IRS Issues Temporary Guidance on Stock Distributions by Real Estate Investment Trusts SUMMARY On, the Internal Revenue Service issued Revenue Procedure 2008-68 which provides, on a temporary basis, that certain stock distributions made by real estate investment trusts ( REITs ) will be treated as taxable distributions for the purpose of determining both (1) the treatment of a REIT s shareholders and (2) the dividends-paid deduction of the REIT and whether it meets the distribution requirement for REIT qualification. 1 This temporary rule is intended to permit REITs to limit cash distributions in order to maintain liquidity during the current financial situation. Specifically, distributions of stock made by a REIT will be treated as distributions under Section 301 of the Code if, among other requirements, (1) the REIT is publicly-traded on an established securities market in the United States; (2) the distribution is declared with respect to a taxable year ending before January 1, 2010; (3) the distribution permits shareholders to elect the receipt of either cash or stock subject to a cap (the Cash Limitation ) that limits the total amount of cash equal to 10% or more of the declared distribution; and (4) the amount of stock that is distributed to a shareholder that receives stock in lieu of cash must be determined using a formula that equates the value of the stock received with the amount of cash that would otherwise be payable. If the Cash Limitation prevents a shareholder that elects a cash distribution from receiving the entire distribution in cash, the amount of cash must be prorated among electing shareholders so that no electing shareholder receives less than 10% of that shareholder s total entitlement. BACKGROUND Under Section 857(a)(1) of the Code, a REIT must generally distribute at least 90% of its real estate investment taxable income to shareholders. A REIT that fails to meet this requirement will not be entitled New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com
to a dividends-paid deduction and thus may become subject to entity-level taxation. The distribution requirement may make a REIT depend on capital markets for the majority of its expansion funding and other cash needs. In the current economic environment, however, many REITs are experiencing cashflow challenges and may seek to fulfill the distribution requirement with a distribution that in part consists of stock, rather than a distribution made entirely in cash. Although under Section 305(a) of the Code, gross income of a shareholder does not generally include distributions of stock made by a corporation to its shareholders, an exception in Section 305(b)(1) of the Code treats a distribution, made in stock, as taxable if the distribution may at the election of any shareholder be paid in stock or cash. 2 Under applicable treasury regulations, 3 if any shareholder may elect whether a distribution is made in cash or, alternatively, in stock or other securities of the corporation, that distribution is treated as a taxable distribution of property and a dividend to the extent paid out of the earnings and profits of the corporation. 4 In the past, entities seeking to maintain REIT status or make a REIT election have sought private letter rulings from the Internal Revenue Service to the effect that an elective distribution of stock or cash, but subject to limitation on the amount of cash, will be a taxable distribution. 5 We understand that these rulings generally required that the lower limit on cash distributions be at least 20% of the total dividend. THE REVENUE PROCEDURE The Revenue Procedure provides that the Internal Revenue Service will treat stock distributions made by REITs as distributions to which Section 301 of the Code applies because of Section 305(b), provided that certain requirements are met. It is effective with respect to dividends made in respect of a taxable year ending on or before December 31, 2009 which are declared on or after January 1, 2008. To qualify under the Revenue Procedure: The distribution must be made by a REIT to its shareholders and with respect to its stock; Stock of the REIT paying the distribution must be publicly traded on an established securities market in the U.S.; The distribution must be declared on or after January 1, 2008 with respect to a taxable year that ends before January 1, 2010; Subject to the Cash Limitation, each shareholder must be entitled to receive its entire distribution in either cash or stock; The Cash Limitation may not limit the total amount of cash that may be paid to less than 10% of the aggregate, declared distribution; If the aggregate cash amount is oversubscribed (i.e., limited by the Cash Limitation), each shareholder must receive a pro rata amount of cash that corresponds to its relative entitlement and is at least 10% of its total entitlement; The number of shares that are received by any shareholder receiving property must be determined, as close as practicable to the payment date, 6 using a formula that equates the market value of the shares distributed with the cash that would otherwise be paid; and -2-
In the event an automatic dividend reinvestment plan (a DRIP ) is in effect with respect to a shareholder, the DRIP must apply only to the extent that, without the DRIP being in effect, that shareholder would have received a cash distribution. 7 The Revenue Procedure only addresses REITs and does not provide comparable guidance with respect to other entities such as regulated investment companies. 8-3-
ENDNOTES 1 2 3 4 5 6 7 8 In general, under Section 857(a) of the Code, the application of Subchapter M to a REIT requires that it distribute at least 90% of its real estate investment trust taxable income to shareholders and under Section 857(b) a deduction is allowed for dividends paid to shareholders. Moreover, Section 305(b)(2) provides that Section 305(a) does not apply to distributions that result in the receipt of property by some shareholders and cause the proportionate interests of other shareholders in the corporation s earnings and profits to increase. Treas. Reg. 1.305-2. Code 316(a). See, e.g., PLR 200817031 (Jan. 28, 2008); PLR 200618009 (Nov. 03, 2005); PLR 200615024 (Jan. 10, 2006); PLR 200406031 (Oct. 29, 2003). Revenue Procedure 3(5). Under a DRIP, shareholders typically receive a small discount on shares acquired pursuant to the DRIP relative to the market price. It is noteworthy, however, that analogous guidance has been provided in private letter rulings with respect to companies in the process of electing regulated investment company status. See, e.g., PLR 9211052 (Dec. 18, 1991); PLR 9051024 (Sep. 24, 1990). Copyright Sullivan & Cromwell LLP 2008-4-
ABOUT SULLIVAN & CROMWELL LLP Sullivan & Cromwell LLP is a global law firm that advises on major domestic and cross-border M&A, finance and corporate transactions, significant litigation and corporate investigations, and complex regulatory, tax and estate planning matters. Founded in 1879, Sullivan & Cromwell LLP has more than 700 lawyers on four continents, with four offices in the U.S., including its headquarters in New York, three offices in Europe, two in Australia and three in Asia. CONTACTING SULLIVAN & CROMWELL LLP This publication is provided by Sullivan & Cromwell LLP as a service to clients and colleagues. The information contained in this publication should not be construed as legal advice. Questions regarding the matters discussed in this publication may be directed to any of our lawyers listed below, or to any other Sullivan & Cromwell LLP lawyer with whom you have consulted in the past on similar matters. If you have not received this publication directly from us, you may obtain a copy of any past or future related publications from Jennifer Rish (+1-212-558-3715; rishj@sullcrom.com) or Alison Alifano (+1-212- 558-4896; alifanoa@sullcrom.com) in our New York office. CONTACTS New York Andrew S. Mason +1-212-558-3759 masona@sullcrom.com David C. Spitzer +1-212-558-4376 spitzerd@sullcrom.com Willard B. Taylor +1-212-558-3604 taylorw@sullcrom.com NY12530:285387.2D -5-