President Obama signed into law on December 18, 2015 the Protecting Americans from Tax Hikes Act of 2015 (the "Act"), which makes several notable changes to the Internal Revenue Code of 1986, as amended, concerning real estate investment trusts (REITs), including changes to provisions under the Foreign Investment in Real Property Act of 1980 (FIRPTA) relating to REITs. This client alert discusses some of these changes that may impact private investment funds that invest in real property or interests in REITs.
In summary, the Act: (1) increases the permissible ownership percentage in a publicly-traded REIT; (2) exempts certain foreign pension plans from FIRPTA; (3) changes the rules for determining when a REIT is "domestically controlled"; (4) exempts certain non-U.S. investment funds from FIRPTA; (5) increases the FIRPTA withholding tax rate to 15%; and (6) makes certain changes to the so-called "cleansing rule."
Increase of Permissible Ownership Percentage in a Public REIT
Generally, FIRPTA treats gain from a sale or disposition of a U.S. real property interest (USRPI) as income that is effectively connected with U.S. trade or business (ECI), which income is subject to tax on a net basis when earned by a foreign person. A USRPI is generally defined to include shares in a United States Real Property Holding Corporation (USRPHC), which is a U.S. corporation at least 50% of the assets of which are comprised of USRPIs. Prior to the enactment of the Act, publicly-traded shares of a USRPHC were not treated as a USRPI with respect to a shareholder if the shareholder did not hold more than 5% of the class of the publicly traded stock of such corporation at any time during the 60 month period ending on the date of the disposition of the shares.
The Act increases the permissible ownership percentage from 5% to 10% with respect to publicly-traded REIT shares. Accordingly, a foreign person that owns 10% or less (as opposed to 5% or less under prior law) of a class of publicly-traded REIT shares may avoid the application of FIRPTA on gains from sales of REIT shares and distributions from the REIT that are attributable to gains from a sale of a USRPI. The 5% threshold remains applicable to publicly-traded shares of USRPHCs that are not REITs.
Exempting "Qualified Foreign Pension Funds" from FIRPTA
The Act provides that FIRPTA does not apply any USRPI held directly (or indirectly through one or more partnerships) by a "qualified foreign pension fund" (or a wholly-owned subsidiary thereof), which is generally defined to include employee retirement funds that are (i) established outside of the United States, (ii) subject to government regulation and (iii) tax exempt or otherwise subject to a preferential tax treatment under the applicable foreign law. This provision is expected to result in substantial additional investment in U.S. real property by foreign pension plans.
Ownership Rules for Determining Domestic Control
Under FIRPTA, a USRPI does not include an interest in a "domestically controlled" REIT. Therefore, gains from sales of shares of a domestically controlled REIT are not subject to U.S. federal income tax under FIRPTA. In contrast, distributions from domestically controlled REITs that are attributable to gains from a sale of USRPI are subject to U.S. federal income tax under FIRPTA. A REIT is generally considered domestically controlled if less than 50% of its interests are held by non-U.S. persons throughout the applicable testing period.
The Act adds the following three new rules that relate to the determination of the domestically controlled status of REITs.
- First, in the case of a publicly traded REIT, a holder of less than 5% of the publicly traded shares at all times during the applicable testing period is treated as a U.S. person, absent the REIT's actual knowledge to the contrary.
- Second, if shares of a REIT are held by a public REIT, the shares are treated as held by a foreign person unless the public REIT is itself domestically controlled, in which case the shares would be treated as held by a U.S. person.
- Third, any stock in a REIT held by a non-public REIT is treated as held by a U.S. person only to the extent that the stock of the non-public REIT is held by U.S. persons.
Certain Foreign Investment Funds Exempt from FIRPTA
The Act provides that REIT stock held directly (or indirectly through one or more partnerships) by a "qualified shareholder" is not a USRPI in the hands of such qualified shareholder, except to the extent that an investor in the qualified shareholder (other than an investor that is itself a qualified shareholder) holds (through the application of certain constructive ownership rules) more than 10% of the class of stock of the REIT.
For these purposes, a qualified shareholder generally means a foreign person (i) who is eligible for the benefits of a comprehensive U.S. income tax treaty or whose principal class of interests is regularly traded on a recognized stock exchange, (ii) who is a "qualified collective investment vehicle" and (iii) who maintains records on the identity of its 5% shareholders. A qualified collective investment vehicle generally means a foreign person that (i) would be eligible for a reduced rate of withholding under the treaty, even if such person holds more than 10% of the stock of the REIT, (ii) is a publicly traded partnership that is not taxed as a corporation, that has entered into a withholding partnership agreement with the Internal Revenue Service, and that would have been a USRPHC if it were a U.S. corporation, or (iii) is designated as a qualified collective investment vehicle by Treasury and is either fiscally transparent or is entitled to a deduction for distributions to its investors.
Increase of Applicable FIRPTA Withholding Tax Rate
The substantive tax imposed on FIRPTA gain is collected through a withholding regime, which, under prior law, generally required transferees of USRPI (including USRPHCs making redemption payments) to deduct and withhold 10% of the amount realized (i.e., the gross proceeds), unless the transferor furnishes a certificate to the effect that it is a U.S. person, obtains a reduction in such withholding from the IRS or is otherwise exempt from FIRPTA withholding.
The Act increases the applicable withholding rate from 10% to 15%.
Amendments to the "Cleansing Rule"
Under the so-called "cleansing rule," interests in a USRPHC are not considered USRPI if, at the time of the sale of the interests, the USRPHC has disposed of all U.S. real property in one or more taxable transfers. Therefore, the cleansing rule effectively allows non-U.S. persons to liquidate its investments in U.S. real property without a shareholder-level tax upon the liquidation of the USRPHC.
Under the Act, a non-U.S. shareholder of a U.S. corporation may apply the cleansing rule only if the corporation (or its predecessor) was not a RIC or REIT during the applicable testing period.
The foregoing amendments take effect as of December 18, 2015, and will generally apply to dispositions or distributions made after such date. The amendment as to the FIRPTA withholding rate will apply to dispositions made after the date which is 60 days after December 18, 2015.
If you have any questions regarding the issues discussed herein, please contact Jonathan P. Brose (212-574-1615), Ronald P. Cima (212-574-1471), James C. Cofer (212-574-1688), Daniel C. Murphy (212-574-1210) or Peter E. Pront (212-574-1221).
If you have any questions regarding the matters covered in this memo, please contact any of the partners and counsel listed below or your primary attorney in Seward & Kissel's Investment Management Group.
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