Proposed regulations on domestically controlled REITs introduce seismic changes
Originally Published in the June 2023 Edition of Practical Tax Strategies, a Thomson Reuters Publication.
This article examines proposed regulations concerning the qualification of a real estate investment trust or a registered investment company as a domestically controlled qualified investment entity.
On 12/29/2022, 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”).1 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 of 1980 (“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.2
A USRPI includes any non-creditor interest in a U.S. real property holding corporation (“USRPHC”), i.e., a U.S. corporation with 50% or more of the fair market value of its business assets consisting of interests in U.S. real estate and related assets.3 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.4 Accordingly, any gain on the sale or disposition of stock in a domestically controlled QIE, such as a DC REIT, is not subject to tax under FIRPTA. However, distributions from a DC REIT that are attributable to net capital gain from the sales or exchanges of USRPIs (referred to as capital gain dividends) received by a non-U.S. person are still subject to tax under FIRPTA.5
A domestically controlled QIE is any QIE in which less than 50% of the value of its stock was held directly or indirectly by “foreign persons” during the shorter of (1) the five-year testing period ending on the date of the disposition or distribution, as applicable, or (2) the period during which the QIE was in existence.6
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 Reg. 1.857-8, must be taken into account.7 The actual owner of REIT shares is the person who is required to include the dividends received on the shares in gross income.8 Generally, such person is the shareholder of record of the REIT.9
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 should 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.10 Under the facts presented in this ruling, the REIT in question was held by two fully taxable U.S. corporations that were, in turn, partly owned by non-U.S. persons. The IRS referred to the “actual owners of stock” pursuant to Reg. 1.897-1(c)(2)(i) and held that the two fully taxable U.S. corporations that held interests in the REIT qualified as actual owners of stock, despite the fact that these U.S. corporations were held, in part, by non-U.S. persons. Therefore, the ruling determined the REIT qualified as a DC REIT.
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
Look-through rule for foreign owned domestic corporations.
Pursuant to the Proposed Regulations, “foreign-owned domestic corporations” are treated as flow through entities for purposes of determining DC REIT status.11 A “foreign-owned domestic corporation” is any non-publicly traded domestic C corporation if non-U.S. persons hold directly or indirectly 25% or more of the value of its outstanding stock, after applying certain look-through rules.12 The Proposed Regulations aggregate the ownership of non-U.S. persons in a non-publicly traded domestic C corporation to determine if such ownership, collectively, totals 25% or more of the value of such domestic C corporation.13
The Proposed Regulations provide an example where 51% of the stock of a REIT is held by a non-publicly traded U.S. corporation and the remaining 49% is owned by non-U.S. individuals.14 The stock of the U.S. corporation is owned as follows: 20% by a non-U.S. corporation, 5% by a non-U.S. individual, and 75% by U.S. persons. The non-publicly traded U.S. corporation is a foreign-owned domestic corporation because 25% 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% of its stock is owned by non-U.S. persons (i.e., 49% direct ownership by non-U.S. persons plus 12.75% indirect ownership by non-U.S. persons).
The preamble to the Proposed Regulations (the “Preamble”) reasons that although U.S. corporations are generally taxed as non-look through persons, a limited look through approach should be applied to non-publicly traded U.S. corporations in which non-U.S. persons hold a meaningful ownership interest. This rule seeks to ensure that a U.S. corporation is not used by non-U.S. investors to create DC REITs that could exempt such non-U.S. investors in the U.S. corporation (or other non-U.S. investors in the REIT) from tax under FIRPTA.
Moreover, the Preamble notes that the Treasury and IRS believe reliance on Reg. 1.857-8 alone to determine DC REIT status is incorrect, as Reg. 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 Reg. 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 corporation, for purposes of determining DC REIT status.
Treatment of QFPFs and QCEs.
In addition, the Proposed Regulations clarify that qualified foreign pension funds (“QFPFs”) or qualified controlled entities (“QCEs”) will always be treated as “foreign persons” when determining whether a REIT qualifies as a DC REIT.15 QCEs are entities (i.e., corporations or trusts) all of the interests of which are held by QFPFs.
Specifically, neither a QFPF nor a QCE is treated as a nonresident alien individual or a foreign corporation (i.e., a non-U.S. person) for FIRPTA purposes, and hence, is completely exempt from FIRPTA.16 Further, neither a QFPF nor a QCE is treated as a “foreign person” for U.S. withholding tax purposes, with respect to FIRPTA, and both a QFPF and a QCE can provide a non-foreign affidavit to the relevant withholding agent to claim an exemption from FIRPTA.17
The Preamble notes that the IRS and Treasury received comments requesting clarification as to whether QFPFs or QCEs qualify as “foreign persons” for purposes of determining DC REIT status. In response to these comments, the Preamble notes that Section 897(h)(4), relating to determining DC REIT status, uses the term “foreign persons,” and not “nonresident individuals or foreign corporations” (as used in Section 897(l)). Even though Section 897(l) provides that a QFPF or a QCE is not treated as a nonresident alien individual or a foreign corporation for purposes of FIRPTA, it does not expressly provide that a QFPF or a QCE is not treated as a foreign person for purposes of determining DC REIT status.
Accordingly, the Preamble concludes that it does not appear that Congress intended for Section 897(l) to provide that QFPFs and QCEs are not treated as “foreign persons” for purposes of applying the DC REIT exemption to other non-U.S. persons (who may invest in such REIT) that are neither QFPFs nor QCEs. Otherwise stated, the majority ownership of a REIT by a QFPF or a QCE should not allow other non-U.S. persons to avoid FIRPTA on a sale or disposition of such non-U.S. persons’ interests in the REIT.
Practical application of Proposed Regulations
Look-through rule for foreign owned domestic corporations.
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. Particularly, sponsors should closely scrutinize DC REIT structures that include U.S. corporations that have sizable non-U.S. ownership. Sponsors may need to request additional information and certifications relating to the beneficial ownership of their investors.
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. Further, sponsors may wish to add transfer and/or redemption restrictions in any applicable fund documents to ensure that any indirect non-U.S. shareholding (through U.S. corporations) does not cause a REIT that is intended to qualify as a DC REIT to lose its qualification as a DC REIT.
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% of the stock of a REIT may be held by U.S. taxable investors and U.S. tax-exempt investors, and 49% of the stock may be held by a non-publicly traded U.S. corporation that is held collectively by non-U.S. investors (please refer to the structure in Exhibit 1). Here, the look-through rule of Prop. Reg. 1.897-1(c)(3)(iii)(B) is not expected to impact the REIT’s qualification as a DC REIT because 51% 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.
By contrast, the Proposed Regulations are expected to impact real estate funds that do not rely on the direct shareholding of their U.S. investors, but rather, rely on the direct, majority ownership of a U.S. corporation that includes material ownership by non-U.S. investors for purposes of qualifying a REIT as a DC REIT.
Treatment of QFPFs and QCEs.
The treatment of QFPFs and QCEs as “foreign persons” for purposes of determining DC REIT status, pursuant to the Proposed Regulations, is primarily expected to impact non-U.S. investors that do not qualify as QFPFs or QCEs (or that are not entitled to an exemption pursuant to Section 892),18 rather than QFPFs or QCEs and, in particular, where an exit is planned to be structured as a sale of the REIT. Specifically, to the extent a sponsor of a real estate fund has historically been treating any ownership by a QFPF or a QCE in a REIT as ownership by a U.S. person for purposes of determining DC REIT status, then such REIT may no longer qualify as a DC REIT.
As such, a non-U.S. investor (who does not qualify as a QFPF or a QCE or is not otherwise exempt from tax pursuant to Section 892) is expected to be subject to tax under FIRPTA on a sale or disposition of its interest in such REIT. However, a QFPF or a QCE is expected to continue to be exempt from tax under FIRPTA on a sale or disposition of its interest in such REIT, regardless of the REIT failing to qualify as a DC REIT.19
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.20 However, the Preamble indicates that the IRS may challenge positions contrary to Prop. Regs. 1.897-1(c)(3) and (4) before the issuance of final regulations relating to topics addressed in the Proposed Regulations (i.e., presumably to attribute indirect ownership through a look-through person in certain circumstances).
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.
Conclusion
The Proposed Regulations significantly impact the determination of a REIT’s qualification as a DC REIT. First, the Proposed Regulations consider a fully taxable U.S. corporation that qualifies as a “foreign owned domestic corporation” to be a look-through entity (similar to a partnership) for U.S. federal income tax purposes. Accordingly, REITs that previously took the position that they qualified as DC REITs may no longer qualify as DC REITs pursuant to the Proposed Regulations. As a result, non-U.S. investors in such REITs are generally expected to be subject to tax pursuant to FIRPTA upon a sale or disposition of their interest in such REITs (assuming that the non-U.S. investor does not qualify for a special exemption as a QFPF, QCE, or pursuant to Section 892).
Second, the Proposed Regulations clarify that a QFPF or a QCE is treated as a “foreign person” for purposes of determining whether a REIT qualifies as a DC REIT. This change is likely to impact non-U.S. investors that do not qualify as QFPFs or QCEs (or that are not otherwise exempt under Section 892) in a REIT that fails to qualify as a DC REIT. However, QFPFs or QCEs (and Section 892 investors that meet the requirements of that Section) are expected to continue to be exempt from tax under FIRPTA on a sale or disposition of their interest in such REIT, regardless of the REIT failing to qualify as a DC REIT.
Finally, sponsors of funds or tax structures that currently use REITs that qualify as DC REITs should factor in the possible retroactivity of the Proposed Regulations. Particularly, the Proposed Regulations apply to transactions (here, the sale or disposition of REIT stock) occurring on or after the date when the Proposed Regulations are finalized. Because a REIT must qualify as a DC REIT at all times during the five-year testing period, a sale of DC REIT stock may occur after the date of finalization of the Proposed Regulations, but the testing period may stretch into periods prior to the finalization of the Proposed Regulations. As such, the look-through rule for foreign-owned domestic corporations may apply to periods prior to the finalization of the Proposed Regulations.
Although it is possible that the Proposed Regulations may not be finalized as issued, sponsors should nonetheless consider the possible retroactivity of the Proposed Regulations prior to undertaking any restructuring transactions. In this respect, the Preamble also warns that the IRS may challenge positions contrary to the Proposed Regulations relating to the topics addressed in the Proposed Regulations. This statement leaves open the possibility of the IRS attributing indirect non-U.S. ownership through a direct U.S. corporate owner in periods before the Proposed Regulations are finalized.
Both sponsors and investors in real estate funds, private equity funds, and other investment structures involving domestically controlled REITs should analyze the application of the Proposed Regulations to their funds or investment structures.
Sponsors of funds or tax structures that currently use REITs that qualify as domestically controlled REITs should factor in the possible retroactivity of the Proposed Regulations.
Vasudha Anil Kumar is an Associate in Linklaters LLP’s U.S. Tax Group and Max Levine is a Partner and the Head of Linklaters LLP’s U.S. Tax Group. The authors are grateful to their colleague, Gabriel Grossman, for his comments to this article.
1 REG-100442-22, issued on 12/29/2022.
2 Section 897(a).
3 Section 897(c)(2).
4 Section 897(h)(2); Reg. 1.897-1(c)(2)(i).
5 Section 897(h)(1). However, a special exemption may be available to “qualified foreign pension funds.”
6 Section 897(h)(4).
7 Reg. 1.897-1(c)(2)(i).
8 Reg. 1.857-8(b).
9 Id.
10 Ltr. Rul. 200923001 (6/5/2009).
11 Prop. Reg. 1.897-1(c)(3)(iii)(B).
12 Prop. Reg. 1.897-1(c)(3)(v)(B).
13 The authors note that other areas of the Code, such as the pension-held REIT rules under Section 856(h)(3)(D), analyze the ownership of a single investor to determine if a similar 25% ownership threshold is met.
14 Prop. Reg. 1.897-1(c)(3)(vi)(B), Example 2.
15 Prop. Regs. 1.897-1(c)(3)(iv)(A), 1.897-1(c)(3)(vi)(A), Example 1(4). The Proposed Regulations also provide that an international organization as defined under Section 7701(a)(18) is treated as a “foreign person” for purposes of determining DC REIT status (See Prop. Reg.1.897-1(c)(3)(iv)(A)).
16 Section 897(l)(1); Reg. 1.897(l)-1(b)(1).
17 Section 1445(f)(3); Regs. 1.1445-2(b)(2)(i), 1.1445-5(b)(3)(ii)(A).
18 Any gain realized by a foreign government from a disposition of stock in a non-controlled USRPHC, including a REIT, is generally exempt from tax under Section 892, provided that neither the USRPHC nor its foreign government shareholder is a controlled commercial entity (See Regs. 1.892-3T(a)(1), 1.892-3T(b), Example 1, and 1.892-5T(b)(1)). A detailed discussion of the exemption under Section 892 is beyond the scope of this article.
19 QFPFs and QCEs are expected to be exempt from any gain on the sale or disposition of their interest in a REIT and on any capital gain dividends from a REIT, regardless of the REIT’s qualification as a DC REIT (Section 897(l)(1); Reg. 1.897(l)-1(b)(1)).
20 Prop. Reg. 1.897-1(a)(2).
