The Internal Revenue Service (the “IRS”) released Revenue Procedure 2018-43 (“Rev. Proc. 2018-43”) in mid-September regarding the treatment of certain items of income from foreign subsidiaries of real estate investment trusts (“REIT’s”) for purposes of the REIT income qualification tests under Sections 856(c)(2) and 856(c)(3) (respectively, the “95% gross income test” and the “75% gross income test” and together the “REIT Income Tests”) of the Internal Revenue Code (the “Code”). This provides welcome certainty as to how global intangible low-taxed income (“GILTI”)—a new category of non-U.S. source income for U.S. shareholders of “controlled foreign corporations”, which was added by the Tax Cuts and Jobs Act of 2017 (“TCJA”)—is to be taken into account for purposes of the REIT Income Tests.
Frequently, U.S. REITs own subsidiaries treated as “taxable REIT subsidiaries” (each a “TRS”). A TRS is subject to tax at the corporate level and serves as a “blocker” for income that would not be good REIT income for purposes of the REIT Income Tests if paid directly to the REIT.
TRSs that are foreign corporations (or treated as such for U.S. tax purposes) are also subject to the U.S.’s international tax regime. That regime includes the Subpart F rules governing controlled foreign corporations (“CFCs”), the passive foreign investment company (“PFIC”) rules, and, after the TCJA, the GILTI rules form parts of this regime.
Very generally, the Subpart F rules relate to any CFC at least 50% of the shares of which (determined by vote or value) are owned, directly or indirectly, by one or more U.S. persons each of which owns at least 10% of its shares (each a “U.S. Shareholder”). The Subpart F rules, under certain circumstances, require the income of a CFC to be included (“Subpart F Income”) in the incomes of its U.S. Shareholders.
Somewhat similarly, the PFIC rules require income inclusion for all U.S. persons owning PFIC shares -- PFICs being foreign corporations the income of which is predominantly passive income or the assets of which are predominantly devoted to the production of passive income. More specifically, PFIC income may be included in the incomes of U.S. persons owning PFIC shares using a variety of methods, including (i) where the PFIC has made an election (a “QEF Election”) to calculate and report its annual net earnings and net capital gains, and (ii) where PFIC shares are marketable and an election of the U.S. person has been made to mark its PFIC shares to market for U.S. tax purposes (a “Mark-to-Market Election”).
As set forth in the statute and regulations, the REIT Income Tests do not explicitly address how Subpart F income or PFIC inclusions are to be treated. In multiple private letter rulings, however, the IRS has construed the REIT Income Tests by treating Subpart F inclusions and PFIC inclusions to U.S. shareholders as qualifying income for purposes of those Tests. The new GILTI provisions raise a similar question for U.S Shareholders of CFCs. Broadly, GILTI is excess of CFC income over what is deemed to be the CFC’s return (10%) on its investment in its tangible business assets. For U.S. tax purposes, GILTI is treated as realized by the CFC’s U.S. Shareholders. Again, the REIT Income Tests failed explicitly to address how this additional measure of income should be treated introducing new uncertainty. Accordingly, the IRS received requests from practitioners for definitive guidance. In response, Rev. Proc. 2018-43 was issued.
Rev. Proc. 2018-43 clarifies the IRS’s position on the treatment of several types of foreign income for purposes of the REIT Income Tests.
- Subpart F Income is treated as qualifying income under the 95% gross income test. However, this treatment does not apply to inclusions under the TCJA’s new transition tax provided for in Section 965 of the Code.
- Inclusions under the PFIC rules by reason of a QEF Election or a Mark-to-Market Election are treated as qualifying income under the 95% gross income test.
- GILTI inclusions are treated as qualifying income for purposes of the 95% gross income test.
- In addition, foreign currency gains on distributions by foreign subsidiaries of previously taxed income are not treated as gross income for purposes of both the 75% and 95% gross income tests.
Rev. Proc. 2018-43 is effective for tax years beginning after September 13, 2018 but may be applied by REIT’s to all prior years.