To Our Clients and Friends Memorandum friedfrank.com Copyright © 2015 Fried, Frank, Harris, Shriver & Jacobson LLP 12/22/15 A Delaware Limited Liability Partnership 1 Tax Extenders Act Makes Significant Changes Affecting Real Estate Investments and REITs On December 18, 2015, the President signed into law the Protecting Americans from Tax Hikes Act of 2015 (the “Act”). Most of the Act consists of so-called “extender” provisions that extend certain temporary provisions of the Internal Revenue Code of 1986, as amended (the “Code”), which were set to expire or had already expired. However, the Act also makes some very significant, permanent changes affecting investments in real estate. In particular, the Act exempts qualifying foreign pension funds from tax under “FIRPTA” (Foreign Investment in Real Property Tax Act of 1980), thereby potentially allowing them far greater flexibility to invest in U.S. real property than had previously been possible. The Act also severely curtails the ability of real estate investment trusts (“REITs”) to engage in certain tax-free spin-offs. Finally, the Act makes a number of other changes to the REIT and FIRPTA rules. Each of these areas is summarized below. I. FIRPTA and Foreign Pension Funds As background, the United States does not generally tax the capital gains of non-U.S. investors derived from their U.S. investments that are not related to a U.S. trade or business. However, since 1980, most non-U.S. investors in U.S. real property interests (“USRPIs”) (which is broadly defined and includes, in many cases, the stock of U.S. corporations the majority of the assets of which consist of USRPIs (“USRPHCs”)) have been subject to full U.S. tax on their gains from the sale of such USRPIs under FIRPTA. One of the most significant aspects of the Act is the repeal of FIRPTA for qualified foreign pension funds. It also repeals the correlative FIRPTA withholding rule in the case of USRPIs sold by such foreign pension funds. These provisions apply to dispositions and distributions after the date of enactment of the Act. For purposes of these rules, a qualified foreign pension fund is defined to mean any trust, corporation, or other organization or arrangement which meets a five-part test, as follows: 1. It is created or organized under the law of a country other than the United States. 2. It 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. 3. No single participant in the pension fund has a right to more than 5% of its assets or income. Fried Frank Client Memorandum 2 4. It 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. 5. Under the laws of the country in which it is established or operates, either (i) contributions to it, which would otherwise be subject to tax, are deductible or excludible or taxed at a reduced rate or (ii) taxation of any investment income of such trust, corporation, organization or arrangement is deferred or such income is taxed at a reduced rate. The apparent intention of this provision was to equalize the tax treatment of qualified foreign and domestic pension funds with respect to their dispositions of USRPIs. However, the Act does not appear to harmonize either the definitions of “qualified” U.S. and foreign pension funds, or the scope of the tax exemption available to each insofar as sales of USRPIs are concerned. For example, U.S. pension funds must meet a complex nondiscrimination test to be eligible for tax exempt treatment. Qualified foreign pension funds do not appear to face any similar set of limitations, presumably because local law may vary in this regard. Hopefully, the “subject to government regulation” and tax benefit requirements in (4) and (5) above will also be interpreted in a way which is sensitive to the varying tax and regulatory structures that may be applicable in other countries. Once a U.S. pension fund qualifies for tax exemption, however, it is still subject to the unrelated business taxable income (“UBTI”) rules, which may cause it to pay tax on sales of USRPIs (among other assets), for example, in the case of debt financed real property or income derived from pension held REITs. A qualified foreign pension fund would not appear to be subject to FIRPTA tax in the same situation. In that sense, the exemption accorded to qualified foreign pension funds appears in some cases to be broader than that accorded to U.S. pension funds. On the other hand, foreign investors (including qualified foreign pension funds) may still be subject to tax on their effectively connected income in some cases in which U.S. pension funds would be exempt from tax under the UBTI rules. The asymmetries created by this provision extend to other issues. For example, as a result of this provision, the tax consequences applicable to a sovereign wealth fund which invests in stock of a USRPI may vary considerably from those applicable to a qualified foreign pension fund. Overall, these provisions will be welcome relief for qualified foreign pension funds. However, depending on the circumstances, including the type of investment and expected exit, and whether the qualified foreign pension funds are investing alone or in tandem with other investors, maximizing tax benefits may prove complex and, in many cases, may continue to require utilization of separate REITs or other special structures. II. REIT Spin-Offs The Act forecloses a corporation from separating its real estate assets from its operating business in a tax-free division, or spin-off. These transactions had recently gained favor for a variety of reasons, including as a means to increase the value of the historically combined enterprise (by lowering its effective tax rate) through an “opco-propco” structure. The opco-propco tax-free spin-offs that have occurred in the last few years have been principally in the areas of hospitality and gaming. For example, in 2013, Penn National Gaming contributed most of its casino properties to a newly-formed corporation and then distributed tax-free all of the shares of the newco to its shareholders. In connection with the distribution, the newco leased its properties back to Penn Gaming pursuant to a long-term triple-net lease agreement, generating a corporate level deduction to the opco; after the distribution, the newco (propco) elected REIT status, effectively allowing its earnings (i.e., the lease payments it receives from Penn Fried Frank Client Memorandum 3 Gaming) to avoid corporate level tax. In conjunction with the U.S. Internal Revenue Service’s (“IRS’s”) increasingly permissive views on qualifying REIT assets, the IRS’s approval of this transaction in a private letter ruling led many corporations to consider opco-propco spin-offs. The momentum that had been gathering behind REIT spin-offs over the last few years hit a speed bump when the IRS announced, in September 2015, that it had “significant concerns” about the structure under current law, and that no rulings would be issued while the IRS studied the area. The Act short-circuits that study by (i) prohibiting REIT elections by the distributing or spun-off corporation for ten years following a tax-free spin-off without regard to whether or not the transaction fits within the “opco-propco” framework described above and (ii) denying tax-free treatment to spin-offs in which the distributing or spun-off corporation (but not both) is a REIT. An exception permits a REIT to effect a tax-free spin-off of a taxable REIT subsidiary (“TRS”) of which the REIT has had Code section 368(c) control (generally stock representing 80% of voting power) for at least three years, assuming both the REIT and the TRS have been a REIT and a TRS, respectively, for at least three years. The rules described above apply to any distribution made on or after December 7, 2015, subject to an exception for distributions described in a ruling request submitted to the IRS on or before (and still pending as of) December 7, 2015. III. Other Changes to the REIT and FIRPTA Rules The Act enacted a number of other REIT and FIRPTA related changes, some of which are highlighted below. a. Modification of REIT Domestic Control Determination An interest in a domestically controlled REIT (i.e., a REIT less than 50% of the value of which was held directly or indirectly by foreign persons) is not a USRPI. The Act modifies the determination of whether a REIT will be treated as domestically controlled for this purpose by providing three presumptions regarding a shareholder’s status as a U.S. or foreign person. First, all shareholders of a REIT holding less than 5% of a publicly traded class of stock of such REIT are presumed to be U.S. persons, unless the REIT has actual knowledge that a shareholder is a foreign person. Second, a REIT shareholder that is itself a REIT will, if it is publicly traded, be treated as a foreign person, unless it is domestically controlled, in which case such REIT shareholder will be treated (entirely) as a U.S. person. Finally, any REIT shareholder that is itself a REIT that is not publicly traded will be treated as a U.S. person in proportion to the stock of such shareholder REIT that is (or is treated as) held by a U.S. person. These amendments are effective as of the date of enactment of the Act. b. Exception from FIRPTA for Stock of REITs Held by Certain Investors The FIRPTA rules generally exempt small holders of publicly traded USRPHCs, including REITs, from FIRPTA tax on sale; in the case of REITs, these rules also exempt distributions that would otherwise be subject to FIRPTA. Under prior law, these exemptions applied if a person held 5% or less of a publicly traded class. In the case of a publicly traded REIT (but not other USRPHCs), the Act increases the threshold to 10%. These modifications are effective for any disposition on or after the date of enactment of the Act, and for any distribution on or after such date that is treated as a deduction by a REIT in a taxable year ending after such date. Fried Frank Client Memorandum 4 c. Interests in REITs Not Eligible for “Cleansing” Dispositions A USRPHC has historically been able to “cleanse” its status as a USRPI by disposing of all of its USRPIs in one or more taxable transactions prior to liquidating. Since a REIT does not pay corporate level taxes, application of this so-called “cleansing rule” to REITs allowed the FIRPTA taint to disappear without payment of tax. The Act excludes REITs from the application of this rule. This provision applies to dispositions on or after the date of enactment of the Act. d. Increase in Rate of FIRPTA Withholding The FIRPTA rules have generally required 10% withholding on the (gross) proceeds realized by a foreign person from the sale of USRPIs (and have similarly required withholding in certain other situations). The Act increases this withholding rate to 15% for dispositions after the date of enactment of the Act, but maintains the 10% rate for residences (as determined in the hands of the buyer) sold for between $300,000 and $1,000,000 and an exemption from withholding for residences sold for $300,000 or less. e. Other REIT Related Modifications The Act also contains a number of other amendments to the rules governing the maintenance of REIT status. TRS Limitation The Act lowers the percentage of a REIT's assets that may be comprised of interests in a TRS from 25% to 20%. This change is effective prospectively for taxable years beginning after December 31, 2017. Prohibited Transaction Safe Harbors The Act expands the safe harbors from the prohibited transaction tax imposed on certain sales of “dealer” property (such as assets characterized for tax purposes as inventory) to permit annual sales of property with an aggregate adjusted basis of up to 20% (instead of 10% under prior law) of the aggregate basis of assets held by the REIT at the beginning of such taxable year, and also sales of property with a fair market value of up to 20% (instead of 10% under prior law) of the fair market value of all assets held by the REIT at the beginning of such taxable year (in each case, as long as certain additional requirements are met). This change is effective for taxable years beginning after the date of enactment of the Act. Preferential Dividend Rule The Act repeals the “preferential dividend” rule for all publicly offered REITs effective for all taxable years beginning after December 31, 2014. In the case of all non-publicly offered REITs, the Act gives the IRS the authority to provide discretionary relief when the payment of its preferential dividend is due to reasonable cause for all taxable years beginning after December 31, 2015. Debt Instruments of Publicly Offered REITs Among other requirements, REITs must meet certain asset and income tests. The Act broadens the types of assets a REIT can hold by allowing debt instruments issued by publicly offered REITs to count toward the REIT asset test (however, the income from such assets does not count toward the 75% Fried Frank Client Memorandum New York Washington, DC London Paris Frankfurt Hong Kong Shanghai friedfrank.com 5 income test and certain limitations apply). These changes apply to taxable years beginning after December 31, 2015. Deferral of Tax on Net Built-In Gains Conversion of a C corporation to a REIT generally results in deferral of tax on net built-in gains existing at the time of conversion. Under prior law, if those gains are recognized within the first 10 years following conversion to a REIT, a corporate level tax applies. For taxable years beginning in 2012, 2013, and 2014, the 10-year period was temporarily reduced to 5 years. The Act makes permanent the 5-year period for taxable years beginning after December 31, 2014. * * * Authors and Contacts: New York Robert Cassanos +1.212.859.8278 [email protected] Andrew Falevich +1.212.859.8363 [email protected] Christopher Roman +1.212.859.8985 [email protected] David I. Shapiro +1.212.859.8039 [email protected] Richard A. Wolfe +1.212.859.8922 [email protected] Washington, D.C. Alan S. Kaden +1.202.639.7073 [email protected] This memorandum is not intended to provide legal advice, and no legal or business decision should be based on its contents. If you have any questions about the contents of this memorandum, please call your regular Fried Frank contact or an attorney listed.