REIT’s income inclusions from its foreign subsidiaries are qualifying income
REIT’s income inclusions from its foreign subsidiaries are qualifying income
In a private letter ruling, IRS has determined that, for purposes of Code Sec. 856(c)(2)’s 95% gross income test to qualify as a real estate investment trust (REIT), income inclusions attributable to a REIT’s ownership in foreign subsidiaries that are either controlled foreign corporations or passive foreign investment companies constitute qualifying income. IRS reasoned that treating these inclusions as qualifying income was consistent with the income test’s policy objective of ensuring that a REIT’s gross income is primarily composed of passive income. IRS also found that certain foreign currency gains that the REIT expected to recognize with respect to certain distributions of previously taxed earnings and profits are not required to be taken into account for Code Sec. 856(c)(2) purposes.
Background on REITs. To qualify as a REIT, a corporation must satisfy a 2-part income test aimed at ensuring that income is primarily derived from passive real estate investments. An entity must derive at least 95% of its gross income from sources listed in Code Sec. 856(c)(2), and at least 75% must be from sources listed in Code Sec. 856(c)(3).Code Sec. 856(c)(2) includes income derived from dividends, interest, rents from real property, gain from the sale or other disposition of stock, securities, and real property (including interests in real property and interests in mortgages on real property) which is not property described in Code Sec. 1221(a)(1), and certain other sources (“qualifying income”). Legislative history shows that a central concern behind the gross income restrictions is that a REIT’s gross income should largely be composed of passive income.
Under Code Sec. 856(c)(5)(J), IRS is authorized to determine whether any item of income or gain which otherwise constitutes gross income not qualifying under Code Sec. 856(c)(2) or Code Sec. 856(c)(3) may nonetheless be considered qualifying income.
Background on Subpart F. Under the Code’s Subpart F, if certain requirements are met (namely, if at least 50% of the voting power or stock value is owned by “U.S. shareholders”; a U.S. shareholder is a U.S. person who owns (directly, indirectly, or constructively) 10% or more of the corporation’s voting power), the U.S. shareholders of a controlled foreign corporation (CFC) are taxed on their pro rata share of the CFC’s “subpart F income” (Code Sec. 951) and investments in U.S. property (Code Sec. 956), even if the amounts aren’t actually distributed to them. Subpart F income is generally passive-type income, including foreign base company sales income (FBCSI), which in turn includes foreign personal holding company income (FPHCI), which consists of, among other things, dividends, interest, royalties, rents, and annuities. (Code Sec. 954(c)(1)(A)) Also included are gains from the sale or exchange of property that would otherwise give rise to FPHCI. (Code Sec. 954(c)(1)(B))
Background on PFICs. A PFIC is defined as any foreign corporation if either: (1) at least 75% of the corporation’s income for the tax year is passive income; or (2) the average percentage of assets held by the corporation during the tax year that produce, or are held for the production of, passive income is at least 50%. (Code Sec. 1297(a) Passive income for purposes of the PFIC income test is defined as income which is of a kind that would be foreign personal holding company income under Code Sec. 954(c), subject to certain exceptions. (Code Sec. 1297(b))
A PFIC will be treated as a qualified electing fund (QEF) with respect to a shareholder if: (1) the shareholder makes a Code Sec. 1295(b) election that applies to the PFIC for the tax year; and (2) the PFIC complies with Treasury requirements that may be prescribed for purposes of determining the ordinary earnings and net capital gains of such company. (Code Sec. 1295(a)) Under Code Sec. 1293(a), every U.S. person who owns stock of a QEF at any time during the tax year of such fund includes:
- …as ordinary income, the shareholder’s pro rata share of the funds ordinary earnings for the year; and
- …as long-term capital gain, the shareholder’s pro rata share of the fund’s net capital gain for the year.
Background—distributions of previously taxed earnings. In general, Code Sec. 959(d) and Code Sec. 1293(c) provide that when a taxpayer includes in income a Subpart F Inclusion or QEF Inclusion, the subsequent distribution to the shareholder of the previously taxed earnings and profits (previously taxed income, or PTI) attributable to the inclusion is not treated as a dividend for purposes of chapter 1 of the Code (i.e., Code Sec. 1 through Code Sec. 1400U-3).
Under Code Sec. 986(c)(1), foreign currency gain or loss with respect to distributions of PTI (as described in Code Sec. 959 or Code Sec. 1293(c)) attributable to movements in exchange rates between the times of the deemed and actual distribution is recognized and treated as ordinary income or loss from the same source as the associated income inclusion. Code Sec. 856(n)(1)(A) provides that “passive foreign exchange gain” (generally, real estate foreign exchange gains and certain other foreign currency gains) for any tax year will not constitute gross income for purposes of Code Sec. 856(c)(2).
Facts. Taxpayer is a U.S. corporation that has elected to be taxed as a REIT. Taxpayer was organized to make direct and indirect investments in commercial timberland businesses, and realizes profits from the harvest and sale of timber and the long-term appreciation of the underlying timber properties.
Taxpayer operates in foreign countries through one or more foreign subsidiaries and associated intermediate holding companies. Some of the foreign subsidiaries are qualified REIT subsidiaries (QRSs) under Code Sec. 856(i), partnerships, or disregarded entities. Taxpayer has jointly elected Code Sec. 856(l) taxable REIT subsidiary (TRS) status with other foreign subsidiaries that are corporations for federal income tax purposes.
Taxpayer expects that its foreign TRSs will be either (i) CFCs with respect to which Taxpayer will be a U.S. shareholder, (ii) PFICs for which Taxpayer has made or intends to make elections under Code Sec. 1295(a) to treat as QEFs for all tax years during which the corporation was a PFIC that are included in the Taxpayer’s holding period of the PFIC stock (“pedigreed QEFs”), or (iii) PFICs for which Taxpayer has not made a mark-to-market election and which are not pedigreed QEFs with respect to Taxpayer.
Taxpayer is required to include in gross income:
- …with respect to the CFCs, under Code Sec. 951(a)(1)(A)(i), its pro rata share of the CFCs’ subpart F income, which Taxpayer expects will consist of items that are foreign personal holding company income (FPHCI) within the meaning of Code Sec. 954(c).
- …with respect to the PFICs for which the Taxpayer has made QEF elections, under Code Sec. 1293(a), its pro rata share of the earnings and profits of each QEF.
- …with respect to the PFICs for which Taxpayer has not made mark-to-market elections and which are not pedigreed QEFs with respect to Taxpayer, certain amounts under the rules set out in Code Sec. 1291(a)(1)(B).
The above income inclusions are generally attributable to the underlying entities’ deriving of interest, dividends, certain gains, and items that, if received by a REIT, would constitute rents from real property under Code Sec. 856(d).
Taxpayer also expects to recognize foreign currency gains with respect to distributions of PTI under Code Sec. 986(c)(1) attributable to the Subpart F and QEF inclusions (Code Sec. 986(c) gains).
Issues. Taxpayer requested rulings that, for purposes of Code Sec. 856(c)(2), the Subpart F and PFIC inclusions will be treated as qualifying income and the Code Sec. 986(c) gains won’t be taken into account.
Favorable rulings. IRS observed that the Subpart F inclusions attributable to Subpart F income of the CFCs consist of interest, dividends, certain gains, and items that also would constitute “rents from real property” under Code Sec. 856(d) if received by a REIT. Therefore, treatment of these Subpart F inclusions attributable to such income as qualifying income for purposes of Code Sec. 856(c)(2) does not interfere with or impede the policy objectives of Congress in enacting the income test under Code Sec. 856(c)(2) .
IRS similarly concluded that Taxpayer’s PFIC inclusions are qualifying income for purposes of Code Sec. 856(c)(2). Specifically, with respect to inclusions attributable to income of PFICs for which a QEF election has been or will be made, the income consists of interest, dividends, certain gains, and items that also would constitute “rents from real property” under Code Sec. 856(d) if received by a REIT. Taxpayer’s non-QEF inclusions derived from the PFICs for which no such election was made generate the same types of passive income. So, treatment of the PFIC inclusions as qualifying income also doesn’t interfere with or impede Congress’s policy objectives in enacting the income test.
With respect to the Code Sec. 986(c) gains, the PLR states that, while these gains aren’t foreign currency gains defined in Code Sec. 988(b)(1), they are attributable to the Subpart F Inclusions and QEF Inclusions—items of income that are qualifying income for purposes of Code Sec. 856(c)(2). The PLR then reasons that the Code Sec. 986(c) gains are substantially similar to passive foreign exchange gain described in Code Sec. 856(n)(3)(B)(i), so, under Code Sec. 856(n)(3)(C) and Code Sec. 856(n)(1)(A), they are also excluded from gross income for purposes of Code Sec. 856(c)(2).
References: For the REIT income tests, see FTC 2d/FIN ¶ E-6521 ; United States Tax Reporter ¶ 8654.03 ; TaxDesk ¶ 600,200 ; TG ¶ 20576 .