FIRPTA Implications of New Protocol to the U.S. - Japan Income Tax Treaty - Lost Special Benefits to the Japanese Residents 

On January 24, 2013, the governments of Japan and the United States signed a new Protocol to the U.S. – Japan income tax treaty. This Protocol will enter into force after completion of the ratification procedures of each country. While the protocol includes amendments beneficial to taxpayers, including exemption of withholding tax on interest, it also shuts down the special treatment that has been available to residents of Japan in connection with application of FIRPTA1 provisions. This article will examine how the protocol would change the way FIRPTA provisions would be applied to the Japanese residents as the treaty is amended by the protocol.


Introduction - What is FIRPTA?

The primary objective of FIRPTA, which was enacted in 1980, may be stated in very simple terms: To ensure that foreign persons are paying taxes in the U.S. on gains derived from the sale of U.S. real estate. In fact, even before FIRPTA was enacted, there was an established principle that gain on direct sale of U.S. real estate should be taxed in the U.S. However, at the same time, both U.S. domestic rules and the treaties to which the U.S. was a party provided that gain on sale of stock in a corporation should be taxed in accordance with the residence of the seller. Thus, for example, if a Japanese resident sells stock in a U.S. corporation, the gain generally may only be taxed in Japan but not in the U.S.


Taking advantage of this disparity, a foreign taxpayer could avoid the tax in the U.S. by having a corporation hold the real property and selling the stock in the corporation instead of selling the real property directly. In order to close such loophole, FIRPTA provides that gain on sale of stock in a corporation would be taxed in the U.S. if 50 percent or more of the assets held by the corporation consists of real property located in the U.S. in terms of fair market value.


Definition of "U.S. Real Property Interest"

If we look closer at the FIRPTA provisions, the statutory language says that the U.S. tax is imposed on gain "of a nonresident alien individual or a foreign corporation from the disposition of a United States real property interest." Apparently, the key word here is the term "U.S. real property interest" or "USRPI," which is defined to include direct interest in real property located in the United States or the U.S. Virgin Islands as well as stock in a "U.S. real property holding company ("USRPHC")."


Whether a U.S. corporation is a USRPHC is determined based on whether the percentage yielded by the following formula equals or exceeds 50 percent:



Fair Market Value ("FMV") of USRPIs
FMV of USRPIs + FMV of Non-USRPIs + FMV of Business Assets



Regarding the timing of applying the test based on the above formula, FIRPTA provides that a U.S. corporation is considered a USRPHC unless it is established that the corporation has not been a USRPHC based on the formula during the period of 5 years ending on the date of disposition ("5-Year Look Back Test"). However, under an exception, a corporation which disposed of all USRPIs in taxable transactions and holds no USRPI would not be a USRPHC and would not be required to perform the 5-Year Look Back Test.


Information Reporting and Withholding

Further, to ensure compliance, FIRPTA provides stringent information reporting and withholding rules. For example, if A, a U.S. resident, buys stock in X, a U.S. corporation, from B, a Japanese resident, A would be required to withhold 10 percent of the purchase price of X stock unless B provides a representation that X would not be a USRPHC on the transaction date. Failure to comply could result in assessment of penalties and interest. While penalties may be abated based on a reasonable cause, interest may not be abated. FIRPTA reporting and withholding rules apply not only to actual sales of stock but also to corporate reorganizations involving change of ownership of a U.S. corporation.


Current Treaty Provision

In order to understand the relationship between FIRPTA and the treaty, we first must understand the concept of the "lex posterior principle" adopted by the U.S. Under this principle, if a provision of the treaty is in conflict with a provision under the U.S. domestic law, the rule that came into effect later overrides the older rule. 


The original treaty between the U.S. and Japan, which was entered into force in 1972, simply provided for taxation of gain on sale of real property in accordance with the place of the real property and also provided for taxation of gain on sale of stock in accordance with the residence of the seller. Because FIRPTA was enacted in 1980, full provisions of FIRPTA applied to Japanese residents because FIRPTA overrode the 1972 version of the treaty under the lex posterior principle.


When the treaty was virtually re-written in 2003, a provision apparently intended to confirm application of FIRPTA to Japanese residents was added. Specifically, Article 13(2)(a) stated:


"Gains derived by a resident of a Contracting State from the alienation of shares or other comparable rights in a company that is a resident of the other Contracting State and that derives at least 50 percent of its value directly or indirectly from real property situated in that other Contracting State may be taxed in that other Contracting State….."


As this treaty provision is applied in a FIRPTA context, "other Contracting State" is the U.S. The provision basically states that the U.S. can tax the Japanese resident's gain on sale of stock of a U.S. corporation if at least 50 percent of the value of the corporation's assets comes from real property located in the U.S.   


However, the treaty provision does not clearly indicate that all FIRPTA provisions, including the 5-Year Look Back Test, are applied to Japanese residents even though it seemingly approves application of the core concept of FIRPTA. Further, because of the way the treaty provision was written2, it has been commonly interpreted that the U.S. will have the right to tax the gain on the transfer of the stock if at least 50% of the value of the assets held by the corporation is attributable to U.S. real property at the time of the transfer.  As the 2003 version of the treaty overrides the FIRPTA enacted in 1980 in accordance with the lex posterior principle, many taxpayers took a position that, in applying FIRPTA to Japanese residents, whether a U.S. corporation is a USRPHC may be determined based on the test performed at the date of the transfer only without applying the 5-Year Look Back Test.


As it is rare to find treaties with the same or similar language, waiver of the 5-Year Look Back Test accorded a special benefit to Japanese residents. Application of the 5-Year Look Back Test would require a costly analysis. Also, Japanese residents could have avoided application of FIRPTA as long as they could pass the test on the transaction date regardless of how high the USRPI ratio was in the past.


Effect of the New Protocol

The protocol recently signed by the two governments includes the provision to revise Article 13(2) of the treaty as follows:


For purposes of this Article the term "real property situated in the other Contracting State" shall include:


(a) [Omitted]

(b) [Omitted]

(c) where that other Contracting State is the United States, a United States real property interest


The term "United States real property interest" for treaty purposes apparently is the same as the term defined in accordance with FIRPTA provisions. Accordingly, under the amended treaty, the Japanese residents would be required to apply the 5-Year Look Back Test.



As a result of the U.S.-Japan Income Tax Treaty being amended by the 2013 Protocol, when the Protocol is ratified and goes into force, Japanese residents will no longer be entitled to the special treatment and will become subject to the regular "5-Year Look Back Test" in determining whether a U.S. corporation is a USRPHC. It is important to keep in mind that reorganizations involving transfer of U.S. subsidiary stock in most cases require some kind of FIRPTA reporting, failure of which may result in potentially significant interest and penalties even where no actual tax is imposed under FIRPTA. As application of the 5-Year Look Back Test would be time consuming, it is advisable to start considering FIRPTA implications as early as possible when contemplating a corporate reorganization or other transfer involving a U.S. subsidiary.






The views and opinions are those of the author and do not necessarily represent the views and opinions of KPMG LLP. All information provided is of a general nature and is not intended to address the circumstances of any particular individual or entity.


Related Materials



1. Foreign Investment in Real Property Tax Act of 1980.

2. Note that the word "derives" is in present tense.


Makoto Nomoto


Makoto Nomoto

Partner, Tax