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.
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.