Canada: IRS Announces That Certain Distributions By U.S. REITS To Foreign Investors Will Be Taxable

  1. Introduction

    The U.S. Internal Revenue Service announced yesterday that it will issue regulations to prevent foreign government investors and other foreign investors from avoiding the application of FIRPTA1 through the use of certain U.S. REIT structures that have become popular in recent years. The announcement, contained in Notice 2007-55, addresses taxpayers who take the position that certain distributions by U.S. REITs of proceeds realized by the REIT from the disposition of U.S. real property are not taxable to the foreign investors under Section 897(h)(1) of the Internal Revenue Code (the "Code") either because the investors are exempt from the application of Section 897(h)(1) by virtue of the "governmental exemption" contained in Code Section 892 or because the distributions are made in the context of a complete liquidation of the REIT under Section 331 of the Code. The Notice indicates that the Service intends to issue regulations to "clarify" the interpretation of these statutory provisions dealing with distributions by U.S. REITs of the proceeds realized by the REIT from the sale of U.S. real property. The Notice states that the regulations will apply to any distribution occurring on or after June 13, 2007. In addition to announcing its intention to issue the regulations, the Notice also states that the Service intends to challenge the position taken under current law by any taxpayer that 897(h)(1) does not apply to these distribution by virtue of either Section 892 or Section 331.

  2. Background

    Section 897(a) imposes a tax on the disposition of a United States real property interest (a "USRPI") by a non-U.S. owner. A USRPI generally includes shares in a U.S. corporation that holds predominantly U.S. real estate. However, Section 897(h)(2) provides that stock in a "domestically controlled" REIT is not considered a USRPI. As a result, Section 897(a) does not apply to a disposition of shares in a domestically controlled REIT.

    Under Section 897(h)(1), if a REIT pays dividends attributable to the sale by the REIT of U.S. real estate, the dividends are treated in the hands of the REIT’s foreign shareholders as gain subject to tax under Section 897(a). Section 897(h)(1) also applies to domestically controlled REITs.

  3. Interaction of Section 892 and Section 897(h)(1)

    Section 892 provides that a unit of a foreign government, such as a pension fund for government employees, is exempt from U.S. tax with respect to its investment income. Exempt investment income includes, for this purpose, dividend income as well as income from the sale of corporate shares. Historically, the general consensus of U.S. tax practitioners knowledgeable in this area is that Section 892 should apply to exempt a foreign government from U.S. taxation of dividend distributions that would otherwise be subject to tax under Section 897(h)(1). There are strong technical arguments supporting this view based on the current regulations issued under Sections 892 and 897.

    Under Section 892(c), however, the Service is given broad authority to issue regulations under Section 892. This grant of authority should allow the Service to issue the regulations announced in the Notice. Thus, for all practical planning purposes, Section 892 will no longer apply to exempt dividends subject to Section 897(h)(1). It is less likely, however, that the Service would prevail in its view that the regulations, as currently drafted, support the position announced in the Notice, if it were to actually litigate such a case in the courts.

  4. Interaction of Section 331 and Section 897(h)(1)

    Section 331 generally provides that a shareholder that receives a distribution from a corporation that is completely liquidating will be treated as if the shareholder has having received a payment in exchange for its stock. Since REITs are generally treated as corporations for U.S. tax purposes, if the liquidating corporation is a domestically controlled REIT, this generally means that a non-U.S. shareholder that receives a liquidating distribution is treated as having received a payment in exchange for its shares (which, as noted above, are not treated as a USRPI), and is not subject to tax under Section 897(a).

    There are strong technical arguments that this type of liquidation is not a "distribution" subject to Section 897(h)(1) even if the distribution represents the proceeds from a disposition by the REIT of US real property, because it is treated under Section 331 as a disposition of shares. In fact, the Service itself reached the same conclusion in a well reasoned private ruling that it later withdrew. As noted, however, the Notice indicates that the Service plans to issue regulations to "clarify" that this is not the correct interpretation of Section 897(h)(1). When issued, these regulation will create some tension between Section 331(a) and Section 897(h)(1) and the IRS will have to rely on its general authority to issue interpretive regulations, since it is granted no specific authority under section 331 or section 897(h). As this rule operates independently of Section 892, it will also affect foreign taxpayers other than foreign governments.

    The Service also indicates in the Notice that it intends to take the position that Section 897(h)(1) applies to a Section 331 liquidation under current law. Given the Service's own historic position to the contrary, this is a surprising assertion and one that would be hard for the Service to litigate successfully. Interestingly, the Service's position could create a situation where a taxpayer is treated as realizing a gain under Section 897(h)(1), while simultaneously recognizing a loss under Section 331 in the event that the basis of the taxpayer's shares exceeds the amounts treated as received in exchange for their shares (which arguably should be reduced for the amounts treated as subject to Section 897(h)(1)). Ironically, such a loss could not be used to offset the gain taken into account under Section 897(h)(1), however, unless the shares of the REIT with respect to which the loss is recognized are treated as a USRPI (that is, where the REIT is not domestically controlled).

  5. Future Planning Implications

    For future planning purposes, the preferred exit scenario for an investment by a non-U.S. shareholder of a U.S. REIT will likely be a sale of the shares of the REIT, rather than a sale of property by the REIT followed by a distribution by the REIT of the proceeds of the sale or a complete liquidation of the REIT. Single-property REITs will continue to be an important planning tool, and will likely increase in importance, in order to facilitate a sale of shares where a buyer only wishes to buy a single property rather than an entire portfolio. A critical business negotiation will be getting a buyer to agree to buy REIT shares rather than property. It will become necessary for potential buyers to understand the potential benefits of owning property in a REIT and how to unwind the REIT structure after their acquisition in a tax-efficient manner in the event they do not wish to continue to hold the property in a REIT.

In compliance with U.S. Treasury Department Circular 230, you are hereby notified that any discussion of U.S. federal tax issues contained herein is not intended nor written to be relied upon, and cannot be relied upon, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

Footnotes

  1. "FIRPTA" is the popular acronym for the Foreign Investors in Real Property Tax Act of 1980, which governs the taxation of foreign investors in U.S. real property.

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