President Obama signed the Protecting Americans from Tax Hikes Act of 2015 (the “Act”) into law on December 18, 2015. The Act extends retroactively certain provisions of the Internal Revenue Code (the “Code”) that had expired at the end of 2014 and makes a number of other changes to the Code. The Act makes significant changes to the tax treatment of non-U.S. investors with respect to investments in regulated investment companies (“RICs”), real estate investment trusts (“REITs”) and U.S. real property more generally.
The changes include:
Permanent Extension of Certain Provisions Related to Non-U.S. Shareholders in RICs
- The Act makes permanent a provision that had expired allowing RICs, under certain circumstances, to pass through the character of certain U.S. source interest income and net-short term capital gains on distributions of such items to non-U.S. shareholders. In such a case, U.S. tax withholding generally does not apply with respect to such distributions. Although the provision expired for taxable years of RICs beginning on or after January 1, 2015, the Act reinstates the provision retroactively and makes it permanent. Enactment of this provision ends the uncertainty regarding the status of this U.S. nonresident withholding tax exemption, and should make investments in U.S. registered funds and business development companies investing primarily in U.S. debt obligations more attractive to non-U.S. investors.
- The Act also makes permanent the inclusion of a RIC within the definition of a “qualified investment entity” under the FIRPTA rules in Section 897 of the Code.
Provisions Impacting Controlled Foreign Corporations
- The Act makes permanent a provision that expired at the end of 2014, which excluded certain income derived in the active conduct of a banking, financing or similar business, or the conduct of an insurance business from treatment as subpart F foreign personal holding company income and foreign base company services income.
- The Act extends for five years (for taxable years beginning before January 1, 2020) the look-through treatment under Section 954 of the Code for certain payments between related controlled foreign corporations under the foreign personal holding company rules.
Provisions Impacting REITs
- Most prominently, the Act generally provides that a spin-off transaction involving a REIT qualifies for tax-free treatment only, if immediately after the distribution, both the distributing and controlled parties to the transaction qualified as REITs. Furthermore, the Act prevents the parties to a tax-free REIT spin-off transaction from electing to be subject to tax as a REIT for a ten-year period following the consummation of such transaction. This provision generally applies to distributions made pursuant to such transactions on or after December 7, 2015. However, the REIT spin-off restrictions imposed by the Act do not apply to any transaction for which an outstanding ruling request was submitted to the Internal Revenue Service on or before December 7, 2015.
- The Act limits the aggregate amount of dividends that may be designated by a REIT as qualified dividend income or capital gain dividends to the amount of dividends actually paid by the REIT. This provision applies to REIT taxable years beginning after December 31, 2014.
- The Act reduces the allowable percentage of a REIT’s gross assets represented by the value of one or more taxable REIT subsidiaries (“TRSs”) held by a REIT at the close of a taxable quarter end from 25% to 20%, effective for REIT taxable years beginning after December 31, 2017.
- The Act permits debt instruments issued by “publicly offered” REITs and interests in mortgages on interests in real property to be treated as “real estate assets” for purposes of the 75% qualifying REIT asset test. However, no more than 25% of the value of a REIT’s gross assets at a REIT’s taxable quarter end may be comprised of such debt instruments. For this purpose, a REIT is publicly offered if it is required to file annual and periodic reports with the Securities and Exchange Commission under the Securities Exchange Act of 1934. While the Act treats gross income derived from debt instruments issued by publicly offered REITs as qualifying REIT gross income for purposes of the 95% qualifying REIT gross income test, such treatment continues not to apply for purposes of the 75% qualifying REIT gross income test (unless such gross income is treated as qualifying REIT gross income under current law). These changes to the REIT qualifying asset and qualifying gross income test apply to REIT taxable years beginning after December 31, 2015.
- The Act changes the rules for computing a REIT’s earnings and profits when determining the taxable amount of a REIT’s distributions made to its shareholders. Under this rule, current (but not accumulated) REIT earnings and profits for any taxable year are not reduced by the amount this is not allowable in computing a REIT’s taxable income for such taxable year and was not allowable in computing the REIT’s taxable income in a prior taxable year. This rule does not change the method of computing a REIT’s current earnings and profits for purposes of computing dividends paid deduction. This change to the REIT earnings and profit calculations apples to REIT taxable years beginning after December 31, 2015.
- The Act repeals the preferential dividend rule for publicly offered REITs, thereby conforming the treatment of publicly offered REITs with that of publicly offered RICs. For this purpose, a REIT is publicly offered if it is required to file annual and periodic reports with the Securities and Exchange Commission under the Securities Exchange Act of 1934. This change is effective for REIT dividend distributions made in REIT taxable years beginning after December 31, 2014.
- The Act does not repeal the preferential dividend limitation for non-publicly offered REITs. However, the Act gives the Treasury Department and IRS regulatory authority to allow such REITs to cure failures to comply with the preferential dividend rule if such failures are inadvertent or due to reasonable cause and not willful neglect. This change in regulatory authority is effective for distributions in REIT taxable years beginning after December 31, 2015.
- The Act allows REITs that are publicly traded in the United States to presume that less than 5% shareholders are U.S. persons for purposes of the domestically-controlled REIT exception from the FIRPTA rules. This change is effective as of the date of enactment of the Act.
- The Act provides for an additional safe harbor to the 100% tax on net income otherwise imposed on certain REIT “prohibited transactions” involving the sale of dealer property (i.e., property primarily held by a REIT either as inventory or for sale to customers in the ordinary course of its trade or business). Under this safe harbor, a REIT would be able to generally employ a three-year averaging methodology for purposes of determining the percentage of assets the REIT may sell in a taxable year as well as to permit TRSs to develop REIT real property without being subject to the 100% tax on prohibited transactions. This provision is generally effective for REIT taxable years beginning after the date of enactment of the Act.
Provisions Impacting Non-U.S. Investment in U.S. Real Estate
- The Act creates a new exemption from the FIRPTA tax rules with respect to sales of U.S. real property interests by “qualified foreign pension funds” (and entities wholly owned by such pension funds). In order to be treated as a “qualified foreign pension fund”, a fund would have to (i) be created or organized under the laws of a foreign country, (ii) be established to provide retirement or pension benefits to participants or beneficiaries that are current or former employees (or their designees) of one or more employers for services rendered, (iii) have no single participant or beneficiary with a right to more than 5% of the assets or the income of the fund, (iv) be subject to government regulation in its jurisdiction of organization or operation and provide annual information reports about its beneficiaries to the relevant foreign tax authorities, and (v) under relevant foreign tax law, either (a) benefit from tax exemption (i.e., contributions to the fund are tax-deductible or the fund is exempt or pays a reduced rate of tax on such contributions) or (b) provide tax-deferral or a reduced rate of tax on investments within the fund. The exemption would apply to dispositions and distributions after the date of enactment of the Act.
- The Act increases from 5% to 10% the maximum stock ownership a shareholder may hold in a publicly traded REIT (i.e., a REIT whose shares are regularly traded on an established securities market) to generally avoid having the sale of that stock subject to FIRPTA tax. The 5% maximum stock ownership remains applicable to the sale of corporations other than REITs that are treated as “United States Real Property Holding Corporations.” This change applies to dispositions and distributions on or after the date of enactment of the Act.
- The Act generally increases the rate of FIRPTA withholding tax on gross proceeds with respect to the sale of a U.S. real property interest from 10% to 15%. This increase is effective for dispositions after the 60th day following the date of enactment of the Act.
Permanent Reduction in REIT and RIC Recognition Period for Built-In Gains Tax
When a taxable C corporation elects to be a REIT or RIC (or transfers its property to a REIT or RIC on tax-free basis), unless such C corporation elects “deemed sale” treatment, it is generally subject to a corporate-level “built-in gains” tax under Section 1374 of the Code on the taxable disposition or deemed disposition of assets. Following such a conversion, the REIT or RIC must hold its assets for a certain period in order to avoid a tax on any built-in gains that existed at the time of the conversion. The required holding period was originally 10 years but had been shortened to 5 years. The Act permanently reduces the applicable holding period to 5 years.