We as humans have been aware of making investments in a distant and foreign land ever since we learned to cross the oceans and travel to places that were beyond our reach before the idea of frequently crossing those deadly seas. The development of trade and commerce across borders, in terms of both land and sea, gave birth to the concept of people investing in businesses located in foreign lands in hopes of making profits and looking for opportunities that provided them with more remarkable growth.
The process of shrinking borders through faster and safer means of travel and more efficient means of communication gave birth to the idea of foreign investment where people belonging to one country were investing in businesses and properties in other countries. The developing idea of investing in trade and commerce in foreign lands gave way to most countries making some regulations to monitor and manage foreign investments.
However, these regulations imposed are only sometimes easy to adhere to, which is why we at Legamart bring you this article to tell you about the compliance difficulties with domestic purchases by foreign investors.
A Background to Origin of Foreign Investments and Domestic Purchases Laws
The most significant traces we can note of people looking for trade opportunities in a foreign land and investing their wealth with hopes of making a profit belong to the colonial period. It was when the Europeans developed strong navies that they decided to set sail to places that were located across the sea; it was not the first time man was crossing the giant water bodies for trade and economics. However, it was the first time that travelling by sea became so common. With new sea routes, new opportunities were discovered and people saw the business potential of the newly discovered places and the profits they had to offer.
These discoveries resulted in companies setting up trade centres in foreign lands to conduct their businesses. Eventually, this practice resulted in the setting up of European colonies all across the globe. As a result of colonization, the governments of different countries decided to set up specific rules and regulations that were to be followed by foreign investors while making domestic purchases in a host nation, and with time several compliance difficulties with domestic purchases rose due to the lack of legal knowledge relating to domestic investments by foreign investors.
An Introduction to Domestic Purchases and Foreign Investments
Before we move further in our discussion over the compliance difficulties with domestic purchases faced by foreign investors with domestic purchases, we must make you familiar with the terms Domestic Purchases and Foreign Investments.
Foreign Investment
Foreign investment involves capital flows from one country to another, with foreign investors gaining substantial ownership stakes in domestic companies and assets. Foreign investment implies that foreigners have an active role in management as part of their investment or a large enough equity stake to influence business strategy. As a modern trend relating to globalization, multinational corporations are investing in various countries to explore opportunities.
It is widely regarded as a future catalyst for economic growth. Individuals can make foreign investments, but companies and corporations often pursue them with substantial assets to expand their horizons in pursuit of commercial growth.
Domestic Purchases or Acquisitions
While speaking of the term domestic purchases by foreign investors, all we can think of is people from a foreign country purchasing or investing in assets located in another. To some extent, this put definition is correct. Domestic Purchases by foreign investors usually comprise mergers and acquisitions. Mergers and acquisitions involve the transfer of ownership of existing assets to a foreign owner. A merger occurs when two companies merge to form one, whereas an acquisition occurs when one company acquires another.
Now that you have developed an understanding of the concepts of foreign investments and domestic purchases by foreign investors, we shall move further to make you knowledgeable of the compliance difficulties with domestic purchases faced by investors relating to domestic purchases and acquisitions.
Key Compliance Issues with Domestic Purchases by Foreign Investors in USA
With the Opening of the Chinese markets and several other factors involved, the acquisition or Domestic Purchases by foreign investors have come up as a prime source of Foreign Direct Investment. In the following discussion, we will familiarize you with a few key compliance issues that may come your way as a foreign investor wanting to invest in the USA.
Procedural Compliance
If the acquisition takes place in China, the Ministry of Commerce must approve the transaction (MOFCOM). In certain restricted industries, pre-approval by an industry regulatory authority is required, and such approval should be obtained before submitting an application to MOFCOM. Furthermore, if the target business involves the military, sensitive or key industries, or the parties’ business turnover exceeds the filing threshold, a national security review or anti-trust clearance may be required.
If the acquisition takes place in China, the Ministry of Commerce (MOFCOM) must approve the transaction. Pre-approval by an industry regulatory authority is required in certain restricted industries, and such approval should be obtained before submitting an application to MOFCOM. A national security review or anti-trust clearance may also be required if the target business involves the military, sensitive or key industries, or the parties’ business turnover exceeds the filing threshold.
If the acquisition is not for a QFII (qualified foreign institutional investor), the investment must be approved by MOFCOM and the China Securities Regulatory Commission (CSRC) and must follow the statutory processes of assignment by agreement or private placement. Following receipt of the aforementioned approvals, the acquired enterprise or the investor should register amendments to the existing corporate profile or the formation of a new enterprise with the State Administration for Industry and Commerce (SAIC).
If the target in Question is an existing FIE in China and the ultimate shareholder holds its interest through an intermediary holding company, the transaction may be completed through the acquisition of the intermediary. In this case, the transaction is generally exempt from PRC laws and regulations. However, if the transaction includes factors that may necessitate a national security review or anti-trust clearance under applicable PRC rules, filings with Chinese authorities will be required.
It is worth noting that if the transfer occurs in an offshore tax haven with a corporate tax rate lower than 12.5%, the selling party must file with the tax bureau where the FIE is domiciled. If the Chinese tax bureau determines that the arrangement is designed to avoid paying taxes and that the offshore intermediary has no economic substance, the transaction will be treated as a direct transfer of equity interests in a PRC resident enterprise, and the seller will be required to pay PRC corporate income tax on its capital gains.
Access Compliance
A foreign investor’s acquisition must first meet market access requirements. The investor should ensure that the enterprise, following the acquisition, meets the requirements for business scope established by state policy regarding foreign investments. If any industry-specific qualification requirements have been imposed on foreign shareholders, such as in the advertising and telecommunications industries, the investor must also meet these requirements.
In practice, there are cases where an area is permitted by industrial policy, but the industry’s regulatory authority still needs to develop implementation rules for foreign investment entry. In such cases, the relevant industry remains a minefield for foreign investors. Take, for example, the third-party payment industry. Although a few foreign-invested enterprises (FIEs) have been granted operation permits, the People’s Bank of China has yet to issue detailed regulations governing foreign-invested payment institutions, leaving a significant degree of uncertainty for businesses backed by foreign investments in this area.
Timing Requirements
Foreign investors are subject to timing requirements for capital contributions under applicable rules if the acquisition is conducted through a subscription of newly increased capital or asset purchase. For example, in a capital increase acquisition, 20% of the capital contribution must be paid before the change is registered with SAIC. Given the recent changes to the Company Law regarding registered capital, such mandatory arrangements are expected to be phased out soon. If an acquisition occurs indirectly offshore, parties may freely agree on the terms of the transaction at their own discretion, subject to the restrictions imposed by applicable laws of foreign jurisdictions, with less regard for the implications of PRC rules.
The changes to corporate names, trademarks, and management must still be approved by MOFCOM and SAIC. However, these procedures are significantly less complicated than those involved in direct acquisitions by foreign investors.
Investment Committee
Corporate transactions that could result in non-US ownership or control of a US business undergo scrutiny for national security considerations through the Committee on Foreign Investment in the United States (CFIUS), an inter-agency governmental body. CFIUS can impose restrictions on such transactions without necessarily blocking them. Assessing potential concerns for CFIUS and devising strategies to mitigate those risks are crucial steps in any proposed acquisition or investment involving non-US investors.
US businesses that fall into one of two categories pose a specific national security risk for the US government:
- Those that collect or store sensitive personal data of US citizens, encompassing identifiable financial data, consumer reports, individual health data, and genetic test results, or
- Those engaged in the production, testing, or development of critical technologies. Critical technologies encompass defense articles and services listed on the US munitions list, select items on the commerce control list, certain nuclear-related facilities and components, specific agents and toxins, and emerging and foundational technologies regulated for export under the Export Control Reform Act of 2018.
Mandatory filings with CFIUS are obligatory for certain transactions involving substantial interests or those involving regulated technologies. A successful filing can lead to a safe harbor, preventing the government from ordering a divestment post-acquisition.
For Japanese companies seeking to invest in the US, conducting a comprehensive investigation into the target company is essential. This includes assessing its intellectual property, technology assets, market share, government contracts, proximity to military bases, and any cybersecurity or personal data considerations.
Foreign Investment Purchases in US Real Estate
When it comes to investing in US real estate as a foreign buyer, there are a few essential things to keep in mind:
Customs and Expectations
Local Laws and Customs Vary. This is because real estate laws and practices differ from state to state in the US, such that some states have specific taxes related to mortgage recording, while others tax property transfers differently. Additionally, Title insurance is common in the US but is not widely used in many foreign countries.
Be Aware of Surprise Costs. Certain unexpected costs can arise during property transactions. For example, buying a New York City condominium over $1,000,000 may incur a 1% mansion tax. When purchasing property based on floor plans for a building yet to be constructed, you may be expected to pay the seller’s New York State and New York City transfer taxes, which get added to the purchase price.
Are you passionate about international real estate law and intrigued by the challenges faced by foreign investors in domestic property purchases? Legamart invites you to join a vibrant global online network of legal professionals eager to explore the complexities of compliance in this domain. Our platform provides a unique opportunity to connect with like-minded lawyers and experts, fostering discussions, sharing insights, and staying updated on the latest developments in this field.
Cooperative and Condominium Ownership for Foreign Buyers
When considering buying a cooperative apartment in places like New York City, foreign buyers should be cautious as Co-op boards can accept or reject buyers for various reasons, as long as it does not violate discrimination laws. They often request extensive financial and personal information, which might not be comfortable for foreign buyers. Compared to condominiums, co-op ownership has more restrictions, such as limited subleasing and specific occupancy requirements. Condo purchases usually have a less stringent approval process and rarely forbid corporate ownership preferred by foreign investors. Condo boards typically have a “right of first refusal” rather than outright approval authority. If a board exercises this right, it can deter lenders from granting a mortgage, though such cases are uncommon. Foreign buyers may consider sponsoring cooperative units that don’t require board approval to avoid board approval issues.
Added Complexities for Foreign Buyers:
Financing a property as a foreign buyer can be more complex, requiring additional documentation to prove creditworthiness and confirm international assets. This is because documents from a foreign country requiring recording in the US must go through an authentication process, usually involving an apostille from a designated authority.
Foreign Investors’ Tax and Structural Considerations:
Foreign individuals buying or selling US property should consider various tax factors, including income, gains, transfer, and estate taxes. The property’s nature, intended holding period, buyer/seller’s situation, US connections, tax treaties, income repatriation, investor’s organizational structure, and investment size all influence the best approach. Deciding whether an individual or an entity (US or foreign) should purchase the property is crucial. Commonly, limited liability companies (LLCs) are used due to their tax benefits and privacy advantages. However, IRS regulations for single-member foreign-owned LLCs have complex requirements, including designating a responsible party and complying with reporting and record-keeping obligations, with hefty penalties for non-compliance.
Income Tax Issues:
Income tax implications depend on property use. For personal properties without income generation, different rules apply. However, for rental income properties, the IRS has two approaches. Effectively connected income is taxed at regular rates after deducting related expenses like mortgage costs. Alternatively, Fixed, Determinable, Annual, or Periodic (FDAP) income, like rent, dividends, or royalties, is taxed at a flat 30% rate with no deductions. In some cases, foreign investors with rental income can make a special election for net taxation. Additionally, extended presence in the US may lead to foreign individuals being treated as US residents for tax purposes, requiring them to file US tax returns and pay taxes on worldwide income. Consulting an experienced tax advisor is essential to navigate these complexities
FIRPTA Liability for US Purchasers:
FIRPTA, which stands for the Foreign Investment in Real Property Tax Act, is a law that requires foreign sellers of US real estate to pay a capital gains tax. Typically, 15% of the property’s purchase price must be sent to the IRS. It’s essential for US buyers to ensure FIRPTA compliance because they could become liable for unpaid taxes if the foreign seller doesn’t pay them.
During a typical property closing, the buyer gets an affidavit from the seller confirming they are not a foreign person. If the seller is foreign and cannot provide a FIRPTA affidavit, the law makes the buyer responsible for the seller’s unpaid capital gains taxes. To avoid this, sellers often apply for a determination of a lower tax amount, and the 15% tax is held in escrow until the IRS makes a decision. The buyer may request proof of this process and want to know the seller’s property basis to calculate the potential tax liability, which could be lower if the property was sold at a loss.
Restrictions and Reporting Requirements for Foreign Buyers:
Foreign individuals are not prohibited from owning US real estate, but there are specific reporting requirements and restrictions they must consider, which include:
BEA Reporting Requirements:
- The Bureau of Economic Analysis (BEA) collects data on international investments in the US.
- Foreign investors with a 10% or more interest in a US business investing in US real estate must report this interest to the BEA.
Agricultural Foreign Investment Disclosure Act:
- This act mandates reporting when foreign persons acquire or transfer agricultural land in the US. Failure to report can result in significant fines.
Foreign Asset Control Rules:
- The US government sanctions certain countries, entities, individuals, and organizations.
- US persons, including entities with US ties, must comply with these sanctions.
Patriot Act Compliance:
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- The Patriot Act aims to combat terrorism and restricts business dealings with Specially Designated Global Terrorists.
- Non-compliance can lead to substantial fines and penalties.
- Most real estate agreements now include representations regarding Patriot Act compliance, making it crucial to thoroughly assess the background of all parties involved in a transaction.
Asset Protection Strategy:
Planning for asset protection is essential when investing in a foreign country like the United States. For instance, many foreign investors opt for a Limited Liability Company (LLC), which shields them from personal liabilities and debts. An LLC is not only a well-thought-out structure but can also offer tax benefits based on location and tax situation.
Some use separate LLCs for each property, while others group two to five properties under one LLC. Regardless of your approach, you’ll need to place your properties in an LLC in the state where you’re investing. Additionally, an LLC safeguards your assets in case of lawsuits related to injuries on your property.
US Tax Returns:
Understanding US tax regulations is crucial for foreign real estate investors. Tax treatment may vary for different foreign investors, so ensure timely IRS payments and compliance. You can also consider hiring a tax professional experienced in working with foreign non-residents in the US.
Avoiding Estate Tax:
Contrary to expectations, the US can impose estate taxes on foreign investors upon their death. US taxpayers benefit from a substantial estate tax exemption. However, non-U.S. citizens have a lower exemption. Even owning a valuable rental property could trigger estate taxes for foreign investors. It is, therefore, crucial to follow the right strategies to prevent the US from levying taxes on your estate after your passing.
Do the regulations treat investors from certain countries differently?
FIRRMA doesn’t block investments from any specific country. It means that foreign investments, regardless of the country of origin, are still subject to CFIUS oversight if they could lead to foreign control of a U.S. business. However, FIRRMA and its regulations set limits on CFIUS’s authority regarding non-controlling “covered investments” and specific real estate transactions. These limits apply to certain foreign individuals or entities from specific “excepted foreign states.” To qualify for these exceptions, the investor and their home country must meet particular criteria.
Conclusion
We know that in the USA, various regulatory measures have been put into place for the purpose of regulating investments in domestic purchases by foreign investors, and sometimes due to a lack of legal knowledge, the investors tend to get flustered and face several compliance difficulties with domestic purchases. Those who find themselves confused while trying to understand the trade regulations related to foreign investment in the USA should look for the necessary legal assistance in understanding and following the investment laws, which they can get at the Legamart directory, where they can find and communicate with several experts of foreign investment laws.
