The Controlling Interest Transfer Tax
Since 2006, purchasers of a “controlling interest” in an entity that directly or indirectly owns commercial real property located within New Jersey have been subject to a special tax known as the “Controlling Interest Transfer Tax,” or the “CITT.” N.J.S.A. §54:15C-1 and N.J. Admin. Code §§18:16A-1.1 to 1.5. The CITT is calculated according to one of the following two methodologies, depending on whether the entity in which ownership interests were purchased owns assets other than commercial real property (such as personal property). If the entity owns only commercial real property, then the CITT is equal to 1% of the consideration paid for the purchased ownership interests. However, if the entity owns, directly or indirectly, an interest in any assets other than commercial real property, then the CITT is equal to 1% of the equalized assessed value of the commercial real property (prorated with respect to the percentage of ownership of the entity purchased).
The CITT was enacted as a companion to the 1% tax imposed on the direct transfer of classified commercial real property for a consideration in excess of $1 million. Ostensibly, the purpose of the CITT was to prevent taxpayers from avoiding the 1% tax on direct transfers, by instead transferring interests in the entity owning the real property.
The CITT can be substantial, especially in relation to the purchase price. For example, assume that a limited liability company (“LLC”) owns commercial real property with an equalized assessed value of $50 million that is subject to a mortgage of $45 million. The LLC also owns assets of insignificant value in addition to the commercial real property, and thus, upon a sale of a “controlling interest” of the LLC’s membership interests, the CITT is required to be calculated based on the equalized assessed value of the commercial property rather than the consideration paid for the interests. Assume a purchaser pays $5 million (the net value of the real property) for 100% of the membership interests. That purchaser would be subject to a CITT of $500,000 (1% of $50 million, the equalized assessed value of the real property), constituting 10% of the purchase price paid for the membership interests. Note that, if the mortgage were large enough, the CITT could actually exceed the purchase price of the interests.
What Is a “Controlling Interest”?
Despite the substantial nature of the tax, the vagaries of the CITT statute and regulations leave its application uncertain, including with regard to the meaning of the term “controlling interest.” Under the statute, “controlling interest” means, in the case of a corporation, more than 50% of the total combined voting power of all classes of stock of the corporation and, in the case of an entity taxed as a partnership (such as most multimember LLCs), more than 50% of the beneficial ownership of the commercial real property of the partnership.
Consistent with its apparent purpose of preventing taxpayers from avoiding the 1% tax on direct transfer of classified commercial property, the CITT clearly applies to a purchase of 100% of the interests in an entity owning commercial real property. In such a case, there is no doubt that a “controlling interest” has been transferred. However, ambiguity arises with more complex transactions. For example, assume that a purchaser of voting stock already owns 49% of the voting stock of a corporation and plans to purchase only an additional 2%. This transaction would thus effectuate a shift in control of the corporation to the purchaser. Is this a transfer of a controlling interest? Similarly, if a purchaser already owns a controlling interest in a corporation, is the acquisition of an additional interest subject to the CITT? While there is no published guidance from the Division of Taxation on these questions, the answers may hinge on whether the acquisition of the interests in question (i.e., the interests currently held by the purchaser and the additional interests to be acquired by the purchaser) were related transactions that occurred within six months of each other. Another question arises in the context of preferred stock, which may carry contingent voting rights. Specifically, does the right to control the company in only certain cases constitute a “controlling interest”?
The law is even less clear with regard to partnerships (and LLCs taxed as partnerships). As discussed above, in the context of a partnership, a “controlling interest” means more than 50% of the beneficial ownership of classified real property of the partnership. The statute does not define “beneficial ownership,” and the regulations promulgated by the Division of Taxation are nearly inscrutable. To wit: “‘Beneficial ownership’ means ownership of tangible or intangible property by a person or entity that does not have legal title to the property but has ultimate control of the property in regard to the transfer of a controlling interest in class 4A commercial real property between that person or entity and a separate legal entity.”
Thus, the regulations merely shift the inquiry from the definition of “beneficial interest” to the definition of “ultimate control,” which the regulations leave undefined. Is “ultimate control” signified by an affirmative right to sell the property or is veto power sufficient? In addition, as in the case of corporations, it is unclear how to treat already-owned interests and contingent voting rights.
Due to the short period of time since the enactment of the CITT, the New Jersey courts have yet to interpret the statute and regulations. With all these questions left unanswered, guidance from the courts is hopefully not far off. Until then, however, investors and other purchasers of interests potentially subject to the CITT should proceed with extreme caution and are welcome to contact any of the members of our Real Estate Practice Group to discuss the structuring of proposed transactions and potential CITT consequences.