Proposed Tax Extenders Legislation Would Limit Opco/Propco Spinoffs, Modify FIRPTA and Affect Proposed Legislation Would Limit Opco/Propco Spinoffs and Make Changes to Treatment of Some Foreign Investment in U.S. Real Estate and to Real Estate Investment Trusts SUMMARY On December 15, 2015, the joint leadership of the House of Representatives and the Senate tentatively agreed to an amendment to H.R. 2029 (the Bill ) entitled the Protecting Americans From Tax Hikes Act of 2015. The Bill was passed by the House of Representatives on, and it is expected that the Bill will be passed by Senate and that the President will sign the Bill into law in substantially its current form. The Bill, which would extend certain provisions of the Internal Revenue Code (the Code ) set to expire, would make significant changes to the U.S. federal taxation of real estate. 1 The Bill would (i) limit the establishment of so-called Opco/Propco structures through tax-free spinoffs, (ii) extend favorable treatment to certain foreign investment in real property, and (iii) make other technical changes to REIT provisions of the Code. The Bill includes provisions intended to limit tax-free spinoffs establishing so-called Opco/Propco structures by disqualifying spinoffs from tax-free treatment if either (but not both) the distributing corporation ( parent ) or the distributed corporation ( spinco ) is a real estate investment trust ( REIT ), and prevents either parent or spinco from electing REIT status for 10 years after a tax-free spinoff. 2 Second, the Bill includes amendments to the Foreign Investment in Real Property Tax Act of 1980 ( FIRPTA ) that would affect the ability of foreign persons to invest in U.S. real estate, including by: increasing the rate of FIRPTA withholding on gross purchase price from 10% to 15%; New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com
excluding REIT and regulated investment company ( RIC ) stock from the FIRPTA cleansing rule for former United States real property holding corporations; exempting qualified foreign pension funds from FIRPTA tax and withholding; increasing the 5% shareholder limit to a 10% shareholder limit under the publicly traded exception under FIRPTA in the case of REITs; and allowing REITs that are publicly traded in the United States to presume that less than 5% shareholders are United States persons for purposes of the domestically controlled REIT ( D- REIT ) exception from FIRPTA. Third, the Bill would modify certain other rules relating to the U.S. federal taxation of REITs, including: reducing the percentage of a REIT s assets that may constitute securities in taxable REIT subsidiaries ( TRSs ) from 25% to 20%; permanently extending the reduced five-year recognition period during which a REIT is subject to entity-level tax on built-in gain property; treating unsecured debt instruments issued by publicly offered REITs as real estate assets for purposes of the REIT asset qualification requirements; treating certain personal property ancillary to real property as well as mortgages securing both real property and ancillary personal property as real estate assets for purposes of the REIT asset qualification requirements; permitting REITs to use a three-year averaging method to qualify for the safe harbor for sales of 10% or less of assets from the 100% tax imposed on prohibited transactions (subject to a 20% current-year limitation); repealing the limitations on preferential dividends for publicly offered REITs; and clarifying that the dividends received deduction otherwise allowed to corporations for dividends received through certain 10%-owned foreign corporations is not allowed to the extent attributable to dividends paid by REITs or RICs to the foreign corporation. BACKGROUND A C-corporation is generally subject to U.S. federal income taxation at a 35% rate on its net income. The income of a real estate investment trust ( REIT ), however, generally is not subject to entity-level tax as a result of the dividends paid deduction allowed to REITs. To qualify as a REIT, an entity must comply with a number of detailed and technical requirements, including that a REIT must satisfy two annual income tests (the Income Tests ) and a quarterly asset test (the Asset Test ). The 75% Income Test requires that at least 75% of the REIT s gross income for a taxable year be derived from rents from real property, qualifying interest on loans secured by real property, gain from the disposition of real property, and other qualifying income from real property or temporary investments, 3 and the 95% Income Test requires that at least 95% of the REIT s gross income for a taxable year be derived from income satisfying the 75% Income Test and other passive-type income including interest and dividends. 4 Among other requirements, the Asset Test requires at the close of each quarter of the entity s taxable year that at least 75% of the value of the entity s total assets be real estate assets, cash and cash items (including -2-
receivables), and government securities. REITs often have taxable REIT subsidiaries ( TRSs ), taxed as C-corporations, allowing a REIT to indirectly hold assets and receive income through the TRS that, if held or received directly, might otherwise prevent the REIT from satisfying the Asset and Income Tests. Increasingly, Opco/Propco structures have been utilized in which operating and real estate assets are separated with Opco, a C-corporation, holding the operating assets, and Propco, usually a REIT, holding related real estate assets. For example, a restaurant chain or retailer might contribute its real estate to a new Propco, while retaining the restaurant or retail business assets, and thereafter spin off Propco to shareholders. Opco leases real estate from Propco, with rents under the lease often including a fixed percentage of the revenues from Opco s operation of the leased properties. Amounts paid under the lease generally are deductible to Opco (reducing income subject to entity-level taxation), and the income to Propco generally avoids entity-level taxation under the REIT rules. Such structures have come under increased scrutiny. For example, in September, the Treasury Department and Internal Revenue Service ( IRS ) announced that the IRS would no longer issue private letter rulings for spinoffs establishing Opco/Propco structures. 5 The Foreign Investment in Real Property Tax Act of 1980 ( FIRPTA ) generally requires a foreign person to pay U.S. tax on gains from the disposition of U.S. real property interests ( USRPIs ). 6 A USRPI generally includes real property located in the United States, as well as certain interests in entities holding real property, including United States real property holding corporations ( USRPHCs ), 7 and also applies to capital gain dividends by REITs to the extent attributable to gains from the sale of USRPIs. FIRPTA generally requires the transferee of a USRPI (and the REIT in the case of a capital gain dividend) to withhold tax on the amount realized by a foreign transferor on disposition of the USRPI. 8 DISCUSSION A. ANTI-SPINOFF PROVISIONS The Bill would target new Opco/Propco structures by disqualifying tax-free treatment of spinoffs or splitoffs for transactions in which parent or spinco (but not both) is a REIT, and would prevent any C- corporation involved in a tax-free spinoff or split-off (and any successor corporation) from electing REIT status for 10 years following such spinoff or split-off. 9 However, the Bill would continue to permit tax-free distributions where both parent and spinco are REITs immediately after the distribution. In addition, the Bill would provide an exception for distributions where (i) parent has been a REIT for the three-year period ending on the date of the distribution, (ii) spinco has been a TRS of the REIT for the same threeyear period, and (iii) parent has owned stock of the TRS constituting control for the three-year period. 10 The anti-spinoff provisions of the Bill would be effective for distributions on or after December 7, 2015 other than a distribution for which a private letter ruling request has been submitted to the IRS as of -3-
December 7, 2015, if such ruling request remains pending as of such date. Accordingly, a tax-free distribution before that date would not trigger the 10-year limitation on electing REIT status. B. FIRPTA PROVISIONS As described above, FIRPTA generally requires foreign persons to pay U.S. federal income tax and withholding on disposition of USRPIs (including on capital gains dividends from a REIT to the extent attributable to the disposition of USRPIs by the REIT), subject to certain exceptions. The Bill contains several modifications to FIRPTA, including those described below. 1. Increase in FIRPTA Withholding Rate When a USRPI is disposed by a foreign person, FIRPTA currently requires a foreign transferee to withhold 10% tax of the gross purchase price. 11 This 10% withholding is also required on certain redemptions by and liquidations of USRPHCs and distributions of USRPIs by partnerships, trusts and estates. 12 The Bill would increase such 10% withholding rate to 15%, except for property acquired for use as a residence where the amount realized is not more than $1,000,000. 13 This increase would be effective for dispositions after the 60th day following the date of enactment. 2. Exclusion of REIT and RIC Stock from FIRPTA Cleansing Rule USRPIs subject to FIRPTA generally include stock in domestic corporations that were treated as USRPHCs at any time during the shorter of the taxpayer s holding period of such stock or the five-year period ending on the date of disposition of such stock (the Lookback Period ). 14 However, current law provides a cleansing rule exception from FIRPTA for dispositions of stock in a corporation if (i) as of the date of disposition, the corporation did not hold any USRPIs and (ii) any USRPI held by the corporation in the Lookback Period either (a) was disposed in a transaction in which any gain is fully recognized or (b) was stock of a USRPHC that ceased to be treated as a USRPI. The requirement that gain on disposition of a USRPI be recognized technically does not require that such gain actually be taxable. 15 For example, gains recognized by REITs and regulated investment companies (e.g., mutual funds) ( RICs ) are generally not subject to entity-level tax. The Bill would remove the cleansing rule exception as applied to stock in a corporation if such corporation (or its predecessor) was treated as a REIT or a RIC at any time during the Lookback Period, effective for dispositions on or after the date of enactment. 16 3. Exception for Interests Held by Foreign Retirement or Pension Funds Under current law, U.S. pension funds are generally exempt from U.S. federal income tax, while foreign pension funds are generally required under FIRPTA to pay U.S. federal income tax on gain from disposition of a U.S. real property interest. The Bill would eliminate this disparity by exempting USRPIs held (directly or indirectly through one or more partnerships) by qualified foreign pension funds (and entities wholly owned by such pension funds) from FIRPTA tax and withholding, both with respect to REIT -4-
stock and other assets that would otherwise be treated as USRPIs. 17 The pension fund would, however, continue to be subject to tax on rent and other operating income earned directly or through a partnership. To be treated as a qualified foreign pension fund, a fund would have to (i) be created or organized under the laws of a foreign country, (ii) be established to provide retirement or pension benefits to participants or beneficiaries that are current or former employees (or their designees) of one or more employers for services rendered, (iii) have no single participant or beneficiary with a right to more than 5% of the assets or the income of the fund, (iv) be subject to government regulation in its jurisdiction of organization or operation and provide annual information reports about its beneficiaries to the relevant foreign tax authorities, and (v) under relevant foreign tax law, either (a) benefit from tax exemption (i.e., contributions to the fund are tax-deductible or the fund is exempt or pays a reduced rate of tax on such contributions) or (b) provide tax-deferral or a reduced rate of tax on investments within the fund. The exemption would apply to dispositions and distributions after the date of enactment. 4. Increase of Portfolio Investor Limit Under current law, FIRPTA does not apply to publicly traded stock except in the case of a shareholder who holds, or has held in the five-year period ending on the disposition date, at least 5% (actually or constructively) of the class of stock. 18 Similarly, capital gains dividends paid by a REIT on publicly traded stock are not subject to FIRPTA, except in the case of a shareholder who owned more than 5% of the class of stock during the one-year period ending on the distribution date. 19 The Bill would increase the limitation for this portfolio investor exception from 5% to 10% in the case of REIT stock. 20 The Bill would also provide exceptions qualifying certain treaty-qualified collective investment vehicles (for example, listed Australian property trusts, or LAPTs) meeting shareholder recordkeeping requirements for the portfolio investor exceptions, even if the 10% limitation is not satisfied, except to the extent attributable to investors of the collective investment vehicle holding more than a 10% interest in the REIT. The increase would be generally effective for dispositions and distributions on or after the date of enactment. 5. Determination of D-REIT Status The sale of stock in a domestically controlled REIT ( D-REIT ) is not subject to the FIRPTA tax. 21 REIT is a D-REIT if, for the entire five-year period ending on the determination date (or the period of the REIT s existence, if shorter), less than 50% of the value of the REIT s stock was held directly or indirectly by foreign persons. 22 Since the information available to publicly traded REITs regarding the foreign or U.S. status of their shareholders is often not readily available, publicly traded REITs may have difficulty establishing their -5- A
status as D-REITs. The Bill would remedy this difficulty by providing that, if any class of a REIT s stock is regularly traded on an established securities market in the United States, a person holding less than 5% of such class during the five-year testing period is presumed to be a United States person unless the REIT has actual knowledge otherwise. 23 The Bill would provide that stock held by another REIT that is publicly traded is treated as held by a United States person if such other REIT is itself domestically controlled, and is otherwise treated as held by a foreign person. 24 If the stock of a REIT is held by another REIT that is not publicly traded, such stock would be treated as held by a United States person in proportion to the holdings of stock in the other REIT. 25 of enactment of the Bill. C. OTHER REIT PROVISIONS 1. Reduction of Limitation on TRS Securities These provisions would be effective as of the date Under current law, the Asset Test requires that not more than 25% of the value of the gross assets of a REIT be represented by the securities of one or more TRSs. 26 For property held directly by a REIT, the Asset Test looks to the gross value without reduction by any encumbering debt. However, the value of TRS stock (the asset directly held by the REIT) will effectively be reduced by third-party debt at the TRS level, effectively permitting a REIT to take into account the net value of TRS assets for purposes of the Asset Test. 27 The Bill would reduce the limit on TRS stock from 25% to 20%, reversing a 2008 increase in such limit. 28 Such reduction would be effective for taxable years beginning after December 31, 2017. 2. Permanent Extension of the Reduced Five-Year Recognition Period During Which a REIT is Subject to Entity-Level Tax on Built-In Gain Property Entity-level income tax is generally imposed upon gains recognized by a REIT within a statutory period after conversion from a C-corporation to the extent these gains were built-in gains at the time of the REIT conversion. 29 Similarly, this entity level tax would apply to gains recognized after a REIT s acquisition of property from a C-corporation in certain carryover basis transactions. The statutory period during which the entity-level tax on such built-in gains would apply was originally ten years from the conversion or acquisition, but was reduced to seven years for taxable years beginning in 2009-2011, and to five years for taxable years beginning in 2012-2014. However, the statutory recognition period was set to revert to ten years for taxable periods beginning in 2015 and thereafter. The Bill would retroactively reduce the statutory recognition period to five years for taxable years beginning in 2015, and would permanently extend such reduction for later taxable years. 30 3. Unsecured Debt Instruments of Publicly Offered REITs Qualify as Real Estate Assets Under current law, shares of stock held by REITs in other REITs qualify as real estate assets for purposes of the Asset Test. 31 The Bill would expand this provision to include debt instruments issued by -6-
publicly offered REITs as real estate assets regardless of whether the debt is secured by a real estate asset. 32 However, the Bill would provide limitations on instruments that would not qualify as a real estate asset without the provision (e.g., unsecured debt securities), which the Bill calls nonqualified debt instruments, Interest from nonqualified debt instruments does not qualify for the 75% Income Test, and the Bill would add a requirement to the Asset Test that no more than 25% of the total value of the REIT s assets consist of nonqualified debt instruments. beginning after December 31, 2015. 4. Ancillary Personal Property Qualifies as a Real Estate Asset These provisions would apply to taxable years For purposes of the Income Tests, rent attributable to personal property that is leased under a lease of real property is treated as rent from real property if the rent attributable to such personal property does not exceed 15% of the total rent for the taxable year attributable to both the real and personal property under the lease. 33 The Bill would provide that such personal property giving rise to rent so qualifying for purposes of the Income Tests is treated as a real estate asset for purposes of the Asset Test. 34 The Bill would also provide that a debt instrument secured by a mortgage on both real and personal property is treated as a real estate asset for purposes of the Asset Test and as giving rise to interest qualifying for both Income Tests, if the fair market value of the personal property does not exceed 15% of the total fair market value of all real and personal property securing the mortgage. These provisions would apply to taxable years beginning after December 31, 2015. 5. Three-Year Averaging Method for 10% Sale Safe Harbor from Prohibited Transactions A 100% tax is imposed on income from prohibited transactions generally defined as sales of real estate assets in the ordinary course of business (i.e., dealer property). 35 However, the Code currently provides a safe harbor that a sale of property held for at least two years generally will not be treated as a prohibited transaction if, among other requirements, during the taxable year of sale either (i) the REIT does not make more than seven property sales, or (ii) the aggregate amount of property sold during the year does not exceed 10% of the amount of all of the REIT s assets at the beginning of the year, based either on adjusted basis or fair market value (the 10% Test ). In addition to the existing current-year 10% Test, the Bill would generally permit a REIT to meet the 10% Test for sales of property in a taxable year if, based on adjusted basis or fair market value, the amount property sold by the REIT in the taxable year and two preceding taxable years does not exceed 10% of the sums of the beginning-of-year REIT asset values for such years subject to a 20% current-year limitation. 36 Under this optional three-year averaging method, the amount of sales that could be made by a REIT in any single taxable year and still satisfy the 10% Test is as much as twice as without the Bill. The addition of the three-year averaging method would generally be effective for taxable years beginning after the date of enactment. -7-
6. Repeal of Preferential Dividend Rule for Publicly Offered REITs A REIT generally must distribute at least 90% of its taxable income each taxable year. 37 Under current law, preferential dividends do not count toward the distribution requirement, and are not eligible for the dividends paid deduction. 38 Dividends are considered preferential unless made in a pro rata distribution with respect to each share in a class, and with no preference to any class of stock not entitled by its terms to such preference. Conforming the treatment of public offered REITs with that of publicly offered RICs, the Bill would repeal the preferential dividend rule for publicly offered REITs effective for distributions in taxable years beginning after December 31, 2014. 39 The Bill would not repeal the preferential dividend limitation for non-publicly offered REITs. However, the Bill would give the Treasury Department and IRS regulatory authority to allow such REITs to cure failures to comply with the preferential dividend rule if such failures are inadvertent or due to reasonable cause and not willful neglect. Such regulatory authority would be effective for distributions in taxable years beginning after December 31, 2015. 40 7. Elimination of Deduction for Dividends Received from REITs and RICs Through 10%- Owned Foreign Corporations Dividends received from a foreign corporation by a domestic corporation owning at least 10% (by vote and value) of the foreign corporation generally give rise to a 70%-100% deduction (depending on ownership) to the extent of the U.S.-source portion of such dividends. 41 The U.S.-source portion of a dividend received from a 10%-owned foreign corporation includes amounts attributable to dividends received (directly or through a wholly owned foreign corporation) from a domestic corporation at least 80% owned (by vote and value) by the foreign corporation. The Bill would clarify that REITs and RICs are not considered domestic corporations for this purpose. 42 Therefore, dividends received from a 10%- owned foreign corporation attributable to a dividend paid by a REIT or RIC would not give rise to a dividends received deduction, even if the foreign corporation owns 80% or more of the REIT or RIC. This provision would be effective for dividends received from a REIT or RIC on or after the date of enactment; however, the Bill states that the amendment is not to be construed to create any inference as to the proper treatment of a dividend from a REIT or RIC before the date of enactment. * * * Copyright Sullivan & Cromwell LLP 2015-8-
ENDNOTES 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 We will be distributing a separate memorandum addressing non-real estate provisions of the Bill, including so-called extenders (which include the delayed effectiveness of the so-called Cadillac tax ), which may be obtained by following the instructions at the end of this memorandum. An earlier draft of the Bill imposed a diversification requirement for fixed percentage rents and interest received from a single C-corporation (or affiliated group) for purposes of the REIT income qualification requirements. The current draft of the Bill does not contain such a provision. Code Section 856(c)(3). Code Section 856(c)(2). Notice 2015-59. See S&C publication of September 15, 2015, Internal Revenue Service Limits Rulings on Tax-Free Spinoffs for a detailed description of the notice. Code Section 897. A corporation is a USRPHC if at least 50% of the combined fair market value of its USRPIs, interests in foreign real property and other trade or business assets are USRPIs. Code Section 897(c)(2). Code Section 1445. Bill Section 311. For this purpose, control would be defined to mean at least 80% of the voting stock TRS by voting power and at least 80% of the number of shares of each class of nonvoting stock of the TRS, either directly or indirectly. In addition, spinco would be deemed to meet requirements (ii) and (iii) if spinco was distributed by a TRS in a tax-free distribution and the assets of the TRS consist solely of stock or assets held by one or more TRSs of parent meeting the requirements of (ii) and (iii). Section 1445. The Bill would not affect the 35% rate of withholding required by FIRPTA (i) on REIT capital gain dividends attributable to USRPI gains, (ii) by domestic partnerships, trusts and estates for USRPI gains to foreign persons, or (iii) on gains recognized by foreign corporations on the distribution of USRPIs. Bill Section 324. Code Section 897(c)(1). However, the IRS issued a notice in 2007 (Notice 2007-55) effectively asserting a contrary view in the circumstances described in the Notice. Bill Section 325. Bill Section 323. Code Section 897(c)(3). Code Section 897(h)(1). Even if a REIT dividend is not treated as a capital gain dividend (subject to FIRPTA), it will generally be subject to non-firpta withholding on an ordinary dividend. However, the exception from the FIRPTA tax may be beneficial to foreign investors qualifying for an exemption or reduced treaty rate on such dividends. Bill Section 322(a). In addition, foreign investors would be exempt from filing U.S. tax returns upon receipt of a capital gain dividend as a result of this exemption from FIRPTA, Code Section 897(h)(2). -9-
ENDNOTES (CONTINUED) 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 Code Sections 897(h)(4)(B), (D). Bill Section 322(b). Under the Bill, stock in a REIT held by a RIC that is a qualified investment entity (e.g., RICs qualifying as U.S. real property holding corporations) and that issues redeemable securities is treated in the same manner as stock held by a publicly traded REIT. Stock in a REIT held by a RIC that is a qualified investment entity but that does not issue redeemable securities is treated in the same manner as stock held by a non-publicly traded REIT. Code Section 856(c)(4)(B)(ii). Thus, in addition to the use of a TRS to block nonqualifying income, the use of a levered TRS may permit a REIT to indirectly hold nonqualifying assets that might otherwise prevent the REIT from satisfying the Asset Test if held directly, as long as the TRS stock held by the REIT does not exceed the percentage limit on TRS securities. Bill Section 312. Code Section 1374(a); Treasury Regulations Section 1.337(d)-7. Bill Section 127. Code Section 856(c)(5). Bill Section 317. Code Section 856(d)(1)(C). Bill Section 318. Code Section 857(b)(6). Bill Section 313. Code Sections 561, 857(a). Code Sections 562(c). Bill Section 314. The Bill defines a publicly offered REIT as any REIT required to file annual and periodic reports with the Securities and Exchange Commission under the Securities Exchange Act of 1934. Bill Section 315. Code Section 245. Bill Section 326. -10-
ABOUT SULLIVAN & CROMWELL LLP Sullivan & Cromwell LLP is a global law firm that advises on major domestic and cross-border M&A, finance, corporate and real estate transactions, significant litigation and corporate investigations, and complex restructuring, regulatory, tax and estate planning matters. Founded in 1879, Sullivan & Cromwell LLP has more than 800 lawyers on four continents, with four offices in the United States, 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 Stefanie S. Trilling (+1-212-558-4572; trillings@sullcrom.com) in our New York office. CONTACTS New York Eli D. Jacobson +1-212-558-3645 jacobsone@sullcrom.com Andrew S. Mason +1-212-558-3759 masona@sullcrom.com David C. Spitzer +1-212-558-4376 spitzerd@sullcrom.com Davis J. Wang +1-212-558-3113 wangd@sullcrom.com Jameson S. Lloyd +1-212-558-4464 lloydj@sullcrom.com Todd I. Pollock +1-212-558-4771 pollockt@sullcrom.com Washington, D.C. Donald L. Korb +1-202-956-7675 korbd@sullcrom.com -11- SC1:4011007.1