On December 18, 2015, Congress passed the “Protecting Americans from Tax Hikes Act of 2015” (the “Act”), which provides significant reforms to the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”) and to the rules applicable to real estate investment trusts (“REITs”).
Under FIRPTA, non-U.S. persons are subject to U.S. federal income and withholding tax on the disposition of a U.S. real property interest (“USRPI”), which includes U.S. real estate and interests in a U.S. real property holding corporation (“USRPHC”), as well as capital dividends from a REIT (to the extent attributable to gain from the disposition of a USRPI by the REIT). Generally, a USRPHC is a domestic corporation in which the fair market value of its USRPIs is equal to at least 50 percent of the fair market value of its total assets. A REIT (other than a “domestically controlled” REIT, as defined below) will constitute a USRPHC, and the sale or other disposition of the REIT shares will thus generally be subject to FIRPTA.
1. Foreign Pension Funds
Foreign pension funds are currently subject to U.S. tax on gain realized from the disposition of a USRPI pursuant to FIRPTA. Under the Act, “qualified foreign pension funds” are exempt from FIRPTA tax and withholding on the disposition of a USRPI (whether directly or through one or more partnerships). A foreign pension fund will qualify for this rule if it (i) is established to provide retirement or pension benefits, (ii) has no single participant or beneficiary with a greater than 5 percent interest, (iii) is subject to government regulation reporting requirements, and (iv) is eligible under applicable foreign law for tax benefits on either contributions or its investment income.
2. FIRPTA Withholding Tax Rate
A non-U.S. person who disposes of a USRPI (including certain redemptions by and liquidations of USRPHCs and certain distributions by partnerships and other pass-through entities) is currently subject to withholding on 10 percent of the gross proceeds, unless an exemption applies. Under the Act, effective for dispositions occurring 60 days after the date of enactment, the withholding rate is generally increased to 15 percent of the gross proceeds.
3. Publicly Traded Stock Exception
Foreign shareholders who own 5 percent or less of the stock of a publicly traded company are generally exempt from FIRPTA tax and withholding. Under the Act, in the case of a publicly traded REIT, the ownership percentage threshold for purposes of this exception to FIRPTA is increased to 10 percent.
4. Domestically Controlled REIT
A domestically controlled REIT is not subject to FIRPTA. A REIT is treated as domestically controlled if less than 50 percent of the REIT’s shares are held, directly or indirectly, by foreign persons. Under current law, it was often difficult for publicly traded REITs to take advantage of this exception because of the lack of information necessary to determine the ownership of both small and indirect shareholders. Under the Act, a publicly traded REIT may presume that a person who holds less than 5 percent of the REIT’s shares is a U.S. person unless the REIT has actual knowledge to the contrary. In addition, REIT shares that are held by a publicly traded REIT or regulated investment company (“RIC”) are treated as held by a U.S. person if the REIT or RIC shareholder is itself domestically controlled. If a REIT or RIC shareholder is not publicly traded, then the stock ownership of the lower tier REIT is determined based upon the proportionate ownership of the REIT or RIC shareholder.
5. FIRPTA Cleansing Rule
Under current law, FIRPTA does not apply to a disposition of a corporation if (i) as of the date of disposition, the corporation did not hold any USRPIs and (ii) all of the USRPIs held by such corporation during the shorter of the shareholder’s holding period or the last five years were disposed of in a transaction in which the full amount of gain was recognized. Under the Act, a corporation that is (or was during the relevant testing period) a REIT or a RIC is not eligible for this cleansing rule.
A REIT is generally not subject to corporate level tax on its income as a result of the dividends paid deduction allowed to a REIT. In order to qualify as a REIT, an entity must satisfy a number of tests and requirements, including certain income and asset tests. REITs often own taxable REIT subsidiaries (“TRSs”) that are taxed as C-corporations, thereby allowing the REIT to indirectly hold assets and earn income that might otherwise prevent the REIT from satisfying the REIT income and asset tests.
1. Limitation on REIT Spin-Offs
The Act limits tax-free REIT spin-offs to transactions in which both the distributing and controlled corporations are REITs. In addition, neither a distributing nor a controlled corporation can elect to be treated as a REIT for 10 years following a tax-free spin-off transaction. Thus, the Act would prevent the use of “Opco/Propco” spinoffs through which a corporation with appreciated real estate could avoid corporate level tax on the appreciated real estate by spinning off a newly formed “Propco” subsidiary that would immediately make a REIT election and lease back the real estate to the “Opco.”
2. Taxable REIT Subsidiaries Limitation
Under the REIT asset test, the securities of one or more TRSs may not comprise more than 25 percent of a REIT’s gross assets. Under the Act, effective for tax years beginning after December 31, 2017, the maximum amount of TRS securities as a percentage of a REIT’s total assets will be 20 percent.
3. Expansion of Prohibited Transaction Safe Harbor
A REIT is subject to subject to a 100 percent tax on its net income arising from “prohibited transactions” which includes sales of real estate assets held for sale to customers in the ordinary course of its business, (i.e., dealer property). However, a safe harbor exception currently applies if, among other requirements, the amount of property sold during the year does not exceed 10 percent of the amount of all of the REIT’s assets as of the beginning of the tax year. The Act expands this requirement by establishing an alternative three-year averaging safe harbor for determining the percentage of assets that a REIT may sell annually and which also allows the sale of real property held for sale to customers to constitute up to 20 percent of the amount of a REIT’s assets in the applicable year.
4. Preferential Dividend Rules
A special set of rules applies to “preferential dividends” (i.e., dividends that are not distributed pro rata with respect to each share in a class). The Act repeals the preferential dividend rules for publicly offered REITs, i.e., REITs required to file annual or periodic reports with the SEC under the Securities Exchange Act of 1934. Although the Act does not repeal the “preferential dividend” rule with respect to non-publicly offered REITs, the Act provides the U.S. Department of the Treasury and the IRS with regulatory authority to allow such REITs to cure failures to comply with the preferential dividend rule in certain cases in lieu of treating the dividend as not qualifying for the REIT dividend deduction and as not counting towards the 90 percent of REIT income distribution requirement.
5. Debt Instruments of Publicly Offered REITs
The Act provides that, for tax years beginning after December 31, 2015, the REIT asset test will include unsecured debt instruments issued by publicly offered REITs if the value of those debt instruments does not exceed 25 percent of the gross asset value of the REIT. However, interest from, and gain on the disposition of, such debt instruments will not be treated as qualifying income for purposes of the REIT income test.
6. RIC and REIT Dividend Received Deduction Limitation
Under current law, a U.S. corporation is entitled to a dividend received deduction on dividends received from certain foreign corporations if such dividends arose from another corporation whose income was subject to U.S. tax. The Act provides that for purposes of determining whether dividends received from a foreign corporation are eligible for a dividend received deduction, dividends attributable to RICs and REITs are not treated as dividends from corporations that have already been subject to U.S. tax.