Are you considering investing in a real estate investment trust (REIT) through a wholly-owned U.S. corporation? If so, you might want to pay attention to the new proposed regulations recently released by the Internal Revenue Service (IRS) and the Treasury Department. These regulations have the potential to affect the way non-U.S. persons can invest in REITs and maintain their "domestically controlled" status.
Understanding the Current Landscape
Under the existing tax code, a REIT is considered domestically controlled if less than 50% of its stock by value is held by foreign persons. This status has certain tax benefits, such as exemption from U.S. income tax under the Foreign Investment in Real Property Tax Act (FIRPTA). However, the rules surrounding what constitutes "direct or indirect" ownership have been unclear.
To address this ambiguity, a commonly used structure involves foreign investors creating a domestic C corporation that holds a significant portion of the shares in a REIT. This structure ensures that the REIT maintains its domestically controlled status. This approach has been approved through private letter rulings and has become widely adopted.
Proposed Regulations: Impact on REIT Investments
The newly proposed regulations introduce a set of look-through rules to determine a REIT's domestically controlled status. These rules categorize shareholders as either "look-through persons" or "non-look-through persons." Look-through persons are those who are not U.S. non-look-through persons, including foreign corporations, international organizations, qualified foreign pension funds (QFPFs), and more. Non-look-through persons, on the other hand, include individuals, domestic C corporations, publicly traded REITs, and others.
The proposed regulations also require a closer examination of the ownership structure. If a REIT has foreign-owned domestic corporations that hold 25% or more of its fair market value, those corporations should be looked through to determine the REIT's domestically controlled status. This change could have a significant impact on real estate funds that utilize domestic blocker structures for their non-U.S. investors.
Potential Retroactive Effect
If the proposed regulations are finalized, they could apply retroactively. This means that existing REITs that rely on a non-U.S. owned U.S. corporation for their domestically controlled status could be subject to scrutiny by the IRS based on the new look-through rules. Real estate fund sponsors and non-U.S. investors should carefully evaluate their current investment structures and consider alternative approaches to meet the domestically controlled test.
Alternative Structures to Consider
One possible alternative to the domestic C corporation structure is to replace it with a leveraged U.S. corporation that is partially owned by foreign investors. This alternative structure involves a combination of direct investment in the REIT, loans to the U.S. corporation, and contributions from unrelated U.S. owners. While this approach may change the economics of the investment, it could potentially satisfy the domestically controlled test under the proposed regulations.
Section 892: Impact on Foreign Government Investors
The proposed regulations also address the impact of section 892 on foreign government investors. This section exempts foreign governments from U.S. tax on income from certain securities, including stock of a USRPHC (United States real property holding corporation). However, the exemption doesn't apply to income derived from commercial activities or dividends received from a controlled commercial entity (CCE).
The proposed regulations introduce an exception to the current regulations that automatically classify foreign government-controlled USRPHCs as CCEs. Under the proposed rules, if a USRPHC is controlled by a foreign government but is solely engaged in holding interests in other USRPHCs that are not controlled by the foreign government, it would not be deemed a CCE. This exception provides helpful guidance for foreign government investors and eliminates the need for complex investment structures to avoid deemed CCE status.
Conclusion
As the proposed regulations on domestically controlled REITs and section 892 investors move forward, it is crucial for real estate fund sponsors and non-U.S. investors to stay informed and evaluate the potential impact on their investment structures. Seeking professional advice and exploring alternative approaches can help navigate the changing tax landscape and ensure compliance with the new rules.