On December 18, 2015, President Obama signed into law the Protecting Americans from Tax Hikes Act of 2015 (the “PATH Act”). Among other changes,1 the PATH Act significantly modifies provisions of the Internal Revenue Code of 1986, as amended (the “Code”) with respect to real estate investment trusts (“REITs”) and the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”). FIRPTA was enacted by Congress in 1980 as a means to tax the gains on foreign investors’ income from the sale of U.S. real property. FIRPTA effectively limited the amount that foreign investors were able to invest in U.S. REITs, which created barriers to foreign investment in U.S. infrastructure and real estate. The PATH Act benefits both existing and newly created REITs by alleviating those obstacles in attracting foreign investors and reducing certain tax liabilities.2 This client alert provides a high-level overview of the provisions in the PATH Act that impact REITs and FIRPTA.
The PATH Act introduces several significant changes to the existing FIRPTA rules.3 The following provision is effective for tax years beginning after December 31, 2014:
“Sting” Tax Period Reduced from 10 Years to Five Years. If a C corporation converts into a REIT or if a REIT acquires assets from a C corporation in a tax-free transaction, the REIT will be subject to corporate level tax on any built-in gain upon the sale of the C corporation’s assets for a specified amount of time. Under prior law, the specified amount of time was for a period of 10 years, but the PATH Act permanently reduces this period to five years.
The following provision is effective for distributions occurring after December 7, 2015:
Restrictions on Tax-Free REIT Spinoffs. Corporations with significant real estate assets have used the tax-free spinoff provisions under section 355 of the Code, combined with an immediate REIT election, to effectively achieve tax-free distributions of real estate assets of a corporate subsidiary. In order to curb this particular use of section 355 of the Code, the PATH Act prohibits tax-free spinoffs when either the distributing corporation or the distributed subsidiary is a REIT, with a few specified exceptions.
The following provisions are effective for distributions occurring on or after December 18, 2015:
Exemption of Foreign Pension Funds. The PATH Act exempts “qualified foreign pension funds” that invest in U.S. real estate from tax penalties imposed by FIRPTA, placing foreign pension funds in a similar tax position as U.S. pension funds. A “qualified foreign pension fund” is defined as any trust, corporation, or other organization or arrangement that (1) is created outside the United States, (2) is established to provide retirement or pension benefits to current or former employees, (3) does not have any participant or beneficiary owning more than 5 percent of its assets or income, (4) is subject to government regulation and annual reporting in its home jurisdiction, and (5) is entitled to certain tax benefits under the laws of the country in which it was formed.
Increase in Ownership Threshold of Publicly Traded REITs. Under prior law, foreign investors owning less than 5 percent of a publicly traded U.S. REIT did not trigger FIRPTA liability upon the sale of stock or receipt of capital gain distributions. The PATH Act increases this threshold from 5 percent to 10 percent, and extends the provision to certain collective investment vehicles.
New Exemption of Qualified Shareholders. The PATH Act provides a new exemption from FIRPTA for a “qualified shareholder.” A “qualified shareholder” under the PATH Act is defined as a foreign person that (1) is eligible for a reduced rate of withholding under a comprehensive income tax treaty with the United States, (2) is a “qualified collective investment vehicle,” and (3) satisfies certain recordkeeping requirements on the identity of its owners. The “qualified collective investment vehicle” is a new concept under the PATH Act and is defined as a foreign person that: (1) is eligible for a reduced rate of withholding on REIT dividends under a comprehensive income tax treaty, even if it owns more than 10 percent of the REIT’s stock; (2) is a publicly traded partnership for U.S. federal income tax purposes, is a withholding foreign partnership, and would qualify as a U.S. real property holding corporation if it were a domestic corporation; or (3) is another entity designated as a qualified collective investment vehicle by the Secretary of the Treasury that is either “fiscally transparent” within the meaning of section 894 of the Code, or includes dividends in its gross income but is entitled to a deduction for dividends paid. This exemption does not apply to foreign investors owning more than 10 percent of the REIT’s stock.
FIRPTA Withholding Tax Increased to 15 Percent. In an effort to increase compliance with FIRPTA, the PATH Act increased the previous withholding tax on the sale of U.S. real property interests by foreign persons from 10 percent to 15 percent. This change does not alter the actual tax liability imposed under FIRPTA as originally enacted, but only increases the withholding. A foreign investor will be eligible for a refund to the extent substantive tax was less than the amount withheld. This provision is effective for dispositions occurring 60 days after December 18, 2015.
Removal of the “Cleansing Rule” for REITs. Under prior law, the “cleansing rule” provided that a U.S. corporation could avoid FIRPTA liability or “cleanse” itself of its FIRPTA taint if, at the date of disposition, it (1) had no U.S. real property interests and (2) disposed of all of its U.S. real property interests held at any time during the relevant testing period in which the full amount of the gain was recognized. However, the PATH Act provides that the cleansing rule does not apply to U.S. corporations or their predecessors that were REITs during the relevant testing period.
The following provision is effective for tax years beginning after December 31, 2015:
Debt Instruments Classified as Good REIT Assets. Under prior law, shares (but not debt) of publicly offered REITs were considered qualified real estate assets. The PATH Act treats certain debt instruments as qualified real estate assets for purposes of the 75 percent asset test, but only if the value of those debt instruments does not exceed 25 percent of the gross asset value of the REIT. Income from debt instruments is considered good income under the 95 percent income test, but does not qualify under the 75 percent income test.
The following provision is effective January 1, 2016:
Domestically Controlled Determination Clarified. Foreign investors are not subject to FIRPTA taxation on the gain resulting from the sale of stock of a “domestically controlled” REIT.4 Historically, the determination of “domestically controlled” status was difficult to assess due to the lack of information necessary to determine the domestic or foreign status of a small investor. The PATH Act provides clarification for when a listed REIT can be considered “domestically controlled”. The PATH Act allows U.S. publicly traded REITs to treat shareholders owning less than 5 percent of their stock for the specified period of time as U.S. persons, unless the REIT has actual knowledge that such shareholder is not a U.S. person. This rule is also applied to regulated investment companies (“RICs”) retroactively to January 1, 2015. Further, the PATH Act provides additional rules for stock in a REIT held by other REITs or RICs.
The following provision is effective for tax years beginning after December 31, 2017:
Percentage Limitation on REIT Assets That May Be Taxable REIT Subsidiaries Reduced to 20 Percent. Under prior law, the securities of one or more taxable REIT subsidiaries held by a REIT could not represent more than 25 percent of the gross asset value of the REIT. The PATH Act reduces this percentage to 20 percent.
The PATH Act generally is good news for REITs and foreign investors as it takes significant steps toward facilitating foreign investments in U.S. real estate and U.S. infrastructure projects. The PATH Act, however, also significantly restricts REIT spinoff transactions, limits certain avenues to reduce tax liability, and imposes additional reporting requirements.