Real Estate Group Addresses Impact of Proposed Debt-Equity Regs

The Real Estate Roundtable appreciates the opportunity to submit comments on the Notice of Proposed Rulemaking regarding the treatment of certain interests in corporations as stock or indebtedness ("Proposed Section 385 Regulations").

U.S. real estate is far removed from the principal international tax problem, corporate inversions, identified by President Obama and Treasury Secretary Lew when the proposed regulations were unveiled.¹ On the contrary, U.S. real estate is a magnet for foreign capital that drives domestic job creation as buildings are constructed, upgraded, and maintained. In recent years, the Admininistration and Congress have embraced the effort, and enacted policies, to attract greater foreign investment for productive U.S. real estate and infrastructure projects. Depending on their final form, however, the Proposed Section 385 Regulations could have the opposite effect -- unintentionally deflecting foreign capital to other parts of the world and discouraging new real estate and infrastructure investment. In order to minimize the detrimental impact, the regulations should look through partnerships when applying the control test for related party lending. A look-through approach is consistent with both the underlying objectives of the proposed regulations and historical precedent.

Commercial real estate is extremely capital intensive and relies heavily on a combination of debt and equity. A tax and business environment that helps import foreign capital for real estate and infrastructure projects benefits the broader economy. For example, real estate investment creates hundreds of thousands of jobs in construction, architecture and engineering, building management, and related industries. Congress and the Administration took a major step forward late last year when the President signed into law the first major changes to the Foreign Investment in Real Property Tax Act (FIRPTA) since its enactment in 1980.

In light of the recent progress enacting FIRPTA reforms that lower tax barriers to foreign investment in U.S. real property, we urge you to carefully consider how regulatory changes to the taxation of inbound investment will affect our ability to further mobilize foreign capital for U.S. real estate and infrastructure projects that create jobs, improve communities, and expand the tax base at all levels of government. For example, comments recently submitted by one of the largest managers of foreign pension assets warned that the Proposed Section 385 Regulations would negatively impact the returns on U.S. infrastructure investments and "threaten to completely undo any benefits afforded by section 897(l) and put U.S. infrastructure investments in an even less appealing position than prior to the enactment of section 897(l)."² We urge you to carefully consider the potential solutions offered in these comments and others that are focused on inbound investment.

Additionally, in our view, the new rules should not apply to indebtedness issued by investment funds that are structured as partnerships in situations where the partners do not otherwise meet the control requirement on a look-through basis.³ The same policy concerns motivating the proposed rules do not apply to these types of structures. The mechanics and scope of the Proposed Section 385 Regulations address perceived abuses in expanded groups of related corporations. In an investment fund structure, to the extent the ultimate investor may be a corporation, such corporation typically would have a very small ownership interest in the fund (likely 5% or less). Thus, to include fund blockers within an expanded group based on the partnership's controlling ownership interest would mean that a mere 5% or smaller corporate investor would be treated as part of an expanded group. Extending the proposed regulations to reach such a result would require treating the fund as an "entity" for the limited purpose of finding control, and then an "aggregate" to ultimately get to the corporate investor. In effect, the government would be applying divergent concepts to the same fact pattern in order to achieve its desired result -- application of related party lending rules to a partner that has a limited ownership interest in the fund. Such treatment would be both unfair and of questionable authority.

In contrast, there is strong precedent and rationale for looking through a partnership to the ultimate partners when assessing whether a lender has too much control over the borrower to justify favorable tax treatment of the debt. Under the portfolio interest exemption, favorable treatment of interest income is limited to lenders with less than a 10% ownership interest in the borrower.⁴ The regulations look through the partnership and apply the ownership test at the partner level.⁵ First, in the preamble to the 2006 proposed portfolio interest exemption regulations,⁶ Treasury concluded that, although there was no statutory guidance on how to test control when the direct lender is a partnership, it was more appropriate to treat partnerships as an aggregate to give proper effect to the portfolio interest exemption and not to penalize an investor merely because it invested indirectly as opposed to directly. Second, the preamble relied heavily on the notion that the partner is the true, beneficial owner with respect to interest paid on the debt. Treasury emphasized that "the tax on interest paid to a partnership is substantively imposed on the nonresident alien individual or foreign corporation that is a partner in the partnership." Third, the preamble also expressed concern with disallowing a foreign beneficial owner's entitlement to a tax benefit where the holder of the obligation, the partnership, is not an actual taxpayer. Fourth, as an added rationale for looking through partnerships, Treasury cited the presence and application of other attribution rules in the statutory framework, specifically section 318, which police the ownership test, as well as the general liberalization of the attribution rules to reach "more subtle ownership arrangements."

All of these factors are present in the case of investment partnerships or funds and the Proposed Section 385 Regulations. But perhaps most importantly, at the time it issued the portfolio interest exemption regulations, Treasury was concerned that applying the ownership test at the partnership level would "impair[] the free-flow of foreign capital to U.S. business." This fundamental concern is the same reason why Treasury should not extend the Proposed Section 385 regulations to investment partnerships where none of the partners meet the control test.

Consistent with the aggregate treatment of partnerships in the proposed regulations generally, the control test should look through the partnership to its partners. Applying entity treatment to investment partnerships for purposes of the proposed regulations would have far-reaching, unintended, and detrimental consequences for U.S. real estate. Commercial real estate investment is completely removed from the inversion problem the regulations are intended to police. Creating per se presumptions and raising the risk that real estate debt could be recharacterized as equity would inject harmful and unnecessary confusion and uncertainty in the marketplace, stifling foreign investment and undermining new construction and property improvements that put people to work.

Finally, The Real Estate Roundtable concurs with, and endorses, the comments provided by the National Association of Real Estate Investment Trusts (NAREIT). The NAREIT comments illustrate other important ways in which the regulations could adversely affect U.S. real estate. We urge Treasury to carefully consider NAREIT's comments, in addition to the comments above.

Thank you for your interest and attention to these matters.

The Honorable Kevin Brady, Chairman, House Committee on Ways and Means

The Honorable Sander M. Levin, Ranking Member, House Committee on Ways and Means

The Honorable Orrin G. Hatch, Chairman, Senate Committee on Finance

The Honorable Ron Wyden, Ranking Member, Senate Committee on Finance

Mr. Thomas C. West, Jr., Tax Legislative Counsel, Department of the Treasury

² Letter from Guthrie Stewart, Senior Vice President and Global Head of Private Investments, Public Sector Pension Investment Board to Treas. Ass't Sec. Mark Mazur et al, Comments on Section 385 Proposed Regulations (June 30, 2016). In the absence of the regulations, the letter noted that the foreign pension fund expected to significantly increase its direct and indirect financial participation in U.S. infrastructure projects as a result of the recent FIRPTA changes.

³ The preamble to the proposed regulations requests comments on "whether certain indebtedness commonly used by investment partnerships, including indebtedness issued by certain 'blocker' entities, implicate similar policy concerns as those motivating the proposed regulations, such that the scope of the proposed regulations should be broadened. . . .". Preamble to Proposed Section 385 Regulations (Apr. 8, 2016).

⁴ I.R.C § 871(h)(3).

⁵ Treas. Reg. § 1.871-14(g)(3)(i) ("Partner level test. Whether interest paid to a partnership and included in the distributive share of a partner that is a nonresident alien individual or foreign corporation is received by a 10 percent shareholder shall be determined by applying the rules of this paragraph (g) only at the partner level.")

⁶ REG-118775-06, Fed. Reg. Vol. 71, No. 113, p. 34047 (6/13/2006).