QUESTION: What are the rules regarding using foreign investors in a real estate syndication that is buying property in the United States?
A. Applicable Securities Laws
Regulation S and Rule 144—The applicable laws are found in U.S. Securities and Exchange Commission (SEC) Regulation “S” (17 Code of Federal Regulations [CFR] Sections 230.901 through 230.905, aka Rules 901 through 905) and Rule 144. Regulation S provides a “safe harbor” to issuers of securities from the registration requirements of The Securities Act of 1933 as long as the offer and sale of securities occurs exclusively “offshore” (defined herein).
Regulation D—There is no prohibition against bringing foreign investors into a Regulation D, Rule 506 offering. However, the Private Placement Memorandum (PPM) and Subscription Agreement will need additional clauses regarding eligibility of the foreign investor(s) and the restrictions on resale described later in this article.
B. Benefits of a Regulation S Offering
1. Under Regulation S, issuers can sell securities “offshore” without regard for the sophistication, number of purchasers or dollar amount of the offering.
2. Further, unlike Regulation D, Regulation S does not contain specific disclosure requirements. Note: Although a PPM is not required for a Regulation S offering, it would be prudent to provide one to ensure the foreign investors understand the structure, risks and conflicts associated with an offering.
3. In addition, Regulation S permits issuers and distributors to advertise the offering offshore, which would otherwise be prohibited in a private placement offered to “U.S. persons.”
U.S. persons are defined as U.S. residents or citizens, U.S. companies, persons living in the U.S. regardless of nationality or U.S. residents living abroad (Rule 902[k]).
4. An issuer that chooses to effect an offering via an Internet website may do so without jeopardizing its exemption by including prominent statements on the applicable web pages indicating that the offer is directed only outside the U.S., and by implementing means to preclude sales to U.S. persons.
5. No SEC filings are required for a private Regulation S offering.
C. Regulation S Rules
The following rules apply to a Regulation S offering:
1. The offer or sale of securities for a Regulation S offering must occur in an “offshore transaction.” Per Rule 902(h), an offer or sale of securities is made in an “offshore transaction” if (a) The offer or sale is not made to a person in the United States; and (b) Either at the time the Subscription Agreement (i.e, “buy order”) is executed, the buyer is outside the United States, or the transaction is executed via a foreign securities exchange located outside the U.S. or through a designated offshore securities market.
2. No “directed selling efforts” may be made in the U.S. by the issuer, and no offers and sales may be made to “U.S. Persons.”
3. Rule 144 prohibits foreign investors from reselling the securities to U.S. persons within one year of purchase. The offering documents must contain “legends” describing this restriction. The issuer must refuse to register any transfer of securities in violation of this rule (Rule 902[g]).
4. The issuer must obtain certification and proof from foreign purchasers that they are not U.S. persons.
Per the SEC, compliance with the compliance requirements of a Regulation S offering will require the professional skills of attorneys specializing in securities law.
D. Applicable Tax Laws
Under the Foreign Investors in Real Property Tax Act of 1980 (FIRPTA), the issuer must withhold a certain percentage of any distribution or return to foreign investors and remit it to the IRS on the investor’s behalf. The tax due from a non-U.S. person depends on the terms of any tax treaty between their country and the U.S. The foreign investor will file a U.S. tax return directly with the IRS to apply for a refund of the withheld tax, if any is due. However, for countries without a U.S. tax treaty, the tax will simply be the cost of doing business in the U.S.
An issuer that fails to withhold the proper tax on behalf of a foreign investor will be liable for payment of the tax to the IRS. The additional accounting costs associated with the FIRPTA research and tax filings, etc. will be borne by the issuer. An issuer should check with his or her tax adviser to determine the applicable requirements and anticipated costs for accepting money from a foreign investor. Additionally, the foreign investor will have to comply with rules regarding transferring money from the U.S., which may involve additional fees or taxes imposed by his or her home country.
E. Homeland Security Issues
Certain “Sanctioned” or “Blocked” foreign nationals, nationals or residents of sanctioned countries or persons with more than 15% of their assets invested in sanctioned countries designated by the U.S. government are prohibited from directly or indirectly investing in a U.S. company. These restrictions are aimed at persons or countries identified by the U.S. as rogue nations, terrorist facilitators, weapons of mass destruction (WMD) proliferators, money launderers, drug kingpins and other national security threats. Specific prohibitions identify individuals, residents of certain countries and persons with 15% investments in certain countries.
Interests in a U.S. company may not be offered, sold, transferred or delivered—directly or indirectly—to any such “prohibited persons.” A list of prohibited persons and countries is maintained and periodically updated by the U.S. Department of Treasury, Office of Foreign Assets Control (OFAC) under the USA PATRIOT Act and related Acts. See http://www.ustreas.gov/offices/enforcement/lists.
An issuer of securities to foreign investors will have strict liability for conformance with these requirements. Failure to comply may subject the issuer to civil and/or criminal penalties. This means that for any foreign investment, the issuer must inquire, verify and keep records of:
1. Whether the investor is prohibited from investing in the U.S. (by obtaining a copy of a passport or other applicable residency documentation), and
2. Whether the funds are pooled from other investors, and if so, whether the individual investors are prohibited investors or U.S. persons.
Issuers must verify and maintain records of such compliance.
In addition to the above requirements, banks may be required to report to various federal and/or state agencies any cash deposits into a U.S. LLC’s bank account by a foreign investor. An issuer should check with its banking institution to determine the applicable banking rules and whether its foreign investors’ deposits will trigger such reporting. Finally, exchange rates must be factored into each transaction involving a foreign investor.
F. What About Foreign Laws?
A foreign investor should be required to certify in the offering documents that he or she has inquired and is in compliance with the rules of his or her own country regarding investment in a U.S. securities offering. Before making an offer to foreign investors, or stepping foot on foreign soil to solicit investors for a Regulation S offering, the issuer should make sure the offering is compliant with the laws of that country. Failure to do so could result in severe, unexpected penalties, such as arrest and incarceration in the foreign country!
Is There An Easier Way To Use Money From Foreign Investors?
Possibly! You may be able to shift some of the liability for these requirements by having the foreign investor form and fund a U.S. limited liability company, partnership or corporation that becomes the purchaser of the securities. In the process of setting up the legal entity in the U.S., the foreign investor will have effectively become a U.S. person, who can now invest in a Regulation D private placement offering (but will no longer be eligible to invest in a Regulation S offering). Some of the liability (and costs) for compliance with U.S. banking requirements, laws related to transferring funds from foreign countries, issues associated with IRS withholding and foreign taxation and eligibility for investment in the U.S. under the U.S. PATRIOT Act may be shifted from the issuer to the investor.
Remember, when dealing with U.S. persons in a private placement offering (such as Regulation D, Rule 506), the issuer must comply with the applicable rules of the exemption for its securities offering, which may include a prohibition against general solicitation or advertising for investors inside the U.S.
Regardless of the exemption being used, when dealing with foreign investors, the issuer should always verify whether the investor is a U.S. person or whether he or she is prohibited from investing under the U.S. PATRIOT Act and related acts pertaining to Homeland Security. Further inquiry and verification will be required if the issuer suspects or has reason to believe that the investor is among the list of prohibited persons, or that the investor has pooled funds from others in order to make the investment.
A second option for alleviating issuer responsibility would be to use a licensed broker-dealer, or its equivalent, in the foreign country where the securities will be sold. Inquiry with licensed agents in the foreign country should be made if this is an option an issuer would like to consider. An agent contract should include specific clauses to ensure that the agent is not violating any of the U.S. securities laws or the laws of their country regarding the offering and should indemnify the issuer if such violations occur.
A third option would be to conduct the entire offering outside the U.S., by registering the company issuing the offering in a foreign country, which would not fall within the jurisdiction or be bound by U.S. offering restrictions. For information on this option, an issuer will need to consult with an attorney in the country where the issuer entity will be formed. Bringing the offering proceeds into the U.S. likely will require additional advice of U.S. counsel versed in international business transactions.
NOTE: This article specifically pertains to a domestic (U.S.) issuer of securities (aka, a syndicator, manager or promoter) that is seeking to solicit and/or pool money SOLELY from foreign investors to acquire U.S real estate. This article does not pertain to a non-U.S. issuer of securities, nor does it apply to including foreign investors in a Regulation D, Rule 506 offering.
This information is of a general, educational nature and may not be construed as legal advice pertaining to your specific offering, exemption or situation. Any such advice must be sought from your own attorney pursuant to an attorney-client relationship, after consideration of your specific facts or questions. At Syndication Attorneys, PLLC, we will be happy to discuss your investing goals with you. You can schedule a free, 30-minute consultation by clicking this link.