Proposed Regulations Relating to Domestically Controlled REITs Impact Non-U.S. Investors and Sponsor
On December 29, 2022, the IRS and Treasury issued proposed regulations relating to the qualification of a real estate investment trust (“REIT”) or a registered investment company (“RIC”) as a domestically controlled qualified investment entity (the “Proposed Regulations”). The Proposed Regulations may impact sponsors and non-U.S. investors in real estate funds, private equity funds and other tax structures involving REITs.
Overview of Regulatory Position Prior to Proposed Regulations
Pursuant to the Foreign Investment in Real Property Tax Act (“FIRPTA”), any gain or loss of a non-U.S. investor from the sale or other disposition of a U.S. real property interest (“USRPI”) is considered to be income that is effectively connected with the conduct of a U.S. trade or business.
A USRPI includes an interest in a U.S. real property holding corporation (“USRPHC”), i.e., a U.S. corporation with 50 percent or more of the fair market value of its business assets consisting of interests in U.S. real estate and related assets. A REIT is generally considered a USRPHC because of the composition of its assets.
However, an interest in a domestically controlled qualified investment entity (“QIE”), such as a domestically controlled REIT (“DC REIT”), is not a USRPI. A domestically controlled QIE is any QIE in which less than 50 percent of the value of its stock was held directly or indirectly by foreign persons during the shorter of (i) the five-year period ending on the date of the disposition or distribution, as applicable, or (ii) the period during which the QIE was in existence.
The Code and the Treasury Regulations do not clearly state how to determine “indirect” ownership for purposes of determining whether a REIT qualifies for DC REIT status. However, the Treasury Regulations do provide that the “actual owners of stock”, as determined under Treas. Reg. Sec. 1.857-8, must be taken into account. The actual owner of REIT shares is the person who is required to include the dividends received on the shares in gross income. Generally, such person is the shareholder of record of the REIT.
Further, the IRS issued a private letter ruling in 2009 that provided that REIT stock owned by a non-U.S. person through a fully taxable U.S. corporation is to be treated as owned by such U.S. corporation, and not as owned “indirectly” by the non-U.S. person, for purposes of determining DC REIT status. However, because a private letter ruling may only be relied upon by the taxpayer to which it is issued, it is not binding precedent with respect to other taxpayers.
Proposed Regulations
Pursuant to the Proposed Regulations, “foreign-owned domestic C corporations” are treated as flow-through entities for purposes of determining DC REIT status. A “foreign-owned domestic C corporation” is any non-publicly traded domestic C corporation if non-U.S. persons hold directly or indirectly 25 percent or more of the value of its outstanding stock, after applying certain look-through rules.
The Proposed Regulations provide an example where 51 percent of the stock of a REIT is held by a non-publicly-traded U.S. corporation and the remaining 49 percent is owned by non-U.S. individuals. The stock of the U.S. corporation is owned as follows: 20 percent by a non-U.S. corporation, 5 percent by a non-U.S. individual and 75 percent by U.S. persons. The non-publicly traded U.S. corporation is a foreign-owned domestic C corporation because 25 percent of its stock is owned by non-U.S. persons, and hence, the REIT must look-through the U.S. corporation to its owners. Therefore, the REIT is not a DC REIT because 61.75 percent of its stock is owned by non-U.S. persons (i.e., 49 percent direct ownership by non-U.S. persons plus 12.75 percent indirect ownership by non-U.S. persons).
The preamble to the Proposed Regulations (the “Preamble”) notes that the Treasury and IRS believe reliance on Treas. Reg. Sec. 1.857-8 alone to determine DC REIT status is incorrect, as Treas. Reg. Sec. 1.857-8 is only intended to ensure that the beneficial owner of stock is taken into account when different from the shareholder of record. The Preamble also notes that Treas. Reg. Sec. 1.897-1(c)(2)(i) does not provide any guidance on the meaning of “held directly or indirectly by foreign persons”. The Preamble does not directly address the potential inconsistency with the 2009 IRS private letter ruling, which also cited those regulations to support its conclusion.
Therefore, pursuant to the Proposed Regulations, a REIT is required to look through a fully-taxable U.S. corporation that qualifies as a foreign-owned domestic C corporation, for purposes of determining DC REIT status.
Practical Application of Proposed Regulations
Both sponsors and investors in real estate funds, private equity funds and other investment structures involving DC REITs should analyze the application of the Proposed Regulations to their funds or investment structures. Additionally, sponsors and investors may need to review their fund documents -- including side letters and subscription documents -- to ensure that any covenants and/or representations are still accurate in light of the Proposed Regulations.
In practice, some real estate funds may currently rely on the direct shareholding of their U.S. taxable investors and U.S. tax-exempt investors for purposes of qualifying a REIT as a DC REIT and therefore may not be impacted by the Proposed Regulations. Particularly, U.S. taxable investors generally would choose to invest directly in a REIT, rather than through a U.S. corporation, to avoid the additional layer of tax introduced by investing in a REIT indirectly through a U.S. corporation. U.S. tax-exempt investors may also choose to invest directly in a REIT, as the REIT often shields such investors from incurring unrelated business taxable income (assuming that the U.S. tax-exempt investors’ interest in the REIT is not debt financed and that the pension-held REIT rules under Section 856(h)(3)(D) do not apply).
For example, 51 percent of the stock of a REIT may be held by U.S. taxable investors and U.S. tax-exempt investors, and 49 percent of the stock may be held by a non-publicly-traded U.S. corporation that is held collectively by non-U.S. investors. Here, the look-through rule of Prop. Reg. Sec. 1.897-1(c)(3)(iii)(B) is not expected to impact the REIT’s qualification as a DC REIT because 51 percent of the REIT’s direct shareholders constitute U.S. taxable investors and U.S. tax-exempt investors (regardless of the non-U.S. investors’ indirect shareholding through the U.S. corporation), assuming that no transfers or redemptions cause the percentage of the REIT that is owned by U.S. investors to fall below the required threshold.
Effective Date
The Proposed Regulations apply to transactions that occur on or after the date on which the Proposed Regulations are published as final in the Federal Register. However, the Preamble indicates that the IRS may challenge positions contrary to Prop. Reg. Sec. 1.897-1(c)(3) and (4) before the issuance of final regulations relating to topics addressed in the Proposed Regulations.
Finally, the Proposed Regulations may be relevant for determining DC REIT status during periods before the date on which the Proposed Regulations are finalized, to the extent the testing period for DC REIT status relates to a transaction that occurs after the Proposed Regulations are finalized, but includes periods before the date of finalization.