Delay Effective Date of REIT TMP Guidance

Transcription

1 OFFICERS Chair Arthur M. Coppola The Macerich Company President and CEO Steven A. Wechsler First Vice Chair Martin E. Stein, Jr. Regency Centers Corporation Second Vice Chair Christopher J. Nassetta Host Hotels & Resorts, Inc. Treasurer Jeffrey H. Schwartz ProLogis 2007 NAREIT Board of Governors Andrew M. Alexander Weingarten Realty Investors Bryce Blair AvalonBay Communities, Inc. Jon E. Bortz LaSalle Hotel Properties David M. Brain Entertainment Properties Trust John Bucksbaum General Growth Properties, Inc. Debra A. Cafaro Ventas, Inc. Richard J. Campo Camden Property Trust Richard B. Clark Brookfield Properties Corporation Gordon F. DuGan W. P. Carey & Co. LLC Michael A. J. Farrell Annaly Capital Management, Inc. James F. Flaherty, III Health Care Property Investors, Inc. Laurence S. Geller Strategic Hotels & Resorts, Inc. Randall M. Griffin Corporate Office Properties Trust Keith R. Guericke Essex Property Trust, Inc. William P. Hankowsky Liberty Property Trust Ronald L. Havner, Jr. Public Storage, Inc. Mitchell E. Hersh Mack-Cali Realty Corporation Rick R. Holley Plum Creek Timber Company, Inc. David H. Hoster II EastGroup Properties, Inc. Richard D. Kincaid Equity Office Properties Trust Charles B. Lebovitz CBL & Associates Properties, Inc. Alan M. Leventhal Beacon Capital Partners, LLC Peter S. Lowy The Westfield Group Hamid R. Moghadam AMB Property Corporation Constance B. Moore BRE Properties, Inc. Brad A. Morrice New Century Financial Corporation David J. Neithercut Equity Residential Dennis D. Oklak Duke Realty Corporation Edward J. Pettinella Home Properties, Inc. Michael E. Pralle GE Real Estate Charles A. Ratner Forest City Enterprises, Inc. Scott Rechler Reckson Associates Realty Corporation Steven G. Rogers Parkway Properties, Inc. R. Scot Sellers Archstone-Smith David E. Simon Simon Property Group Jay Sugarman istar Financial Inc. Gerard H. Sweeney Brandywine Realty Trust Robert S. Taubman Taubman Centers, Inc. C. Reynolds Thompson, III Colonial Properties Trust Garrett Thornburg Thornburg Mortgage, Inc. Thomas W. Toomey United Dominion Realty Trust Scott A. Wolstein Developers Diversified Realty Corporation Donald C. Wood Federal Realty Investment Trust Mr. Glenn Kirkland Internal Revenue Service Room Constitution Avenue, NW Washington, D.C Re: IRS Notice : Taxation and Reporting of Excess Inclusion Income by REITs, RICs, and Other Pass-Through Entities Dear Mr. Kirkland: The National Association of Real Estate Investment Trusts (NAREIT) 1 encourages the Internal Revenue Service (the Service) to develop guidance regarding the taxation and reporting of excess inclusion income of real estate investment trusts (REITs) and qualified REIT subsidiaries (QRSs) that are treated as taxable mortgage pools (TMPs) (each, a REIT TMP), as contemplated by Notice (the Notice). We appreciate the opportunity to comment on the Notice. Delay Effective Date of REIT TMP Guidance As an initial matter, NAREIT wishes to note its strong agreement with the Investment Company Institute (ICI) that the effective date of the Notice and any subsequent regulations be deferred until after appropriate computational and reporting guidance is issued, for all of the reasons set forth in ICI s comment letter dated December 29, 2006, regarding the Notice (the ICI Letter). The points made in the letter regarding the difficult problems and heavy burdens associated with retroactive application of the Notice to regulated investment companies (RICs) that own interests in REIT TMPs apply equally to REITs and to shareholders and nominees who hold REIT shares other than through RICs.We also believe that any effort to impose the Notice or any other computational and 1 NAREIT is the representative voice of United States real estate investment trusts and publicly traded real estate companies worldwide. Our members include U.S. REITs and other public businesses that own, operate, and finance income-producing real estate, as well as those firms and individuals that advise, study, and service these businesses I.R.B. 904, Nov. 13, I Street, NW, Suite 600, Washington, D.C Phone Fax

2 Page 2 reporting guidance with respect to REIT TMPs on a retroactive basis would result in significant public relations and administrative problems for the Internal Revenue Service without producing any material amounts of tax revenue. 3 The remainder of this letter sets forth NAREIT s specific comments regarding the guidance contemplated by the Notice. TMP Provisions In 1986, Congress enacted the TMP rules 4 to force the use of real estate mortgage investment conduits (REMICs) when taxpayers issue time-tranched mortgage-backed securities. 5 Because securitizing mortgage loans through a REMIC is considered, in whole or in part, as a sale of the loans for tax purposes, 6 and a REIT is subject to a 100% prohibited transactions tax on its net income from sales or other dispositions of dealer property, 7 there is a risk that any taxable gain recognized by a REIT from a REMIC securitization of loans that it has originated or purchased would be subject to the 100% prohibited transactions tax. As a result, REITs generally structure securitizations of their mortgage loans as non-remic collateralized mortgage obligation (CMO) transactions, which are classified as borrowings for tax purposes. These CMO issuances are conducted through special purpose trusts or other entities (SPEs) that are wholly-owned by the REIT and consolidated with it for federal income tax purposes. The TMP rules contain special provisions for REITs. Although an SPE formed by a REIT to issue multi-tranched, non-remic CMOs technically is subject to the TMP rules, 8 the SPE is not treated as a taxable corporation. Instead, it is classified as a QRS, which is consolidated with the REIT for federal income tax purposes and is not subject to corporate income tax. 9 Thus, the TMP rules do not subject the REIT or the QRS to corporate income tax or otherwise adversely affect the tax status of the REIT. 3 For 2004, NAREIT identified only one listed REIT generating approximately $25 million of Excess Inclusion Income. For 2005, NAREIT identified nine REITs (eight listed and one private) generating about $173 million of Excess Inclusion Income. Methodology: Excess Inclusion Income data was found from REITs' websites, press releases and annual reports. Data from SNL Financial was used to determine common shares outstanding, distribution per share, and total distribution paid for public REITs. The amount of Excess Inclusion Income was calculated by multiplying the percentage of dividends declared by the REIT to be Excess Inclusion Income by the Total Dividends Paid. 4 I.R.C. 7701(i). 5 Under the TMP rules, any entity issuing time-tranched mortgage-backed securities that otherwise would be treated as a pass-through entity for income tax purposes generally is treated as a taxable corporation. S. Rep. No. 313, 99 th Cong., 2 nd Sess. 800 (1986). The imposition of entity-level tax generally would make a securitization uneconomic for the sponsor. 6 I.R.C. 860F(b); Treas. Reg F-2. 7 I.R.C. 857(b)(6). 8 I.R.C 7701(i)(1)-(2). 9 I.R.C. 856(i); see also 7701(i)(3).

3 Page 3 However, section 7701(i)(3) 10 provides that if a REIT or a QRS is a TMP, under regulations to be prescribed by the Secretary, adjustments similar to the adjustments provided in section 860E(d) will apply to the REIT s shareholders. Section 860E(d) provides that, if a REIT holds one or more residual interests in a REMIC (each, a REMIC Residual Interest), under regulations prescribed by the Secretary, 11 the excess of the aggregate excess inclusion generated by the REMIC Residual Interests over the REIT s taxable income (within the meaning of section 857(b)(2), excluding any net capital gain) will be allocated among the REIT s shareholders in proportion to the dividends received by the shareholders from the REIT, and treated as excess inclusion in the hands of the shareholders. 12 The pass-through of excess inclusion from REMIC Residual Interests to a REIT s shareholders has the following tax consequences for the REIT s shareholders: A shareholder s share of the excess inclusion generated by the REMIC Residual Interests may not be offset by any losses or deductions otherwise available to the shareholder; 13 A tax-exempt shareholder s share of excess inclusion generally is subject to tax as unrelated business taxable income (UBTI); 14 and A non-u.s. shareholder s share of excess inclusion is subject to U.S. withholding tax at the maximum rate (30%), without being eligible for reduction under any income tax treaty that otherwise might be applicable. 15 NAREIT s Comments and Recommendations 1. Methods for Computing Excess Inclusion Generated by a REIT TMP The Notice states that a REIT TMP must calculate its excess inclusion under a reasonable method. As discussed above, the TMP rules indicate that the regulations to be issued by the 10 For purposes of this submission, section or refers to the Internal Revenue Code of 1986, as amended (Code), unless otherwise indicated. 11 These regulations have not yet been issued. See Treas. Reg E-1(b). 12 Section 860E(d) states that similar rules will apply to RICs and certain other pass-through entities that hold REMIC Residual Interests E(a)(1) E(b) G(b).

4 Page 4 Secretary should treat a REIT TMP similarly to a REMIC for purposes of calculating and allocating excess inclusion. 16 Under the REMIC rules, excess inclusion is calculated each calendar quarter and is an amount equal to the excess, if any, of: i) the total daily portions of REMIC taxable income allocable to the holder of a REMIC Residual Interest for the quarter over ii) the total daily accruals allocable to the holder. 17 A daily portion is the holder s ratable daily portion of REMIC taxable income or net loss for the quarter. 18 A daily accrual is the product of: a) the adjusted issue price of the residual interest at the beginning of the quarter multiplied by b) 120% of the longterm federal rate published by the Treasury Department (determined at the close of the quarter and properly adjusted for the length of such quarter). 19 The adjusted issue price of a REMIC Residual Interest at the beginning of any quarter is the issue price increased by the amount of daily accruals from prior quarters and decreased by any distributions made with respect to the residual interest before the beginning of that quarter. 20 Consistent with the intent of the TMP rules to treat a REIT TMP similarly to a REMIC for purposes of calculating and allocating excess inclusion, NAREIT believes that one reasonable method for calculating excess inclusion of a REIT TMP is the synthetic REMIC method. Under this approach, excess inclusion would be computed by assuming that the REIT TMP is a REMIC and that the equity interest in the TMP is comprised of two components: i) a synthetic regular interest that is entitled to all of the cash flows associated with the equity interest and ii) a non-economic residual interest. For example, if a REIT owns a QRS that is a TMP (a QRS TMP), the REIT s equity interest in the QRS TMP (excluding any bond classes that are issued by the QRS TMP and retained by the REIT) 21 would be bifurcated into a cash-flowing regular interest and a non-economic residual interest for purposes of computing excess inclusion. Under this approach, the synthetic regular interest would have an issue price equal to its fair market value at issuance, and the synthetic non-economic residual interest would have a zero issue price. 22 Consequently, all of the taxable income allocable to the synthetic non-economic residual interest would be excess inclusion because the product of the adjusted issue price of the 16 See 7701(i)(3) E(c). 18 Id E(c)(2) E(c)(2)(B). 21 Because retained bond classes are similar to retained regular interests in a REMIC, which are considered outstanding for tax purposes (see 860B(a), 860F(b)(1)), such bond classes should be treated as separate regular interests for purposes of calculating excess inclusion. 22 See PLR (Apr. 6, 1992).

5 Page 5 residual interest and 120% of the long-term federal rate would always be zero. 23 The taxable income of the synthetic REMIC for any calendar quarter would equal the income accruing on the mortgage loans and the other assets of the synthetic REMIC for that quarter minus the sum of: i) the interest and original issue discount expense accruing during the quarter on the various regular interests, which would include the bonds issued by the TMP (regardless of whether held by third-party investors or the REIT) and any synthetic regular interest; and, ii) servicing fees and other administrative expenses of the TMP accruing during the quarter. NAREIT believes that a second reasonable method for calculating the excess inclusion of a REIT TMP is the economic residual method. Under this approach, excess inclusion also would be computed by assuming that the REIT TMP is a REMIC, but the entire equity interest in the TMP would be an economic residual interest. In the case of a QRS TMP, the REIT s equity interest in the TMP 24 should exclude any bond classes retained by the REIT. 25 The issue price of the REIT s residual interest in the deemed REMIC would equal its fair market value at the time of issuance. The adjusted issue price of the residual interest in the deemed REMIC would be the initial issue price increased by income accruals at a rate equal to 120% of the long-term federal rate published by the Treasury Department (determined at the close of the calendar quarter and properly adjusted for the length of such quarter) and reduced by cash distributions made with respect to the residual interest. Under this method, the amount of excess inclusion in any calendar quarter would equal the excess, if any, of: i) the taxable income allocable to the residual interest in the deemed REMIC for the quarter over ii) the product of a) the adjusted issue price of the residual interest at the beginning of the quarter multiplied by b) 120% of the long-term federal rate published by the Treasury Department (determined at the close of the quarter and properly adjusted for the length of such quarter). The legislative history to the TMP rules could be read to support using the economic residual method rather than the synthetic REMIC method to calculate the excess inclusion of a REIT TMP. 26 However, the legislative history to the Tax Reform Act of 1986 did not anticipate the development in the REMIC market pursuant to which REMICs eventually began to issue noneconomic residual interests on a virtually exclusive basis. It would be punitive to require REITs to report substantially greater amounts of excess inclusion than similarly situated REMICs. Moreover, the legislative history to the TMP rules generally addressed situations in which the 23 The excess inclusion for any calendar quarter equals the excess, if any, of: i) the taxable income allocable to a REMIC residual interest for the quarter over ii) the product of a) the adjusted issue price of the residual interest at the beginning of the quarter multiplied by b) 120% of the long-term federal rate published by the Treasury Department (determined at the close of the quarter and properly adjusted for the length of such quarter). 860E(c). 24 The REIT s equity interest in a QRS TMP typically takes the form of a trust certificate. 25 Because retained bond classes are similar to retained regular interests in a REMIC, which are considered outstanding for tax purposes (see 860B(a), 860F(b)(1)), such bond classes should be treated as separate regular interests for purposes of computing excess inclusion. 26 See H.R. Rep. No. 841, 99 th Cong., 2 nd Sess. 240 (1986).

6 Page 6 entire REIT, rather than a portion comprising a QRS, was the TMP. As the Service acknowledges in Section 2 of the Notice, today s REITs typically engage in securitization transactions through QRSs or disregarded entities and, as a result, not all of the REIT s income is attributable to a TMP. Consequently, we believe that economic realities have changed since the 1986 legislative history and that the Service should allow the synthetic REMIC method as a permissible method for calculating the excess inclusion of a REIT TMP. Although NAREIT recommends the synthetic REMIC method as the most accurate approach for calculating the excess inclusion that likely would be produced by a REIT TMP if it were structured as a REMIC, the Service should allow either of the two methods described above to be used, at the discretion of the REIT TMP. Either of the foregoing methods should be considered reasonable so long as the chosen method is consistently applied by a particular REIT TMP. 27 Allowing a REIT TMP to choose between the synthetic REMIC and economic residual methods for calculating excess inclusion is entirely appropriate in light of the unfettered flexibility that REMIC sponsors have in structuring their REMICs to provide for either economic or noneconomic residual interests. 2. De Minimis Exclusion The Notice requests comments regarding whether there should be a de minimis exception for REITs, RICs, and other pass-through entities that have only small amounts of excess inclusion. The interim guidance in the Notice provides a de minimis rule for RICs pursuant to which a RIC generally must report information to its shareholders regarding its excess inclusion only if the RIC s excess inclusion exceeds 1% of its gross income. However, even if the RIC s excess inclusion is less than or equal to 1% of its gross income, the RIC still must report to its shareholders any excess inclusion that is allocated from REITs whose excess inclusion exceeded 3% of their total dividends for the applicable year. The 1%/3% de minimis rule for RICs set forth in the Notice is not an effective exception because REITs that have excess inclusion in most cases will have excess inclusion far in excess of 3% of their total dividends for the year. As a result, a RIC that receives any excess inclusion from a REIT generally will not be able to take advantage of the de minimis rule, but instead will be required to report at least some excess inclusion to its shareholders. NAREIT recommends that future guidance instead adopt a de minimis rule pursuant to which REITs, RICs, and other pass-through entities are not required to report excess inclusion to their shareholders or owners for a particular taxable year if the amount of excess inclusion that would be reported by a particular REIT, RIC, or pass-through entity does not exceed 1% of the total dividend or other taxable income that the entity reports to its shareholders or owners for that year. We believe that such a rule would represent an appropriate balance between the 27 Under this approach, if a REIT owns more than one QRS TMP, the QRS TMPs could adopt different computational methods so long as each QRS TMP consistently and reasonably applies its chosen method.

7 Page 7 administrative costs and burdens to taxpayers of complying with the excess inclusion rules, on the one hand, and revenue generation for the government, on the other hand. The Code and the Treasury regulations contain similar de minimis exceptions of 1% or higher. For example, a REIT may receive a de minimis amount of impermissible tenant services income with respect to a property in a taxable year without causing all of the rents received with respect to that property to be nonqualifying income for purposes of the REIT gross income tests. 28 The de minimis amount is 1% of all income received by the REIT with respect to that property for the taxable year. 29 As another example, to qualify as a REMIC, substantially all of the entity s assets must be qualified mortgages or permitted investments. 30 The statute does not define substantially all ; however, the REMIC regulations provide that a REMIC s assets will be considered to meet this requirement if the REMIC owns no more than a de minimis amount of non-permitted assets. 31 The Treasury regulations provide a safe harbor defining de minimis for this purpose as less than 1% of the aggregate adjusted bases of all the REMIC s assets. 32 Accordingly, we believe that 1% is a fair and appropriate de minimis threshold for the reporting of excess inclusion by REITs, RICs, and other pass-through entities. 3. Specific Issues Regarding Computational Items a. The REIT TMP s Initial Tax Balance Sheet When a REMIC is formed and assets are transferred to the REMIC, the REMIC receives a fair market value basis in the assets. 33 We believe that, by analogy to the REMIC rules, a REIT TMP s initial tax balance sheet for purposes of computing excess inclusion theoretically should be based on the fair market value of the TMP s assets. However, this approach would require a REIT TMP to maintain two different tax balance sheets: one for purposes of calculating excess inclusion, on which it has an initial fair market value tax basis in its assets, and one for all other tax purposes, including calculating taxable income, on which it has a carryover basis in its assets. The resulting administrative burden may be too great to justify the increased congruence between the TMP excess inclusion calculation and the amount that would have been produced if the TMP had been structured as a REMIC. In addition, if it is ultimately determined that a fair market value tax basis should be used for purposes of the excess inclusion calculation, the amount of excess inclusion in any quarter (d)(7). 29 Id D(a)(4). 31 Treas. Reg D-1(b)(3). 32 Id F(b)(2).

8 Page 8 should be limited to the amount of taxable income derived by the holder from its equity interest in the TMP (i.e., the amount of excess inclusion should not be allowed to exceed the TMP s taxable income in any period). 34 b. Non-Qualifying REMIC Assets A REIT TMP may own assets, such as hedging instruments and certain reserve funds, that would not be qualifying REMIC assets. Under the REMIC rules, a REMIC s assets generally may include only qualified mortgages and permitted investments. 35 If non-qualifying assets are included in a REMIC securitization, such assets are treated as held outside of the REMIC in a grantor trust. 36 In order to maintain consistency with the treatment of a REIT TMP as a REMIC for purposes of calculating excess inclusion, we recommend that any assets that would not be included in a REMIC (and therefore would not be included in the REMIC s excess inclusion calculations) should be similarly excluded for purposes of calculating the excess inclusion of the REIT TMP. 37 c. Transaction Fees Upon the formation of a REMIC, the related transaction expenses generally are either included in the sponsor s tax basis in the various interests in the REMIC or deducted from the amount realized on the sale of REMIC interests. 38 As a result, those expenses effectively are deductible to the extent that the sponsor sells the REMIC interests to third parties. Accordingly, those expenses are not available to the REMIC to offset excess inclusion. NAREIT recommends that, consistent with the treatment of a REIT TMP as a REMIC for purposes of calculating excess inclusion, transaction expenses incurred by a REIT TMP that would not be deductible or amortizable by a REMIC in computing excess inclusion similarly should not be deductible or amortizable by the TMP for purposes of its excess inclusion calculation. 34 Excess inclusion could exceed taxable income in situations where there is a divergence in the tax basis of the TMP s assets for purposes of computing of those two amounts D(a)(4). Outside reserve funds that are maintained to pay REMIC expenses or make payments to REMIC interest holders will not be treated as assets of the REMIC as long as the REMIC s organizational documents clearly so provide and identify which class of REMIC interest holders owns the fund. See Treas. Reg G-2(h). 36 See Treas. Reg G-2(h)-(i). 37 For example, interest rate derivatives would be excluded because they would not be qualifying REMIC assets. Excluding such derivatives from excess inclusion calculations potentially could reduce the amount of excess inclusion generated by a particular TMP to the extent that the TMP is expected to be receiving periodic payments from its derivative position (e.g., receiving payments under a cap contract). The reverse is true if the TMP is expected to be making periodic payments under the derivative (e.g., making net payments under a fixed to floating interest rate swap). 38 See Treas. Reg F-2(b)(3).

9 Page 9 4. Methods for Allocating Excess Inclusion As a general matter, NAREIT believes that excess inclusion for a taxable year should be allocated pro rata among all dividends paid by the REIT during that taxable year. This rule is consistent with Revenue Ruling 89-81, 39 which requires that distributions made to different classes of RIC shares not be composed disproportionately of dividends of a particular type. However, a few issues related to the adoption of such a general rule should be addressed in final guidance. a. Limited Use of Non-Annual Allocations We believe that, in general, excess inclusion of a REIT TMP should be allocated on an annual basis. An annual allocation rule makes sense because a REIT TMP will not know how much excess inclusion must be allocated to its shareholders for any taxable year until it determines both its total excess inclusion and its aggregate dividends (which, in turn, requires a determination of its taxable income and earnings and profits) for that year. For example, if a REIT elects to retain taxable income equal to part or all of its excess inclusion and to pay corporate income tax on that amount, 40 it is not required to allocate the retained excess inclusion to its shareholders. 41 Because the total amount of excess inclusion that is allocable to the REIT s shareholders as a result of distributions made by the REIT cannot be known with any certainty until after the end of the year, it generally would not be feasible to allocate excess inclusion to shareholders on a quarterly or other non-annual basis. Notwithstanding the foregoing, in the event that a REIT starts or stops generating excess inclusion in the middle of a particular taxable year, we believe that the REIT should have the option to allocate the excess inclusion only to dividends paid after it commences, or before it ceases, generating excess inclusion. For example, assume that, at the beginning of a particular taxable year, a REIT has in place a policy of not entering into TMP or REMIC transactions that would produce excess inclusion for its shareholders. Assume further that, on July 1, the REIT s board and management decide that, due to changes in market conditions or other circumstances, the most desirable technique currently available for financing its mortgage loans is to issue non-remic CMOs backed by the loans. Because these non-remic CMO transactions will be treated as QRS TMPs, the REIT issues a press release stating that it now intends to engage in transactions that will produce excess inclusion that will be allocable to its shareholders. This press release is designed to allow shareholders who do not wish to receive allocations of excess inclusion to sell their shares in the C.B Any retention of taxable income by a REIT that is comprised of or includes excess inclusion would, of course, be subject to the 90% distribution requirement applicable to REITs, including the rules relating to excess noncash income (see subsequent comment in this letter). 857(a), (e). 41 See 860E(d)(1).

10 Page 10 REIT. 42 However, if the excess inclusion generated by the REIT after June 30 is allocated in part to dividends paid before the REIT announces its change in policy, shareholders who wish to avoid deriving excess inclusion will not be able to do so. Consequently, we believe that a REIT that starts or stops generating excess inclusion during a taxable year should be allowed to allocate excess inclusion only to dividends paid during the portion of the year in which it produces excess inclusion. Based on the foregoing, we recommend that a REIT that has no excess inclusion generating assets (EI Assets) 43 at the beginning of a taxable year and that acquires one or more EI Assets during the year be given the option of allocating its excess inclusion for that year only to dividends with a record date on or after the date on which it first acquires an EI Asset. Similarly, a REIT that disposes of all of its EI Assets during a taxable year should have the option of allocating its excess inclusion for that year only to dividends with a record date on or before the date on which it disposes of its last EI Asset. The ability to use this optional allocation method should be contingent on the REIT paying sufficient dividends after the relevant acquisition date or before the relevant disposition date, as applicable, to cover all of the excess inclusion that is allocable to shareholders for the taxable year (excluding any income retained by the REIT and subject to corporate-level tax). We believe that this optional allocation method would allow investors the time needed to respond to changes in a REIT s excess inclusion policy without creating any potential for abusive allocations of excess inclusion. b. Allocation of Dividends to the Taxable Year For purposes of the requirement that a REIT distribute at least 90% of its taxable income each year, generally only distributions paid during the relevant taxable year are taken into account. However, dividends with declaration and record dates falling in the fourth quarter of a calendar year that are paid in January of the following year are treated as paid on December 31 of the record date year for all federal income tax purposes. 44 In addition, if a REIT declares a dividend prior to the due date of its tax return (including extensions) and distributes the dividend to its shareholders in the 12-month period following a taxable year, and not later than the first regular dividend payment date after the declaration, it can elect on its tax return to have all or a portion of such dividend be treated as having been paid in the prior taxable year, but only for purposes of the dividends paid deduction applicable to REITs The types of shareholders who might want to avoid deriving excess inclusion would include tax-exempt investors who are subject to the tax on UBTI and foreign investors who are resident in treaty countries. 43 EI Assets would include REMIC Residual Interests, equity interests in QRS TMPs, and ownership interests in other REITs and pass-through entities that own EI Assets (b)(8) (a).

11 Page 11 As a result, for purposes of the dividends paid deduction, some of the dividends actually paid by a REIT during a taxable year may be allocated to the prior taxable year, and others paid after the end of the year may relate back to the year. Future guidance should adopt a consistent rule for determining which dividends are considered attributable to a taxable year for purposes of allocating that year s excess inclusion to the REIT s shareholders. We recommend that, for reasons of consistency and ease of administration, a REIT s excess inclusion for a particular year be allocated among the dividends that give rise to the REIT s dividends paid deduction for that year. This approach would be consistent with the rule that a REIT is not required to allocate excess inclusion accruing in a particular year to its shareholders to the extent that its taxable income exceeds its dividends paid deduction for that year Mechanics of Reporting Excess Inclusion REITs that have been reporting excess inclusion information to their shareholders generally have been using one or a combination of the following methods: including the information in an annual shareholder letter or notice describing the tax treatment of the REIT s dividends; posting the information on the REIT s website; or including the information in a press release or an SEC filing (e.g. Form 8-K or 10-K). NAREIT believes that those methods are the best ones for communicating excess inclusion information to investors and recommends that REITs be permitted to elect among those methods. That approach is similar to the system currently in place for the reporting of capital gains by REITs. Under that system, REITs may provide to shareholders certain information regarding capital gains either in a written notice mailed within a certain number of days after the end of the taxable year or with the REIT s annual report. 47 REITs are already familiar with these requirements and have administrative systems and procedures in place for compliance. We do not believe that excess inclusion should be required to be reported on Form 1099-DIV. 48 Forms 1099-DIV generally are sent only to non-institutional shareholders, such as individuals E(d)(1) (b)(3)(C)-(D). 48 Any person who pays in the aggregate $10 or more in dividends to another person (other than an exempt recipient defined in note 48 below) during a calendar year generally is required to furnish a Form 1099-DIV to the recipient identifying the amount of dividends paid and any federal income tax withheld. Treas. Reg (a). Forms 1099-DIV must be furnished to recipients no later than January 31 of the year following the year in which the dividends were paid. Treas. Reg (e). 49 A Form 1099-DIV is not required to be sent to an exempt recipient. Exempt recipients include corporations, tax-exempt entities under section 501(a), individual retirement plans, U.S., state, and foreign governments, securities and commodities dealers, REITs, RICs, common trust funds, financial institutions, nominees, custodians, brokers, swap dealers, and tax-exempt trusts under section 664(c). Treas. Reg (a)(i), (c)(1)(ii).

12 Page 12 The types of taxpayers that are most likely to be affected by excess inclusion -- tax-exempt organizations, corporations with net operating losses, and withholding agents -- are exempt recipients who generally do not receive Forms 1099-DIV. 50 Moreover, adding excess inclusion information to Forms 1009-DIV also would require a costly modification to the mechanized systems for generating Forms 1099 that are used by most dividend paying agents. Consequently, we believe that it would be inappropriate and administratively burdensome to require the inclusion of excess inclusion information on Forms 1099-DIV. NAREIT recommends that, consistent with the existing requirements for the provision of REMIC Schedule Qs, on which excess inclusion is reported to holders of REMIC Residual Interests, 51 the due date for annual TMP excess inclusion reporting by REITs, RICs, and other pass-through entities that generate excess inclusion directly be set at January 31 after the end of the relevant calendar year. However, we believe that REITs, RICs, and other pass-through entities that do not generate excess inclusion directly but instead are allocated excess inclusion from other entities (such as a RIC that is allocated excess inclusion from a REIT) should have a February 15 reporting date to give such entities time to compile all information received regarding excess inclusion from the January 31 reporting date. To the extent that a reporting entity to whom excess inclusion is allocated from a pass-through entity misses its reporting date or must amend its excess inclusion reporting due to delayed reporting by the pass-through entity, such entity should not be penalized. 6. Foreign Withholding Mechanics The excess inclusion rules directly impact foreign shareholders and withholding agents by eliminating their ability to rely on reduced withholding rates provided by tax treaties to the extent that REIT dividends are treated as excess inclusion. There currently is no guidance as to how and when excess inclusion information should be communicated to withholding agents. 52 The most problematic aspect of this issue is the impossibility of knowing how much of a dividend will be characterized as excess inclusion under the general excess inclusion allocation rules at the time that the dividend is paid. To solve this problem, NAREIT recommends the existing Treasury regulations relating to withholding on capital gain dividends 53 as a model for excess inclusion withholding. We suggest that these existing rules be used as a template for both 50 Id. 51 See Treas. Reg F-4(e) 52 See Treas. Reg G-3T(b)(2) and T(b)(5) for rules regarding REMIC excess inclusion income allocated by pass-through entities to foreign persons. 53 See Treas. Reg

13 Page 13 determining the portion of a particular dividend that is treated as excess inclusion for withholding tax purposes and communicating that information to withholding agents. Under that approach, if a REIT allocates excess inclusion to dividends that have already been paid, the REIT would classify each subsequent distribution as excess inclusion for withholding tax purpose until the amounts so characterized equal the aggregate amount of excess inclusion allocated to prior dividends. 54 Thus, the allocation of excess inclusion among dividends for withholding tax purposes would differ from, and generally lag, the allocation of excess inclusion for other purposes. Excess inclusion information would be communicated to withholding agents using the qualified notice procedure set out in the applicable Treasury Regulations $1000 Threshold for UBTI Under the REMIC rules, a tax-exempt shareholder s share of excess inclusion generated by a REIT generally is subject to tax as UBTI. 56 In the Notice, the Service requested comments regarding whether the $1,000 deduction provided by section 512(b)(12) in the calculation of UBTI should be available. A related provision exempts a tax-exempt organization from the requirement to file a tax return to report UBTI if its gross UBTI for a particular taxable year does not exceed $1, NAREIT believes that both the $1,000 deduction and the $1,000 return filing exemption should be available for a tax-exempt organization to which excess inclusion is allocated. There is nothing in the Code that would indicate that either the $1,000 deduction set forth in section 512(b)(12) or the $1,000 return filing exemption would not apply to excess inclusion. Those provisions are designed to avoid the administrative costs and burdens to both taxpayers and the government that are associated with tax-exempt organizations filing returns and paying tax on de minimis amounts of UBTI. 58 The same tax policy considerations should apply in the case of excess inclusion and, therefore, we believe that both the $1,000 deduction and the $1,000 return filing exemption should be available for a tax-exempt organization to which excess inclusion is allocated. 54 See Treas. Reg (c)(2)(ii)(C). 55 See Treas. Reg (f) E(b). 57 Treas. Reg (e). 58 Both the House and Senate Reports on the Revenue Act of 1950, which added the UBTI provisions (including the $1,000 deduction), state that imposing the tax on UBTI below this $1,000 threshold would involve excessive costs of collection and payment. H.R. Rep. No. 2319, 81 st Cong., 2 nd Sess. 37 (1950); S. Rep. No. 2375, 81 st Cong., 2 nd Sess. 30 (1950).

14 Page Applying Disqualified Organization Tax to TMP Excess Inclusions The interim guidance in the Notice requires a REIT TMP to pay the tax imposed by section 860E(e)(6) on excess inclusion income that is allocable to its shareholders that are disqualified organizations. 59 As a threshold matter, we believe that there is no statutory basis under the TMP rules to impose a tax on a REIT or other pass-through entity or a nominee with respect to excess inclusion generated by a TMP that is allocable to disqualified organizations. The tax imposed on REITs, RICs, other pass-through entities, and nominees by section 860E(e)(6) is determined with reference to excess inclusion with respect to any residual interest in a REMIC. 60 Section 7701(i)(3) provides only that the Secretary may issue regulations under which adjustments similar to the adjustments provided in section 860(E)(d) will apply to REIT shareholders and does not reference the tax imposed under section 860E(e)(6). Consequently, we believe that a legislative change would be required to impose the disqualified organization tax with respect to REIT TMP excess inclusion. Such a legislative change should apply only on a prospective basis since there is no indication in prior legislative history that Congress intended to impose the disqualified organization tax on REIT TMP excess inclusion. Furthermore, in order to comply with the interim guidance in the Notice, a REIT TMP would need to identify which of its shareholders are disqualified organizations. What the Notice omits is any mechanism or procedure for allowing REITs, RICs, other pass-through entities, and nominees to identify disqualified organizations among their shareholders and owners. Virtually all shares in publicly-traded REITs are held in street name through large broker-dealers. The logistics of setting up a system to allow broker-dealer nominees to identify disqualified organizations among their customer base and to match identified customers with allocated excess inclusion amounts would be complex, costly, and time-consuming. Detailed guidance and significant lead time would be required to implement such a system. We request that any effort to apply the disqualified organization tax to REIT TMP excess inclusion be deferred until appropriate mechanical guidance can be provided. 9. Allow REIT TMPs to Dispose of Excess Inclusion Taint as REMICs Do As discussed above, NAREIT believes that REIT TMPs should be treated like REMICs for purposes of calculating excess inclusion. As a corollary to that proposition, NAREIT recommends that future regulatory guidance permit the creation of a non-economic REIT TMP residual interest that functions in the same manner, and is subject to the same requirements and 59 Section 860E(e)(6) provides that if a pass-through entity, including a REIT, owns a REMIC Residual Interest, a 35% tax will apply to the portion of any excess inclusion from such interest equal to the percentage of the passthrough entity s stock held by disqualified organizations. Disqualified organizations include federal, state, and foreign governmental entities, international organizations, any agency or instrumentality of a governmental entity (including state pension plans) or an international organization, certain tax-exempt organizations that are exempt from the tax on unrelated business taxable income, and rural electric and telephone cooperatives. 60 See I.R.C. 860E(c)(1).

15 Page 15 restrictions on transferability, as a non-economic REMIC Residual Interest. 61 Those requirements and restrictions would assure that the holders of REIT TMP residual interests, like holders of REMIC Residual Interests, could not avoid paying federal income tax on the excess inclusion generated by such interests. In addition, it would be necessary to clarify that the creation of such a non-economic residual interest does not prevent the TMP from being treated as a QRS of the REIT. 62 We believe that the Treasury Department and the Service have sufficiently broad regulatory authority under section 7701(i)(3) to issue such guidance. With a non-economic REIT TMP residual interest, a REIT would be able to dispose of the excess inclusion taint in the same manner that most REMIC sponsors do: by paying an inducement fee to the purchaser of the non-economic REMIC Residual Interest. This mechanism would provide flexibility to REITs who do not want the administrative burden of calculating excess inclusion and allocating and reporting it to their shareholders. Assuming that appropriate guidance is issued, we expect that most mortgage REITs would adopt this mechanism for dealing with excess inclusion. 10. Clarify that REIT TMP Excess Inclusion Income is Excess Non-Cash Income Under Section 857 NAREIT requests a clarification that excess inclusion of a REIT TMP is excess noncash income within the meaning of section 857(e). Each taxable year, a REIT must distribute dividends (other than capital gain dividends and deemed distributions of retained capital gain) to its shareholders in an aggregate amount at least equal to the sum of i) 90% of its REIT taxable income (computed without regard to the dividends paid deduction and net capital gain) and ii) 90% of its after-tax net income, if any, from foreclosure property, minus its excess noncash income If a REMIC residual interest is transferred to a disqualified organization, the transferor is subject to a tax at the highest corporate income tax rate on the amount equal to the present value of the total anticipated excess inclusions from the time of the transfer. 860E(e). In addition, a transfer of a REMIC residual interest that has tax avoidance potential will be disregarded for tax purposes if the transferee is a foreign person. Treas. Reg G-3(a). Finally, any transfer of a non-economic REMIC residual interest is disregarded for all federal income tax purposes if a significant purpose of the transfer was to enable the transferor to impede the assessment or collection of tax. Treas. Reg E-1(c)(1). This significant purpose will exist if the transferor, at the time of the transfer, either knew or should have known that the transferee would be unwilling or unable to pay taxes due on its share of the REMIC s taxable income. Id. The Treasury regulations provide safe harbors under which the transferor is presumed not to have such improper knowledge. Treas. Reg E-1(c)(4)-(5). 62 A REIT must own 100% of the equity interests of a corporation for it to be treated as a QRS. See 856(i)(2). In order to prevent corporate income taxation of the related securitization, it is critical that a QRS TMP in fact qualify as a TMP. As a result, the regulatory guidance should expressly provide that a non-economic REIT TMP residual interest is not treated as stock of the QRS for this purpose (a)(1)(B).

16 Page 16 As a result, although items of excess noncash income are included in a REIT s gross income, they are deducted from the amount that a REIT must distribute in order to satisfy the 90% distribution requirement. Among other items, excess noncash income includes excess inclusion from REMIC Residual Interests, that exceeds any actual cash distributions received by the REIT from the REMIC Residual Interests. 64 Congress enacted the excess noncash income provision in recognition of the fact that these sources of income in effect are phantom income (i.e., no equivalent cash is received) and, consequently, a REIT may not have sufficient cash on hand to pay dividends based on those amounts. 65 The same tax policy considerations that support treating excess inclusion from REMIC Residual Interests as excess noncash income apply to excess inclusion from TMPs. The Treasury Department and the Service have broad regulatory authority under the specific delegation of section 7701(i)(3). That authority should be exercised to create a reasonable and administrable reporting system and to resolve the host of uncertainties surrounding the application of the REIT TMP excess inclusion rules. Sound administration of the federal tax system, including principles of fairness, adequate notice, and cost-effectiveness, supports deferring the application of the Notice until appropriate guidance can be issued. We appreciate the opportunity to express our views on the best methods of resolving these complex issues. Please contact me or my colleague, Dara Bernstein, if we can provide you with any additional information regarding the various issues or our views with respect to them. Respectfully submitted, Tony M. Edwards Executive Vice President & General Counsel cc: Lon B. Smith Associate Chief Counsel (Financial Institutions & Products) Internal Revenue Service Clarissa Potter Deputy Chief Counsel Internal Revenue Service (e)(2)(C). 65 See S. Rep. No. 313, 99 th Cong., 2 nd Sess. 780 (1986).

17 Page 17 Michael Desmond Tax Legislative Counsel Department of the Treasury Michael Novey Associate Tax Legislative Counsel Department of the Treasury William Coppersmith Branch Chief, Financial Institutions & Products Internal Revenue Service Alice Bennett Branch Chief, Financial Institutions & Products Internal Revenue Service Anna Kim Attorney, Financial Institutions & Products Internal Revenue Service