Ernst & Young Seeks Withdrawal of Guidance on Forthcoming Regs on Distributions Between Foreign Governments, REITs

To: Harrington, John

Attached is a copy of the cover letter and comments on Notice 2007-55 that were mailed to you at the end of last week. Copies also were mailed to Jesse and Itai, but I would appreciate it if you could forward this e-mail as well.

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Thank you again for the time that you and your colleagues recently spent with us in discussing the significant issues that have been raised by the issuance of Notice 2007-55. As a follow-up to our meeting, we have enclosed an outline of the issues we discussed during our meeting. As you may recall from our comments and as described in our outline, many foreign governments and other foreign investors in REITs were surprised by the manner in which the Notice seems to contradict prior guidance from the IRS on these issues. Accordingly, given the proximity of the 2007 financial year-end for many of the these investors and the need to immediately address the potential effects of the Notice as required by FIN 48 in their year-end financial statements, we think it is very important to act quickly in withdrawing Notice 2007-55. Instead, we think the process would be greatly improved by requesting comments from taxpayers and practitioners (essentially a "comment period") to allow for a public discussion of the very significant issues raised in the Notice.

We look forward to continuing our dialogue and once again express our thanks for your attention to these issues. If you have questions, please do not hesitate to call any of us: Ken Appel at 603-634-4524, Jim Lowy at 415-894-8602, or Rob Hanson at 202-327-5696.

I. Introduction

A. In Notice 2007-55 (the "Notice") the Treasury Department ("Treasury") and the Internal Revenue Service ("IRS") announced an intent to issue "clarifying" Regulations and to challenge under existing law the treatment by a foreign government of certain distributions received from a real estate investment trust (a "REIT") or a regulated investment company (a "RIC").¹ The Notice states that the Regulations will be effective for distributions made on or after the date of the Notice.

B. With respect to distributions attributable to gains from REIT sales of U.S. real property interests ("USRPIs"), where the distribution is pursuant to a plan of liquidation adopted by the REIT, the Notice states that section 897(h)(1) causes such distributions to be taxable notwithstanding that Subchapter C of the Code treats such distributions as in exchange for the shareholder's stock.²

C. With respect to non-liquidating distributions attributable to gains from REIT sales of USRPIs, the Notice states that section 897(h)(1) causes such distributions to be taxable, and the section 892 exemption will not apply.

II. Overall Summary

A. The Notice should be withdrawn, the policy objectives should be rethought, and the numerous technical issues described below need to be carefully considered in the context of a request for public comments and a public hearing.

B. The Notice creates poor and frequently inconsistent policy results, and certain of the positions taken in the Notice appear to require statutory changes.

C. The Notice is not supported by the manner in which the law has reasonably been interpreted by many practitioners over the last 20 years.

III. General Explanation of Section 892

A. Section 892 exempts from taxation income earned by a foreign government from investments in the U.S. in stocks and certain other sources, except that the exemption does not apply to income derived from a commercial activity or income received by or from a controlled commercial entity.

B. Regulations section 1.892-3T(a)(1) restates the basic exemption but also provides that income from sources other than as described (such as income earned from a USRPI described in section 897(c)(1)(A)(i)) is not exempt. Regulation section 1.892-3T(a)(1) further states that any gain from the disposition of a USRPI defined in section 897(c)(1)(A)(i) shall in no event qualify for exemption.

IV. General Explanation of Section 897

A. Section 897(a)(1) generally provides that gain or loss of a foreign corporation or nonresident alien individual (a foreign taxpayer") from the disposition of a USRPI is taken into account as if such gain or loss were effectively connected with a trade or business within the U.S.

B. Section 897(c) generally defines a USRPI as an interest in real property in the U.S. and an interest (other than an interest solely as a creditor) in a U.S. real property holding corporation (a "USRPHC"). Section 897(h)(2) provides, however, that an interest in a domestically-controlled REIT or RIC is not a USRPI.

C. Section 897(h)(1) provides that a distribution by a REIT or RIC to a foreign taxpayer, to the extent attributable to gain from the sale or exchange by the REIT or RIC of USRPIs, is treated as gain recognized by the foreign taxpayer from the sale or exchange of a USRPI. (An exception exists with respect to certain interests in publicly-traded REITs or RICs.)

V. Liquidating REIT Dividends

A. Treatment of Transactions Under Current Law

1. Regulations section 1.856-1(e) provides that provisions of the Code and Regulations applicable to domestic corporations shall apply to REITs and their shareholders to the extent not inconsistent with the REIT provisions.

a. In particular, sections 302, 303, 304 and 331 apply to determine if REIT distributions are in exchange for stock.³

b. Section 331(a) provides that amounts received by a shareholder in a liquidating distribution are treated as in exchange for the stock.

2. A REIT is entitled to a deduction for dividends paid (a "DPD"), as described in section 561.⁴

a. Under section 561, the DPD is determined by reference to section 562.

b. Section 562(b) provides that, for purposes of computing the DPD: (i) a liquidating distribution is treated as a dividend to the extent of accumulated earnings and profits;⁵ and (ii) in the case of a complete liquidation within 24 months of adoption of the plan of liquidation, distributions within such period are treated as dividends to the extent of current earnings and profits for the year of distribution.⁶

3. Under these statutory rules, therefore, a REIT that sells it property and distributes the proceeds pursuant to a plan of liquidation may recognize a DPD to reduce its REIT taxable income, although the shareholders are required to treat the liquidating distributions received as in exchange for their stock.

4. Under section 897, a minority interest in a domestically-controlled REIT is not a USRPI.⁷ Accordingly, proceeds from the sale of a minority interest in a domestically-controlled REIT are not subject to U.S. tax by reason of section 897.⁸

5. Foreign investors, including but not limited to foreign governments, have relied on this relatively simple statutory analysis for purposes structuring investments in REITs. Essentially the same analysis was confirmed by the IRS as being correct in PLR 9016021, described below, which remained in place for nearly 15 years before being revoked, prospectively, in 2004. With no other guidance from the IRS, both practitioners and the IRS had quite reasonably looked to PLR 9016021 as the proper interpretation and application of the rules in this area.

B. Private Letter Ruling 9016021

1. Private Letter Ruling 9016021 (January 18, 1990), addresses certain issues with respect to a series of liquidating distributions by a foreign-controlled REIT owned principally by two foreign pension trusts.

a. The ruling confirms that the REIT is entitled to a DPD with respect to liquidating distributions made in accordance with the requirements of section 562.

b. The ruling indicates that for purposes of determining the tax treatment of the foreign shareholders, the shareholders are treated as receiving amounts in exchange for their stock. Thus, initial distributions are treated as a return of capital in accordance with the rules under section 331. Because the REIT is not domestically-controlled, the foreign shareholders are treated as disposing of USRPIs when they receive the liquidating distributions (i.e., the REIT stock is stock in a USRPHC).

2. As discussed above, foreign investors interpreted Private Letter Ruling 9016021 as confirmation of the statutory analysis described in Section V.A. above, which, as noted, is relatively straightforward.

3. In Private Letter Ruling 200453008 (September 27, 2004), the IRS announced that it was withdrawing for reconsideration its ruling in Private Letter Ruling 9016021 to the extent it addressed the applicability of section 897 to liquidating distributions. Private Letter Ruling 200453008 did not discuss, however, why the earlier ruling was being withdrawn, what study was being undertaken by IRS, why input from the public and practitioners was not requested or what precise policy and technical issues the IRS might be focused on in the context of undertaking this reconsideration.

C. Issues Associated with Notice 2007-55

1. In the Notice, the IRS and the Treasury take the view that section 897(h)(1) applies to all distributions by a REIT, including liquidating distributions, to the extent attributable to REIT gains from the sale or exchange of a USRPI. Although the Notice is directed to foreign governments, this portion of the Notice affects non-government foreign investors as well.

2. Under section 331, liquidating distributions clearly must be treated by recipient shareholders as in exchange for their stock. Under section 897, because a minority interest in a domestically-controlled REIT is not a USRPI, gains from a foreign shareholder's disposition of such an interest is not subject to U.S. tax.

3. Nothing in section 897(h)(1) or the section 897 Regulations states an intent to override the treatment provided by sections 331 and 897(h)(2). Indeed, this seems to be the IRS's long-held view, as expressed in Private Letter Ruling 9016021. The position in the Notice interpreting Sections 897(h)(1) and 897(h)(2) appears, therefore, to be inconsistent with regard to the treatment of liquidating distributions by domestically-controlled REITs to minority shareholders.⁹

4. The position taken in the Notice creates inappropriate results from a policy perspective. Consider the following examples:

a. If a domestic taxpayer purchases a minority interest in a REIT, and the REIT then sells its property and liquidates, the REIT can avoid tax under section 562 by reason of the DPD. The domestic purchaser, who has a basis in his REIT stock equal to fair market value, realizes no gain upon receipt of the liquidating distribution.¹⁰ By comparison, under the Notice, liquidating distributions to a foreign purchaser would be subject to tax under section 897(h)(1) to the extent of the foreign purchaser's share of the REIT's capital gains from the sale of the REIT's USRPIs. The foreign purchaser would realize a capital loss with respect to its REIT stock but this loss is not useable because it is not effectively connected to a U.S. trade or business. As a result the foreign purchaser pays what amounts to a confiscatory tax on the return of his investment. There appears to be no policy justification to place the foreign purchaser in a disadvantageous position compared to the domestic purchaser.

b. The impact of the Notice can be avoided if a foreign shareholder sells its REIT stock. A foreign shareholder's sale of a minority stock position in a domestically-controlled REIT is not taxable under section 897, and the position taken in the Notice would not change this result. Therefore, a foreign shareholder that is a minority owner in a domestically-controlled REIT can sell its REIT stock without U.S. tax. The REIT then could sell its property and liquidate. A domestic purchaser of the foreign shareholder's interest would have no gain to recognize on the liquidating distribution to the extent the purchase price was equal to the purchaser's share of the liquidation proceeds. Thus, a well-advised foreign REIT shareholder would seek a purchaser of its stock prior to the time the REIT enters into an agreement to sell all of its real estate. In such a circumstance, as a commercial matter, the foreign shareholder likely would have to agree to accept a discounted price in order to dispose of its stock in a timely manner. There does not appear to be any policy justification for creating the distinction between the tax consequences of the stock sale and the tax consequences of the liquidating distributions.

c. Under the Notice, if a foreign corporate shareholder (including a foreign government) recognizes gain as the result of the receipt of a liquidating distribution, which gain were treated under the Notice as effectively connected income under section 897(a), it appears that the foreign shareholder may be subject to branch profits tax unless the branch termination exception described in Regulation section 1.884-2T(a) applies. This treatment appears to be contrary to the policy underlying the branch profits tax, which is to conform the tax consequences of operating a U.S. business through a branch of a foreign corporation to the tax consequences of operating through a U.S. subsidiary of a foreign corporation. Consider that if the REIT stock was owned by the foreign investor's U.S. corporate subsidiary, the REIT's liquidating distribution to the U.S. subsidiary would be subject to tax but no tax would be imposed, generally, upon the liquidation of the U.S. subsidiary.

4. A position that section 897(h)(1) governs liquidating distributions appears to require a statutory change, and cannot be addressed by a mere change in the interpretation of existing law or by the issuance of Regulations. When an analogous issue arose with respect to liquidating distributions to controlling REIT shareholders, Congress saw fit to enact section 332(c). Neither the IRS nor the Treasury sought to address the perceived abuse by other means.

a. In 1998, Congress and the Treasury became aware of transactions in which a non-REIT corporation would establish an 80 percent or more owned private RIC or REIT (typically holding mortgages generating interest income). After a period, the corporate parent would adopt a plan of liquidation of the REIT or RIC subsidiary qualifying for non-recognition treatment under section 332. For the permitted period of the plan of liquidation, e.g., two or three years, the recipient parent corporation would claim non-recognition treatment on receipt of the periodic distributions in liquidation of the REIT or RIC. The REIT or RIC would continue to be eligible for the DPD for such distributions during the period of liquidation. The net effect was that neither the parent nor the REIT or RIC was subject to tax on the earnings of the REIT or RIC during the liquidation period.

b. Congress and the Treasury believed that this practice was clearly not consistent with the intent of Congress in establishing the tax benefits of the REIT and RIC rules. However, Congress and the Treasury believed that administrative action through issuance of rulings or new regulations would not be sufficient to correct this practice, and that new legislation was needed (see comments of Senator Roth and Moynihan, and Representative Archer at introduction of this legislation May 22, 1998). Accordingly, in the 1998 Tax Extension Act, P.L. 105-277, § 3001, Congress added section 332(c), providing that income not subjected to corporate tax at the REIT or RIC level because of the DPD should not be excluded from the income of the parent corporation as liquidating distributions under section 332. It is significant that, even though the abuse Congress was trying to cure was viewed as inconsistent with the original intent of Congress in establishing REITs and RICs, the curative provision was made prospective only, becoming effective for distributions on or after May 22, 1998.

c. The includible amount under section 332(c) is treated as a dividend received from the REIT or RIC. The provision does not otherwise change the tax treatment of the distribution to the parent corporation, or to the REIT or RIC. Neither the statute, nor the legislative history indicates any anti-abuse rule that would extend the principles of section 332(c) to any other distributions from a REIT that would otherwise not be subject to US tax, e.g., gain recognized by a foreign person in a section 331 liquidation.

d. Legislation similar to section 332(c) could be enacted to provide that to the extent a REIT liquidating distribution was attributable to gain from the sale by the REIT of a USRPI a foreign shareholder would be treated as subject to potential taxation under section 897(h)(1), without otherwise affecting the tax treatment of the distribution. However, it appears that such a change could not be made without legislative action.

VI. Non-Liquidating Distributions to Foreign Governments

A. Section 892 -- Generally

1. As described above, section 892(a)(1)(A)(i) and Regulation section 1.892-3T(a)(1)(i) expressly provide that income from investments in stock is exempt. The term stock includes USRPHCs as long as the USRPHCs are not controlled commercial entities.

2. Because shares in a REIT are stock, all of the income of a foreign government from shares in a REIT should be exempt under section 892.

B. Section 897/Section 892 Interaction

1. Section 897(h)(1) provides that distributions received by a foreign REIT shareholder that are "attributable to" REIT gains from the sale of USRPIs are "treated as" gains from the sale of USRPIs.

2. Neither section 892 nor section 897 (nor the legislative history of either section) suggests that the general exemption under section 892 for income from stock is not to apply in the case of REIT capital gain distributions.

a. Regulation section 1.892-3T(a)(1) provides that income earned from a USRPI described in section 897(c)(1)(A)(i) is not exempt, and also provides that any gain derived from the disposition of a USRPI defined in section 897(c)(1)(A)(i) is not exempt. Section 897(c)(1)(A)(i) treats a direct interest in U.S. real property as a USRPI. Presumably, these provisions are based on the view that the disposition of a direct ownership in the U.S. real property amounts to a commercial activity. However, ownership of stock is not described in section 897(c)(1)(A)(i). (Stock in a USRPHC may be a USRPI by reason of section 897(c)(1)(A)(ii).) Thus, ownership of a minority interest in REIT stock is never a commercial activity, and income with respect to the passive ownership of such stock should not fall within the carveout contained in Regulation section 1.892-3T(a)(1). Indeed, Regulation section 1.892-3T(b) Example (1) makes clear that gain from the sale of a minority stock position in a USRPHC is exempt, even though the interest in the USRPHC is a USRPI. This indicates that the carveout to the exemption was meant to apply to direct ownership of real estate and nothing else.

3. While section 897(h)(1) may provide that certain REIT distributions are "treated as" gains from the sale of a USRPI, the dividend income earned by the foreign government-shareholder is not from a USRPI and the government has not disposed of an interest described in section 897(c)(1)(A)(i). It is important to note that section 897(h)(1) characterizes the income as gain from the sale of a USRPI, not as gain from the sale of an asset described in section 897(c)(1)(A)(i). Because section 897(h)(1) does not reference section 897(c)(1)(A)(i) the general exemption in Regulation section 1.892-3T(a)(1) should apply.

a. Section 897(h)(1) should be read merely as a characterization provision treating dividend income as if it were income from the sale of a USRPI, and not as income from an actual sale of USRPI. Because no actual sale of a USRPI is conducted by the foreign government, or by a partnership acting on behalf of a foreign government-partner, no commercial income should arise for the foreign government. The foreign government is at all times a passive owner of REIT stock, and never is the direct owner of U.S. real estate.

b. Regulation section 1.897-9T(e) provides that a foreign government shall be treated as a foreign person with respect to USRPIs, and shall be subject to sections 897, 1445 and 6039C on the disposition of a USRPI "except to the extent specifically otherwise provided" in the section 892 Regulations. A similar provision is contained in Regulation section 1.1445-10T(b). These provisions do not mention section 897(h)(1) as coming within their scope, and the Preamble (T.D. 8198) does not mention section 897(h)(1) as authority for the issuance of Regulation section 1.897-9T(e).¹¹ The Regulation effectively states that section 897 does not override section 892. As stated above, Regulation section 1.892-3T(a) specifically provides that income from the ownership of stock is exempt. Thus, the exemption contained in section 892 should apply. There is nothing inherent in section 897 or the underlying Regulations that states otherwise.

c. Curiously, the Notice refers to Regulation section 1.897-9T(e) (and Regulation section 1.1445-10T(b)) as the basis for the position that section 897 overrides section 892, and states that "[t]he regulations issued under section 892 do not specifically exempt foreign governments from taxation under sections 897 and 1445. . . ." Treas. Reg. section 1.897-9T(e) was issued on May 4, 1988. However, Treas. Reg. section 1.892-3T -- the provision that the Notice says does not preclude the possibility of FIRPTA taxation of foreign governments -- was issued on June 24, 1988. As Treasury issued the two sets of regulations about only 50 days apart, clearly it had both sets of rules in mind at the same time. Therefore, if it wished for section 897 to override the section 892 rules in the case of dispositions of USRPHCs, it would have so provided. It did not. Instead, the section 892 regulations that were issued explained that only gain from the disposition of direct interests in U.S. real property -- i.e., section 897(c)(1)(A)(i) property -- would be subject to section 897. No mention is made about the sale of stock. In fact, the only mention of USRPHCs in the Regulations under section 892 is in Regulation section 1.892-5T(b) -- also issued on June 24, 1988 -- which explains that the only kind of USRPHC from which income or gain is not exempt under section 892 is a USRPHC in which a foreign government holds a controlling interest. Thus, the general rule of section 892(a)(1) that (1) is clearly articulated in Regulation section 1.892- 3T(a)(1)(i), (2) specifically provides that "income from investments in the United States in stocks" is exempt, and (3) was issued shortly after Regulation section 1.897-9T(e) came out, was never disturbed by section 897 in the case of minority investments in stock and therefore controls.

d. Accordingly, foreign governments have reasonably taken the position that 897(h)(1) does not override 892. The Treasury should reconsider its position in Notice 2007-55.

² Unless otherwise noted, all references to the term "Code" or "IRC" are to the Internal Revenue Code of 1986, as amended, all references to the term "section" are to sections of the Code and all references to the term "Treas. Reg." or "Regulations" are to the Treasury Regulations promulgated under the Code.

³ Treas. Reg. § 1.856-1 (e)(3).

⁴ IRC § 857(b)(2)(B).

⁵ IRC § 562(b)(1)(a).

⁶ IRC § 562(b)(1)(b).

⁷ IRC § 897(h)(2).

⁸ A foreign government's sale of a minority interest in a REIT is not subject to tax whether the REIT is controlled by domestic or foreign shareholders. See Treas. Reg. § 1.892-3T(b) Example (1).

⁹ The legislative history merely states as follows: "Distributions by a real estate investment trust (REIT) to foreign shareholders would be treated as gain on the sale of U.S. real property to the extent of the shareholder's pro rata share of the net capital gain of the REIT. In the case of REITs which are controlled by U.S. persons, sales of the REIT shares by foreign shareholders would not be subject to tax (other than in the case of distribution by the REIT)." Thus, it is made clear that a foreign shareholder's capital gain dividends will be subject to tax, and sales of interests in domestically- controlled REITs will not be subject to tax. Conf. Comm. Rpt. 96-1479 (Omnibus Budget Reconciliation Act of 1980), 1980-2 C.B. 575. The treatment of foreign governments is not addressed.

¹⁰ This assumes that the purchase price is equal to the purchaser's share of the liquidation proceeds.

¹¹ The Preamble does cite section 897(e) which governs the circumstances in which nonrecognition provisions apply but seems to read section 897(e) as addressing nonrecognition exchange transactions. See also T.D. 8321 regarding FIRPTA withholding regulations on REIT distributions.