In recent years, tax-free spinoffs under Sec. 355 involving real estate investment trusts (REITs) became increasingly popular among corporations with sizable real estate holdings. Since a REIT is generally not subject to corporate-level taxes on income distributed to its shareholders, it is an attractive entity in which to house income-producing real estate. The essence of REIT spinoffs is that valuable real estate leaves the corporation and moves tax-free into the favorable REIT tax regime, which creates value for shareholders while reducing corporate-level taxes for the real estate portion of a business. However, new tax legislation, effective for distributions on or after Dec. 7, 2015, curbs this tax planning strategy by severely restricting the application of tax-free spinoff treatment under Sec. 355 to REITs.
The REIT Spinoff Transaction
From a tax perspective, the type of REIT spinoff addressed by the recent legislation can be described as follows: A corporation conducting the core operating business (OpCo) contributes its real estate assets to a controlled subsidiary (SpinCo) in exchange for 100% of the SpinCo stock. OpCo then distributes the SpinCo stock to the OpCo shareholders in a tax-free spinoff transaction under Sec. 355. If the transaction qualifies under Sec. 355, neither OpCo nor its shareholders will recognize any income or gain.
Shortly after the spinoff, SpinCo elects REIT status, and OpCo then leases the real estate from the REIT, with the rental income passing through to the REIT investors free of corporate-level taxes. The lease is typically a long-term, arm's-length "triple net lease," whereby OpCo is responsible for the maintenance, taxes, and insurance of the leased properties. Since triple net lease activities may not meet the "active trade or business" requirement of Sec. 355 (discussed in more detail below), the OpCo usually contributes a small amount of its active trade or business assets to the REIT.
The effect of this transaction is that OpCo makes deductible rent payments to the REIT, thereby reducing its taxable income. The REIT initially is owned by OpCo's shareholders and pays dividends funded by the rental income received from OpCo. Under the REIT tax regime (outlined below), these dividend payments are deductible from the REIT's taxable income. The depreciation deductions for the real property held by the REIT reduce its taxable income enough to allow it to make distributions equal to or exceeding the REIT's taxable income.
Since dividends paid by a REIT to its shareholders are deductible for tax purposes, the distribution eliminates taxable income, along with any corporate-level taxes, to the REIT. Since there is generally no entity-level tax as a result of this mechanism, the dividends are subject to ordinary income tax rates at the shareholder level, as opposed to the more favorable capital gains tax rates applicable to dividends from most domestic C corporations and certain foreign corporations. From the shareholders' perspective, the steady dividend payments from the REIT and the higher valuation multiples generally applicable to real estate mean that their REIT shares are potentially valued higher than C corporation shares would be. Often, the sum of the parts is greater than the whole.
REIT Taxation and Tax-Free Spinoffs Under Sec. 355
A REIT is a U.S. entity that owns and operates income-producing real estate assets and otherwise would be taxed as a corporation but elects to be taxed under a special REIT tax regime. A REIT is effectively exempt from entity-level taxation but must annually distribute at least 90% of REIT taxable income (except net capital gain) to its shareholders in the form of dividends that are generally subject to ordinary income tax rates. REITs are taxed at corporate tax rates on amounts not distributed; in addition, strict distribution requirements must be met to avoid an excise tax under Sec. 4981. To be a REIT, the entity must meet the following requirements under Sec. 856 with respect to its income and assets:
1. REITs are restricted to earning certain types of income. At least 75% of annual gross income must be derived from passive real estate-related sources such as real estate rents, gains from the disposition of real property and interests in real property, or interest on mortgages secured by real property (Sec. 856(c)(3)). Moreover, at least 95% of a REIT's annual gross income must be from these passive sources and a second permitted category of other sources such as capital gains, interest, or dividends (Sec. 856(c)(2)).
2. As of the close of each quarter of a REIT's tax year, at least 75% of total assets (by value) must be held in real estate assets, cash, cash items including receivables, and government securities (Sec. 856(c)(4)(A)). Real estate assets generally include real property, interests in real property or in mortgages on real property, and shares in other REITs.
For all years other than its first tax year for which the REIT election is made, a REIT must have transferable interests and at least 100 shareholders for 335 days of a tax year (Sec. 856(a)(5)), and no more than 50% of the REIT interests may be owned by five or fewer individual shareholders (as determined using the personal holding company stock ownership tests of Sec. 542(a)(2)). Finally, a REIT may not have accumulated earnings and profits (E&P) from prior non-REIT years. Therefore, to elect REIT status, an upfront (taxable) purging distribution to the shareholders is necessary to eliminate non-REIT E&P.
Taxable REIT Subsidiary
Generally, a REIT must not own securities representing more than 10% of the securities of any issuer, by vote or by value (Sec. 856(c)(4)(B)(iv)). However, there is an exception for ownership of a taxable REIT subsidiary (TRS). A TRS must be a corporation and must meet either of two tests: (1) The REIT (directly or indirectly) owns stock of the corporation, and the REIT and the corporation jointly elect TRS status for the corporation; or (2) a TRS owns more than 35% of the voting power of all of the corporation's securities or owns securities (including stock) worth more than 35% of the value of all of the corporation's securities (Sec. 856(l)).
While REITs themselves may not engage in business activities other than leasing real property, TRSs may engage in any kind of business activity (with the exception of operating health care or lodging facilities). A TRS typically is used to provide REIT tenants with services that cannot be provided by the REIT directly. The activities of a TRS are not attributed to the REIT (Sec. 856(d)(7)(C)(i)), even if the REIT receives rent in part due to the TRS's activities.
Under Sec. 311(b), a corporation must generally recognize gain (but may not recognize a loss) on the distribution of property (including stock of its subsidiary) to its shareholders as if the corporation had sold the property at fair market value. The shareholder is treated as receiving a dividend equal to the value of the distribution to the extent of the distributing corporation's E&P, or capital gain, in the case of a stock redemption that results in a meaningful reduction in the shareholder's interest in the corporation.
However, where a transaction qualifies as a tax-free spinoff under Sec. 355, there is no tax to the distributing corporation, its shareholders, or the spun-off entity. This is based on the rationale that the spinoff is merely a separation of divisions of a business that continues to be owned and operated by the same shareholders. To qualify as a tax-free spinoff under Sec. 355, the transaction must meet the following statutory and judicially developed requirements:
Control: The distributing corporation must be in control of the spun-off corporation immediately before the distribution. "Control" for purposes of Sec. 355 is defined in Sec. 368(c), requiring ownership of at least 80% of the total combined voting power of all classes of stock entitled to vote and 80% of the total number of shares of all other classes of stock.
Not a device: The distribution of the controlled corporation's stock cannot be "used principally as a device" for the distribution of E&P of the distributing, controlled, or both corporations (Sec. 355(a)(1)(B)).
Distribution of all stock and securities: The distributing corporation must generally distribute all of the stock and securities in the controlled corporation held immediately before the distribution.
Continuity of interest: The regulations under Sec. 355 require that the shareholders of the distributing corporation maintain, in the aggregate, an amount of stock establishing a minimum level of continuity of interest in both the distributing and the controlled corporation following the Sec. 355 transaction (Regs. Sec. 1.355-2(c)(1)). Thus, the transaction cannot be followed immediately by a sale of the stock of either of the two corporations. The examples in the regulations state that 50% continuity of interest is sufficient, while 20% continuity is insufficient (Regs. Sec. 1.355-2(c)(2), Examples (1) through (4)). Moreover, the Taxpayer Relief Act of 1997, P.L. 105-34, added Sec. 355(e) to the Code. Under Sec. 355(e), the "anti-Morris Trust" provision (from Mary Archer W. Morris Trust, 367 F.2d 794 (4th Cir. 1966)), a distributing corporation will recognize gain if one or more persons acquire, directly or indirectly, 50% or more of the stock (measured by vote or value) of the distributing or any controlled corporation as "part of a plan (or series of related transactions)" that was in place at the time of the distribution (Sec. 355(e)(2)(A)(ii)).
Active trade or business: Immediately after the distribution, there must be two separate active businesses—one retained by the distributing corporation and the other being continued by the spun-off corporation. The two businesses each must have conducted an active trade or business for five years prior to the distribution. For purposes of determining whether an active trade or business existed immediately after and five years prior to the distribution, Sec. 355(b)(3) treats all members of a corporation's separate affiliated group (SAG) as one corporation; i.e., the separate existence of subsidiaries is disregarded.
Pursuant to the regulations under Sec. 355, a trade or business is a group of activities carried on for the purpose of making a profit. For a trade or business to be considered actively conducted, the corporation itself generally must perform active and substantial management and operational functions (Regs. Sec. 1.355-3(b)(2)(iii)).
The issue for real property holding companies is that holding passive assets such as stock, land, or other property for investment purposes does not constitute an active business (Regs. Sec. 1.355-3(b)(2)(iv)(A)). Moreover, owning and operating (including leasing) personal or real property used in a trade or business generally does not constitute an active business, unless the owner significantly participates in the operation and management of the property (Regs. Sec. 1.355-3(b)(2)(iv)(B)).
Business purpose: Literal compliance with the statutory requirements of Sec. 355 is not sufficient; the transaction must be "carried out for one or more corporate business purposes" (Regs. Sec. 1.355-2(b)(1)), as opposed to a shareholder purpose of separating the two trades or businesses to create more market value.
Meeting REIT and Sec. 355 Requirements
At first blush, the rules for REITs and tax-free spinoffs seem mutually incompatible, since REITs are limited to passive real estate-related operations, while the spinoff rules require the conduct of an active trade or business. In fact, the regulations under Sec. 355 stress that "[s]eparations of real property all or substantially all of which is occupied prior to the distribution by the distributing or the controlled corporation . . . will be carefully scrutinized with respect to the requirements of section 355(b)" (Regs. Sec. 1.355-3(b)(2)(iii)).
Due to a lack of authoritative guidance in this area, REIT spinoffs did not become a viable strategy until 2001, when the IRS announced in Rev. Rul. 2001-29 that a REIT managing its properties through independent contractors may satisfy the active trade or business test for purposes of Sec. 355 without forfeiting REIT status. The business purpose requirement of Sec. 355 may be met by prevalent nontax reasons for a REIT spinoff: appealing to a broader investor base, higher valuation multiples, increased efficiency and clarity in the market through separate management, or alleviating any conflicting interests of the separate business lines.
In a highly publicized transaction in November 2013, publicly traded casino and race track operator Penn National Gaming Inc. spun off its real estate holdings tax-free into a controlled corporation that elected REIT status. The company had received a favorable private letter ruling from the IRS (Letter Ruling 201337007), relying on the active trade or business conducted in a subsidiary of the controlled corporation that elected TRS status. This transaction illustrated that the SAG rules in Sec. 355(b)(3) can allow the businesses involved in a spinoff to meet the active trade or business requirement while the REIT assets remain large enough to satisfy the requirements of Sec. 856. While only the taxpayer to whom a private letter ruling is issued may rely on it, this favorable outcome signaled expanded opportunities to taxpayers.
In May 2014, the IRS issued proposed regulations (REG-150760-13) defining "real property" for REIT purposes to include permanent structures that go beyond basic real estate, such as transmission lines, pipelines, and telephone poles, as well as cell, broadcast, and electrical transmission towers. This guidance further contributed to an increase in REIT spinoff transactions. In April 2015, publicly traded telecommunications provider Windstream Holdings spun off its copper and fiber network into a new REIT, announcing that this was based on a favorable private letter ruling in which the IRS confirmed that copper and fiber networks are qualifying real estate assets that could be spun off tax-free into a new entity that immediately elects to be taxed as a REIT.
However, the increasing use of REIT spinoffs by large, publicly traded companies as a tax reduction strategy raised concerns that these transactions reduce federal tax revenue. Moreover, the fact that a small amount of "active trade or business" assets of the operating corporation is typically contributed to the REIT calls into question whether these transactions should be considered to meet the "active trade or business" and "business purpose" requirements of Sec. 355.
Impact of Recent Tax Law Changes
In September 2015, the IRS issued Notice 2015-59 and Rev. Proc. 2015-43, announcing that it was studying spinoffs where either the distributing or spun-off entity (1) has significant investment assets, (2) has qualifying business assets with a relatively small value, or (3) elects to be treated as a REIT following the spinoff. The IRS indicated that these types of transactions may fail to satisfy one or all of the "active trade or business," "business purpose," and "not a device" requirements of Sec. 355 and that no private letter rulings would be issued until its study of these transactions is complete. The IRS clarified, however, that tax-free spinoffs of REITs by REITs are not of concern.
On Dec. 18, 2015, President Barack Obama signed the Consolidated Appropriations Act, 2016, which contains the Protecting Americans From Tax Hikes (PATH) Act of 2015 (P.L. 114-113, Division Q). This law includes several taxpayer-favorable REIT provisions—for instance, significant reforms of the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA, Title XI, Subtitle C, of the Omnibus Reconciliation Act of 1980, P.L. 96-499) that make foreign investment in REITs more attractive, and making permanent the reduction of the recognition period for a REIT's built-in gains from 10 to five years. However, the most significant change is the PATH Act's restrictive provisions regarding tax-free REIT spinoffs, which make REITs generally ineligible to participate in a tax-free spinoff either as a distributing or a controlled corporation under Sec. 355.
The act, through newly enacted Sec. 355(h)(1), provides that tax-free treatment is not available where either the distributing or the controlled corporation is a REIT. There are two exceptions for existing REITs:
1. Tax-free treatment under Sec. 355 is still available for the spinoff of a REIT by another REIT where, immediately after the distribution, both the distributing and the controlled corporation are REITs (Sec. 355(h)(2)(A)). This exception is granted, presumably, because the combined businesses would have been entitled to elect REIT status as a single corporation.
2. A REIT may spin off its TRS if (a) the distributing corporation has been a REIT at all times during the three-year period ending on the date of the distribution, (b) the controlled corporation has been a TRS of the REIT at all times during that period, and (c) the REIT has had control (defined in Sec. 368(c) as ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock, taking into account stock owned directly or indirectly, including through one or more partnerships) of the TRS at all times during that period (Sec. 355(h)(2)(B)). Moreover, under newly enacted Sec. 856(c)(8), if a non-REIT was a distributing or controlled corporation in a transaction to which Sec. 355 applies, that corporation (and any successor corporation) may not make a REIT election before the end of a 10-year period beginning on the date of the distribution.
These provisions took effect for distributions on or after Dec. 7, 2015, but do not apply to transactions with a pending ruling request that was submitted to the IRS on or before that date. Several companies, among them Hilton Worldwide Holdings Inc. and Caesars Entertainment Corp., requested a ruling prior to the act's effective date to be granted IRS permission to spin off their real estate holdings. Other companies have already started pursuing alternate strategies to monetize real estate value; among them is publicly traded casino, hospitality, and entertainment company MGM Resorts International, which has announced its plan to contribute some of its real estate assets to a newly formed REIT and to use a triple net lease structure without a tax-free spinoff.
The recent legislation makes it almost impossible for an existing business to separate its operations from the ownership of real estate without incurring significant tax liability. This addresses policy questions under Sec. 355 as well as concerns that an increasing popularity of REIT spinoffs was eroding the corporate tax base. While the restriction of tax-free REIT spinoffs marks a significant change to the restructuring environment for the real estate industry, its impact remains to be seen.
Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Washington.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or email@example.com.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.