E&Y Provides Additional Comments on Guidance on Forthcoming Regs on Distributions Between Foreign Governments, REITs

Gentlemen:

These comments are submitted on behalf of a U.S. corporate client that manages U.S. real estate investments for the benefit of entities owned by a foreign government.

In Notice 2007-55 (the "Notice"), the Treasury Department ("Treasury") and the Internal Revenue Service ("IRS") addressed the application of section 897(h)(1) to certain distributions by a real estate investment trust (a "REIT") or a regulated investment company (a "RIC") to foreign shareholders.¹ The Notice states an intent to issue Regulations and to challenge under existing law the positions that certain distributions described in section 897(h)(1) to a foreign government are exempt under section 892 and that section 897(h)(1) does not apply to liquidating distributions by a REIT or RIC to any foreign shareholder.² Based on our discussions, we understand that you are working on drafting the Regulations described in the Notice.

The focus of public discussion with respect to Notice 2007-55 has principally been with respect to the portion of the Notice that addresses the treatment of certain liquidating distributions by REITs to foreign investors generally. (In November, 2007 Ernst & Young LLP submitted an outline of comments that primarily addressed the treatment of liquidating distributions to foreign investors although it also discussed the treatment of nonliquidating REIT distributions to foreign governments.) This letter provides further comments on the treatment of distributions described in section 897(h)(1) to a foreign government. We appreciate your willingness to consider these additional comments.

As described above, in the Notice the IRS takes the position that section 892 does not exempt from taxation distributions described in section 897(h)(1), apparently relying, at least in part, on various Regulations.³ None of the cited Regulations specifically addresses the treatment of such distributions to a foreign government. More importantly, we believe it is difficult to justify the position under the express terms of existing statutory law (and under the apparent policy underlying such statutory law) in the case of distributions with respect to a noncontrolling interest in a REIT held by a foreign government (unless the distributee is a controlled entity that is otherwise engaged in commercial activity).⁴

Section 892(a)(1) exempts from U.S. taxation certain items of income received by a foreign government that would be subject to tax under other sections of the Code if received by a taxable domestic investor or non-government foreign investor. In that regard, the statute broadly excludes, among other items, income of a foreign government received from investments in the United States in stock owned by the foreign government. The only statutory exclusion from the section 892(a)(1) exemption is for income derived from the conduct of any commercial activity or income received by, from, or with respect to the disposition of an interest in, a "controlled commercial entity."

Section 892 has always contained the exemption for income from investments in the U.S. in stock. The Tax Reform Act of 1986 (the "'86 Act") amended section 892 to create the carveout for income derived from commercial activity or with respect to controlled commercial entities.⁵ The Conference Report accompanying the '86 Act states that the '86 Act codifies the rule taxing the commercial activities of foreign governments.⁶ A carveout for commercial activities previously had been incorporated in former Treas. Reg. § 1.892-1(c).⁷ Section 892(c), enacted as part of the '86 Act, directs the Secretary to issue Regulations to carry out the purposes of the new legislation. Temporary Regulations were issued in 1988, including Treas. Reg. § 1.892-4T, which generally is consistent with former Treas. Reg. § 1.892-1 in carving out from the definition of "commercial activities" investments in stock.⁸

By its terms, therefore, section 892(a)(1) appears to exempt all income received by a foreign government with respect to a noncontrolling interest in a REIT unless the ownership of REIT stock is not treated as "stock" for purposes of section 892(a)(1), ownership of REIT stock is treated as a commercial activity, the distributions from the REIT are treated as derived from the conduct of a commercial activity or the receipt of REIT income causes a shareholder that is a controlled entity to be treated as engaged in commercial activity.⁹

Is an Ownership Interest in a REIT "Stock" for Purposes of Section 892(a)(1)? Does the Ownership of REIT Stock Constitute a Commercial Activity? By reason of a REIT's ability to claim a dividends paid deduction and eliminate any entity-level tax consequences, the tax treatment of a REIT has certain similarities to a partnership. However, other than as provided by Subchapter M of the Code, a REIT is an entity that is treated for federal tax purposes as a domestic corporation.¹⁰ The ownership interests in a REIT are treated as stock.¹¹ Section 892 does not carve out from the exemption income with respect to the ownership of REIT stock, and there is nothing in the legislative history of the '86 Act or any other section of the Code that expressly causes a minority ownership interest in REIT stock to be treated for section 892 purposes differently than such an interest in any domestic corporation. Indeed, if REIT stock was not treated as "stock" for purposes of section 892(a)(1) or the mere ownership of REIT stock was treated as causing the shareholder to be engaged in commercial activity, the section 892 exemption would not apply to the receipt of ordinary REIT dividends with respect to a noncontrolling interest owned by an integral part or a controlled entity that is not a controlled commercial entity. We believe that the IRS has never contended that such far reaching flow-through or conduit treatment was appropriate in the case of a REIT investment. Accordingly, REIT stock should be treated as "stock" for purposes of section 892(a)(1) and, unlike an interest in a partnership or simple trust, the ownership of REIT stock should not cause a foreign government to be engaged in the commercial activity engaged in by the REIT.

Are Distributions Described in Section 897(h)(1) Derived from a Commercial Activity? Ordinary dividend distributions paid by a corporation operating a commercial business are in a sense "derived from" a commercial activity. However, it is clear that such dividends received by a foreign government are exempt unless the payor or recipient is a controlled commercial entity. Distributions described in section 897(h)(1) are treated under section 897(a) as income that is effectively connected with a U.S. trade or business. Does this characterization automatically cause the foreign government to be treated as deriving income from a commercial activity? The answer should be "no." The legislative history of the '86 Act does not mention section 897 or otherwise suggest that income is "derived from a commercial activity" for purposes of section 892 simply because it is characterized as effectively connected income under section 897. Similarly, there is no such suggestion in either section 892 or section 897. Indeed, an example contained in the temporary Regulations indirectly acknowledges that the characterization of income under section 897 does not of itself result in the income being treated as "derived from a commercial activity" under section 892.¹² The example concludes that the section 892 exemption applies to a controlled entity's gain from the sale of a minority interest in a USRPHC, which would be treated under section 897(a) as income effectively connected with a U.S. trade or business if realized by a non-government foreign investor.¹³ Thus, it appears that any income received by a foreign government (other than a controlled entity that is otherwise a controlled commercial entity) with respect to a noncontrolling stock investment is not "derived from" a commercial activity under section 892.¹⁴ Is a different result warranted by reason of the nature of the distributions described in section 897(h)(1)? Again, the answer should be "no." While section 897(h)(1) looks to gains from REIT property sales for purposes of determining the amount of distributions treated as effectively connected income, the distributee is not treated as owning and selling the underlying property. The distributee's income still is with respect to its ownership of REIT stock. Section 897(h)(1) simply subjects to tax certain of the distributions received by a foreign investor unless an exemption applies. Income attributable to REIT distributions with respect to a minority ownership interest should be treated as "investment income" exempt under section 892 just as gain from the sale of a minority interest in a USRPHC is treated as exempt.

Does the Receipt of Income Characterized as Effectively Connected Cause the Foreign Government to be Engaged in a Commercial Activity? In the case of the ownership of REIT stock, the "activity" engaged in by the foreign government is the ownership of the stock, and the owner passively receives the income with respect to such stock. Again, there is no indication in section 897 or the legislative history of the '86 Act that a foreign government is engaged in commercial activity by reason of the characterization of income under section 897 as effectively connected.¹⁵

The intention of section 892 appears clearly to exempt from taxation all income items with respect to minority stock investments unless the ownership of such stock is a commercial activity or the stock is owned by an entity that is otherwise a controlled commercial entity. As noted above, there is no indication that REIT stock is to be treated any differently than the stock of any other domestic corporation for purposes of determining if the owner of the stock is engaged in commercial activity or if the income arising with respect to such stock is derived from a commercial activity. Thus, in the case of a distribution with respect to a noncontrolling interest in REIT stock held by an integral part or a controlled entity that is not otherwise a controlled commercial entity, section 892 clearly provides that such distributions are exempt from taxation.

In summary, we believe that Notice 2007-55 is incorrect in taking the view that the exemption contained in section 892 does not apply with respect to income attributable to a noncontrolling minority interest in a REIT. Instead, we believe that implementing the position taken in the Notice with respect to the treatment of foreign governments would require a statutory change to section 892 or section 897.

We respectfully request that you consider these views in drafting the upcoming Regulations. If you would like to discuss these issues further, please to do not hesitate to contact the undersigned.

² This analysis focuses on the consequences of distributions by REITs. The general rule of section 897(h)(1) does not apply to distributions with respect to certain publicly traded stock if the shareholder does not own more than five percent of such stock at any time during the one-year period ending on the date of distribution. IRC § 897(h)(1) [last sentence]. For purposes of this analysis, we assume that this exception does not apply.

³ The Notice cites Treas. Reg. §§ 1.897-9T(e), 1.1445-10T(b), and 1.892-3T(a)(1)(iii).

⁴ Treas. Reg. § 1.892-2T(a)(3) defines the term "foreign government" to include both "integral parts" of a foreign sovereign and "controlled entities."

⁵ The provision excluding income derived from the disposition of an interest in a controlled commercial entity (section 892(a)(2)(A)(iii)) was added by the Technical and Miscellaneous Revenue Act of 1988. The same Act modified the language of section 892(a)(2)(A)(ii).

⁶ H.R. Rep. No. 841, 99^th Cong, 2d Sess. (Vol. II), 11-654 (1986).

⁷ Former Treas. Reg. § 1.892-1(c)(2) provided in part, as follows:

⁸ Treas. Reg. § 1.892-4T does treat as "commercial activities" any activities as a dealer or investments by banking, financing or similar businesses. Former Treas. Reg. § 1.892-1 was withdrawn when the temporary Regulations were issued in 1988.

⁹ There are three circumstances in which the section 892 exemption would not apply. First, section 892 would not apply to income of the shareholder if the REIT is a "controlled commercial entity," as such term is defined by section 892(a)(2)(B) and Treas. Reg. § 1.892-5T. For purposes of this analysis, it is assumed that the REIT is not controlled, directly or indirectly, by the foreign government and that the foreign government does not have "effective control" of the REIT. Second, section 892 would not apply if the shareholder is a controlled entity that is engaged in commercial activity. For purposes of this analysis, it is assumed that the sole activity of any controlled entity that is a REIT shareholder is the ownership of the REIT stock. Third, if the REIT stock is owned by a controlled entity that is treated as a U.S. real property holding corporation (a "USRPHC"), the controlled entity will be treated as a "controlled commercial entity" and no portion of its income will be exempt under section 892. This is because Treas. Reg. § 1.892-5T(b)(1) provides that a USRPHC shall be treated as engaged in commercial activity. If a controlled entity's sole asset is a minority ownership position in an equity REIT, the controlled entity probably would be treated as a USRPHC under section 897(c)(2) if the REIT is foreign-controlled because the controlled entity's sole asset, the stock of the foreign-controlled REIT, would be a U.S. real property interest (unless the controlled entity is treated as owning less than five percent of the foreign-controlled REIT's stock under section 897(c)(3), with the result that the REIT stock would not be a USRPI). On the other hand, if the REIT is "domestically-controlled" (as such term is defined in section 897(h)(4)(B)), the REIT stock would not be a U.S. real property interest and the controlled entity would not constitute a USRPHC In that case, therefore, the mere ownership of the REIT stock by the controlled entity would not cause section 892 to be inapplicable. We believe the distinction drawn between a minority (but more than five percent) ownership position in a foreign-controlled REIT and a domestically-controlled REIT is not warranted under section 892. In any event, we assume for purposes of our analysis that the REIT in which the foreign government owns an interest is a domestically-controlled REIT.

¹⁰ IRC § 856(a)(3).

¹¹ See Treas. Reg. § 1.856-1(e).

¹² Treas. Reg. § 1.892-3T(b), Example (1).

¹³ The facts of the example state that the controlled entity is not engaged in commercial activity. Presumably, this is meant to say that the entity is not engaged in commercial activity by reason of activities not described in the example.

¹⁴ By contrast, if an integral part or controlled entity owns a direct interest in U.S. real estate or an interest in a partnership that owns U.S. real estate, the "activity" is the ownership of the real estate (given that the partnership's activity is attributed to its partners under Treas. Reg. § 1.892-5T(d)(3)), which is a commercial activity.

¹⁵ As noted in footnote 7, the preamble to the former Regulations expressly stated that the character of the activity, and not the character of the income as effectively connected, was relevant for purposes of determining whether a particular activity was a commercial activity.