On June 7, Treasury and the IRS issued temporary (TD 9770) and proposed regulations (REG-126452-15) that impose a corporate-level tax on certain transactions in which property of a C corporation becomes the property of a real estate investment trust (REIT). According to Treasury and the IRS, these regulations are necessary to prevent abuses of sections 355(h) and 856(c)(8) and to further the purposes of the repeal of the doctrine established under General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935) by the Tax Reform Act of 1986.
Under General Utilities and its subsequent codification in sections 311(a) and 336(a), corporations could distribute appreciated property to their shareholders tax free. Following repeal of the General Utilities doctrine (“GU repeal”), the Code generally imposes two levels of tax (one at the corporate entity level and one at the shareholder level) on distributions of appreciated property, including stock of a subsidiary, outside corporate solution. Section 355 offers a limited exception to GU repeal, providing that the distribution of stock of a subsidiary (“controlled corporation”) that is “controlled” by another corporation (“distributing corporation”) may not be subject to tax either at the corporate or at the recipient shareholder level if several requirements are met.
Historically, GU repeal could be avoided in certain cases if property of a C corporation became property of a regulated investment company (RIC) or a REIT (“converted property”) by a transfer of the converted property from a C corporation to a RIC or a REIT or by the qualification of the C corporation as a RIC or a REIT (both “conversion transactions”). A conversion transaction could result in elimination of the corporate level of gain in the converted property, including gain from the sale of the property, because RICs and REITs generally are not subject to tax on income that is distributed to their shareholders. Section 337(d) provides broad authority to the Treasury Department to issue regulations necessary to enforce the principles of GUrepeal and to ensure that such principles are not circumvented through the use of any provision of law or regulations or through the use of a RIC, REIT, or tax-exempt entity.
Pursuant to this authority, the IRS finalized regulations in 2003, providing that the rules of section 1374 apply to a conversion transaction as if the RIC or REIT were an S corporation, unless the C corporation elects deemed sale treatment for that transaction. Treas. Reg. 1.337(d)-7(a). Section 1374 imposes a corporate-level tax on the net built-in gain of the property if an S corporation disposes of the property in a taxable transaction within the recognition period.
If the REIT does not dispose of the property within the recognition period, however, the built-in gain is wholly free of corporate tax. Moreover, a REIT generally avoids corporate income tax on future rental income because it receives a dividends paid deduction and thus is not subject to corporate tax if it distributes to its shareholders substantially all of its taxable income for the year. This is what made so-called “OpCo-PropCo” transactions (such as those completed by Penn National Gaming Inc., Windstream Holdings Inc., and Darden Restaurants Inc.) so appealing. In an OpCo-PropCo transaction, “OpCo” transfers a portion of its real estate assets to a new company, “PropCo,” that it plans to spin off in a section 355 transaction, thus allowing for tax-free treatment. PropCo then elects to be treated as a REIT and generally leases the real estate back to OpCo through a triple net lease. The triple net lease strips income from OpCo's tax base through deductible rent payments.
The release of Rev. Proc. 2015-43 and Notice 2015-59 on September 14, 2015 made it clear that the IRS was concerned about spinoff transactions in which either the distributing corporation or controlled corporation makes an election to be a REIT. Rev. Proc. 2015-43 announced that the IRS would not issue private letter rulings for spinoff transactions involving REIT or RIC elections, and Notice 2015-59 indicated that Treasury and the IRS were studying the extent to which some REIT spinoffs may circumvent GU repeal.
PATH Act of 2015
Following the release of Notice 2015-59 and Rev. Proc. 2015-43, the Protecting Americans From Tax Hikes (PATH) Act of 2015 (P.L. 114-113) was enacted, adding sections 355(h) and 856(c)(8) to the Code. Section 355(h) generally makes tax-free treatment under section 355 inapplicable to any distribution if either the distributing corporation or controlled corporation is a REIT. The law provides exceptions for spinoffs of a REIT by another REIT and for spinoffs of some taxable REIT subsidiaries. Section 856(c)(8) generally provides that following a distribution to which section 355 applies, the distributing corporation and controlled corporation (and any successor corporation) are ineligible to make a REIT election for any tax year beginning before the end of the 10-year period beginning on the date of that distribution. The PATH Act applied only to REIT elections, not to other conversion transactions. Thus, for example, a spun-off controlled corporation could merge into a REIT, even though it could not elect REIT status. For more information on the PATH Act provisions, click here.
Temporary and Proposed Regulations
The preamble to the temporary regulations states that Treasury and the IRS are concerned that taxpayers may engage in transactions to circumvent the purposes of the PATH Act provisions described above, and thus have determined that temporary regulations are necessary to prevent abuses of sections 355(h) and 856(c)(8) and to further the purposes of GU repeal.
The temporary regulations provide that a C corporation engaging in a conversion transaction involving a REIT within the 10-year period following a related section 355 distribution will be treated as making the deemed sale election to recognize gain and loss as if it had sold all of the converted property to an unrelated party at fair market value on the deemed sale date. In addition, the temporary regulations provide that a REIT that is a party to a section 355 distribution occurring within the 10-year period following a conversion transaction for which a deemed sale election has not been made will recognize any remaining unrecognized built-in gains and losses resulting from the conversion transaction (after taking into account the impact of section 1374 in the interim period).
Consistent with the PATH Act provisions, the temporary regulations do not apply if both Distributing and Controlled are REITs immediately after the date of the section 355 distribution. The temporary regulations go beyond the PATH Act by also requiring that the distributing corporation and controlled corporation remain REITs at all times during the two years following the section 355 distribution. Second, the temporary regulations do not apply to certain section 355 distributions in which the distributing corporation is a REIT and the controlled corporation is a taxable REIT subsidiary. To prevent avoidance, the temporary regulations apply to predecessors and successors of the distributing corporation or controlled corporation and to all members of the separate affiliated group, within the meaning of section 355(b)(3)(B), of which the distributing corporation or controlled corporation are members.
In response to section 127 of the PATH Act, the temporary regulations also amend the recognition period in Treas. Reg. 1.337(d)-7. The PATH Act amended section 1374(d)(7) to permanently shorten the length of the “recognition period” from 10 years to five years with respect to C corporations that elect to be, or transfer property to, S corporations. The previous section 337(d) regulations cross-referenced section 1374(d)(7) to define the recognition period, but the temporary regulations de-link the two. Accordingly, the temporary regulations replace the term “10-year recognition period” in Treas. Reg. 1.337(d)-7 with the new defined term “recognition period” and define the recognition period as the 10-year period beginning on the first day of the RIC’s or the REIT’s first taxable year (in the case of a conversion transaction that is a qualification of a C corporation as a RIC or a REIT) or on the date the property is acquired by the RIC or REIT.
Proposed regulations issued with the temporary regulations request comments on the temporary regulations. The proposed regulations also include a modification to the definition of converted property. Such modification would treat as converted property any property the basis of which is determined, directly or indirectly, in whole or in part, by reference to the basis of property owned by a C corporation that becomes the property of a RIC or a REIT.
According to Lisa Zarlenga, partner at Steptoe, these temporary regulations close perceived gaps in the PATH Act and put a nail in the coffin of REIT spinoffs once and for all.
The temporary regulations are effective June 7. Consistent with the effective date in the relevant provisions of the PATH Act, the temporary regulations do not apply to distributions pursuant to a transaction described in a ruling request initially submitted to the IRS on or before December 7, 2015, which request has not been withdrawn and with respect to which a ruling has not been issued or denied in its entirety as of December 7, 2015. Comments on the proposed regulations and requests for a public hearing must be received by August 7.