The IRS recently issued proposed regulations (the “Proposed Regulations”) that provide certain modifications to existing regulations issued under Section 337(d) of the Internal Revenue Code of 1986, as amended, relating to transfers of property from a C corporation to a regulated investment company ("RIC”) or a real estate investment trust (“REIT”). Under Treasury Regulation Section 1.337(d)-7 as currently enacted (the “Final Regulations”), if the property of a C corporation is transferred to a RIC or REIT, either by qualification of the C corporation as a RIC or REIT or a transfer of the C corporation’s property to a RIC or REIT, the transferee RIC or REIT would be subject to Code Section 1374 built-in gain tax treatment (or the property of the C corporation would be subject to immediate deemed sale treatment). The Proposed Regulations, however, provide an exception to this treatment contained in the Final Regulations to the extent the transfer to the RIC or REIT qualifies for non-recognition treatment under Code Sections 1031 or 1033. In addition, the Proposed Regulations also add a provision that excludes certain “tax-exempt entities” from the definition of a C corporation and the application of the Final Regulations.
The General Utilities1 doctrine provided a common law and statutory exception to the general corporate tax principle of double taxation2 by allowing a corporation to liquidate without paying a corporate level tax on the net built-in gains in its property. The Tax Reform Act of 1986 (the “Act”), however, repealed the General Utilities doctrine by amending Code Sections 336 and 337 to generally require C corporations to recognize gain on appreciated property upon complete liquidation.3 In other words, realized gain occurring at the corporate level upon liquidation would no longer escape the corporate level of tax.4
Code Section 337(d) empowers the Secretary of the Treasury to prescribe such regulations as may be necessary or appropriate to carry out the purposes of the Act. However, as opposed to the commonly seen general mandate of authority often given to the Secretary of the Treasury under other Code Sections, this mandate specifically identifies certain objectives, including ensuring that RICs, REITs and tax-exempt entities are not used to circumvent the purposes of the Act relating to the repeal of the General Utilities doctrine.5 The IRS first announced its intention to issue regulations pursuant to this mandate in Notice 88-19 (the “Notice”).6 The Notice outlined a default rule to be included in the regulations under which the transferor C 8 corporation would be treated as if it had sold its property at fair market value and then immediately liquidated.7 The regulations were to equally apply where the property was transferred via the qualification of the C corporation as a RIC or REIT, or a “carryover basis transaction” to such an entity.8 Under the Notice, the term “carryover basis transaction” refers to transactions or events that result in the transfer of ownership of a C corporation’s assets to a RIC or REIT and in which the basis of the assets is determined by reference to the C corporation’s basis.
Temporary regulations implementing the rules outlined in the Notice were first issued in 2000,9 followed by revisions in 200210 and the issuance of the Final Regulations in 2003.11 In a departure from the Notice, the Final Regulations refer to “conversion transactions” and forego the reference to “carryover basis transactions.”12 A “conversion transaction” is defined as “the qualification of a C corporation as a RIC or REIT or the transfer of property owned by a C corporation to a RIC or REIT.”13 Further for purposes of the Final Regulations, the term “C corporation” is defined as a corporation which is not an S Corporation, RIC or REIT.14 In the preamble to the Final Regulations and a subsequent IRS Revenue Ruling, the IRS recognized the possibility that a tax-exempt entity could be treated as a C corporation and, therefore, fall within the purview of the Final Regulations.15
Concerns with the Existing Regulations
The Final Regulations generated a considerable amount of editorial commentary, and the issues contained therein were included in the IRS’ 2008-2009, 2009-2010, and 2010-2011 Priority Guidance Plans.16 In particular, one such commentary, a letter to the Commissioner from the American Bar Association Section of Taxation (the “ABA”) entitled Comments Concerning Final Regulations Under Section 337(d) Relating to Conversion Transactions, outlined certain concerns with the Final Regulations that have largely formed the basis for the revisions contained in the Proposed Regulations.17
Specifically, the ABA noted in the letter that the use of the term “conversion transactions” in the Final Regulations (rather than the term “carryover basis transactions” as contemplated in the Notice) served to greatly expand the scope of the transactions covered.18 Specifically, the ABA pointed out that the Final Regulations require application of Code Section 1374 (or deemed sale treatment) to property acquired in certain non-recognition transfers (i.e., transfers that do not constitute “carryover basis transactions”) between a C corporation and a RIC or REIT where the basis of the property received by the C corporation is determined by reference to the basis of the property transferred to the C corporation.19 For example, where a C corporation receives property in a transfer that otherwise would qualify for non-recognition treatment under Code Sections 1031 or 1033, the transfer would constitute a “conversion transaction” under the Final Regulations and, therefore, require application of Code Section 1374 (or deemed sale treatment) with respect to the property acquired by the RIC or REIT.20 The ABA concluded that the application of the Final Regulations to such transactions (i.e., transaction that are 9m“exchanged basis transactions”) was inappropriate because the built-in appreciation in the asset received by the C corporation remained subject to the corporate level tax and, thus, does not circumvent the purposes of the repeal of the General Utilities doctrine.21 Echoing these concerns, other commentators have pointed out that such transactions, such as a transfer of real property by a C corporation to a REIT in a Code Section 1031 like-kind exchange, are “commonplace” and “non-abusive.”22
In addition, the ABA expressed its concern regarding the inclusion of tax-exempt entities within the definition of a “C corporation,” particularly in situations where property is transferred by a partnership to a RIC or REIT and the partnership’s partners include both taxable and taxexempt corporations.23 If the partnership makes the deemed sale election under the Final Regulations, the tax-exempt partners will pay no tax, however, the taxable corporate partners’ gain will be accelerated.24 If the partnership does not make the deemed sale election, the rules of Code Section 1374 will apply imposing Code Section 1374 treatment on the RIC or REIT by reference to the amount of deemed gain that would be allocated to all partners, including taxexempt entities.25 Including tax-exempt entities within the definition of a “C corporation” (and, thus, within the scope of the Final Regulations) was viewed by the ABA as overreaching because most transfers of property by tax-exempt entities to REITs or RICs do not present the same potential avoidance of General Utilities repeal as do other transfers involving taxable corporations.26 This is because, in most cases, the tax-exempt entity would have been exempt from tax on gain recognized in connection with the sale of the property that it otherwise transfers to a RIC or REIT in a “conversion transaction.”27 The ABA noted, however, that an exception to this rule does exist in the case where gain from the sale of property by a tax-exempt entity would be characterized as unrelated business taxable income under Code Section 511.28
Changes in the Proposed Regulations
Exchanged Basis Transactions
The preamble to the Proposed Regulations acknowledges the commentators’ concerns that the Final Regulations may expose property transferred in certain “exchanged basis” transactions (i.e., like-kind exchanges and involuntary conversions) to the application of Code Section 1374 (or deemed sale treatment) despite the fact that circumvention of General Utilities repeal was not present.29 To address this concern, the Proposed Regulations provide an exception for a transfer of property by a C corporation to a RIC or REIT to the extent that the transfer otherwise qualifies for non-recognition treatment under Code Sections 1031 or 1033.30 In such a transaction, the C corporation transferor’s basis in the property it receives is determined by reference to the basis in the property it transferred (i.e., exchanged basis), and thus reflects the built-in gain. At the same time, as the preamble points out, the basis of the transferee RIC or REIT in the converted property has no relation to the C corporation transferor’s basis therein. Thus, the Proposed Regulations prevent the application of the Final Regulations to such transactions (i.e., transaction that are “exchanged basis transactions”) in part because the builtwww. bryancave.com A Broader Perspective 10 in appreciation in the asset received by the C corporation remains subject to corporate level tax and, thus, does not circumvent the purposes of the repeal of the General Utilities doctrine. The preamble notes, however, that the changes contained in the Proposed Regulations are not intended to apply to all “exchanged basis transactions.”31
Tax-Exempt Entity Transactions
Again acknowledging the commentators’ concerns, the preamble notes that the application of the Final Regulations to transactions involving tax-exempt entities only furthers the purposes of General Utilities repeal to the extent that those entities would have been subject to tax had a deemed sale election been made.32 To avoid the unintentional imposition of tax on tax-exempt entities, the Proposed Regulations amend the definition of “C corporation” to specifically exclude certain tax-exempt entities.33 “Tax-exempt entity,” for purposes of “conversion transactions” in the Proposed Regulations, means an entity described in Treasury Regulation Section 1.337(d)- 4(c)(2) that would not be subject to tax with respect to any gain (if any) resulting from a deemed sale election made pursuant to Treasury Regulation Section 1.337(d)-7(c)(5).34 Thus, where property is transferred by a partnership to a RIC or REIT, the Proposed Regulations would only apply to the extent of any gain or loss in the converted property that would be allocated to a C corporation (as defined in the Proposed Regulations) if the partnership sold the converted property to an unrelated party at fair market value on the deemed sale date.35 For example, if a partnership in which a tax-exempt C corporation is a partner transfers property to a RIC or REIT in a “conversion transaction,” and the tax-exempt entity would not have been subject to unrelated business income tax under Code Section 511 or to tax under any other provision of the Code had the partnership made a deemed sale election, the transfer would be excluded from the scope of the Final Regulations to the extent of the tax-exempt entity’s distributive share of the built-in gain or loss in the converted property.36
In addition, the Proposed Regulations also add definitions for the terms RIC, REIT and S corporations.37 While the preamble notes that the meanings of these terms are “both selfevident and unambiguous,” it explains that the Proposed Regulations add the explicit definitions for “clarification and ease of use.” Adding nothing new to the commonly used and understood definitions of RIC, REIT and S corporation, the Proposed Regulations define such terms by reference to Code Sections 851(a), 856(a) and 1361(a)(1), respectively.38
Acknowledging the concerns of the ABA and other commentators, the Proposed Regulations seek to rectify applications of the Final Regulations that unintentionally and improperly impose tax in situations where General Utilities repeal is not subject to circumvention. By specifically carving out the problematic situations from the Final Regulations, and doing so largely 11 consistent with the manner proposed by the commentators, the Proposed Regulations appear to provide an effective solution to the improper imposition of tax under the Final Regulations.