A growing business trend to watch for 2016 is increased foreign investment in U.S. assets, particularly real estate. Individuals and companies based outside the U.S. are vying with domestic investors to pursue real estate in major markets like Boston, New York, and San Francisco. In addition to Class A office buildings, condos, hotels, and mixed-use developments, investors have their sights set on high-end residential properties and residences. Investors hail from a handful of industrious nations, including China and other Asian countries where there are economic concerns. This increase of investment could price out domestic buyers while raising the cost of living in major metros. Here, we discuss the basics of what foreign direct investment is, federal policy that regulates foreign direct investment, and why it continues to increase.
What is foreign direct investment?
The Bureau of Economic Analysis defines foreign direct investment as “an investment in which a resident of one country obtains a lasting interest in, and a degree of influence over the management of, a business enterprise in another country.” Simply put, foreign direct investment is an investment made by a company or entity based in one country, into a company or entity based in another country. These types of investment are distinct from indirect investments like portfolio flows, a more passive type of investment where overseas institutions invest in equities listed on a nation’s stock exchange. Companies making direct investments usually have a substantial amount of influence and control over the company in which they invest. Control is usually in the form of voting shares, and can include control of technology, management, and crucial inputs. The investment can be made by purchasing a company in the target nation or expanding operations of an existing company in that nation.
Since 2006, the United States has been the world’s largest recipient of foreign direct investment. More companies establish new operations in the U.S. or provide additional capital to established businesses every day. The United States presents an attractive investment climate for companies globally because of its sizeable consumer market, skilled labor force, acceptance of innovation, ample legal protections, and predictable regulatory environment. Essentially, the United States has an open economy with relatively low barriers to foreign direct investment. Inflows of FDI total $1.5 trillion since 2006. In 2012 alone, FDI inflows totaled $166 billion and net U.S. assets of foreign affiliates totaled $3.9 trillion. A considerable share of FDI dollars is drawn by the manufacturing sector, predominantly by pharmaceutical and petroleum and coal products. Additionally, wholesale trade, mining, finance and insurance, and banking receive large shares of foreign investment. Inflows of FDI come mainly from a small group of industrial countries. Since 2010, Japan, Canada, Australia, Korea, and seven European countries have collectively accounted for over 80 percent of new FDI. Flows from emerging economies like China and Brazil are increasing quickly.
Unsurprisingly, foreign direct investment has had a substantial effect on U.S. employment and output. During the 2008-2009 recession, employment at U.S. affiliates was more stable than overall private-sector employment. U.S. affiliates’ share of total U.S. manufacturing employment, for instance, rose from 14.8 percent in 2007 to 17.8 percent in 2011. In 2011, value-added by majority-owned U.S. affiliates of foreign companies constituted 4.7 percent of total U.S. private output. These firms employed 5.6 million people in the U.S., which is 4.1 percent of private-sector employment. Furthermore, the affiliates account for 9.6 percent of U.S. private investment and 15.9 percent of U.S. private research and development spending. Foreign direct investment comprises an equivalent to approximately 16.6 percent of U.S. gross domestic product according to a 2014 report by the Organization for International Investment.
Critics of the United States’ policy believe it is too liberal, allowing foreign investors to exert too much influence over the American economy, making it vulnerable to foreign domination. They assert that key defense-related industries are being dominated by foreign investors, and that the ability of the country to protect itself in a time of national emergency could be hindered as a result. Furthermore, critics say, such extensive foreign investment drives up prices, leaving Americans to foot the bill for more costly investments, houses, and farmland.
Is there legislation in place to regulate FDI?
There is no comprehensive federal restriction on foreign investment in the United States. Four of the major federal statutes which regulate foreign investment in the United States are information-gathering and disclosure statutes (as opposed to restriction statutes). Additionally, Congress has set limits on foreign investment in these certain industries deemed to affect national security. One of the four statutes is the International Investment and Trade in Services Survey Act of 1976. Under the Act, the President delegated responsibility for studying direct investment by executive order to the Commerce Department and portfolio investment to the Treasury Department. The act also provides for a benchmark survey of foreign direct investment in the U.S. to be conducted every five years by the President. Amendments to the Act in 1990 directed the President to make public information concerning foreign investment, for instance data on the ownership or control of United States affiliates of business enterprises where foreign control is over 50 percent of the voting securities. The Foreign Direct Investment and International Financial Data Improvements Act of 1990 provides that the Bureau of the Census shall exchange with the Bureau of Economic Analysis of the Department of Commerce any information collected under census provisions and under the International Investment and Trade in Services Survey Act which pertains to a business enterprise operating in the United States, if the Secretary of Commerce determines the information is relevant to improving the quality of the data collected under the Survey Act. The Agricultural Foreign Investment Disclosure Act of 1978 does two things: 1. requires any foreign person who acquires or transfers any interest in agricultural land to submit a report to the Secretary of Agriculture no later than 90 days after the acquisition or transfer and 2. requires any foreign person who holds any interest in agricultural land on a date before the effective date of the act to submit a report to the Secretary of Agriculture no later than 180 days after the effective date of the act. The Domestic and Foreign Investment Improved Disclosure Act of 1977 is a requirement added to the Foreign Corrupt Practices Act of 1977. It requires anyone who acquires 5% or more of the equity securities of a company registered with the Securities and Exchange Commission to disclose certain specified information including citizenship and residence. Based on hearings, this statute apparently aims to improve the federal government’s ability to monitor foreign investment.
In addition to these statutes, Congress has provisions in place to restrict foreign investment in certain industries. These include the maritime industry, aircraft industry, banking, resources and power, and various business which are parties to government contracts.
Generally, the United States does not tax or impose a filing obligation on the acquisition or ownership of real property by a foreigner. Foreigners are subject to U.S. income taxation for only certain U.S. sourced income. Typically this does not include U.S. capital gains tax on the sale of U.S.-sitused capital assets. However, the Foreign Investment in Real Property Tax Act (FIRPTA) created an exception to the rule for U.S. sitused real property.The Act was passed by Congress in 1980 and taxes foreigners’ gains on income from and sale of U.S. real estate. Under FIRPTA, a foreigner is required to pay regular U.S. income tax rates on the gain in the sale of U.S. real property, as it is considered income effectively connected with a U.S. trade or business (as opposed to being characterized as passive investment income). Prior to FIRPTA, the U.S. had no way to tax foreigners on real estate profits.
Why is FDI increasing?
Although the United States continues to be the largest recipient of FDI inflows, it has lost significant traction in the global race for FDI. Despite substantial FDI inflows, the United States’ share has declined from 31 percent of global FDI in 1980 to 13 percent in 2006. Since regaining its lead position in 2006, the United States can expect to see increased FDI, especially in the real estate industry. This shift can be attributed to a number of changing factors in the global economy’s climate, including optimal conditions in the investment environment of the U.S., new industry targets of major investors like China, and policy reform regarding FDI.
The United States is simply an appealing destination for investment. In A.T. Kearney’s 2015 FDI Confidence Index, a survey that has consistently predicted FDI trends, the United States ranked #1 for the third consecutive year. The analysis discusses various factors that make the United States an attractive destination for investment such as: an open investment regime, diverse consumer markets, a skilled labor force, community colleges that incorporate skill-development, top research universities, new sources of energy, and ample intellectual property protections.
According to an article in Forbes, The U.S. is poised for increased foreign investment from China. Previously, the majority of Chinese foreign investment was in energy, natural resources, and related transportation infrastructure. These investments were made in countries where it was less costly and there was lower political risk than in the United States. Now that investment return on commodities are low, China is targeting industries with higher rates of return like entertainment, real estate, insurance, and technology, making the U.S. an appealing destination. The U.S. is seen as a particularly good environment for real estate investment, which is currently the most rapidly burgeoning part of the Chinese portfolio. The purchase of Waldorf Astoria hotel by the Anbang Insurance Group is evidence of this trend.
These factors are combined with proposed reforms to the Foreign Investment in Real Property Tax Act, or FIRPTA. As discussed, the regulations under FIRPTA are substantial disincentives for potential foreign investors. As such, they have had a chilling effect on foreign investment in U.S. real estate and infrastructure as compared to corporate stock, for instance, which is not subject to U.S. taxes on the gains made.
A set of tax incentives that exempted certain foreign investments from taxes expired at the end of 2014. On December 7, House Ways and Means Committee Chairman Kevin Brady (R-Texas) proposed a plan to reinstate these tax breaks for two more years. The proposed changes would relax FIRPTA rules that apply to foreign investments in U.S. real estate investment trusts. “The FIRPTA provisions are very pro-growth,” Brady told reporters. “In truth, I'd like to eliminate any barriers to foreign investment in the United States. It's good for investment in America. These are commercial buildings that aren't going anywhere.”
Forecasts for Future FDI
In sum, foreign direct investment has had and will continue to have a major impact on employment and output. United States policy changes demonstrate the balance between economic interests and national security concerns. Despite ideal conditions for investment and high inflows, the recession caused the United States to fall behind relative to its competitors in global share of FDI. However, proposed policy changes and other encouraging factors make for a promising future, and Americans can watch for increased investment in real estate.