characterised by clear and easy-to-implement rules, a misjudgement (or, worse, an underestimation) of the specific requirements that an investor – especially a foreign one – has to put in place can be detrimental to the entire investment and can result in significant tax liabilities.

Our aim in this brief overview is to provide the basics for optimising the tax profiles of foreign investors wishing to enter the US real estate market.

 This initial overview already gives us an idea of the fundamental characteristics of the LLC (which was created as a middle ground between a partnership and an INC):

• narrowly based companies;

• direct management by the shareholders (although there is a working distinction between shareholders and directors – managers – of the company. And indeed, for reasons of tax expediency related to the application of the CFC “Controlled Foreign Companies” rules, it is appropriate that this distinction is absolutely real and effective);

• the specific nature of the membership (intuitu personae);

• limited liability of the shareholder for the company’s obligations.
  

An LLC is, from a civil law point of view, broadly similar to an Italian S.r.l. or an English Ltd, with the only difference being that, as we will see on the side of taxation, the LLC is by default a pass-through entity, i.e. a transparent entity (which can, however, opt to become a company subject to corporate tax.

The LLC therefore represents the right balance between shareholder asset protection and tax efficiency.

This is the case if the LLC is not owned by a sole shareholder, in which case it is considered a disregarded entity and therefore is taxed in the same way as a Sole Proprietorship.
In addition, the presence of a single shareholder could generate some risk for the company to be re-classified by the tax authorities of the country of origin as a so-called “foreign invested” entity, with all the relevant tax consequences (this subject, due to the complexity of the discussion and the specific characteristics of the cases, cannot be dealt with here, but requires specific ‘tailored’ advice on a case-by-case basis).

Another element to be taken into account when opting for the LLC is that the profits generated can be allocated to the partners in different proportions than the ownership percentages, and this flexibility allows the corporate instrument to be tailored to the specific needs of each investor.

On a strictly operational level, the European resident partner of the LLC has to apply for a kind of US tax identification number (ITIN, Individual Taxpayer Identification Number), which is necessary for filing the (mandatory) tax return in the USA.

From a tax point of view, as mentioned, the LLC is by default a transparent company, although it may opt to be treated for tax purposes as a corporate entity.

The option (which is referred to as Election C-Corp) must be exercised from the start of the activity and does not result in a different method of determining the tax base.

But now let’s analyse how the LLC is taxed.

Since this is a “transparent” company from a tax point of view, the profits generated by it are not taxed in the hands of the company but are attributed directly to the shareholders – there is no need to proceed to the distribution of profits, in any case they are attributed precisely because it is a transparent company – who will receive the “Schedule K-1” each year (the U.S. counterpart of the Italian RH Form): it indicates the share of profits attributed in the year to the shareholder, a share that is included in the total income to be indicated in the declaration (Tax Return – Form 1040NR), which is mandatory in any case (even if there is no income for the non-U.S. resident shareholder).

But how is the US income attributed to the LLC partner on a transparent basis taxed in Italy?

First of all, it should be clarified that, with respect to profits deriving from the participation in foreign companies received by the Italian resident shareholder, the latter is taxed on a “cash basis” and not on an “accrual basis”, according to the fixed rate of 26% (regardless of whether or not the shareholder holds a so-called “qualified” shareholding).

Therefore, so long as the Italian shareholder does not actually distribute those profits (that is to say, so long as he does not make a material transfer of the sums received as profits to Italy, he won’t be subject to any tax there).

In this respect, it should always be top of mind that:

1. the profit attributable to the shareholder is always lower than what would have been the return on the investment attributable to him as an individual, since the company may deduct specific costs (according to the principle of pertinence) whose deductibility by the individual is excluded;
2. the taxes paid abroad by the company are to a certain extent recoverable either as a tax credit (under Article 165 of TUIR [Italian Income Tax Code]) or as a deduction from the attributable and taxable foreign income;
3. in order to determine the “legitimate” foreign tax actually applicable to the non-US Resident shareholder, reference should always be made to the Convention against double taxation in force between Italy and the United States of America (as well as seeking that it be applied), which provides – for example – for the taxation of profits deriving from a shareholding in US companies at the maximum rate of 15% (so-called Withholding Tax).

There are also other aspects related to the correct filing of the Italian tax return RW Form (also in this respect, the convenience of operating as a company and not as an individual is highlighted), as well as the procedures for deferring the taxation of profits in Italy, but these topics, which must necessarily be adapted to the specificity of the situation of each investor, can be more effectively dealt with in a different and separate forum.