Commentary: Don’t overlook U.S. tax consequences of cross-border mining investments (June 01, 2011)

Canadian-based mining companies investing in U.S. property need to be aware of various U.S. tax provisions that could affect their return on the future sale of this property.

Given the appreciation of the Canadian dollar relative to the U.S. dollar, more Canadian companies are looking into acquiring U.S. companies or assets, or entering joint ventures to develop U.S. assets. When considering acquiring these assets, developing them or disposing of them, Canadian mining companies need to be mindful of the potential costs arising from complex U.S. income tax provisions that can apply to these transactions.

These provisions are commonly referred to as FIRPTA, short for Foreign Investment in Real Property Tax Act of 1980. FIRPTA provisions can cause foreign taxpayers with U.S. real property interests to be taxed in the U.S. when disposing of or reorganizing these assets or participating in a joint venture to develop them. 

This article is an overview of these FIRPTA provisions for Canadian managers so they can take these potential tax consequences into account when considering investing in U.S. real property interests. It also explains how the U.S. like-kind exchange provisions can be used to avoid current recognition of a gain (and a potential tax liability) that would otherwise apply under FIRPTA.

General rules

As an example, a non-U.S. person buys a parcel of land such as a mineral well or other mineral-related real estate. The parcel of land increases in value over time and the owner decides to dispose of it. Because of the FIRPTA rules, the gain on the disposition of the U.S. real property interest (USRPI) is taxed by the U.S. as if it were U.S. business income.

As a result, the foreign individual or corporation must file a U.S. tax return reporting the gain from the disposition and can claim deductions and carry over losses (if the property was sold at loss).

A USRPI includes an interest in real property located the United States or the Virgin Islands. Interest in real property includes an interest in a mine, well or other natural deposits. It is not necessary to hold real estate as an absolute fee owner. An interest in real property includes fee ownership, co-ownership, a leasehold interest, and even an option to acquire an interest in real property.

In certain situations, the disposition of shares in a U.S. corporation can also be taxed under the FIRPTA rules. This can happen when a non-U.S. person disposes of shares in a U.S. corporation that is a U.S. real property holding corporation (USRPHC). Generally, a USRPHC is a corporation heavily invested in USRPI(s).

FIRPTA Operation

To protect its taxing rights, the U.S. requires the purchaser (or otherwise transferee) of USRPI to withhold 10% of the amount realized by the foreign seller on the disposition.

To equalize the tax treatment of the foreign person disposing of a USRPI with the treatment of a U.S. person, the U.S. tax law allows the amount withheld not to exceed the seller’s maximum tax liability on the sale of the USRPI.

Generally, the maximum tax liability is the amount realized minus the adjusted basis of the property multiplied by the seller’s maximum tax rate applicable to long-term capital gain.

For example, if the sale price is US$1 million for USRPI and the basis is US$1.5 million, then the potential withholding tax should be US$100,000. The seller will then be required file a U.S. income tax return and calculate actual U.S. income tax on the amount of the loss from the disposition. Under these facts, the seller should receive a refund of the tax withheld, because the amount of tax withheld (US$100,000) is higher than the maximum tax liability.

Withholding tax

Considering the time value of money and cash flow concerns when tax is withheld and not refunded until a tax return is filed, it is beneficial if the purchaser is not required to withhold 10% from the purchase price if the maximum tax liability will be less than the 10% withholding of the amount realized. To reduce or eliminate having to pay the withholding tax, one of the parties should obtain a withholding tax certificate.

Either a seller or a purchaser can apply to the U.S. Internal Revenue Service for a withholding certificate. The IRS will generally issue a certificate specifying the reduced rate of withholding within 90 days of filing an application. The application must be filed before the sale occurs. If the application has been made and the sale occurs before the receipt of the certificate, the purchaser must still withhold the entire 10% of the consideration and set such funds aside until the IRS acts on the withholding certificate. The applicable withholding is not required to be paid to the IRS until the 20th day after the day the IRS mails the withholding certificate or notice of denial. 

Foreign partners

Very often, investments in mining properties are structured through the use of a partnership. If this form has been chosen, it’s important to know that partnership income is attributed to partners and is not taxed at a partnership level. However, the U.S. tax law provides that a partnership must pay withholding tax on income attributable to a foreign partner that is effectively connected with the U.S. trade or business, even though such income has not yet been distributed to the foreign partner.

A foreign partner is considered to be engaged in a U.S. trade or business if the partnership, of which a foreign corporation or a non-resident alien is a partner, is so engaged. A gain on disposition of USRPI shall be treated as effectively connected with the U.S. trade or business.

That being said, where a partnership disposes of its mining properties, gain on its disposition should be considered as income effectively connected with the U.S. trade or business of the partnership. Special withholding rule are provided for public and tiered partnerships. Generally, a partnership should pay withholding tax in four annual installments.

If a foreign partner disposes of an interest in partnership that owns USRPI, withholding rules depend on the amount of the USRPI that the partnership owns.

Tax-free transfers

In any transfer of a USRPI in a transaction that otherwise qualifies for tax-free (or roll-over) treatment, such treatment will be accorded only if the USRPI is exchanged for an interest that is also a U.S. real property interest and which, immediately following the exchange, would be subject to U.S. tax upon its disposition.

Hence, if a USRPI is transferred in a tax-free transaction to a U.S. corporation that is itself a USRPI (i.e., because of its treatment as a USRPHC), such transfer would still be tax-free. 

There is an exception to this rule for certain transfers to non-U.S. corporations (commonly referred to as “foreign-to-foreign exchanges”) that otherwise qualify for tax-free (or roll-over) treatment. A foreign-to-foreign tax-free exchange covered by the exception is called a §351 transaction or Type B reorganization.

In a §351 transaction, one or more persons transfer property to a corporation, and after the exchange the persons transferring the property own 80% of the stock in the transferee corporation (in terms of both votes and value).

In a Type B reorganization, a target corporation’s stock is transferred in exchange for solely voting stock in the acquiring corporation (or the acquiring corporation’s parent), and after the exchange, the acquiring corporation owns 80% (in votes and value) of the target corporation.

Election treatment

A foreign corporation may elect to be treated as a U.S. corporation for purposes of the FIRPTA provisions if it is entitled to nondiscriminatory treatment under any treaty with the U.S. 

As a condition to making the election, the electing foreign corporation must verify that no interest in the corporation was disposed of during the shorter of: the period running from the date the corporation
first holds a USPRI through the date of the election; or the five-year period ending on the election date.

If the foreign corporation cannot make this verification, then it must pay an amount equal to any taxes that the FIRPTA rules would have imposed on all foreign persons who had disposed of interests in the corporation during that period.

The payment must also include any interest that would have accrued had the tax on the dispositions actually been due.

Like-kind exchange

In addition to the tax-free reorganizations discussed above, another provision that allows taxpayers to defer gain – and avoid the application of FIRPTA rules – is known as the “like-kind exchange rules.”

These rules provide that no gain or loss shall be recognized on exchanges of property solely of like kind, either held for investment or for use in a trade or business. If “boot” (consideration other than property of like kind) is received in the exchange, then the gain, if any, is taxable only to the extent of such boot.

The limited guidance available on whether exchanges of certain mineral properties are of like kind indicates, most notably, that properties were considered to be of like kind if they were producing leases exchanged for producing leases and minerals for surface rights. It is important to note that real property located in the U.S. and real property located outside the U.S. are not of a like kind.

There are generally two types of like-kind exchange transactions. The first is a simultaneous exchange of like-kind properties between two parties. The second is a deferred exchange. Under the deferred-exchange approach, more than two parties may be involved and the exchanges are not simultaneous. Because the deferred-exchange approach is more complex, it is subject to numerous restrictions.

Under the deferred-exchange approach, the taxpayer must demonstrate that it did not actually or constructively receive money or other non-like kind property. Otherwise, the deferral would not be possible and the transaction would be considered taxable. Four “safe harbours” are available, the use of which will result in a determination that the taxpayer has not actually or constructively received money or other property for these purposes. More than one safe harbour can be used in the same deferred exchange, but the terms and conditions of each must be separately satisfied.

The four safe harbours include: the transferee’s obligation to transfer the replacement property to the taxpayer is or may be secured or guaranteed; the transferee’s obligation to transfer the replacement property to the taxpayer is or may be secured by cash or a cash equivalent is held in a qualified escrow account or in a qualified trust; the taxpayer uses a qualified intermediary where such intermediary is not considered the agent of the taxpayer; and lastly, the taxpayer is or may be entitled to receive any interest or growth factor with respect to the deferred exchange.

In addition to the above, a taxpayer using the deferred-exchange method must comply with several deadlines, including: the taxpayer must identify the replacement property on or before the day that is 45 days after the date on which the taxpayer transfers the relinquished property; and the replacement property must be received before the earlier of (i) the day that is 180 days after the date which the taxpayer transfers the relinquished property or (ii) the due date (including extensions) for the transferor’s return in which the transfer of relinquished property occurs.

The use of the like-kind exchange rules can be a powerful tool for mining companies. However, as demonstrated above, careful planning is required to make sure a mining company can qualify for such treatment.

This article just scratches the surface of the various U.S. federal tax issues – let alone state and local tax issues – facing Canadian mining companies investing in U.S. mining properties. These rules are complex but with proper and timely planning, companies can avoid the pitfalls and take advantage of the available opportunities.

– The authors are certified public accountant and Practice Leaders of KPMG’s U.S. corporate tax practice in their Toronto and Calgary offices, respectfully. Visit www.kpmg.com for more details.

Note: Information is current to May 2011. The information contained in this article is of a general nature and is not intended to address the circumstances of any particular individual or entity. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.