On December 18, 2015, President Obama signed the Protecting Americans from Tax Hikes Act of 2015 (the PATH Act). Among other things, the PATH Act includes provisions that likely will facilitate foreign investment in United States real estate and provide real estate investment trusts (REITs) with greater flexibility in satisfying certain REIT-qualification requirements. Significantly, however, the PATH Act will make spinoffs of REITs, in so called "opco/propco" transactions that have become increasingly popular in recent years (including in response to shareholder activism), more difficult to achieve in a tax-deferred manner.
Provisions Relating to the Foreign Investment in Real Property Act (FIRPTA)
Foreign persons that are not engaged in a US trade or business are generally not subject to US tax on capital gains from the sale of stock or other capital assets. However, under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) a foreign person's gain or loss from the disposition of a US real property interest (USRPI) is generally taxable at the income tax rates applicable to US persons, including the rates for net capital gain (because FIRPTA treats gain from the disposition of USRPIs as income effectively connected to the conduct of a US trade or business). For foreign persons, the distribution of a USRPI by a foreign entity results in the recognition of gain (including a distribution in redemption or liquidation) equal to the excess of the fair market value of the USRPI (as of the time of distribution) over its adjusted basis. A foreign person subject to tax on FIRPTA gain is also required to file a US tax return under the normal rules relating to receipt of income effectively connected with a US trade or business. In addition, payors of amounts in respect of USRPIs are required to withhold taxes in respect of payments relating to USRPIs at applicable rates of 15 percent of the sales price (increased from ten percent as a result of the PATH Act, effective with respect to distributions after February 16, 2016) in the event of a direct sale of USRPIs or 35 percent in respect of a distribution to a foreign person of net proceeds attributable to the sale of a USRPI from an entity such as a partnership, REIT, or registered investment company (RIC) (subject to adjustment pursuant to applicable treaties).
Exemption of Non-US Pension Funds from FIRPTA
The PATH Act exempts from FIRPTA withholding any USRPI held directly (or indirectly through one or more partnerships) by, or to any distribution received from a REIT by, a qualified foreign pension fund or by a foreign entity wholly owned by a qualified foreign pension fund. A "qualified foreign pension fund" means any trust, corporation, or other organization or arrangement:
- which is created or organized under the law of a country other than the United States;
- which is established to provide retirement or pension benefits to participants or beneficiaries that are current or former employees (or persons designated by such employees) of one or more employers in consideration for services rendered;
- which does not have a single participant or beneficiary with a right to more than five percent of its assets or income;
- which 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
- with respect to which, under the laws of the country in which it is established or operates, (i) contributions to such organization or arrangement that would otherwise be subject to tax under such laws are deductible or excluded from the gross income of such entity or taxed at a reduced rate, or (ii) taxation of any investment income of such organization or arrangement is deferred or such income is taxed at a reduced rate.
This provision, which applies to dispositions and distributions after December 18, 2015, is designed to put foreign pension funds on the same grounds with respect to FIRPTA as US pension funds and likely will make investing in US real estate by foreign pension funds more attractive. We note, however, that these provisions of the PATH Act apply only to the tax treatment of distributions or transfers of USRPIs. The foreign pension fund would still be liable for taxes on rent and other operating income earned directly or through other entities, unless adjusted or negated by a tax treaty or another section of the Internal Revenue Code, as amended (the Code), such as Section 892.
We also note that there has been some uncertainty as to whether the provisions of the PATH Act apply to public pension funds for the benefit of persons in their capacity as citizens or residents, as distinct from in their capacity as employees. At this stage, while it appears the intent of the provision is for such funds to have the benefit of the exemption from FIRPTA withholding, it may be necessary for the Treasury Department to provide clarifying guidance, or for Congress to clarify through legislation, such as technical corrections.
Increase in Ownership Level of REIT Stock for Exemption from FIRPTA
Prior to adoption of the PATH Act, FIRPTA did not apply to sales of stock of a publicly traded entity as long as the holder did not own more than five percent of the class of the publicly traded stock. The PATH Act increases, in the case of REIT stock only, from five percent to ten percent the maximum stock ownership a shareholder may hold, during the testing period, of a class of stock that is publicly traded to avoid having FIRPTA apply to a disposition of that stock. Similarly, the PATH Act increases from five percent to ten percent the percentage ownership threshold that, if not exceeded, results in treating a distribution to holders of publicly traded REIT stock (if they are attributable to gain from sales or exchanges of USRPIs) as a dividend, rather than a gain subject to FIRPTA. These changes apply to dispositions and distributions on or after December 18, 2015.
Determination of "Domestically Controlled" REIT Status
The sale of stock of a domestically controlled REIT (defined as a REIT as to which less than 50 percent of the value of the outstanding shares of the REIT's stock have been held directly or indirectly by foreign persons during the applicable testing period) is not subject to FIRPTA. Especially for publicly held REITs, it has often been difficult to confirm with certainty that the REIT is domestically controlled. The PATH Act clarifies the determination of "domestic" control of REITs, particularly for publicly traded entities. As a result of the PATH Act, a REIT will now be permitted to assume that all holders of less than five percent of a class of publicly traded stock are US persons throughout the testing period (in general, five years or, if shorter, the period of the REIT's existence), unless the REIT has actual knowledge to the contrary. In addition, any stock in the REIT held by another REIT or qualified investment entity that either (i) has issued any class of stock that is regularly traded on an established stock exchange, or (ii) is a RIC that issues redeemable securities (within the meaning of section 2 of the Investment Company Act of 1940) shall be treated as held by a foreign person unless such other qualified investment entity is domestically controlled (as determined under the new rules), in which case such stock shall be treated as held by a US person. Any stock in a qualified investment entity held by any other qualified investment entity not described in clause (i) or (ii) of the preceding sentence shall be treated as held by a US person only to the extent that the stock of such other qualified investment entity is (or is treated under the new provision as) held by a US person. These changes became effective on December 18, 2015.
FIRPTA "Cleansing" Eliminated for REITs
Under prior law, an interest in a corporation was not a USRPI (and therefore not subject to FIRPTA) if (1) as of the date of disposition of such interest, such corporation did not hold any USRPIs; and (2) all of the USRPIs held by such corporation during the relevant testing period were either disposed of in transactions in which the full amount of the gain (if any) was recognized, or ceased to be USRPIs by reason of the application of the rule described in this clause to one or more other corporations (the so-called "cleansing rule"). The PATH Act eliminates this "cleansing" provision for any corporation that was a RIC or REIT at any time (because although the RIC or REIT might have "recognized" the gain from the sale of USRPIs, it would likely not have paid taxes on the gain). This provision applies to dispositions on or after December 18, 2015.
Other Provisions Affecting REITs
Restrictions on Spinoffs of REITs in Tax-Free Transactions
One of the provisions of the PATH Act that has been the subject of much attention is the imposition of restrictions on "tax-free" spinoffs of REITs. In recent years, a number of companies have engaged in transactions (some at the insistence of activist shareholders) in which the real estate assets of a company are separated from the operating assets of the company in a so-called "opco/propco" spinoff. In the transactions, the "propco" elects REIT status and leases the properties to the "opco." Because the REIT does not pay taxes, such a transaction results in any subsequent appreciation in the value of the real estate, as well as the income from the lease, no longer being subject to corporate-level Federal income tax. Many of these transactions have been effected pursuant to Section 355 of the Code, which permits a corporation to distribute stock of a corporate subsidiary in a tax-free transaction as long as certain criteria are satisfied. The IRS had previously issued a notice stating that it was going to take a closer look at these transactions.
The PATH Act generally prohibits a tax-free spinoff of a REIT under Section 355 and prohibits a corporation being spun off from electing REIT status for a period of ten years following the spinoff transaction, which will significantly limit the ability to engage in such "opco/propco" transactions on a tax-deferred basis. There are two exceptions to the prohibition. First, a spinoff may have the benefit of Section 355 if both the distributing and the controlled corporations are REITs and will be REITs immediately following the spinoff transaction. In addition, a REIT may spin off a "taxable REIT subsidiary" (a TRS) if (1) the distributing corporation has been a REIT at all times during the three-year period ending on the date of the distribution, (2) the controlled corporation has been a TRS of the REIT at all times during such period, and (3) the REIT has had control of the TRS through the ownership of stock at all times during such period.
The provision of the PATH Act relating to spinoffs generally applies to distributions on or after December 7, 2015, but does not apply to any distribution pursuant to a transaction described in a ruling request initially submitted to the IRS on or before that date if the request has not been withdrawn and is still pending as of that date.
Reduction of Percentage of REIT Assets that may be Taxable REIT Subsidiaries
A REIT generally is not permitted to own securities representing more than ten percent of the vote or value of any entity, nor is it permitted to own securities of a single issuer comprising more than five percent of REIT value. The REIT-qualification rules provide an exception from these limitations in the case of a TRS. Under prior law, no more than 25 percent of the value of total REIT assets could consist of securities of one or more TRSs. The PATH Act reduces this limit to 20 percent of total REIT assets that may consist of securities or one or more TRSs. This provision applies to taxable years beginning after December 31, 2017.
Prohibited Transaction Safe Harbors
REITs are subject to a prohibited transaction tax (PTT) of 100 percent of the net income derived from prohibited transactions (sales of property in a specified period in excess of IRS guidelines designed to preclude "dealers" of real property from qualifying as REITs). The PATH Act expands the amount of property that a REIT may sell in a taxable year within the safe harbor provisions, from ten percent of the aggregate basis or fair market value, to 20 percent of the aggregate basis or fair market value. However, in any taxable year, the aggregate adjusted bases and the fair market value of property (subject to certain exceptions) sold during the three taxable year period ending with such taxable year may not exceed ten percent of the sum of the aggregate adjusted bases or the sum of the fair market value of all of the assets of the REIT as of the beginning of each of the three taxable years that are part of the period. This provision generally applies to taxable years beginning after December 18, 2015.
Repeal of Preferential Dividend Rule for Publicly Offered REITS; Authority for Alternative Remedies for Certain REIT Distribution Failures
The PATH Act repeals, for "publicly offered" REITs, the preferential dividend rule that prohibited REITs from paying "preferential" dividends (defined to be dividends not distributed pro rata to shareholders, with no preference to any share of stock compared with other shares of the same class, and with no preference to one class as compared with another except to the extent the class is entitled to a preference). A "publicly offered" REIT is one that is required to file annual and periodic reports with the Securities and Exchange Commission under the Securities Exchange Act of 1934. This provision applies to distributions in taxable years beginning after December 31, 2014.
For REITs that are not publicly offered, the PATH Act authorizes the Treasury Secretary to provide an appropriate remedy to cure the failure of the REIT to comply with the preferential dividend requirements in lieu of not considering the distribution to be a dividend for purposes of computing the dividends paid deduction where the Secretary determines the failure to comply is inadvertent or is due to reasonable cause and not due to willful neglect, or the failure is a type of failure identified by the Secretary as being so described. This provision applies to distributions in taxable years beginning after December 31, 2015.
Debt Instruments of Publicly Offered REITs and Mortgages Treated as Real Estate Assets
Under the PATH Act, debt instruments issued by publicly offered REITs are treated as real estate assets, as are interests in mortgages on interests in real property (for example, an interest in a mortgage on a leasehold interest in real property). Such assets therefore are qualified assets for purposes of meeting the "75 percent asset test" (the REIT-qualification test that 75 percent of the value of a REIT's assets must be real estate assets, cash, and cash items and government securities). For this purpose, real estate assets are real property (including interests in real property and mortgages on real property) and shares (or transferable certificates of beneficial interest) in other REITs. No more than 25 percent of a REIT's assets may be securities other than such real estate assets. However, income from debt instruments issued by publicly offered REITs that would not have been treated as real estate assets but for the new provision is not qualified income for purposes of the "75 percent income test" (the REIT qualification rule that at least 75 percent of a REIT's gross income must be from certain real estate related and other items), and not more than 25 percent of the value of a REIT's total assets is permitted to be represented by such debt instruments. This provision is effective for taxable years beginning after December 31, 2015.
Extension of Five-Year Period REITs are Subject to Tax on Built-in Gain
If a C corporation converts to a REIT and has property with "built-in gain" at the time of conversion, or if a REIT acquires property that has "built-in gain" in a transaction that preserves the basis of that property and does not recognize gain, the REIT is subject to entity-level tax upon recognition of gain in respect of that property. Under the PATH Act, the five-year recognition period for built-in gain following conversion of a C corporation to a REIT has been made permanent (retroactively to tax years beginning after December 31, 2014).