Selected US Tax Developments

Transcription

1 canadian tax journal / revue fiscale canadienne (2009) vol. 57, n o 4, Selected US Tax Developments Co-Editors: Sanford H. Goldberg* and Peter A. Glicklich** A Brief History of US REITs Scott L. Semer** At a time when Canada is dealing with the potential demise of domestic income trusts other than real estate investment trusts (reits), it seems particularly appropriate to consider the us reit rules, how us reit structures have developed over time as those rules have changed, why certain foreign investors find investment in us real estate through reits particularly attractive (even in light of some rather restrictive positions taken by the Internal Revenue Service), and areas in which technical guidance is expected soon. Keywords: REIT n tax n tax policy n united states n internal revenue code n income trusts C o n t e n t s Introduction 960 REIT Qualification and Taxation 963 UPREITs 965 Taxation of Non-US Shareholders 967 Conclusion 971 Introduction The development of public real estate investment trusts (reits) in the United States served, implicitly, two related financial goals. First, reits permit small, noninstitutional investors to invest in us real estate and diversify their portfolios by adding a new class of asset, and to diversify easily within that class. Second, reits provide access to a previously untapped source of capital to real estate principals and developers. From a tax perspective, reits allow the first goal to be pursued in a tax-efficient manner without the imposition of a corporate-level tax (provided that various, and sometimes overly stringent, technical rules are followed by the reit). Without being able to avoid the corporate-level tax, reits would be unattractive for public investors, compared with other potential means of investing in real estate, * Of Roberts & Holland LLP, New York and Washington, DC. ** Of Davies Ward Phillips & Vineberg LLP, New York ( ssemer@dwpv.com). 960

2 selected us tax developments n 961 such as non-corporate private real estate partnerships. reits also allow real estate principals to diversify their portfolio in a tax-efficient manner by utilizing an umbrella partnership structure (an upreit ) that allows partners to defer the recognition of gain when they exchange their interest in a single piece or portfolio of real estate for an interest in the entire portfolio of a reit. reits have also fostered investment in us real estate by non-us institutional investors, by providing two specific tax advantages. First, owing to the requirement that reits earn passive income from real estate, reits earn rental income (or mortgage interest in the case of mortgage reits) and convert this income to dividends paid out to their shareholders. While the normal treaty rates applicable to dividends usually do not apply to reits (because of the absence of any entity-level taxation at the reit level), many us tax treaties have reduced rates that apply to small holders of reits that own a diversified real estate portfolio. In addition, dividends from reits are typically eligible for the zero rate provided in many treaties to non-us tax-exempt entities and pension plans as, for example, under article xxi of the us-canada tax treaty. 1 Similarly, non-us governmental investors, such as sovereign wealth funds and governmental pension plans, are eligible for an exemption from withholding tax on the receipt of dividends from reits as long as they do not own a controlling interest in the reit. 2 reits thus convert passive rental income, which would normally be taxed at a punitive 30 percent rate applied to the gross amount of the rental payment (unless an election is made to voluntarily treat the rental income as income from an active trade or business) into dividends that are either free of withholding tax, for tax-exempt investors in treaty countries and foreign governmental investors, or subject to reduced rates, for other investors in treaty countries. The second tax advantage that reits provide to non-us investors is the rare opportunity to escape the tax normally imposed on gains realized by a non-us person with respect to us real estate, whether the gains are realized directly or by selling shares of a us real property holding corporation (usrphc). If a reit is domestically controlled meaning that a majority of the shares of the reit are owned by us persons a sale of shares of the reit held by a non-us shareholder is generally not subject to tax. Moreover, this benefit is not limited to investors located in a treaty jurisdiction. Where a significant part of the return of an investment in us real estate is expected to arise from appreciation in the value of the asset realized only upon the sale of the asset, this is a significant benefit not readily available in any other form of us real estate investment. 1 The Convention Between the United States of America and Canada with Respect to Taxes on Income and on Capital, signed at Washington, DC on September 26, 1980, as amended by the protocols signed on June 14, 1983, March 28, 1984, March 17, 1995, July 29, 1997, and September 21, 2007 (herein referred to as the US-Canada tax treaty ). 2 The exemption is available under section 892 of the US Internal Revenue Code of 1986, as amended (herein referred to as the Code ).

3 962 n canadian tax journal / revue fiscale canadienne (2009) vol. 57, n o 4 With the development of private reits that are not publicity traded, reits have also become a tax-efficient structure to use for joint ventures investing in us real estate where it is possible to have a majority of the reit held by one or more us joint venture participants, or where multiple foreign governmental investors are together making an investment in real estate and no single one of them will take a majority position in the investment. There are essentially two prices or tradeoffs necessary to secure the tax advantages available to a non-us investor in real estate by utilizing a reit. The first is to make sure that the reit is controlled by us persons so that the reit will be considered to be domestically controlled. The second is the need to comply with the relatively reasonable but sometimes needlessly confusing and restrictive reit qualification rules, which essentially reduce to the cardinal rule that the reit earn passive rental income or passive interest income from mortgages on real property. From a policy perspective, though never stated explicitly, the passive income requirement ensures that non-us investors cannot use the advantages of a reit to compete with a us business, and thus can be said to be consistent with capital import neutrality. The domestic control exemption also provides an incentive to foreign investors in us real estate to let the real estate be controlled by us investors by providing an exception from tax on gains only for domestically controlled reits, and thus can be thought to be either nakedly protectionist or to support, in an appropriately corralled fashion, capital import neutrality from the perspective of investors. By reducing or exempting dividends from the usual withholding tax applicable to passive rental income, the taxation of non-us investors in reits is also consistent with the growing international trend toward territorial taxation, while maintaining, to the extent possible, the tax base associated with investment in us real estate (with respect to the controlling domestic investors). By restricting the complete elimination of withholding to investors that are tax-exempt (either because they are tax-exempt investors or pension plans entitled to benefits of treaties or because they are foreign governmental investors entitled to the exemption provided by section 892 of the Code), these benefits are also consistent with the policy of capital export neutrality; that is, foreign tax-exempt investors who could invest passively in real estate in their local country without being subject to tax can make the same investment in us real estate, and the decision of where to invest can be based on investment factors rather than tax efficiencies. us real estate can then compete for investment dollars from these investors on an equal footing, taking us back to one of the principal advantages that led to the creation of reits in the first place, that of providing an additional capital source for us real estate. The rest of this article will look, briefly, at how the rules with respect to reits have developed to support these policies, and will demonstrate how one relatively recent development, implemented by the us Internal Revenue Service (irs), rather than through congressional action like the other reit developments chronicled here, is at odds both with these implicit policy goals and with sound tax administration generally. It is hoped that this discussion will prove useful to investors, lawyers, and analysts looking at both how investments into the us real estate market can be

4 selected us tax developments n 963 structured and how a reit tax system can be designed to pursue certain fundamental tax policy goals. 3 REIT Qualification and Taxation Although not taxed on a passthrough basis, reits avoid being subject to corporatelevel tax by getting a deduction for dividends paid to their shareholders. In this respect, the reit taxing regime functions as a extremely efficient means to integrate the corporate and individual income taxes to the extent that the corporate tax is viewed as a means of ensuring that taxpayers do not avoid taxation at the individual level by earning money in a corporation and deferring the distribution of that money by the corporation. A reit is not generally a passthrough entity. Distributions that are attributable to ordinary income earned by the reit are treated as dividend income, and deductions and income are calculated at the reit level and do not flow through to the reit s shareholders. There is a limited passthrough for distributions made by a reit attributable to capital gains, to the extent that the reit elects to treat the distribution as a capital gain dividend, in which case individual shareholders are eligible for the reduced rates applicable to capital gains. For non-us shareholders, a more amorphous passthrough rule applies. Under section 897(h)(1) of the Code, any distribution attributable to a sale of a us real property interest (usrpi) by the reit is subject to tax as gain realized by the foreign shareholder from a sale of a usrpi. This gain is generally not eligible for reduction under us income tax treaties and is not exempt for foreign governmental investors under section 892 of the Code. There are no specific regulations or official guidance regarding whether, and to what extent, a distribution is to be treated as attributable to a sale of a usrpi by the reit. In order to qualify as a reit, and so be able to deduct dividends paid to its shareholders, a reit needs to satisfy various requirements, which can be roughly divided into formal requirements, income requirements, and asset requirements. In general, these requirements are designed to ensure that a reit earns passive income from investing in real estate though many of the requirements are anachronistic formalities originally adapted from other areas of the Code that have no particular relevance to any implicit or explicit policy goal. 4 Indeed, it is possible to wonder why the reit rules should be limited to entities that earn passive income, or even why they 3 This article focuses on property-owning REITs, both for convenience and because, in the past, US REITs have typically been used by non-us investors more to facilitate investment in property than investment in mortgages. However, much of what is said here is also applicable to mortgage REITs, which, like property-owning REITS, are restricted to (more or less) passive investment in mortgages (with any origination activity conducted in a taxable REIT subsidiary subject to tax in the same manner as any other mortgage originator). 4 This article focuses on only one of these requirements the requirement to earn passive income, such as rent from real property. For a more detailed discussion, see Scott L. Semer and Michele J. Alexander, Structuring Real Estate Joint Ventures with Private REITs, Tax Management Portfolio no. 743 (Arlington, VA: Bureau of National Affairs, 2009).

5 964 n canadian tax journal / revue fiscale canadienne (2009) vol. 57, n o 4 should be limited to income from real estate, given that the reit mechanism of the dividends-paid deduction and the requirement of current distributions is such an efficient means of integrating the corporate and individual income taxes, and works much better than the reduced rate of tax currently applicable to dividends paid by non-reit corporations, regardless of how long those corporations have waited to distribute their earnings or how much tax those corporations have paid at the corporate level. Nevertheless, although there are good arguments for making the reit taxing regime more broadly available, there has so far been no push to do so, and most countries that have created a reit tax regime have restricted its ambit to (more or less) passive investment in real estate. In order to qualify as a reit, a property-owning reit needs to earn 95 percent of its gross income from passive sources such as rents from real property. Thus, with a few limited exceptions, a reit cannot be in the business of being a dealer in (for example, a regular seller of ) property, such as a condominium developer, or in the business of providing services to customers. This latter prohibition creates particular problems in the case of properties like hotels or health-care facilities (such as an assisted living facility), where what a customer/tenant is paying has some of the qualities of rent but also some of the qualities of a payment for services. Originally, reits had to deal with this problem by master leasing the entire facility to an independent tenant, who then paid good rental income to the reit. The master tenant then contracted directly with the public customer/tenant. While the master tenant could pay rent to the reit based on its gross rental income, it was prohibited from paying rent based on its net profits, to avoid allowing the reit to do indirectly what it cannot do directly. Thus, the independent tenant had to assume both some level of economic exposure to the profitability of operating the property as well as control of the property. reits originally attempted to avoid this difficulty by creating paired share structures. In these structures, the reit and the corporate entity that owned the master tenant and operated the hotel property would issue shares that were stapled together and could only be bought and sold as a pair. Congress eliminated this structure in 1984 by enacting section 269b of the Code, which requires any stapled entities to be considered together for purposes of determining whether either entity is a reit. Thus, in a paired structure, the activities of the operating entity would prevent the investment entity from qualifying as a reit. In 2001, Congress created the taxable reit subsidiary structure to make it easier for hotel reits to have more control over their property. Instead of needing to find an independent tenant, these rules permit a reit to lease a qualified lodging facility to a taxable reit subsidiary (trs), which is an entity that is owned by the reit but is subject to tax as a corporation. The trs cannot operate the property directly but instead needs to hire an eligible independent contractor to manage the hotel. The independent manager can be paid a straight management fee, and the trs retains the ability to fire and replace the independent manager, giving the reit and its trs much greater direct control of the property, while still preserving the reit s role as a passive investor that does not conduct an active business.

6 selected us tax developments n 965 In 2008, the benefits of the trs structure were extended to qualified healthcare properties so that reits owning such properties could utilize the same beneficial structure used by lodging reits. However, other than the somewhat generic list provided in section 856(e)(6)(d)(ii) of the Code, there is no particular guidance defining the limiting parameters of what constitutes a health-care facility. There is also no clear guidance as to whether one of the most popular forms of retirement community mixed-use campuses that consist of assisted living residents, independent living residents, and residents needing more significant care because they suffer from Alzheimer s or other memory-related disorders constitute qualified healthcare properties or whether reits that own such properties still need to master lease them to an independent tenant (assuming that they can find one). UPREITs One of the main benefits of reits listed above, allowing owners of real estate to diversify their portfolios in a tax-efficient manner, became possible only with the development of the upreit. 5 An upreit structure is intended to combine the beneficial features of a reit with those of a partnership. An upreit is a reit that owns all of its property through a partnership. The partnership, often referred to as the operating partnership or op, is owned in part by the reit and in part by third parties usually some of the previous owners of the properties. Normally, an owner of real estate can borrow on a non-recourse basis against the appreciated value of the property without paying current tax on the appreciation in value. 6 Although the taxpayer obtains the benefit of the value of the property, the borrowing is not treated as a realization event because of the corresponding obligation to pay the money back to the lender. When a taxpayer has property subject to a liability, and the amount of the liability exceeds the taxpayer s basis, the taxpayer can structure a contribution of the property to a partnership so that no tax is incurred by the contributing partner. This is done by making sure that the partnership allocates sufficient liabilities to the partner so that the partner is not considered to have received a deemed distribution by virtue of shifting the liabilities on the contributed property to other partners. Ensuring that the partnership allocates liabilities to the contributing partner maintains the obligation to repay the money owed to the lender that justified not treating the original borrowing as a realization event (or justified allowing the contributor of the property to take depreciation deductions with respect to basis attributable to borrowed funds). When the partnership subsequently 5 For a more technical discussion of UPREITs, see ibid., at paragraph IV(B), from which this discussion is adapted. 6 Borrowing on a non-recourse basis essentially comprises two transactions: a monetization of the appreciation in the value of the property, and a hedging of any future downside risk below the amount of the borrowing.

7 966 n canadian tax journal / revue fiscale canadienne (2009) vol. 57, n o 4 realizes gain on the property by disposing of the property (or uses the property to pay off the debt), the resulting gain is allocated to the contributing partner. 7 In a reit, by contrast, there is no mechanism to allocate liabilities or any unrecognized pre-contribution gain to the contributing shareholder. There is therefore no mechanism to ensure that the shareholder faces a gain recognition event when the liability associated with contributed property is paid off. Moreover, when the reit ultimately recognizes the pre-contribution gain, the immediate tax consequences will be borne equally by all shareholders when the reit either pays tax at the reit level or distributes the gain to its shareholders via the payment of a deductible dividend. Generally, sharing of pre-contribution gain is allowed in the case of a contribution of appreciated property to a corporation, including a reit, owing in part to the fact that the shareholder who contributed gain property will have a lower basis in its shares and will therefore, in most circumstances, eventually bear the tax consequences at the individual tax level of the gain that accrued while the shareholder was the owner of the property. However, while the us tax system at times allows deferral of monetized gains and at times allows a partial sharing of the tax consequences of gains or losses without immediate tax consequences, it generally does not allow both with respect to the same gains or losses. Thus, a shareholder making a contribution to a corporation, including a reit (which lacks a mechanism to allocate pre-contribution gain or particular liabilities to particular shareholders), is generally required to recognize gain to the extent that the amount of liabilities assumed by the corporation exceeds the shareholder s basis in the contributed property. As a consequence, a reit cannot be used by an investor to achieve the same kind of tax deferral by contributing property to the reit as can be accomplished by contributing the property to a partnership. By combining the reit with a partnership, however, an upreit is able to offer an ability to contribute property tax-free, even when the property is subject to liabilities that exceed the property owner s basis in its property. By allowing the property owner to contribute the property to a partnership through which all of the reit s properties are held, the property owner can take back partnership interests instead of reit shares. An upreit also allows a reit to continue to acquire property in taxfree transactions after the formation of the upreit in a manner that is tax-free to the owners of the property, who would otherwise not be able to make a tax-free contribution to the reit (because, for example, they would not satisfy the necessary control requirements applicable to tax-free contributions to corporations). An upreit also allows a foreign owner of real estate to enter into a joint venture with us participants in a tax-free manner. If the foreign owner contributed property directly to a reit, the transaction would not be tax-free if the reit was domestically controlled, since the foreign partner would be exchanging a usrpi for something 7 Code section 704(c) and Code reg. section also cause the taxpayer to effectively recognize a portion of this pre-contribution gain by allocating depreciation deductions to partners who have contributed other assets to the partnership and away from the contributing partner.

8 selected us tax developments n 967 that was not a usrpi and would therefore be subject to tax under section 897(e)(1) of the Code. The use of an upreit can avoid this problem, since the foreign partner can continue to hold a usrpi its interest in the upreit partnership 8 so that nonrecognition on the contribution is potentially available. 9 For the upreit to work properly from an economic perspective, it is necessary to make partnership interests as equivalent as possible to reit shares. If partnership units and reit shares were not economically equivalent, the reit and the other partners of the operating partnership would have divergent interests and goals with respect to the property owned by the partnership, since each would seek to maximize the value of its particular claims to the property. Given that the reit is typically the controlling partner in the partnership, a contributor to the partnership would be at a great disadvantage and would be reluctant to make a contribution. The property owner would then be faced with the choice of either protecting its economic interest by exchanging its property for interests in the reit in a taxable transaction, or engaging in a tax-deferred transaction by contributing the property to the partnership and being put at a potential economic disadvantage. The upreit eliminates the need for a property owner to make this choice, but only if partnership units and reit shares are economically equivalent. A well-designed reit system could, in theory, eliminate the need for the upreit structure by modifying the rules applicable to tax-free contributions to a reit. Rather than rules applicable to regular corporations, rules similar to those that apply to partnerships could be used. One objection might be that it would be difficult for a reit to allocate liabilities and gains associated with a particular property to a particular shareholder, and for a tax system to impose a tax on a deemed distribution to the shareholder when those liabilities are paid off. However, a reit that is the general partner of an upreit has to perform these mechanics for the partnership, and this has not proven to be administratively impracticable. For a private reit, at least, such a system would certainly be possible; for a public reit, it might be unworkable, because all reit shares would then no longer be fungible though this difficulty could be resolved by having a special class of shares issued only to shareholders who contribute property subject to the special partnership-type rules. Ta x ation of Non-US Shareholders Because a reit is not subject to tax to the extent that it distributes its income through deductible dividends, most us treaties now provide that the treaty s lowest rate of withholding for dividends often a zero rate does not apply to dividends paid by reits. Such dividends will then normally be subject to the 30 percent rate applicable to dividends paid by us corporations. This is still a lower burden than 8 See Code reg. section T. 9 See Code reg. section T(a)(1). Pursuant to Notice 89-57, CB 698, the foreign contributor needs to either obtain a withholding certificate or provide a notice of nonrecognition to the partnership, which is then submitted by the partnership to the IRS.

9 968 n canadian tax journal / revue fiscale canadienne (2009) vol. 57, n o 4 applies to a foreign shareholder investing in a us corporation, which will normally pay tax at a 35 percent rate, and will still be subject to some level of withholding tax in respect of dividends paid to non-residents (30 percent or a lower treaty rate). However, for individual shareholders who own less than a specified percentage of a reit, for any owner of less than a specified percentage typically 5 percent of a publicly traded reit, or in other specified situations, many us treaties provide a special reduced rate of withholding, generally equal to the rate that a non-controlling shareholder of a corporation is entitled to under the treaty. 10 Foreign investors that are tax-exempt entities in their country of residence are often able to take advantage of provisions that allow them to receive dividends and interest tax-free from non-controlled us entities, including reits. Foreign shareholders that are governmental entities entitled to the benefits of the exemption provided by section 892 of the Code can also receive dividends free of withholding tax from a non-controlled reit. In the case of both tax-exempt and foreign governmental shareholders, however, the ability to receive dividends tax-free applies only to dividends that are not subject to the rule in section 897(h) with respect to dividends attributable to gain recognized by the reit on a sale of property. For investors entitled to an exemption for dividends from a reit, the reit regime is consistent with a policy of capital export neutrality. Given that such investors are typically exempt from tax on passive real estate income (such as rental income and capital gains) earned in their home jurisdiction, tax is a neutral factor when these investors are deciding whether to invest in real estate in their home jurisdiction or in the United States. At the same time, the rules that restrict the activities of the reit for example, the prohibitions on being a dealer in property (such as a condominium developer), the requirement that a reit utilize an independent contractor to manage a lodging facility or a health-care facility, and the requirement that a reit can only offer ancillary services to tenants that are consistent with those customary in its market ensure that these non-us investors cannot compete with active us real estate businesses. The exemption is therefore consistent with a policy of capital import neutrality, since anyone who wants to operate an active real estate business such as developing and selling condominiums or becoming a hotel or health-care operator has to do so through a taxable enterprise that will then compete, from a tax perspective, on a level playing field with us-owned businesses. Prohibitions on paired-share reits also serve to enforce a policy of capital import neutrality by ensuring that a foreign-owned reit cannot pair a passive reit with an active business and effectively subsidize the active business through the ability to receive tax-favoured dividends from the passive side of the business. Requiring a reit to offer only ancillary services that are customary also prohibits foreign investors from leveraging their tax-exempt status to offer extra services that taxable 10 See, for example, the US-Canada tax treaty, article X(7)(c) and United States, Treasury Department, United States Model Income Tax Convention of November 15, See generally Semer and Alexander, supra note 4, at paragraph V(E).

10 selected us tax developments n 969 investors would not be willing to offer, or allow a corporation or reit that they controlled to offer, because they would be too expensive. The exemption for reit dividends extends the policy favouring territorial taxation 11 to include passive rental income, since this income, which would otherwise be subject to a gross withholding tax at a 30 percent rate (which could not be reduced by a treaty or section 892 of the Code), is converted into dividends eligible for reduction or exemption. Allowing the policy of territorial taxation to be implemented only when passive rents are earned through a reit allows the various restrictions on the activities of a reit just discussed to ensure that the policy is extended only to passive investment. While this is not the place to engage in an extensive discussion of the benefits and problems of a policy of territorial taxation, it is worth noting that investors that are entering a market such as the United States, or any other country, because they believe they have a competitive advantage in that particular market as a result of their business strategy and operational acumen should not need the benefits of territorial taxation to either encourage their decision to invest in the market or make them neutral when deciding what market to enter. The policy of territorial taxation with respect to passive income therefore further reinforces the commitment to assist active us business (and the commitment to prevent non-us investors from unfairly competing with us businesses subject to a higher tax burden) by lowering their cost of capital. reits thus become an efficient mechanism to promote all of these policies while effectively restricting their ambit. Domestically controlled reits provide another step in a similar direction. Normally, an interest in a property-owning reit would be a usrpi subject to tax upon its sale by a non-us person. However, an interest in a domestically controlled qualified investment entity is not a usrpi and can be sold by a non-us person without the imposition of us tax. 12 A domestically controlled qualified investment entity includes a reit that at all times during a specified testing period has less than 50 percent of the value of its stock held directly or indirectly by foreign persons. 13 The term testing period means the shorter of (1) the five-year period ending on the date of a disposition or a distribution by the reit and (2) the period during which the reit was in existence The US policy of continuing to reduce withholding rates on dividends and interest as it revises treaties and enters into new ones is clear evidence of a policy favouring whether implicitly or explicitly the (admittedly partial) imposition of territorial taxation. 12 Code section 897(h)(2). See generally Semer and Alexander, supra note 4, at paragraph V(A). 13 Code section 897(h)(4)(B). 14 Code section 897(h)(4)(D). Neither the Code nor any explicit Treasury guidance provides any definition of how stock ownership is determined, or what is meant by direct or indirect ownership for this purpose. One rationale for the policy of exempting foreign owners of domestically controlled REITs from tax on a sale of REIT shares is that 50 percent or more of the dividends paid by the REIT and the gains from a sale of REIT shares will accrue to US persons and therefore will not escape the US tax base. This policy rationale would be served by treating a taxable US corporation as a domestic owner, regardless of the residence status of the corporation s own shareholders. This view was recently adopted by the IRS in Private Letter Ruling

11 970 n canadian tax journal / revue fiscale canadienne (2009) vol. 57, n o 4 Domestically controlled reits provide one of the very few means for a non-us person to invest in US real estate without being subject to tax on gains realized upon exit from the investment. 15 This again serves to promote a policy of capital export neutrality while at the same time encouraging foreign investors to leave control of us real estate in the hands of us investors. Of course, taking advantage of this exemption necessitates exiting the investment via a sale of reit shares rather than a direct sale of the property by the reit. Because it is relatively easy for a new purchaser to either continue to hold the property inside the reit or liquidate the reit and step up the basis of the property in a tax-efficient manner, this does not pose a huge impediment subject to the caveat that real estate buyers generally prefer to purchase just the property, rather than a legal entity, such as a reit, that might have other hidden liabilities, including potentially unpaid tax liabilities. Thus, some form of indemnity is often necessary when all of the shareholders of a domestically controlled reit are selling their shares to a single buyer who otherwise would have bought only the property, making the transaction more complicated than might otherwise be the case. Prior to the issuance of Notice , 16 it was generally thought to be possible for a reit to sell all of its properties and then liquidate without imposing any tax on its foreign shareholders, who would be treated as selling their shares in the liquidation on a tax-free basis. In Notice , however, issued in the spring of 2007, the irs announced that it would challenge this view on a looking-back basis and that it would issue regulations, effective as of the date of the notice, to make it clear that a sale of properties by a reit followed by a liquidation of the reit would be taxable to non-us shareholders under section 897(h)(1) of the Code on a going-forward basis. The notice also stated that section 892 would not change this result for governmental investors. While there are numerous technical difficulties with the reasoning and position expressed in the notice, the irs probably has the authority to issue the regulations promised in the notice. Thus, a non-us shareholder wishing to take advantage of the domestically controlled reit exception needs to make sure that it exits its investment via a sale of shares of the reit rather than a sale of property by the reit followed by the receipt of a liquidating distribution from the reit. In contrast to the other reit rules discussed here, Notice is remarkable for being devoid of any particular policy considerations. It promotes no rational policy of any kind except one of encouraging the increased use of attorneys to structure more complex transactions involving a sale of reit shares rather than a sale of property, and the structuring of more reits owning fewer properties in order to facilitate such share sales. It is the ultimate invocation to taxpayers and their advisers to exalt form over substance. Except perhaps for one-time gains from taxpayers unexpectedly caught in this sudden change of direction, Notice is not even 15 A exemption from tax on gain realized with respect to publicly traded USRPHCs is also available for investors who own 5 percent or less of the corporation. See Code section 897(c)(3) IRB 13.

12 selected us tax developments n 971 justifiable as a rational attempt to raise revenue, since investors will plan around it or, to the extent that they cannot, will simply make other investments. Rather than help us investors or us real estate businesses, it will make it harder for them to attract capital; force them, to the extent that they are able to attract such capital, to engage in much more complex transaction planning than they would otherwise prefer; and generally reduce the opportunities available to all investors, both foreign and us, to invest in us real estate (which seems at odds with a great many other explicit us governmental policies). Conclusion With one notable exception, the rules governing the taxation of us reits and foreign investors in such reits have developed to coalesce around support for a few well-defined and cohesive policies. Looked at systematically, the development of and experience with reits in the United States shows that reits can be used as an efficient and effective vehicle to integrate the corporate and individual tax regimes with respect to real estate investment, allow a broader class of investors to invest in real estate, give real estate principals greater access to capital, promote both capital export neutrality and capital import neutrality (which are often in conflict with one another), and expand the push toward territorial taxation in a controlled fashion to include passive-type investment in real estate.