2016-Issue 4—In past articles, we have discussed the increased corporate interest in unlocking shareholder value via real estate investment trust (REIT) conversion transactions (see “REIT Conversions — A Primer on Key Business and Tax Considerations,” September 2, 2014), as well as the legislative landscape and current trends in corporate REIT conversions (see “2014 REIT Update: The Time Is Ripe for REITs,” November 20, 2014). On December 18, 2015, Congress passed and the President signed into law an agreement on a comprehensive year-end tax extenders package, the Protecting Americans from Tax Hikes (PATH) Act of 2015, which contains impactful measures specifically targeting certain REIT conversion transactions in the form of so-called “OpCo/PropCo” spin-offs. This edition of Tax Advisor Weekly revisits the history of REIT spin-offs by analyzing the PATH Act and the evolution of the Treasury’s position on such transactions.
REIT Spin-Offs in General
REIT spin-off transactions have recently generated plenty of attention as many companies, including those with substantial holdings of real property in non-traditional asset classes, seek to determine whether they could benefit from a successful REIT spin-off transaction. In numerous high-profile cases, activist investors have effectively forced a split-up of real estate and non-real estate assets as a way to maximize shareholder returns.
Generally speaking, in a REIT spin-off transaction, a company with an operating business and a significant amount of real property drops the real estate into a wholly owned subsidiary (a “controlled corporation”) and distributes the stock to its shareholders. In connection with the transaction, the controlled corporation makes a REIT election and the two companies typically enter into a long-term real property lease arrangement (i.e., a triple net lease). The distributor gets a deduction for the rent payments to the REIT, and the REIT avoids corporate-level income tax on the rent payments, assuming that the REIT distributes 100 percent of its taxable income to its shareholders (and many other organizational and operational conditions are met). As discussed in prior articles, but outside the scope of this edition, many other tax considerations may come into play.
For the shareholders to qualify for tax-deferred treatment upon the receipt of the distributed corporation stock, a number of requirements codified in Internal Revenue Code (IRC) Section 355 must be satisfied, including, but not limited to, the following:
- The transaction must not be used principally as a device for the distribution of the earnings and profits of the distributing corporation or the controlled corporation or both (the “device requirement”); and
- The distributing corporation and the controlled corporation are engaged immediately after the distribution in the active conduct of a trade or business (the “active trade or business requirement”).
Evolution of IRS Policy on REIT Spin-Offs
In 1973, the IRS issued Rev. Rul. 73-236 and held that in a spin-off transaction qualifying for tax-free treatment under IRC Section 355, a corporation could not distribute to its shareholders stock of a company that would elect REIT status. Such ruling was predicated on the fact that the leasing of real property by the spun-off REIT did not satisfy the active trade or business requirements of IRC Section 355(b). At the time, limitations on a REIT’s ability to directly conduct active and substantial management and operational functions perhaps lent some credence to the published Internal Revenue Service (IRS) position in Rev. Rul. 73-236.
Fast forward to 2001, at which time the IRS issued Rev. Rul. 2001-29 and sent Rev. Rul. 73-236 into obsolescence. As a result of changes ushered in by the Tax Reform Act of 1986, the ability of REITs to conduct active and substantial management and operational functions was significantly enhanced. The IRS reasoned that these changes to IRC Section 856 now allowed REITs to meet the IRC Section 355 active trade or business requirement. Although some commentators believe that REIT spin-offs had reasonable merit to qualify for tax-free treatment prior to the issuance of Rev. Rul. 2001-29, there was much uncertainty and therefore inherent risk in proceeding with these transactions. Shortly after the issuance of Rev. Rul. 2001-29, Georgia Pacific undertook a tax-free timber REIT spin-off transaction and led the charge into the post-ruling era of REIT conversions, during which time the IRS willingly issued numerous private letter rulings (PLRs) addressing a host of issues in relation to many REIT spin-off transactions.
More recently, on September 14, 2015, the IRS issued Rev. Proc. 2015-43, which added REIT-related OpCo/PropCo spin-off transactions under IRC Section 355 to the list of issues for which it will not ordinarily issue a PLR or other taxpayer specific guidance (i.e., the “no-rule area” list). The ruling states that absent “unique and compelling reasons,” the IRS will not rule on “any issue relating to the qualification, under IRC Section 355 and related provisions, of a distribution … if property owned by any distributing corporation or any controlled corporation becomes the property of … a real estate investment trust.” In conjunction with the issuance of Rev. Proc. 2015-43, and on the same date, the IRS also issued Notice 2015-59, in which it announced that it is studying issues under IRC Section 355 and soliciting public comment related to an election by a distributing or controlled corporation (but not both) to be a REIT. More specifically, the notice expressed the IRS’s concern that such transactions may be utilized with the principal purpose of distributing the earnings and profits of the distributing corporation, the controlled corporation, or both. Additionally, the IRS seems to have reversed course from Rev. Rul. 2001-29 by explicitly stating its reservations that a REIT spin-off transaction may not be able meet the business purpose and/or active trade or business requirement of IRC Section 355.
It should be noted again, however, that the IRS and Treasury do not seem concerned about transactions in which both the distributing corporation and the controlled corporation will be REITs, nor transactions in which the distributing corporation has been a REIT for a substantial period of time, whether or not the controlled corporation will be a REIT after the distribution. The fact that these specific types of REIT spin-off transactions are not covered by the recently updated no-rule area guidance seems to confirm the viewpoint that a distributing and/or controlled REIT can still meet the various requirements of IRC Section 355. As a result, there don’t seem to be any new or valid technical merits to the argument that REITs can’t engage in tax-free spin-off transactions. The IRS and Treasury seem to simply be under pressure from lawmakers and the public to curb a perceived abuse.
Current Legislative Landscape — PATH Act
Legislation targeting tax-free REIT spin-off transactions is not a new phenomenon. However, until the passage of the PATH Act on December 18, such legislation had merely been proposed, with no relevant REIT spin-off limiting provisions passing into law. For example, dating back to the spring of 2014, when former House Ways and Means Committee Chairman Dave Camp (R-MI) released his Tax Reform Act of 2014, lawmakers have attempted to curb what they perceive as a “loophole” in the tax code whereby companies are seeking to avoid taxes at a detriment to tax revenue and the U.S. economy. The Camp proposal sought to prohibit tax-free REIT spin-offs by preventing a REIT from satisfying the active trade or business requirement and by disallowing a REIT election by a C corporation participating in a spin-off for the following 10 years.
Along the same lines, the PATH Act continues the attack on potential REIT spin-off transactions and generally eliminates the ability for corporations to spin-off their real property holdings into a REIT in a qualifying IRC Section 355 transaction. More specifically, the PATH Act:
- Prevents IRC Section 355 from applying to any stock distribution if either the distributing corporation or the controlled corporation is a REIT, unless both the distributing and controlled corporations are REITs immediately after the distribution, or the distributing corporation is a REIT and the controlled corporation is a taxable REIT subsidiary (TRS), subject to certain additional holding period requirements; and
- Amends IRC Section 856(c) to provide that, in general, any distributing or controlled corporation shall not be eligible to make a REIT election for a period of 10 years beginning from the date of a qualifying tax-free distribution under IRC Section 355.
It should be noted that the PATH Act also includes a transition rule whereby tax-free REIT spin-offs are permissible if a ruling request with regards to the transaction had been previously filed prior to December 7, 2015 (so long as the request had not been withdrawn, issued or denied as of that date).
The provisions in the PATH Act that prohibit tax-free REIT spin-off transactions seem clearly intended to curb non-traditional REIT conversion transactions. This seems to be the case because these companies wouldn’t be able to qualify for REIT status absent the separation of their operating business from their real property holdings. However, as discussed in a recent edition of Action Matters on November 12, 2015 (with content originally published in the journal Business Entities), the true economic and the comprehensive tax implications of non-traditional REIT conversions in particular seem generally misunderstood. As a result, the PATH Act is arguably misguided in its tax reform attempt as it relates to non-traditional REIT conversions and may negatively impact the economy and tax revenue in numerous instances and a variety of ways.
Alvarez & Marsal Taxand Says:
The recent passing into law of the PATH Act has dealt a significant blow to the ability of most companies to undergo tax-free REIT spin-off transactions. Clearly, even in the absence of this new legislation addressing REIT spin-off transactions, the IRS and Treasury position is not particularly comforting — even though the carve-out of certain REIT spin-offs seems contrary to the stated technical concerns in general and effectively reaffirms that the IRC Section 355 requirements can still be satisfied by a REIT.
It is unfortunate that that some of the scrutiny from the general public and lawmakers surrounding non-traditional REIT spin-offs may be based on a flawed perception that such transactions are an unfair abuse that must be curbed to preserve the tax revenues. Corporate taxpayers in real estate intensive industries are now severely limited in their options to maximize shareholder value through REIT conversion transactions because of the PATH Act and its misguided political spin.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
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