The PATH Act exempts certain foreign pension funds from taxation under FIRPTA and significantly modifies the tax rules applicable to REITs.
On December 18, 2015 (Enactment Date), US President Barack Obama signed the Protecting Americans from Tax Hikes Act of 2015 (PATH Act), which provides significant benefits for non-US investors in US real estate. Of particular note, the PATH Act exempts certain foreign pension funds from taxation under the Foreign Investment in Real Property Tax Act (FIRPTA) on gains from investment in US real estate. The PATH Act also significantly modifies the rules applicable to real estate investment trusts (REITs).
FIRPTA generally imposes US federal income tax upon the disposition by non-US persons of US real property interests (USRPIs), which include real property located in the United States and stock of regular domestic C corporations and certain REITs that hold USRPIs as the majority of their global real estate and other trade or business assets (USRPHCs).
PATH ACT MODIFICATIONS TO FIRPTA
The PATH Act introduces six significant modifications to the existing FIRPTA rules:
- Exemption for Qualified Foreign Pension Funds
The PATH Act provides a new exemption from FIRPTA for “qualified foreign pension funds.” The exemption also applies to any entity for which all of the interests are held by a qualified foreign pension fund. A qualified foreign pension fund is any trust, corporation, or other organization or arrangement that
- is created or organized under the laws of a country other than the United States;
- is established to provide retirement or pension benefits to current or former employees (or their designees) of one or more employers in consideration for services rendered;
- does not have a single participant or beneficiary entitled to more than 5% of its assets or income;
- is subject to government regulation and provides annual information reporting about its beneficiaries to the relevant tax authorities in the country in which it is established or operates; and
- is entitled to certain tax benefits under the laws of the country in which it is established or operates.
Under the PATH Act, if a qualified foreign pension fund is not otherwise treated as engaged in the conduct of a US trade or business, gain that the qualified foreign pension fund recognizes from the disposition of USRPIs and capital gain distributions that it receives from a REIT will be exempt from taxation under FIRPTA. However, the new exemption does not apply to all income that a qualified foreign pension fund may derive from its direct or indirect ownership of US real estate. For example, the PATH Act does not exempt a qualified foreign pension fund from taxation on its share of rental income received from a real estate partnership, nor does the new rule alter the manner in which ordinary REIT dividends (that is, REIT dividends that are not attributable to gains from the disposition of underlying USRPIs) are taxed.
The new exemption applies to both private and governmental pension funds that satisfy the requirements outlined above. In the case of governmental non-US pension funds, the new exemption supplements and broadens the separate exemption for certain categories of income and gain under section 892 of the Internal Revenue Code (which only applies to minority interests in USRPHCs and requires fulfilling other technical requirements). However, the new exemption does not apply to all non-US governmental investors that may be eligible for the section 892 exemption (such as sovereign wealth funds and controlled entities that are not qualified foreign pension funds).
There are aspects of the new exemption that are somewhat unclear and may require clarification through future Treasury regulations. For example, the precise nature and scope of home country reporting that will satisfy the requirement that a qualified foreign pension fund must be subject to home country governmental regulation and annual tax reporting is unclear, and this could create some level of uncertainty for certain non-US pension funds (particularly governmental pension funds).
- Increase in Exempt Publicly Traded REIT Ownership
Gain from the disposition of stock of a publicly traded REIT, as well as capital gain distributions made by a publicly traded REIT, will be exempt from taxation under FIRPTA in the case of a shareholder that owns 10% or less of the class of publicly traded stock. Prior to modification by the PATH Act, the exemption only applied to minority stakes of 5% or less, and this standard will continue to apply to publicly traded USRPHCs that are not REITs.
- Exemption for Qualified Shareholders
The PATH Act also introduces a new general exemption from FIRPTA for gains from the disposition of REIT stock held by (and certain distributions to) a "qualified shareholder,” which is defined as a non-US person that (a) has a class of interests that is regularly traded and that meets certain other requirements, (b) is a "qualified collective investment vehicle" (which is a new concept defined in the PATH Act), and (c) satisfies certain recordkeeping requirements.
This exemption does not apply to any investor in a qualified shareholder that owns—directly, indirectly, or constructively—more than 10% of the REIT's stock.
- Domestically Controlled REITs and RICs
Gain from the sale of stock of a “qualified investment entity” (which term includes REITs and, prior to 2015, certain regulated investment companies (RICs)) is not subject to tax under FIRPTA if the qualified investment entity’s stock is “domestically controlled” (i.e., less than 50% of the stock was held directly or indirectly by non-US persons) for a specified period. The PATH Act restores this rule for certain RICs retroactively to January 1, 2015.
In addition, the PATH Act clarifies the rules for determining whether a qualified investment entity is “domestically controlled.” For purposes of determining whether less than 50% of the qualified investment entity is held by non-US persons, the PATH Act provides that a person holding less than 5% of a class of stock that is regularly traded on an established US securities market during the applicable testing period is treated as a US person unless the qualified investment entity has actual knowledge that such person is not a US person. The PATH Act provides additional rules for stock in a qualified investment entity held by another qualified investment entity.
- Elimination of the “Cleansing Rule” for RICs and REITs
Prior to the enactment of the PATH Act, a so-called “cleansing rule” generally provided that stock of a USRPHC would no longer be treated as a USRPI if, as of the date of the disposition, the USRPHC did not hold any USRPIs and all of the USRPIs previously held by such USRPHC during the relevant testing period were disposed of in a transaction in which the full amount of gain (if any) was recognized (or such USRPIs ceased to be USRPIs under this rule). The PATH Act provides that the “cleansing rule” does not apply to any USRPHC that was a RIC or a REIT at any time during the relevant testing period.
- Increased Rate of FIRPTA Withholding
The PATH Act also increases the withholding tax rate from 10% to 15% on certain dispositions and distributions of USRPIs (with certain exceptions). This increased rate of withholding applies to distributions or dispositions of USRPIs beginning 60 days after the Enactment Date.
The new rules are generally applicable to dispositions or distributions made after the Enactment Date, unless specified otherwise.
OTHER SIGNIFICANT PATH ACT MODIFICATIONS TO REITS
The PATH Act imposes new restrictions on the ability to undertake tax-free “spin-offs” of REIT assets under section 355 of the Internal Revenue Code. Prior to the PATH Act, the IRS had issued several private letter rulings allowing a non-REIT distributing corporation to contribute its REIT-eligible assets to a new controlled corporation, distribute the stock of the controlled corporation to its shareholders, and have the controlled corporation elect REIT status immediately after the distribution.
Under the PATH Act, a distribution by a non-REIT corporation of the stock of a controlled REIT will no longer qualify for tax-free treatment under section 355. Further, if neither the distributing nor controlled corporation is a REIT immediately after the distribution, neither corporation may elect REIT status during the 10-year period following the distribution.
There are two exceptions to the new prohibitions on REIT spin-offs: First, tax-free treatment may be available if, immediately after the distribution, both the distributing and controlled corporations are REITs. Second, a distributing corporation that has been a REIT for the three-year period before the distribution may distribute the stock of a controlled corporation that has been a taxable REIT subsidiary of the REIT for the same period.
The new rules apply to distributions after December 7, 2015 (other than certain grandfathered transactions, if an IRS ruling request regarding the transaction had been submitted prior to that date).
Other REIT Modifications
In addition to the FIRPTA-related modifications to the rules applicable to REITs and their shareholders discussed above, the PATH Act introduced a variety of other favorable changes to the rules governing REITs, including the following:
- Elimination of the preferential dividend rule for “publicly offered” REITs and authority for the IRS to provide alternative remedies for inadvertent preferential distributions for non-publicly offered REITs (the term “publicly offered” appears broader than the term “publicly traded” and will capture most non-traded SEC registered REITs)
- Expansion of permissible services that may be provided by a taxable REIT subsidiary
- Expansion of the definition of the term “real estate assets” with respect to certain debt instruments and personal property
- Expansion of the 95% income test to include gains from non-mortgage debt of publicly offered REITs
- Expansion of the exclusion of certain hedging transactions from the 95% and 75% income tests
- Expansion and clarification of the prohibited transactions safe harbor
- Decrease in the holding period from 10 to 5 years for certain built-in gain property
- Modification of current REIT earnings and profits calculation to avoid duplicate taxation with respect to certain amounts not allowable in computing taxable income
The modifications described above have varying effective dates.
In addition, the PATH Act introduces an unfavorable modification to the REIT rules by lowering the threshold from 25% to 20% for REIT assets that can be held in a Taxable REIT subsidiary (TRS), effective for tax years beginning in 2018.