The IRS has issued a private letter ruling (PLR 201103001) that
may provide greater flexibility to real estate investment trusts
(REITs) using the consent dividend mechanism to avoid US tax on
liquidations. In some cases, this mechanism could be used by a REIT
to pay a tax-free debt financed distribution to a foreign investor
prior to the ultimate liquidation of the REIT.
REITs are required to distribute the bulk of their ordinary income
annually and are permitted to claim a deduction for ordinary
dividends and capital gain dividends paid to their shareholders. A
REIT that does not have sufficient cash or other assets to fund the
distributions the REIT needs to make in order to maintain its
qualification as a REIT or to eliminate its taxable income is
permitted, with the consent of its shareholders, to designate an
amount that is not actually distributed as a deemed dividend
("consent dividend"). A consent dividend is treated like
an actual distribution under the Internal Revenue Code for all
purposes, permitting the REIT to deduct the amount of the consent
dividend and requiring the shareholders to include the amount in
income as a dividend.
These rules operate differently in the year(s) that the REIT is
liquidated and wound up. A REIT that is undergoing liquidation may
still have some operating income and, moreover, may recognize gain
under Code section 336 on assets that it distributes to its
shareholders in the liquidation. Liquidating distributions are
taken into account by the REIT's shareholders as amounts
received in exchange for their stock in the REIT rather than as
dividends. Nevertheless, such distributions are deductible by the
REIT as if they were dividends paid.
PLR 201103001 involved a private REIT that was structured as a
domestically controlled REIT in order to facilitate an investment
in a US property by a foreign investor (a sale of shares in a
domestically controlled REIT is exempt from US taxation under the
Foreign Investment in Real Property Tax Act). The foreign
investor owned a less than controlling interest in the REIT (the
precise size of that investment is not disclosed in the ruling),
with the balance of the REIT's common stock being owned by a
limited partnership (the "Operating Partnership" or
"OP") which was, in turn, controlled by a publicly traded
REIT. The foreign investor eventually sold its interest in the
private REIT to the OP, which left the OP owning 100 percent of the
private REIT's common shares.
The following year, the private REIT refinanced its property and
distributed proceeds to its shareholder, the OP1 (the
amount of the debt to which the property was then subject exceeded
the basis of the property). Later, the OP decided to liquidate the
private REIT and hold the property directly. The distribution of
the property by the REIT resulted in gain recognition. Normally
such gain would be offset by the deduction for the property being
distributed by the REIT but because the property was subject to a
liability in excess of its basis, the net value of the property
distributed by the REIT was smaller than the amount of gain
recognized to the REIT.
Accordingly, the REIT sought to use the consent dividend
election mechanism in order to shelter the full amount of its gain.
However, the statute provides that a consent dividend cannot be
made for an amount that would not constitute a dividend if it had
actually been distributed to the shareholders on the last day of
the taxable year. It has long been uncertain whether a liquidating
distribution can be the subject of a consent dividend, since such a
distribution would not be treated as a dividend if it were actually
distributed (and indeed the ruling indicates that the OP intended
to treat the consent dividend as an amount received as a
distribution in liquidation rather than as an ordinary dividend).
Fortunately, the IRS issued a favorable ruling that permitted the
consent dividend election to be made.
Since private letter rulings do not constitute binding
precedential authority for taxpayers other than the one to whom the
ruling was addressed, other REITs may be hesitant to take the
position that a liquidating distribution can be the subject of a
consent dividend absent obtaining their own private letter ruling.
However, the possibility of such a consent dividend could give
foreign investors additional flexibility in planning a tax
efficient exit from a domestically controlled private REIT. In some
cases, this may permit the REIT to use excess cash proceeds from
refinancing its property to redeem a foreign investor's shares
prior to liquidation. The tax partners in our New York office are
available to assist clients in deciding whether such a strategy
would be appropriate for their particular circumstances and in
seeking their own private letter ruling from the IRS.
Footnote
1. The property was actually owned by a partnership in which the REIT was a limited partner.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
