Purchase of U.S. Residential Property from a Foreign Entity Causes Withholding Tax Headaches for Buyers

(Parker Tax Publishing June 2021)

A panel of the Ninth Circuit affirmed a district court's dismissal, for lack of jurisdiction, of a couple's action for a declaratory judgment on the effect of the Foreign Investment in Real Property Tax Act (FIRPTA) and fixed, determinable, annual, or periodical (FDAP) income rules on a contract to purchase real property from a foreign entity. The court noted that the tension created by the FIRPTA and FDAP withholding requirements between a foreign entity transferor that wants full payment under a contract and the transferee who does not want to be left owing withholding taxes on the transaction is not resolved by filing litigation but instead by addressing the issue when the terms of the contract are negotiated. Gilbert v. U.S., 2021 PTC 143 (9th Cir. 2021).

Background

In July 2014, Eric and Audra Gilbert contracted to buy residential property in Peoria, Arizona from Namaca Management Limited (Namaca), a purported foreign entity. Namaca's trustee, Philip Leopard, entered into the contract on Namaca's behalf and payments were made by the Gilberts on the contract. In August 2017, the Gilberts notified Leopard that, because Namaca is a foreign entity, they were required to withhold a portion of their agreed purchase price under the Foreign Investment in Real Property Tax Act (FIRPTA) and a portion of their interest payments under the and fixed, determinable, annual, or periodical (FDAP) rules. Leopard disputed that the withholdings were required, claiming he and Namaca were non-resident non-persons exempt from withholding. But the Gilberts insisted that Namaca was not exempt from the withholdings and advised Leopard that they would withhold all additional sums payable under the contract "until their withholding obligation under the FDAP rules have been fulfilled." Leopard continued to dispute the withholdings, arguing the property was not a U.S. real property interest subject to statutory withholding, and that the Gilberts' failure to pay their full payment amount would be a breach of contract.

Ultimately, the Gilberts filed a lawsuit in a district seeking a declaratory judgment that, among other things, withholding money from the agreed upon purchase price of the property to pay the federal taxes required under FIRPTA and the FDAP rules was not a breach of their real estate contract with Namaca. The district court dismissed the claim for lack of jurisdiction because the Declaratory Judgment Act prohibits courts from entering declaratory judgments related to federal taxation obligations. The Gilberts appealed to the Ninth Circuit.

FIRPTA, FDAP, and the Declaratory Judgment Act

Under Code Sec. 1472 and Code Sec. 1445(a), respectively, the FIRPTA and the FDAP rules require the transferee - or buyer - in taxable transactions with a foreign entity to deduct, withhold, and pay a prescribed amount of tax to the IRS. Congress specifically enacted FIRPTA to prevent foreign investors engaging in real property transactions in the United States from avoiding U.S. taxes. The pre-tax withholding requirement ensures that funds to pay the required taxes are collected up front. The requirement obligates the buyer in order to facilitate enforcement and collection. And, under Code Sec. 1461, the party required to make the withholding is liable for any miscalculation.

Under the Declaratory Judgment Act, a federal court may issue a declaration resolving parties' competing legal rights in a case of actual controversy within its jurisdiction, except with respect to federal taxes. In MCA, Inc. v. American Broadcasting Co., Inc., 715 F.2d 475 (9th Cir. 1983), the Ninth Circuit stated that it is fundamental to tax jurisprudence that declaratory judgments and injunctions are rarely, if ever, granted.

On appeal, the Gilberts argued that because the FIRPTA and FDAP withholdings are made before the IRS assesses tax liability, the tax exceptions did not apply to them because a declaration concerning their withholding obligations will not restrain the ultimate assessment of taxes.

Analysis

A panel of the Ninth Circuit affirmed the district court's dismissal, for lack of jurisdiction, of the Gilberts' action for a declaratory judgment on the effect of the FIRPTA and FDAP income rules on their contract to purchase real property from Namaca. The court disagreed with the Gilbert's argument regarding the timing of the withholdings with respect to the assessment of the tax liability. The Declaratory Judgment Act's bar against resolving matters with respect to federal taxes, the court noted, is not conditioned on a determination of ultimate tax liability. Moreover, the court said, the Declaratory Judgment Act is coextensive with the Anti-Injunction Act in Code Sec. 7421 despite the broader language of the former. The Anti-Injunction Act bars jurisdiction over any claim seeking to restrain the assessment or collection of any tax and this bar applies even where the IRS has yet to make a final determination of tax liability.

According to the court, by filing this action and asking the court to declare their tax withholding obligation rather than withholding the required funds and paying them to the IRS and then, if necessary, filing suit against Namaca, the Gilberts were interfering with or restraining the collection of taxes.

Finally, the court said it was understandable why the Gilberts sought clarification of their withholding obligations vis-their contractual obligations owed to Namaca. As has been observed, the FIRPTA and FDAP withholding requirements can create tension between a foreign entity that wants full payment under the contract, and the transferee, who does not want to be left owing the withholding taxes. But this tension, the court stated, is not resolved by filing litigation that interferes with the tax-collection process. It is resolved by parties addressing this issue when they negotiate the terms of their transaction.

For a discussion of the rules on tax withholding on payments to foreign persons, see Parker Tax ¶202,100.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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