PATH Act –FIRPTA-Related Changes

Peter J. GenzKing & Spalding LLP

David A. LevineOffice of Associate Chief Counsel – International

Jason YenOffice of International Tax Counsel

International Tax Institute

Tuesday, March 15, 2016

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Background -- Pre-PATH Act Interface Between REITs and FIRPTA

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DC REIT Exception

• Capital gains recognized by non-U.S. investor on sale of shares of U.S. corporation are exempt from U.S. tax absent FIRPTA.

• Gain recognized by a foreign person from sale of a U.S. real property interest (“USRPI”), including shares of a U.S. real property holding corporation (“USRPHC”) or former USRPHC, is treated as effectively connected income (“ECI”) under section 897 and subject to FIRPTA tax absent an exception.

• REITs are generally USRPHCs unless they are mortgage REITs.• Gain from sale of REIT shares is therefore subject to FIRPTA tax unless the

publicly traded exception in section 897(c)(3) applies or the “domestically controlled REIT” (“DC REIT”) exception in section 897(h)(2) applies.– To qualify as a DC REIT, foreign persons must own, “directly or

indirectly,” less than 50% of value of the REIT’s shares throughout a five-year look-back period – Section 897(h)(4)(B).

– Prior to the PATH Act, no statutory constructive ownership rules applied. The PATH Act introduced certain new presumptions and a limited look-through rule (to be discussed).

– The rationale for the DC REIT exception is shrouded in mystery.

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Section 897(h)(1) -- REIT Distributions

• A REIT can designate dividends as capital gain dividends to the extent REIT recognizes net capital gain from sale of properties.

• REIT “distributions” paid to a nonresident alien or foreign corporation that are “attributable to” gain from sale of USRPIs are treated as FIRPTA gain -- Section 897(h)(1).

• A shareholder of a publicly traded REIT that has owned 10% or less (prior to the PATH Act it was 5% or less) of the REIT’s shares during the one-year period ending on the date of distribution is not subject to section 897(h)(1) (the “Publicly Traded (h)(1) Exception”).– Instead, such distributions are treated as ordinary

dividends and subject to the regular U.S. dividend withholding regime – Section 857(b)(3)(F).

• Section 897(h)(1) distributions are sometimes referred to herein as “FIRPTA distributions.”

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Section 897(h)(1) -- Tiered REIT Rule

• Tiered REIT rule -- capital gain dividends paid by subsidiary REIT to parent REIT retain their FIRPTA taint when paid out as dividends by parent REIT to its non-US shareholders.

– See Section 897(h)(1) (providing for such treatment with respect to distributions from a “qualified investment entity” to another “qualified investment entity”).

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FIRPTA Withholding on Section 897(h)(1) Distributions

• Section 1445(e)(6) provides that a REIT must withhold on any portion of a distribution attributable to USRPI gains a tax equal to 35% (or, to the extent provided in regulations, 20%) of such portion.

• The existing FIRPTA withholding rules applicable to REIT distributions in Treas. Reg. § 1.1445-8 have not been amended since this legislative change.

• The Conference Report accompanying section 1445(e)(6) states that “[n]o inference is intended regarding the existing Treasury Regulations in force under section 1445 with respect to REITs.” H.R. Conf. Rep. No. 455, 109th Cong., 2d Sess. 503, n. 532 (2006).

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IRS Notice 2007-55

• Up until 2007, many tax advisors took the position that section 897(h)(1) applied only to distributions that were or could have been designated as capital gain dividends.– REIT liquidating and redemption distributions cannot be designated as

capital gain dividends because they are not “dividends,” even though they can be deducted by REIT under section 562(b).

– Treas. Reg. § 1.1445-8 requires FIRPTA withholding only on distributions that are or could have been designated as capital gain dividends.

– PLR 9016021 (Jan. 18, 1990), later revoked by PLR 200453008 (Sept. 27, 2004), could fairly be read (until it was revoked) as implying that liquidation distributions were not subject to section 897(h)(1).

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IRS Notice 2007-55

• IRS Notice 2007-55 announced that the IRS intends to issue regulations (retroactive to the date of the Notice) taking the position that section 897(h)(1) applies to liquidating and redemption distributions as well as capital gain dividends – This treatment applies even though liquidating and redemption

distributions are not dividends or income, but rather an amount realized for stock under sections 302(a) and 331, and cannot be designated by the REIT as capital gain dividends.

• This rule applies even if a REIT is a DC REIT and, if the REIT is foreign controlled, even if the foreign investor is a foreign government (a sovereign wealth fund, or “SWF”) entitled to the benefit of section 892 on a minority interest stock sale in a USRPHC that otherwise would be taxed under FIRPTA.

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IRS Notice 2007-55 --Impact on SWFs

• The second part of the IRS Notice proclaims that section 892 does not exempt section 897(h)(1) distributions from FIRPTA tax.

• Real estate capital gains articles of many treaties give US the right to tax gain recognized by home country residents on alienation of real property situated in the United States -- e.g., Article XIII of Canadian treaty.

• Notice 2007-55 states that capital gains articles of tax treaties give the U.S. the authority to tax section 897(h)(1) distributions and that IRS will issue regulations to make this explicit.

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IRS Notice 2007-55

• Compelling arguments can be made that Notice goes beyond Congressional purpose and statutory scheme.– Sections 331 and 302 treat a distribution as a sale or exchange

by the shareholder.– Treas. Reg. § 1.856-1(e)(3) provides that sections 331 and 302

apply to REITs and their shareholders in determining whether REIT distributions are treated as a payment in exchange for stock.

– So, if a third party stock sale is exempt from FIRPTA (due to DC REIT exception or section 892), why should a sale of shares back to liquidating REIT be taxed differently?

– Extensive lobbying efforts with IRS and Treasury to reverse this position have been unsuccessful.

– The 2015-2016 Priority Guidance Plan does not include any guidance under section 897(h)(1).

IRS Notice 2007-55

• In the case of a public REIT liquidation or redemption, Notice 2007-55 does not apply to a shareholder that is entitled to claim the benefit of the Publicly Traded (h)(1) Exception.

• Further, per Advice Memorandum 2008-003 (Feb. 15, 2008), such amounts are likewise not treated as ordinary dividends under section 857(b)(3)(F).

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Sale of Shares of DC REIT Still Exempt From FIRPTA Tax

• Notice 2007-55 did not change the tax treatment of gain from a bona fide sale of DC REIT shares; still exempt from FIRPTA tax for all non-US investors.

• Section 892 still applies to gain recognized on the sale of USRPHC shares for a SWF investor (even as to a USRPHC that is a foreign-controlled REIT) as long as it does not have actual control or effective practical control (directly or through an intervening partnership).

New Path Act FIRPTA Exceptions

• Section 897(l), enacted by the PATH Act, creates another FIRPTA exemption for USRPIs held by “qualified foreign pension funds” and their wholly owned subsidiaries and for REIT distributions they receive.– This exception applies to USRPI shares of all current or

former USRPHCs, including REITs that so qualify.

• Section 897(k)(2) creates another exception for certain “qualified shareholders” of public or private REITs.

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Issues in Structuring REIT Share Sale

• Buyers typically want to buy assets, not shares -- they are often reluctant to buy shares due to the risk of undisclosed tax liabilities and other contingent liabilities.

• At a minimum, buyer will want to perform tax due diligence on current and past REIT tax status, may insist on a tax opinion from seller’s counsel, and probably will require indemnity.– Seller may not want to pay for an opinion and tell buyer to rely solely

on diligence and indemnity.

• Buyer may insist on a price concession to accommodate seller’s FIRPTA tax objectives.

• More difficult to structure a share sale for smaller, non-trophy properties (e.g., multifamily), where buyers and their advisors may be less sophisticated and regard this as an expensive and bewildering deal complication.

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Issues in Structuring REIT Share Sale

• Buyer will typically want to liquidate the REIT to get a stepped up basis in property without incurring any additional tax.

• This works as long as buyer is not a corporation and liquidation can be structured as a section 331 liquidation.– If buyer is a corporation, must structure to avoid section 332

liquidation.

– One possibility is to have buyer form a partnership between two of its corporate affiliates which is the purchaser, then liquidate the REIT into the partnership.

• If buyer is a fund with foreign investors, buyer inherits a built-in section 897(h)(1) issue, which may be a nonstarter (“pass the trash”).

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Seller Concerns in REIT Share Sale

• Ownership of buyer must allow REIT to continue to qualify as a REIT for that taxable year, which means it must meet the “5 or fewer” stock ownership test.– Otherwise, seller loses benefit of DC REIT exception, because it only applies to

a entity that qualifies as a REIT for the taxable year of the share sale.• Seller should negotiate for commitment by buyer not to designate any pre-sale

capital gain dividends or ordinary dividends as FIRPTA gain.• Some tax advisors believe that buyer should be precluded from liquidating the

REIT for some period of time (e.g., until the following taxable year) to avoid the step transaction risk that transaction is recast as an asset sale under a Kimbell-Diamond type theory.– Rev. Rul. 90-95 says no Kimbell-Diamond recast where there is a qualified

stock purchase, but technically its holding is limited to corporate purchasers.– Even if buyer is not a corporation, this should be a non-issue because Kimbell-

Diamond applied only to buyer; case law held that the seller still had stock sale treatment (i.e., one-handed clap).

• A legitimate reason for seller to want buyer to delay a REIT liquidation until following taxable year is to ensure that no property sale gain is recognized in the year of the share sale that could potentially cause any pre-share sale distributions that seller may have received to be treated as FIRPTA gain.

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Foreign Controlled REIT -- Section 892 Exemption

• Safety in numbers -- Foreign sovereign can form a fund with other foreign sovereigns to acquire 100% (other than accommodation shares) of a foreign-controlled private REIT. – This assumes none of the sovereigns qualifies for the new section

897(l) FIRPTA exemption for “qualified foreign pension funds.”

• If no single government investor has effective practical control of the fund or the REIT, and the SWF’s own controlled entity is structured so that it is not a “commercial” entity, then – REIT dividends are exempt from 30% withholding tax, and – gain on sale of REIT shares is exempt under section 892,

even though REIT is foreign-controlled (looking through the domestic partnership) and its shares are classified as USRPIs.

• If REIT does a property sale, however, FIRPTA tax still applies to SWF’s share of distribution of sales proceeds (section 897(h)(1), as interpreted by Notice 2007-55).

SWF Club Deal Example

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SWF Club Deal With Multiple Properties

• Assume SWF wants to invest in a club deal with at least one other SWF and a US fund sponsor. Assume that neither SWF would meet the requirements for the QFP exemption in section 897(l).

• The deal is that any property exit must be structured as REIT share sale so that section 892 exempts the gain.

• Each SWF must not have actual control (50% or more of vote or value) or “effective practical control” of the REIT.

• Bear in mind that SWF’s controlled entity must avoid being classified as a “foreign USRPHC “ to ensure that it is not a “commercial” entity. This may require that any REIT investment be structured as a DC REIT.

• Since the deal involves the purchase of multiple properties, one issue is whether you start off with multiple one-off REITs owned by the fund partnership (or a parent REIT that holds the one-off REITs), or a single REIT that owns the entire portfolio in disregarded SPEs.

• The sponsor may prefer one REIT initially if the intent is to hold for an extended period of time – minimize compliance costs, REIT monitoring, and preferred shareholder leakage.

• Using a single parent REIT also allows income and losses from the various properties to offset, and reduces potential sensitivity to impermissible services and other potential sources of nonqualifying income with respect to a single property.

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SWF Club Deal With Multiple Properties

• The plan could be to have the parent REIT contribute a particular property to a new “baby” REIT (which may be effected by filing a check the box election for the SPE vehicle) prior to sale in a transaction intended to be tax-free under section 351, then negotiate a REIT share sale with buyer.

• To prevent the SPE from simply becoming a “qualified REIT subsidiary” of the parent REIT, preferred accommodation shares must be issued at the time of the intended baby REIT formation.

• To qualify as a section 351 exchange, the parent REIT and accommodation shareholders must have section 368(c) control of the baby REIT immediately after the exchange – control is broken if there is a binding commitment to sell the shares at the time of the contribution.

• Parent REIT recognizes FIRPTA gain if the property is contributed subject to liabilities in excess of basis. Section 357(c).

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Taxation of Distributions to SWF from Parent REIT Attributable to Lower-Tier REIT

• When a foreign-controlled parent REIT sells shares of a subsidiary (baby) REIT, how is the gain characterized for purposes of section 897(h)(1) and the section 892 regulations?

– Under section 897(h)(1)’s tiered-REIT rule, USRPI gains recognized by a lower-tier REIT retain their character as such when distributed to an upper-tier REIT and paid out by the upper-tier REIT to its non-U.S. shareholders, even though the upper-tier REIT is a domestic person.

– The section 892 regulations provide that a foreign government is taxable on gain from the sale of a USRPI described in section 897(c)(1)(A)(i) but is not taxed on gain from the sale of a USRPHC described in section 897(c)(1)(A)(ii) (provided no actual or effective practical control). Treas. Reg. §1.892-3T(b), Example (1).

• Here there is an interesting collision between section 892 and FIRPTA:

– Following the PATH Act changes to the DC REIT rules, the subsidiary REIT is treated as foreign controlled under the look-through rule of section 897(h)(4)(E)(iii), and thus its shares are a USRPI. However, section 892 ought to trump section 897(h)(1) in this context, because gain recognized by the SWF if it directly owned an interest in the subsidiary REIT would be exempt under section 892 (assuming no actual or effective control).

– Stated differently, section 897(h)(1) should not cause gain from the sale of the subsidiary REIT’s shares to be treated as gain from the sale of a USRPI described in paragraph (i) of section 897(c)(1)(A).

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Step Transaction Risk for Baby REIT Formation

• If the baby REIT formation occurs in close proximity to the share sale, and the buyer immediately liquidates the baby REIT, there is a risk that IRS will disregard the baby REIT altogether and treat the transaction as an asset sale by Parent REIT to buyer, triggering FIRPTA gain to the SWFs under section 897(h)(1).– Step transaction doctrine.

– West Coast Marketing, 40 T.C. 32 (1966) – taxpayer contributed vacant land to a C corporation in a purported section 351 exchange at a time when a price had been agreed to with a buyer (a public corporation) and the buyer’s board had approved the transaction.

• The C corporation was then acquired by the public buyer in a share-for-share exchange roughly six months after formation in a purported tax free B reorganization; the buyer liquidated the target one a half months later. Thus, the target’s existence was short-lived

• Tax Court held that the transaction was in substance a taxable asset sale; it noted that the target corporation only held raw land and was merely a conduit for passing title to the buyer

• Rev. Rul. 70-140 is similar; IRS ruled that the transaction violated the “control immediately after the exchange” requirement of section 351

– Court Holding case – sale of property was negotiated by corporation with buyer; corporation then adopted plan of liquidation and distributed the property to its shareholder, who closed on the sale to buyer – Supreme Court held that the sale was in substance made by, and taxed to, the liquidating corporation.

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Issues for Baby REIT Buyer

• If buyer intends to liquidate the corporation immediately after the sale, the West Coast Marketing risk for seller increases if the baby REIT was recently capitalized.

• Buyer typically wants to liquidate the REIT quickly in a section 331 liquidation and obtain a basis step-up in the property reflecting the share purchase price.

• Buyer may be concerned about potential dealer tax in a REIT liquidation since the baby REIT will not have held the property for rent for two years.

• Delaying the REIT liquidation to reduce any potential dealer risk means that the buyer will recognize gain under section 331 on any post-acquisition appreciation in the REIT shares when liquidation occurs.

• Buyer may ask to perform due diligence on parent REIT as well as baby REIT because of “successor rules.”

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FIRPTA Changes Made by PATH Act

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PATH Act of 2015

• The Brady-sponsored Tax Increase Prevention and Real Estate Investment Act of 2015 (H.R. 34, introduced Dec. 7, 2015) (“TIPREIA”) included a number of FIRPTA changes (see sections 213 and 214) that had been proposed in other bills.

• These proposals (with only a few word changes), plus a couple of provisions that were part of S. 915, were incorporated into the PATH Act bill released by the House on December 15, 2015 and signed by the President on December 18, 2015. It also includes a package of extenders, some non-FIRPTA REIT changes, and a permanent enactment of a 5-year recognition period under section 1374 (which also applies to REITs subject to the built-in gains tax).

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JCT Explanation

• The Joint Committee explanation of the bill is really not much of an explanation. See Staff of Joint Committee on Taxation, Technical Explanation of the Protecting Americans from Tax Hikes Act of 2015, House Amendment #2 to the Senate Amendment to H.R. 2029 (Rules Committee Print 114-40), JCX-144-15 (December 17, 2015) (the “JCT Explanation”).

• It is understood that the Bluebook on the PATH Act is due to be released shortly and may contain additional guidance on the FIRPTA changes.

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Summary of PATH Act FIRPTA Amendments

• The PATH Act FIRPTA changes include:– Changes to the DC REIT rules relating to the determination of domestic control (section

322(b)(1)(A)).– A FIRPTA exemption for “qualified foreign pension funds“ and their wholly owned subsidiaries

(section 323).– An increase in the ownership ceilings from 5% to 10% in the Publicly Traded (c)(3) exception

for public REITs only, and a corresponding increase from 5% to 10% for the Publicly Traded (h)(1) exception (section 322(a)(1)).

– An increase in the FIRPTA withholding rate from 10% to 15%), effective for dispositions after the date which is 60 days after date of enactment (i.e., dispositions after February 16, 2016) (section 324).

– A repeal of the section 897(c)(1)(B) “cleansing exception” as applied to REITs (and RICs that are USRPHCs) (section 325).

– A new, complicated (and seemingly limited in scope) “qualified shareholder” FIRPTA exemption for REIT investments made by certain foreign public real estate investment trusts and certain foreign partnerships that are publicly traded in the U.S. and hold predominantly U.S. real estate (section 322(a)).

• The PATH Act also amended section 245(a) to treat dividends received by a foreign corporation from REITSs and RICs as received from corporations that are not domestic persons, for purposes of determining the U.S. source portion of dividends paid by the foreign corporation (section 326).

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Initial PATH Act FIRPTA Regulations

• A first set of regulations dealing with the FIRPTA changes was issued on February 19, 2016. T.D. 9751, 81 Fed. Reg. 8398 (the “PATH Act Regulations”).

• These regulations are very limited in scope and include changes to the existing regulations to:– reflect the repeal of the cleansing rule for USRPHCs that are current or

former REITs (Treas. Reg. § 1.897-2(f)(2(iii)), – reflect the increase in the FIRPTA withholding rate from 10% to 15%

effective for dispositions and distributions occurring after February 16, 2016 (Treas. Reg. § 1.1445-1(h)),

– delete the outdated Philadelphia Service Center mailing address for FIRPTA certificates and notices (now they go to the Ogden Service Center), and

– reflect the exclusion of “qualified foreign pension funds” and their wholly owned subsidiaries (both as defined under section 897(l)) from the definition of “foreign person” in Treas. Reg. § 1.1445-2(b)(2)(i)(C).

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PATH Act -- Increase In FIRPTA Ownership Ceilings for Public REITs

• The PATH Act increased from 5% to 10% the ownership threshold under the publicly traded exception in section 897(c)(3) (the “Publicly Traded (c)(3) Exception”), but only as applied to public REITs. Section 897(k)(1)(A).

– Thus, there is no FIRPTA tax on the sale of public REIT shares by a 10% or less foreign shareholder (taking into account attribution rules). The 5% ownership threshold would continue to apply to sales of shares of publicly traded USRPHCs that are not REITs.

• The PATH Act also increased from 5% to 10% the ownership threshold under the Publicly Traded (h)(1) Exception applicable to public REITs. Section 897(k)(1)(B).

– The ordinary dividend withholding tax applies (subject to applicable treaty reduction) in lieu of the FIRPTA tax. Section 857(b)(3)(F). However, consistent with AM 2008-003 (Feb. 15, 2008), a nondividend distribution (such as a redemption) fully escapes U.S. tax. See S. Rep. No. 114-25, p. 10 (confirming this conclusion).

• Unfortunately, Notice 2007-55 is not repealed by the PATH Act and IRS and Treasury officials have indicated repeatedly the IRS is sticking by the Notice.

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DC REIT Exception (Before PATH Act)

• The FIRPTA regs require “actual owners” of REIT shares, as determined under Treas. Reg. § 1.857-8, to be “taken into account” in making DC REIT determination – Treas. Reg. § 1.897-1(c)(2)(i).– Treas. Reg. § 1.857-8 refers to the person required to include dividends in

income.

• Tax advisors generally agree that a fund partnership would be “looked through” to its partners (the persons required to include dividends in income) for purposes of testing DC REIT status.

• A US “C corporation” (“USCo”) owned by foreign investors is an “actual owner” of the REIT shares and generally should be treated as a domestic owner for DC REIT purposes, with no look-through, and the PATH Act changes reinforce this view (as will be discussed).

• Always desirable for USCo to have other assets and activities to reduce risk of possible sham or section 269 challenge.

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PLR 200923001

• In PLR 200923001 (Feb. 26, 2009), the outstanding common stock of a private REIT was owned by USCo B and USCo C, both of which were domestic, non-REIT C corporations.

• The common stock of USCo B was owned by a foreign partnership, which in turn was owned, in part, by a publicly traded foreign corporation (“Public ForCo”).

• The preferred stock of USCo B was owned by USCo C.

• The direct and indirect owners of the common stock of USCo B were apparently all foreign persons.

• All of the shares of USCo C were owned by a wholly owned foreign subsidiary of Public ForCo.

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PLR 200923001

• In the proposed transaction, USCo C proposed to sell some of its common REIT shares to a fund partnership that would have domestic and foreign investors.

• The taxpayer represented that USCo B and USCo C would own more than 50% of the value of the REIT’s outstanding shares after the transaction.

• The ruling also states that USCo B and USCo C are USRPHCs for FIRPTA purposes and that neither of the C corporations had elected to be taxed as a REIT or RIC and was not otherwise a “conduit” (or some form of lookthrough entity).

• The IRS ruled that “actual owners” of the REIT common shares were USCo B and USCo C because they were the persons required to include the REIT dividends in income. Thus, they constituted "good" domestic ownership for purposes of testing DC REIT status.

• In other words, the IRS adhered to the “actual owner” rule and did not look through the USCos to their foreign shareholders.

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Is a Parent REIT “Looked Through” When Testing a Subsidiary REIT’s DC REIT Status?• Before the PATH Act amendments, it was not clear if “directly or indirectly”

meant that a look-through rule applies when parent REIT owns shares of subsidiary REIT. – Parent REIT is a domestic person and is technically the “actual owner” of the

subsidiary REIT shares that includes the subsidiary REIT dividends in income.– How does a public REIT know who its foreign shareholders are? – What if the public REIT has a known foreign shareholder component that is large?– A private parent REIT was more problematic because the ultimate share ownership

facts were generally (but not always) known.– But if parent REIT was a pre-existing, bona fide REIT with multiple investors and

held other properties besides the shares of the subsidiary REIT, a look-though approach arguably was inappropriate.

– If a REIT fund was an open-end fund, controlling its future non-U.S. investor base was a bigger issue. Will the fund commit that it will not allow foreign ownership percentage to go beyond X%?

– In the absence of guidance, under pre-PATH Act law tax advisors generally were reluctant to opine on a subsidiary REIT’s status as a DC REIT where the parent REIT was substantially or wholly owned by non-U.S. persons and a look-through approach would have caused the subsidiary REIT to be foreign controlled.

– This issue may not matter to a foreign shareholder of the parent REIT that is eligible for section 892 exemption with respect to the parent REIT.

PATH Act – DC REIT Provisions

• The DC REIT changes in the PATH Act are identical to those included in H.R. 2128 and S. 915.

• S. Rep. No. 114-25, p. 12 (accompanying S. 915, which had similar DC REIT provisions) states in the “Reasons for Change” section that “uncertainty [as to whether a REIT is domestically controlled] might affect foreign investment in such entities.”

• The problematic “directly or indirectly” language in the DC REIT ownership test is unchanged, but specific rules are added to section 897(h)(4)(B) (the provision that defines a DC REIT) “for purposes of determining the holder of stock.” Section 897(h)(4)(E).

– Any shareholder holding less than 5% of a publicly traded REIT’s traded class of shares at all times during the testing period is “treated as a United States person” unless the public REIT has actual knowledge to the contrary. Section 897(h)(4)(E)(i).

– Shareholders owning 5% or more will have to be diligenced if their ownership is significant and the public REIT wants to be certain about its DC REIT status.

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PATH Act – DC REIT Provisions

• Any stock of a REIT that is held by a publicly traded REIT (or a RIC that issues redeemable securities) is treated as held by a foreign person, unless the parent entity itself is domestically controlled (after applying the new rules), in which case the parent is treated as a U.S. shareholder of the lower-tier REIT. Section 897(h)(4)(E)(ii).

• This rule is particularly important for non-U.S. investors who invest in a private REIT jointly with a public REIT, and the non-U.S. investor wants the private REIT to qualify as a DC REIT.

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PATH Act – DC REIT Provisions

• Any stock of a subsidiary REIT held by a private parent REIT or RIC is treated as held by a U.S. person in proportion to the stock of the parent REIT or RIC that is “held by” (or treated as held by under one of the new rules) a U.S. person. Note that the look-through provision says “held by,” but does not repeat the general “directly or indirectly” test of ownership. Section 897(h)(4)(E)(iii).

• In other words, a private REIT parent is looked through and its domestic and foreign shareholders are treated as owning a proportionate interest in a lower-tier REIT.

• Example: Publicly traded REIT owns 40% of private REIT 1. The other 60% is owned by foreign persons. Private REIT 1 owns 70% of private REIT 2, and the other 30% is directly owned by U.S. persons. – Assume public REIT is treated as a domestic shareholder in its entirety under the

section 897(h)(4)(E)(i) presumption. Thus, the public REIT is treated as a U.S. person that owns 28% (40% x 70%) of private REIT 2. This indirect U.S. ownership coupled with the direct domestic ownership puts the total U.S. ownership of private REIT 2 at 58%, and it qualifies as a DC REIT.

– Assume instead that private REIT 1 is held 80% by non-U.S. persons and 20% by U.S. persons. This means that 56% (80% x 70%) of the stock of private REIT 2 is owned by foreign persons. It does not qualify as a DC REIT.

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PATH Act – DC REIT Provisions

• This puts the nail in the coffin on the argument that a subsidiary REIT can qualify as a DC REIT if it is owned by a privately held parent REIT (a domestic person), even if the parent REIT is wholly owned by foreign persons.

• Congress once again passed on the opportunity to adopt explicit constructive ownership rules for purposes of the DC REIT test. The only exception is the express look-through rule for a private REIT or RIC shareholder of a lower-tier REIT. “Directly or indirectly” is still the rule of the day. – Tax advisors will continue to assume that domestic partnerships are

looked through under the “indirectly” aspect of the test and the fact that the partners, rather than the partnership, are required to pay tax on REIT dividends received by the partnership.

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PATH Act – DC REIT Provisions

• The express look-through rule for private REITs can be seen as further support for the view that a C corporation shareholder of a REIT is notlooked through, as the IRS ruled in PLR 200923001 (Feb. 26, 2009). – This private ruling was also cited in the discussion of existing law regarding the

“domestically controlled” test in S. Rep. No. 114-25, 114th Cong., 1st Sess. at 6 (2015), which accompanied S. 915.

• It should be stressed that, in contrast to public DC REITs that are treated (under the presumption) as entirely domestic owners of lower-tier REITs, a private REIT parent is NOT treated as a domestic owner of a subsidiary REIT (even if the parent private REIT is a DC REIT). Instead, the parent private REIT is looked through to the persons that hold its shares.

• The DC REIT amendments are effective on the date of enactment. PATH Act Section 322(c)(2).

• S. 915 would have amended section 897(h)(4)(B) to provide that a REIT would not be treated as a DC REIT for any period unless the entity makes a disclosure of such status on its annual report or, if it does not file an annual report, on its website. This was not included in the PATH Act.

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PATH Act Repeals Cleansing Exception for REITs

• Section 325 of the PATH Act repeals the cleansing exception in section 897(c)(1)(B) for REITs (and for RICs that are USRPHCs). This change was not included in TIPREIA and was added in the House-Senate negotiations.

• It has never made any sense for the cleansing rule to apply to a REIT, although it literally does; this may have been an oversight by Congress in 1980.

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PATH Act QFP Exemption

• The PATH Act adds new section 897(l) to provide a FIRPTA exemption for “qualified foreign pension funds” (“QFPs”) and any entity wholly owned by a QFP.

• Before getting to the details, it is useful to review the tax treatment under current law of a foreign pension fund that invests in U.S. real estate without a REIT structure (either directly or through a partnership).

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Background -- U.S. Taxation of a Foreign Pension Entity

• Foreign corporations and nonresident alien individuals engaged in a U.S. trade or business are taxed at the regular graduated rates on income effectively connected with such trade or business, less deductions properly allocated thereto ( “ECI”). Sections 882(a)(1) and 871(b)(1). – A non-U.S. person is deemed to be engaged in the trade or business conducted by any

partnership or trust of which it is a partner or beneficiary. Section 875.

• The term “nonresident alien individual” includes a foreign trust. Reg. §1.871-2(a) (such term includes a nonresident alien fiduciary); section 7701(a)(6) (defining fiduciary).

• Section 641(b) provides that for purposes of determining the taxable income and the tax liability of a “foreign trust,” the trust is treated as a nonresident alien individual that is not present in the U.S. at any time. However, this rule expressly does not apply to domestic pension trusts. Reg. § 1.641(a)-0(a). Thus, this rule may be limited to family foreign trusts.

40

Background -- U.S. Taxation of a Foreign Pension Entity

• The U.S. tax classification of a foreign pension entity is far from clear.

• There is some authority suggesting that it can be classified as an ordinary trust, depending on its form of organization, rather than a “business entity” whose tax status would depend on the default and election rules under the check-the-box regulations.

• See PLR 199936032 (June 11, 1999) (foreign pension trust classified as an ordinary trust under Reg. § 301.7701-4(a)); PLR 200807003 (Nov. 5, 2007) (foreign entity organized to provide superannuation benefits to its members under applicable foreign law classified as an ordinary trust under Reg. §301.7701-4(a)).

• If a foreign pension is classified as a trust, it is entitled to the 20% capital gains rate on effectively connected capital gains. Section 871(b)(1); section 1(h).

• Do the subchapter J rules apply? If the QFP has ECI, are the employee beneficiaries treated as engaged in a U.S. trade or business under section 875?

41

Background – U.S. Taxation of Directly Held U.S. Real Estate Investments

• Rents from real property are FDAP income and subject to 30% withholding (subject to treaty reduction) unless treated as ECI.

• If the operation of U.S. rental real estate is a trade or business, then gain from the sale of the property is also ECI. Section 864(c)(2). Further section 861(a)(5) provides that such gain is U.S. source (this provision was enacted pre-FIRPTA and the PATH Act did not change it).

• Taxpayer can also make a Code (or applicable treaty) net basis election to treat income and gain from U.S. real property as ECI. Sections 871(d) and 882(d).

42

Background – U.S. Taxation of Directly Held U.S. Real Estate Investments

• For cases in which rental real estate was held to be a trade or business, see Pinchot v. Commissioner, 113 F.2d 718, 719 (2d Cir. 1940) (nonresident alien owned a number of parcels of improved land and managed them through an agent; court held that the taxpayer was “engaged in business” in the United States at the time of her death within the meaning of a provision of U.S. federal estate tax law because the management activities, which included maintaining the properties, were considerable, regular and continuous); Lewenhaupt v. Commissioner, 20 T.C. 151 (1953), aff'd per curiam, 221 F. 2d 227 (9th Cir. 1955); Herbert v. Commissioner, 30 T.C. 26 (1958), acq., 1958-2 C.B. 6; De Amodio v. Commissioner, 34 T.C. 894 (1960), aff'd, 229 F.2d 623 (3d Cir. 1962).

43

Background – U.S. Taxation of Directly Held U.S. Real Estate Investments

• There is also authority holding that net leased real property is not a trade or business. See, e.g., Neill v. Commissioner, 46 B.T.A. 197 (1942) (nonresident alien taxpayer leased unimproved real property to a tenant who built a building thereon and occupied it; lease was a long-term lease that required tenant to pay insurance and property taxes and maintain the property; taxpayer retained a U.S. law firm to collect the rents and make payments on the related mortgage; held, taxpayer was subject to gross basis withholding tax on the rents and could not offset the rents with interest expense deductions because the taxpayer’s activities did not rise to the level of a trade or business);

• See also Rev. Rul. 73-522, 1973-2 C.B. 226 (holding that a nonresident alien was not engaged in a trade or business within the meaning of section 871(b)(1) merely by reason of leasing rental properties in the United States where the individual’s activities were limited to the supervision of the negotiation of new leases; the IRS viewed this as not beyond the scope of mere ownership of real property or the mere receipt of income from real property “since such activity was sporadic rather than continuous (that is, a day-to-day activity), irregular rather than regular, and minimal rather than considerable”).

44

How Did Enactment of FIRPTA in 1980 Change Things?

• The enactment of section 897 in 1980 simply plugged what was then considered as “ECI loopholes.”

• By taxing all gain or loss from the sale of USRPIs as ECI, the statute ensured that gain from the sale of passive investment property, e.g., vacant land or residential property, would be taxed as ECI and not escape U.S. tax.

• FIRPTA also made gain or loss from the sale of stock of a current or former U.S. real property holding corporation (“URRPHC”) taxable as ECI; previously a non-U.S. investor could sell the shares of such a corporation free of U.S. tax, and the buyer (under then-existing corporate tax law, which was repealed in 1986) could generally liquidate the C corporation and get a basis step-up without incurring a corporate-level tax.

• FIRPTA also enacted two special rules for REITs: (i) the DC REIT exception to the foregoing USRPHC rule and (ii) section 897(h)(1), which treats distributions attributable to gain from the sale a REIT’s USRPIs as ECI.

• FIRPTA also closed certain other loopholes, such as the use of installment sales of U.S. real property to avoid U.S. tax by deferring gain recognition to taxable years when the non-U.S. investor was no longer in a U.S. trade or business. Section 864(c)(6) and (c)(7).

• FIRPTA also overrode nonrecognition provisions of the Code in certain cases.

45

Taxation of Ordinary REIT Dividends Received by Foreign Pension Trust

• The withholding rate on ordinary REIT dividends paid to foreign pension funds is often reduced to zero under tax treaties (e.g., Canadian, UK, Dutch treaties), provided the foreign pension fund is not related to the REIT.

– The Canadian and Dutch treaties limit this zero rate to amounts received from unrelated parties; the Dutch treaty uses an 80% test for this purpose.

46

PATH Act – Qualified Foreign Pension Fund Exemption From FIRPTA

• Section 323 of the PATH Act adds section 897(l), which provides that section 897 does not apply to any USRPI “held directly (or indirectly through 1 or more partnerships) …by a qualified foreign pension fund” (“QFP”). Section 897(l)(1)(A).

• The exception also applies to USRPIs held by “any entity all of the interests of which are held by a qualified foreign pension fund.” Section 897(l)(1)(B).

• The exemption also applies to any distributions received by a QFP from a REIT. (TIPREIA did not include this language; the PATH Act clarification eliminates what would have been a nagging uncertainty as to whether section 897(h)(1) gain is attributable to USRPIs “held by” a QFP.)

47

QFP Exemption – Effective Date and Reg Authority

• Section 897(l) applies to dispositions and distributions after date of enactment. SeeSection 323(c) of the PATH Act.

• The Secretary is given the authority to issue such regulations as are necessary or appropriate to carry out the purposes of the provision. Section 897(l)(3).

• The Preamble to the PATH Act Regulations requests comments regarding regulations to be issued pursuant to section 897(l)(3).

48

Background -- Administration’s Proposal to Exempt Foreign Pension Funds From FIRPTA

• The Administration’s General Explanations of the Fiscal Year 2015 Revenue Proposals, Department of Treasury, p. 138 (March 2014), described the foreign pension fund FIRPTA proposal as follows: – “The proposal would exempt from the application of FIRPTA gains of

foreign pension funds from the disposition of U.S. real property interests. For this purpose, a foreign pension fund would generally mean a trust, corporation, or other organization or arrangement that is created or organized outside of the United States; generally exempt from income tax in the jurisdiction in which it is created or organized; and substantially all of the activity of which is to administer or provide pension or retirement benefits. The Secretary would be granted authority to issue regulations necessary to carry out the purposes of the proposal, including whether for this purpose an entity or arrangement is a foreign pension fund or a benefit is a pension or retirement benefit.”

49

Background – Administration’s Proposal to Exempt Foreign Pension Funds From FIRPTA

• The Joint Committee’s explanation of the qualified foreign pension fund provision included in the Administration’s Fiscal Year 2014 budget proposals contains some interesting commentary on the Administration’s foreign pension fund proposal. See Staff of Joint Committee on Taxation, Description of Certain Revenue Proposals Contained in the President’s Fiscal Year 2014 Budget Proposal, JCS-4-13 (December 2013) (the “JCT 2014 Budget Explanation”).

50

Alleged Purpose of QFP Exemption: Level the Playing Field With U.S. Pension Funds

• The intent of the provision is to treat foreign pension funds that invest in U.S. real estate comparably to U.S. pension trusts that are exempt from tax. JCT 2014 Budget Explanation, p. 95.

• It certainly does not create parity, however. First, the PATH Act left intact the ECI regime that pre-dated FIRPTA, which means that income and gain from directly held U.S. rental real estate investments are generally taxed as ECI, irrespective of FIRPTA or the PATH Act.

• U.S. pension funds, on the other hand, generally are not taxed on directly held U.S. rental real estate operating income and sale gain.

• On the other side of the coin, a QFP is entitled to the section 897(l) FIRPTA exemption even if it would be subject to UBTI tax if it were a domestic pension fund.– UBTI could result, for example, if a pension fund leveraged its investment in a

USRPHC’s shares or because it invested in a REIT that was a “pension-held REIT” and part of the REIT dividends were taxed as UBTI.

51

Definition of QFP

• A “qualified foreign pension fund” means any trust, corporation, organization or other arrangement if:– Created or organized under the laws of a foreign country.– Established to provide retirement or pension benefits to participants or

beneficiaries that are current or former employees (or persons designated by such employees) of one or more employers “in consideration for services rendered.”

– No single participant or beneficiary has a right to more than 5% of its assets or income.

– Subject to government regulation and provides annual information reporting about beneficiaries to the foreign country’s tax authorities.

– Under the laws of the country in which it is established or operated, either:• contributions to the entity that otherwise would be subject to tax under local law are

“deductible or excluded from the gross income of such entity or taxed at a reduced rate,” or

• taxation of investment income of the entity is deferred or taxed at a reduced rate.

52

Are Foreign Sovereign Pension Plans Covered?

• The JCT 2014 Budget Explanation (pp. 95-97)discusses the administration’s proposal in some detail and suggests possible refinements and modifications. It does not comment on governmental pensions, nor does it give any specific reason why they should not be within the scope of the provision.

• The purpose of the provision was to put foreign pension funds on a parity with domestic pension funds. State pension plans are major players in the U.S. real estate market and they are generally exempt from U.S. tax on their real estate income. It seems illogical that the “parity” policy objective could have only been intended to apply to private foreign pension plans.

53

JCT 2014 Budget Explanation

• The JCT 2014 Budget Explanation suggests that the scope of the proposal might be defined by analogy to the categories of foreign pension funds described in the FATCA regulations, although it cautions that the objective of FATCA, which is transparency of U.S. ownership, is not necessarily the same as the foreign pension fund FIRPTA exemption, and hence the exceptions under FATCA might be too broad or too narrow (depending on the FIRPTA policy to be achieved).

• The FATCA statute does not specifically address foreign pension funds, but does authorize regulations providing for exemptions for certain tax-exempts and “any other class of persons identified by the Secretary … as posing a low risk of tax evasion.” Section 1471(f)(4). The final FATCA regulations identify six categories of foreign pension funds presenting a low risk of tax evasion and therefore deserving of exemption.

54

FATCA Exemption for Foreign Sovereigns

• Treas. Reg. § 1.1471-6(a) provides that the term exempt beneficial owner includes “any foreign government, any political subdivision of any foreign government, or any wholly owned agency or instrumentality of any one or more of the foregoing.”

• Treas. Reg. § 1.1471-6(b) further defines this term to mean (solely for purposes of this regulation) the “integral parts, controlled entities and political subdivisions of a foreign sovereign.”

• Such regulation does not specifically refer to the section 892 regulations’ definition of a separately organized governmental pension trust.

55

QFP Definition Similar to FATCA “Broad Participation Retirement Plan” Definition

• The QFP definition is similar in certain respects to the definition of a “broad participation retirement fund” (“BPRF”) in the FATCA regulations. See Treas. Reg. § 1.1471-6(f).

• Such regulation defines a BPRF as a “fund established to provide retirement, disability, or death benefits, or any combination thereof, to beneficiaries that are current or former employees (or persons designated by such employees) of one or more employers in consideration for services rendered,” provided that the fund—– Does not have a single beneficiary with a right to more than five percent of the

fund's assets;– Is subject to government regulation and provides annual information reporting

about its beneficiaries to the relevant tax authorities in the country in which the fund is established or operates; and

– Satisfies one or more of four conditions relating to the source of its assets, contributions, and timing of distributions. One of these conditions is that the fund is generally exempt from tax on investment income under the laws of the country in which it is established or operates due to its status as a retirement or pension plan.

56

Does QFP Exemption Apply to Foreign Government Plans?

• A foreign government pension fund that benefits governmental employees presumably also can qualify as a QFP if it meets these tests.

• Some government plans are not organized as a separate legal entity; they may be described in terminology similar to a “fund.” Because section 897(l) (2) includes an “arrangement,” the existence of a separate legal entity should not be a precondition.

• What about foreign sovereign social security-type systems? These are typically funded through taxes imposed on employer and/or employee.

– Query whether the “in consideration for services” requirement is met if funding is through governmental levy but benefits are not limited to employees of the sovereign or its agencies. In the broad sense, of course, any government benefits from having its citizens gainfully employed .

– Compare Treas. Reg. § 1.892-2T(c)(1)(i), which defines a “separately organized pension trust” that is a controlled entity of a foreign sovereign as one that is “established exclusively for the benefit of employees or former employees of a foreign government, “ or for the benefit of such persons as well as current or former nongovernmental employees that perform “governmental or social services.”

• What about foreign pension funds whose home country has no tax system (middle east)?

57

What About Disability and Death Benefits?

• What if the plan also provides for other benefits, such as disability benefits or insurance benefits?

– Presumably this will not adversely affect the exemption if the primary purpose of the plan is to provide “retirement or pension “ benefits; the statute does not say the plan must “exclusively” provide retirement or pension benefits.

– Compare Treas. Reg. § 1.892-2T(c)(1)(iii), which defines a “separately organized pension trust” that qualifies as a “controlled entity” of a foreign sovereign as one that provides “retirement, disability, or death benefits in consideration of services rendered,” and Treas. Reg. §1.1471-6(f)(2) , which defines a “broad participation retirement fund” and states that it must be a fund established to provide “retirement, disability, or death benefits, or any combination thereof.”

58

QFP Definition Similar to FATCA “Broad Participation Retirement Plan” Definition

• The first requirement for a BPRF is identical to the first requirement in section 897(l)(2)(B), except that the BPRF refers to “retirement, disability, or death benefits, or any combination thereof” while section 897(l)(2)(B) refers only to “retirement or pension benefits.”

• It seems unlikely that the addition of the word “pension” was intended to cover something not subsumed by “retirement.”

• The fact that “disability or death” benefits appear in the BRPF definition but not in section 897(l)(2)(B) could support a conclusion that plans established solely to provide disability or death benefits do not qualify for the FIRPTA exemption, but it does not necessarily mean that a plan established to provide both retirement benefits and disability or death benefits does not qualify.

59

Entity Owned by Multiple QFPs

• Section 897(l) applies not only to USRPIs held directly a QFP, but also to USRPIs held by “any entity all of the interests of which are held by a [QFP]” (a “QFP Subsidiary”). Section 897(l)(1)(B).

• This rule is written in the singular. Not surprisingly, the PATH Act Regulations do not depart from or expand upon this statutory language. See Treas. Reg. § 1.1445-2(b)(2)(i)(C).

• Suppose a foreign corporation or trust is owned by multiple foreign pension trusts, each of which is a QFP?

• The JCT Explanation refers to “a foreign entity wholly-owned by a qualified foreign pension fund.” JCT Explanation, p. 190.

• Suppose a QFP Subsidiary is indirectly wholly owned by a QFP through intermediate tier entities?

60

Entity Owned by Multiple QFPs

• Under the U.S./Canada Income Tax Treaty, dividends received by a Canadian pension fund from a U.S. corporation (including a REIT) are not subject to U.S. withholding tax if the fund is a resident of Canada, is “generally exempt from income taxation” in Canada, and is operated exclusively to administer or provide pension or retirement benefits -- Article XXI.2(a).

• Under the Fifth Protocol to the Treaty, this exemption also applies to a holding company, trust, organization or other arrangement that is generally exempt from income tax in Canada and operated exclusively to earn income for the benefit of one or more qualifying pension funds described in Article XXI.2 or charities and educational organizations described in Article XXI.1. Article XXI.3.

• This reverses the position that IRS had taken in certain private letter rulings that Article XXI organizations investing through a pooled investment fund could not avail themselves of the Article XXI exemption.

• Congress could have provided a similar exemption for co-owned pension fund vehicles in section 897(l), but did not. Whether IRS and Treasury will feel empowered to issue favorable guidance on this point remains to be seen.

• Section 897(l) expressly applies to indirect investment by QFPs in USRPIs through partnerships, so this issue is essentially limited to entities classified as corporations (and possibly also entities classified as ordinary trusts) for U.S. tax purposes.

61

Purchased QFP Subsidiaries

• Can an entity qualify as a QFP Subsidiary if it is purchased by a QFP rather than formed by a QFP and held by the QFP since inception?

• Suppose Forco is owned by NRA in Foreign Country X. Forco owns a more than 50% interest in a private REIT that owns a Manhattan office building. The shares of the private REIT constitute a USRPI. NRA sells all of the shares of Forco (foreign corporate shares are not a USRPI absent a section 897(i) election) to a QFP organized under the laws of Foreign Country Y.

• Can Forco now qualify as a QFP Subsidiary so that, upon a later sale of the REIT’s property followed by a liquidation of the REIT, Forco can claim the section 897(l) exemption from section 897(h)(1) with respect to the REIT liquidating distributions it receives?

62

Purchased QFP Subsidiaries

• If this works, the NRA may substantially avoid a purchase price haircut that a non-QFP buyer presumably would insist on before buying the stock of Forco.

• Under section 897(l) as it currently reads, this would appear to work – the statute does not specify a time frame during which “all of the interests” in the subsidiary must be “held by” the QFP parent, and the natural reading suggests that the ownership test must be met at the time the USRPI sale or REIT distribution occurs.

• The Secretary may seek to rein in this tactic by using its “necessary or appropriate” regulatory authority in section 897(l)(3) to preclude a purchased foreign corporation from qualifying as a QFP Subsidiary under these circumstances, or possibly by writing an anti-abuse regulation under the authority of the General Utilities repeal provision in section 337(d). Cf.Treas. Reg. § 1.337(d)-4(a)(1) and (2) (taxable corporation’s change in status to a tax-exempt entity treated as it sold the assets immediately prior to change for FMV).

• Exercise extreme caution here if you represent the purchasing QFP.

63

QFP Sale of Shares of USRPHC Stock After PATH Act

• Under section 861(a)(5), gain from a sale of a USRPI (as defined in section 897(c)) is treated as U.S. source income. This includes gain from sale of shares of a USRPHC (or former USRPHC).

• Absent section 861(a)(5), a foreign person’s gain from the sale of U.S. corporate stock (which is intangible personal property) would be sourced under the personal property rules in section 865.

• U.S. source capital gains are generally subject to the 30% withholding tax only if they (i) are described in section 631(b) or (c) or (ii) are from the sale or exchange of patents, copyrights, and similar intellectual property and are contingent on the productivity, use, or disposition of the property. Section 881(a)(2) and (4); section 871(a)(1)(B) and (D); Treas. Reg. § 1.881-2(a)(1) (withholding tax does not apply to gains from the sale or exchange of property except to the extent provided in Treas. Reg. § 1.881-2(c)(1)); section 1441(c)(1); Treas. Reg. § 1.1441-2(b)(2)(i); Treas. Reg. § 1.1441-5(b)(2)(i)(B). – The 30% tax does not apply, however, to the extent the FDAP income, OID, or the limited class of

capital gains described above is effectively connected with the conduct of a trade or business in the United States. Sections 881(a) and 871(a)(1) (flush language); Treas. Reg. § 1.1441-4(a).

64

QFP Sale of Shares of USRPHC Stock After the PATH Act

• A foreign person is exempt from the 30% withholding tax on gain from the sale of shares of a U.S. corporation, even if such gain is U.S. source.

• Such gain is only subject to U.S. tax if it is ECI under FIRPTA.

• After the PATH Act, a QFP’s gain on sale of shares of a USRPHC (including a foreign-controlled REIT) is completely exempt from U.S. tax.

• However, unless the USRPHC is a REIT, the buyer, whether foreign or domestic, inherits a future corporate-level tax liability on the built-in gain in the property and can be expected to discount the share purchase price accordingly.

65

Taxation of REIT Capital Gain Distributions Made to QFP

• REIT capital gain dividends are treated as gain from the sale of a capital asset held for more than one year. Section 857(b)(3)(B).

• With section 897(h)(1) out of the picture, REIT capital gain dividends paid to QFP are exempt from U.S. tax.

• The PATH Act amended section 897(b)(3)(F) to make it clear that certain distributions received by a “qualified shareholder” to which section 897(h)(1) would otherwise apply but that are exempt from FIRPTA under section 897(k)(2) are treated as ordinary dividends. However, no such amendment was made with respect to REIT distributions to which section 897(l) applies. Thus, such REIT distributions are not transmuted to ordinary dividends; rather, to the extent designated as capital gain dividends, they simply become nontaxable U.S. source capital gain – neither FDAP nor FIRPTA gain.

• This result applies even if a QFP receives a dividend from a public REIT, whether the QFP owns more or less than 10% of the REIT. Section 897(l) turns off FIRPTA with respect to such dividends as well, and thus the ordinary dividend rule of section 857(b)(3)(F) never comes into play.

66

Taxation of REIT Capital Gain Distributions Made to QFP

• The authorities below establish that such capital gain dividends paid to a foreign person are not subject to U.S. tax absent FIRPTA -- so a QFP is off the hook.

– Section 865 provides that capital gain recognized by a foreign person on the sale of personal property generally sourced to the person’s country of residence.

– Reg. § 1.1441-2(b)(2)(i) provides that gain from the sale of “property” is not “fixed and determinable annual or periodical” income (FDAP income) subject to two exceptions not relevant here.

– Reg. § 1.1441-3(c)(2)(i)(D) provides that a RIC may elect not to withhold on capital gain dividends paid to non-U.S. persons.

– Rev. Rul. 69-244, 1969-1 C.B. 215, obsoleted by T.D. 8734, 1997-2 C.B. 109, 138, provided that capital gain dividends paid by RIC to a foreign shareholder are treated as capital gain, rather than dividend income, and therefore are not FDAP income subject to withholding tax. The IRS reasoned that section 852(b)(3)(B) treats a capital gain dividend as gain from the sale or exchange of a capital asset, and while section 1441(b) requires withholding on certain enumerated types of capital gains, it does not reference section 852(b)(3)(B) capital gain dividends.

67

REITs Are More Attractive Than Ever For QFPs

• Most REIT-owned real estate would generate ECI for a QFP if held directly or through a fund partnership. So, absent FIRPTA, investing through a REIT converts ECI to ordinary dividends (subject to any applicable FDAP withholding) or capital gain dividends (tax-free).

• The real benefit of the QFP FIRPTA exemption can be seen in the case where a QFP owns shares of a REIT and the exit comes in the form of either:

– a tax-free REIT share sale, where section 897 does not apply to the shares pursuant to section 897(l)(1) (this assumes the Publicly Traded (c)(3) exception and DC REIT exception do not otherwise apply). The buyer inherits no corporate-level tax liability and can often get a basis step-up without adverse tax consequences by liquidating the REIT under section 331.

– a REIT asset sale followed by a liquidation. Here, section 897(l)(1) has a dual role: it disengages the FIRPTA distribution rule and causes the QFP’s “outside” gain to be fully exempt from U.S. tax (even though the REIT’s shares are still technically classified as a FIRPTA interest because the PATH Act repeals the cleansing exception for REITs).

68

Section 291(a)(1) Recapture on a REIT’s Section 1250 Property

• Section 291(a)(1) provides that, in the case of a corporation, 20% of the excess of (i) the amount of depreciation that would be treated as OI if section 1250 property were treated as section 1245 property, over (ii) any “normal” section 1250 recapture, is treated as gain which is OI under section 1250

• Gain recognized notwithstanding any other provision of the Code

69

Section 291(a)(1) Recapture on a REIT’s Section 1250 Property

• A REIT is a “corporation” and thus is subject to section 291, but section 291(d) provides a special character pass-through rule for REITs.

• It states that the difference specified in section 291(a)(1) between regular section 1250 recapture and the amount that would be treated as OI if the section 1250 property were section 1245 property is reduced “to the extent that a capital gain dividend … is treated as paid out of such difference.” This reduction takes place at the REIT level.

• For the REIT’s corporate shareholders, section 291(d) states that any capital gain dividend “treated as having been paid out of such difference retains its character in the hands of the [corporate] shareholder as gain from the disposition of section 1250 property for purposes of applying [section 291(a)(1)] to such shareholder.”

70

Section 291(a)(1) Recapture –Interface With Section 897(l)

• Ordinary income recapture passes out to a corporate shareholder of a REIT under 291(d) only to the extent the REIT pays a capital gain dividend out of the ordinary income recapture amount.

• A REIT can’t designate a redemption or liquidating distribution as a capital gains dividend. Thus, in that context a QFP shareholder is not adversely affected by section 291(a)(1) or (d). – The REIT simply recognizes ordinary income at the REIT

level under section 291(a)(1) but still can claim a dividends paid deduction to zero out REIT-level taxable income.

71

Section 291(a)(1) Recapture –Interface With Section 897(l)

• If a multiple property REIT sells one asset, has section 291(a)(1) ordinary income recapture, and pays a capital gains dividend equal to the full amount of the gain, and a QFP shareholder that is classified as a corporation receives a capital gain distribution, then it “recognizes” ordinary income under 291(a)(1).

• This ordinary tax treatment is completely independent of section 897(h)(1), although section 897(h)(1) can still make the gain ECI for a corporate shareholder of the REIT that is not a QFP.

• Whether the ordinary income is treated as FDAP dividend income subject to withholding (unless a treaty exemption applies) is not entirely clear.

• Section 892 may still exempt such ordinary income for foreign government shareholders.

72

QFP Exemption From Section 1445 Withholding

• Section 1445(f)(3) defines “foreign person” for purposes of the FIRPTA withholding rules, including section 1445(e)(6) (which applies to section 897(h)(1) distributions).

• Section 324 of the PATH Act amended this provision so that a QFP is no longer treated as a foreign person for purposes of section 1445 “except as otherwise provided by the Secretary.” See Section 1445(f)(3)(B); Treas. Reg. § 1.1445-2(b)(2)(i)(C).

73

Proving Entitlement to QFP Exemption -- Withholding Agents

• A foreign corporation provides Form W-8BEN-E (Certificate of Status of Beneficial Owner for United States Withholding and Reporting (Entities)) to qualify for the portfolio interest exemption claim the benefits of a tax treaty, and establish its right to a Chapter 4 (FATCA) exemption.

– Compare Treas. Reg. § 1.1471-3(d)(9)(ii)(A) (permitting withholding agent to treat a payee as a retirement fund described in Treas. Reg. § 1.1471-6(f) if it has a withholding certificate in which the payee certifies that it is so qualified).

– Part XV of Form W8-BEN-E requires a beneficial owner claiming one of the pension fund FATCA exemptions to certify that the owner meets the requirements of such exemption but does not require any documentation to be provided.

• The section 1445 regulations provide a procedure for a seller to certify to the buyer that it is not a foreign person subject to FIRPTA withholding. Treas. Reg. § 1.1445-2(b)(1).

• Because section 1445(f)(3) now provides that a QFP is not a “foreign person,” a QFP should be able to make this same certification that is currently obtained by the buyer from US sellers. The PATH Act Regulations amended Treas. Reg. § 1.1445-2(b)(2)(i) to exclude from the definition of “foreign person” a QFP or an entity wholly owned by a QFP.

74

Proving Entitlement to QFP Exemption -- Withholding Agents

• Query what due diligence obligation the withholding agent has to look behind the statement – for example, suppose the withholding agent is aware of some potential issue under section 897(l), e.g., the party claiming the exemption is owned by multiple QFPs? – Compare Treas. Reg. § 1.1445-2(b)(1) and -2(b)(4) (withholding agent can rely on certificate of

non-foreign status to excuse withholding unless it has actual knowledge that the certificate is false) and Treas. Reg. § 1.1445-2(d)(2)(i) and -2(d)(2)(ii)(B) (withholding agent may rely on notice of nonrecognition transfer provided by foreign transferor unless it knows or has reason to know the transferor is not entitled to nonrecognition treatment).

• Because a withholding agent may not be protected by the normal “don’t know and don’t have reason to know” rule for withholding certificates prior to the issuance of specific regulations/forms/guidance under section 897(l) and section 1445(f)(3), withholding agents may want to consider asking for an indemnity in addition to a certification as to QFP status.

• Some have raised a concern that this certificate of non-foreign status does not apply for purposes of section 1446 withholding. Thus, the argument goes, if the certification turns out to be wrong and the purported QFP partner has taxable ECI resulting from the application of section 897 (e.g., from a section 897(h)(1) REIT distribution), there could be section 1446 withholding even if section 1445 withholding is excused, a nonsensical result that guidance should clear up.

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“Directly or Indirectly (Through 1 or More Partnerships)”

• Section 897(l) applies to exempt from section 897 USRPIs held by a QFP “directly (or indirectly through 1 or more partnerships)”.

• What about through trusts?• Some have wondered whether the placement of the parenthetical

language “or indirectly through 1 or more partnerships” language indicates that such a look-through rule does not apply to the “distributions received from a [REIT]” language – i.e., does the partnership look-through apply if a QFP is a partner in a partnership that receives a section 897(h)(1) distribution from a subsidiary REIT.

• The Preamble to the PATH Act Regulations repeats the statutory language and thus is not helpful in resolving this issue.

• It would be nonsensical to exempt a distribution received directly by a QFP but not indirectly through a partnership and this clearly was not intended. Regulations presumably will confirm this, but in the meantime it is understood some fund sponsors are asking for indemnities to protect themselves with respect to this drafting glitch.

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Bluebook

• The Joint Committee on taxation’s “Bluebook” explanations of the PATH Act was released Monday, March 14, 2016. Although it adds little in the way of explanation, two footnotes on page 283 are worth mentioning here:– n. 967: “Foreign pension funds may be structured in a variety of

ways, and may comprise one or more separate entities. The word “arrangement” encompasses such alternative structures.”

– n. 968: “Multi-employer and government-sponsored public pension funds that provide pension and pension-related benefits may satisfy this prong of the definition. For example, such pension funds may be established for one or more companies or professions, or for the general working public of a foreign country.”

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Liquidating U.S. Blocker Owned by QFP

• Some foreign pension funds have invested through subsidiary U.S. corporations, which in turn own interests in subsidiary REITs, to avoid ECI and return filing obligations and potential branch profits tax (if pension fund is classified as a corporation).

• If the foreign pension fund is a corporation (e.g., a foreign governmental entity) that qualifies under section 897(l), can it now liquidate USCo tax free under section 332 and 337 and hold the REIT shares directly?

• Section 367(e)(2) – enacted as part of General Utilities repeal in 1986 –provides that section 337 does not apply to a liquidating domestic corporation that distributes property to an 80%-owned foreign distributee corporation.

• The issue is whether section 367(e)(2) precludes section 337 from applying. – Note: if the domestic parent owns non-REIT affiliated corporations, beware

the potential application of section 332(d). Section 332(d) is not relevant in this example because the subsidiary owns subsidiary REITs, which are not section 1504(b) affiliates for this purpose.

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Liquidating U.S. Blocker Owned by QFP

• Treas. Reg. § 1.367-2(b)(1) provides that section 337 does not apply to the liquidation except to the extent an exception in paragraph (b)(2) applies.

• The first exception is for property used in a U.S. trade or business of the domestic corporation if the foreign corporation continues to use the property in a U.S. trade or business for 10 years and certain other conditions are met. Treas. Reg. § 1.367-2(b)(2)(i).

• The second exception applies to the distribution by the liquidating domestic corporation of stock of a U.S. real property interest (other than a former U.S. real property holding corporation as to which the five-year clock is ticking under section 897(c)(1)(A)(ii)). Thus, stock of a current U.S. real property holding corporation treated as a USRPI can be distributed tax-free.

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Section 367(e)(2) Anti-Abuse Rule

• Treas. Reg. § 1.367-2(d) provides an anti-abuse rule under which the Commissioner “may require” a domestic liquidating corporation to recognize gain (or treat the corporation as if it had recognized a loss) if “a principal purpose” of the liquidation is the avoidance of U.S. tax (including, but not limited to, a distribution of the liquidating corporation’s E&P with a principal purpose of avoiding U.S. tax).

• Because the QFP will be not be subject to tax with respect to a subsequent disposition of the REIT shares (including an (h)(1) distribution from the REIT), the IRS may assert that the anti-abuse rule applies because the appreciation in the REIT’s shares/assets has escaped U.S. taxing jurisdiction due to section 897(l).

• The Conference Report accompanying the 1986 Act amendments to section 367 states that “the conferees expect that regulations may permit nonrecognition if the appreciation in the distributed property is not being removed from the U.S. taxing jurisdiction prior to recognition.” 1986 Act Conference Report, page II-202.

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PATH Act –Qualified Shareholder FIRPTA Exemption for REIT Investments

• New section 897(k)(2)(A)(i) provides that stock of a REIT -- whether public or private -- held by a “qualified shareholder” (“QS”) is not a USRPI. – This applies whether the USRPI is held directly or indirectly through one or more partnerships.– This provision is primarily intended to benefit foreign public REITs – a listed Australian

property trust and a Dutch beleggingsinstelling are examples of potential beneficiaries.– The exception is not available for stock of USRPHC that is not a REIT.

• New section 897(k)(2)(A)(ii) provides that section 897(h)(1) does not apply to any distribution to a QS to the extent its REIT stock is not treated as a USRPI under section 897(k)(2)(A)(i).– Section 857(b)(3)(F) treats distributions to which section 897(h)(1) does not apply due to the

Publicly Traded (h)(1) Exception, and that that would otherwise be treated as capital gains dividends, as ordinary dividends subject to FDAP withholding.

– Section 213(a)(2)(B) of PATH Act amends section 857(b)(3)(F) to make clear that such ordinary dividend treatment also applies to distributions to a QS that are exempt from section 897(h)(1) under section 897(k)(2)(A)(ii).

• The net result (subject to potential “cut-back” of the benefit, as will be described) is no U.S. tax on a sales of REIT shares by a QS and no ECI tax on FIRPTA distributions received by a QS. The only tax burden in the latter case would be the withholding tax on REIT dividends (typically 15% in these cases).

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PATH Act –Qualified Shareholder FIRPTA Exemption for REIT Investments

• A QS is a foreign person that– Is eligible for treaty benefits under a treaty which has

an exchange of information program and its principal class of interests is listed and regularly traded on or more recognized stock exchanges (within meaning of treaty), or

– Is a foreign limited partnership with a class of limited units regularly traded on NYSE or NASDAQ.

• QS must also be a “qualified collective investment vehicle” (“QCIV”) (as discussed on the next slide) and maintain records on the identity of its 5% or more shareholders.

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PATH Act – Definition of QCIV

• A QCIV is defined as a foreign person that:– is eligible for a reduced rate of withholding on ordinary REIT

dividends under the treaty, even if the foreign person owns more than 10% of the REIT, or

– is a publicly traded partnership under section 7704(b) (but not taxable as a corporation), a withholding foreign partnership for purposes of chapters 3, 4, and 61, and would qualify as a USRPHC (if it were a U.S. corporation) at any time during the five-year period preceding the partnership’s disposition of the REIT’s shares or receipt of a REIT distribution, or

– is designated as a QCIV by the Secretary and is either (i) fiscally transparent under section 894 or (ii) required to include dividends in gross income but entitled to a deduction for distributions to its owners.

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Cut-Back Rule if QS Has “Applicable Investors”

• If the QS has one or more “applicable investors,” then a cut-back rule applies to the new QS FIRPTA exemption. Under this cut-back rule, the exemption does not apply with respect to the QS to the extent of its applicable investors’ collective percentage ownership interest in the QS. Section 897(k)(2)(B). – This is the clear intent of the statute, although the drafting of the cut-

back ratio in subparagraph (i) of section 897(k)(2)(B) is mangled.• An “applicable investor” is any person (other than another QS) that (i)

owns an interest in the QS, and (ii) holds more than 10% of the REIT’sstock “(whether or not by reason of the person’s ownership interest in the [QS])”. Section 897(k)(2)(D).

• It appears that constructive ownership rules were intended to apply in making this 10% determination. See S. Rep. No. 114-25, p. 11 (stating that the section 897(c)(6)(C) constructive ownership rules apply). However, section 897(k)(2)(E) fails to cross-reference subparagraph (D), and instead references subparagraph (C), where constructive ownership rules appear to be irrelevant. Presumably this will be fixed by a technical correction.

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Cut-Back Rule if QS Has “Applicable Investors”

• Section 897(k)(2)(C)(i) provides that if a distribution by a REIT is treated as a sale or exchange of stock under sections 301(c)(3), 302 or 331 with respect to a QS, then “in the case of an applicable investor, subparagraph (B) [the QS exemption cut-back rule] shall apply with respect to such distribution.” – This may be construed as Congressional approval of the

controversial position taken in IRS Notice 2007-55, which provides that section 897(h)(1) applies to REIT distributions even though they are treated as sales or exchanges under the Code at the shareholder level.

– However, “subparagraph (B)” provides for the FIRPTA exemption cut-back both as to dispositions of REIT shares and as to REIT distributions. It is hard to tell exactly what is going on here.

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Cut-Back Rule if QS Has “Applicable Investors”

• Section 897(k)(2)(C)(ii) goes on to provide that “in the case of any other person,” the distribution “shall be treated under section 857(b)(3)(F)” as a dividend from the REIT notwithstanding any other provision of the Code.– The intent appears to be that the normal FIRPTA rules apply to the QS with respect to such

distribution to the extent of its applicable investor percentage ownership, and ordinary dividend treatment applies to the QS for the balance of the distribution, even though a redemption or liquidating distribution is a payment in exchange for stock and not a dividend and thus cannot be designated as a capital gain dividend.

– In this specific context, this reverses the no-dividend conclusion reached in AM 2008-003, where the Office of Chief Counsel concluded that a public REIT’s liquidating distributions that qualified for the Publicly Traded (h)(1) Exception were not dividends under section 857(b)(3)(F) but rather an amount realized in exchange for the REIT’s stock. See JCT Explanation (stating that that this provision is intended to override AM 2008-003).

• The provision is drafted incorrectly because it says the “distribution” is treated as a dividend, not the amount that is treated as gain from a USRPI under section 897(h)(1) (as interpreted by the Notice). It obviously makes no sense to treat a QS’s entire amount realized in a REIT redemption or liquidation as a “dividend.” A technical correction is needed here.

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Cut-Back Rule if QS Has “Applicable Investors”

• The “applicable investor” cut-back rules that apply to a QS’s FIRPTA exemptions in section 897(k)(2)(A) presumably have no effect on the QS’s ability to claim any of the other FIRPTA exemptions potentially applicable to REITs –namely, the Publicly Traded (c)(3) exception, the Publicly Traded (h)(1) exception and the DC REIT exception.

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QS Foreign PTPs With “Applicable Investors”

• If the QS is a foreign publicly traded partnership, special rules are provided in section 897(k)(4) to determine the cut-back limitation if such foreign partnership has “applicable investor” partners (recall that an applicable investor is a person who is not a QS and who owns more than 10% of the REIT) who are nonresident alien individuals or foreign corporations.

• The applicable investor’s distributive share of amounts taken into account under section 897(a)(1) for the taxable year is increased by the excess of the partner’s “proportionate share of USRPI gain” over such partner’s distributive share of USRPI gain for such year.– This appears to be an anti-abuse rule aimed at allocation/disposition schemes that might be

employed to minimize the partnership’s applicable investors’ share of FIRPTA gains and thus reduce the QS exemption cut-back.

– “USRPI gain” is the excess of gains from the disposition of USRPIs plus REIT distributions treated as USRPI gain, over losses from dispositions of USRPIs.

– “Proportionate share of USRPI gain” is determined on the basis of the applicable investor’s “share of partnership items of income or gain,” whichever results in the largest proportionate share (section 704(c) items are excluded), and if that share may vary over the period that the applicable investor is a partner, the proportionate share is the largest share the investor may receive.

– The applicable investor’s share of other partnership items of non-USRPI gain are decreased (but not below zero) by the excess USRPI gain.

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