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New IRS Restrictions on REIT Spinoffs Coupled With Tax-Free Mergers and Extension of “Sting Tax” Period Back to 10 Years

Tax Update

The Internal Revenue Service (IRS) and the U.S. Department of the Treasury have released temporary regulations (Temporary Regulations) that generally impose an immediate corporate-level tax on conversion transactions if such conversion transactions occur in connection with tax-free spinoffs governed by Section 355 of the Internal Revenue Code of 1986.1 Conversion transactions are transactions in which property of a regular corporation (C corporation) becomes property of a real estate investment trust (REIT) in a transaction that is otherwise tax-free under generally applicable tax principles. The Temporary Regulations are intended to prevent what the IRS regards as circumventions of the recently enacted statutory rules limiting REIT spinoffs. In particular, the main target of the Temporary Regulations are spinoffs by C corporations that are preceded or followed by tax-free mergers with the surviving corporation being a REIT. The Temporary Regulations are generally effective starting June 7, 2016, and expire on June 7, 2019.

In addition, and perhaps of more general interest and certainly more general application, if a conversion transaction is not subject to immediate taxation because it is not in connection with a spinoff and is not otherwise taxable, a REIT receiving C corporation property having built-in gain will be subject to corporate taxation on that built-in gain if the property is sold during a succeeding ten-year “recognition period,” rather than the five-year period in effect before the Temporary Regulations.

Background

In recent years, there have been numerous transactions in which a C corporation separated into a real estate business and a non-real estate business by way of a tax-free spinoff. Immediately following those spinoffs, and based on a pre-arranged plan, the corporations that held the real estate business elected to be treated as REITs. If respected, those transactions were tax-free, thereby removing appreciated real estate assets from the scope of the U.S. corporate level tax without an “exit toll charge.” Congress, interested in protecting the corporate tax base, did not like this outcome and enacted a provision in the Protecting Americans Against Tax Hikes Act of 2015 (PATH Act) that denies tax-free spinoff treatment under Section 355 if either the distributing corporation or the controlled corporation is a REIT. In addition, the PATH Act provides that a C corporation involved in a tax-free spinoff may not elect REIT status during the 10-year period following such tax-free spinoff.

Summary of Temporary Regulations

The PATH Act limitations did not shut down all possible tax-free REIT spinoff structures. In particular, the structure in which a C corporation undergoes a tax-free spinoff to separate its real estate business and its non-real estate business into two C corporations, followed by a merger of the C corporation that holds the real estate business with an existing, unrelated REIT, is not covered by the PATH Act limitations. This type of structure is the main focus of the Temporary Regulations.

Specifically, the Temporary Regulations provide that a C corporation or a REIT is covered by the Temporary Regulations only if

  1. the C corporation or the REIT engage in a conversion transaction (including a tax-free merger of a C corporation into an existing, unrelated REIT) during the 20-year period beginning on the date that is 10 years before the date of the tax-free spinoff; and 
  2. the C corporation or the REIT engaging in the tax-free spinoff is either 
     
    1. the distributing corporation or the controlled corporation for Section 355 purposes; or 
    2. a member of the “separate affiliate group” (as defined in Section 355(b)(3)(B)) of the distributing corporation or the controlled corporation. 

If these spin-off-related provisions of the Temporary Regulations apply, then the otherwise tax-free conversion transaction will — under Section 337 and Section 1374 principles — become taxable, as a deemed asset sale by the C corporation, of its (appreciated) assets that become REIT assets as of the time of the conversion transaction. The tax basis of the converted property will be adjusted accordingly and the otherwise tax-free nature of the spinoff will not be affected.

Under the principles of Section 1374, if a conversion transaction (e.g., a C corporation with appreciated real property merges into an existing, unrelated REIT) occurs and it is not treated as a deemed sale, then the REIT’s gain from the post-conversion transaction taxable dispositions of converted properties during the “recognition period” will be subject to corporate level tax. (This is sometimes referred to as the “Sting Tax”). The recognized gain subject to the Sting Tax is limited to the built-in gain at the time the conversion transaction occurs. Historically, the recognition period has been determined by a cross-reference to a similar rule with respect to C corporation that elect to become S corporation. For S corporations, that recognition period was generally 10 years for many years, although it was reduced to 5 years recently through a series of temporary enactments. In an effort to assist small businesses to operate as S corporations, with the enactment of the PATH Act, Congress had reduced the Section 1374 recognition period from 10 years to 5 years permanently. The REIT rules incorporated this change by reference. Apparently, the IRS and Treasury Department found this inappropriate. The Temporary Regulations turn this cross-reference off and define the “recognition period” for REIT purposes as a 10-year period without reference to the S corporation rule. The new 10-year recognition period for the Sting Tax applicable to REITs will apply to conversion transactions that occur on or after August 8, 2016.

Initial Observations

  • Overly Broad Temporary Regulations. The Temporary Regulations seem overly broad because they apply even if the tax-free spinoff is actually taxable on the corporate level by way of Section 355(d) or (e). There appears to be no justification for this result. 
  • REITs Spinning Out REITs or Taxable REIT Subsidiaries Are Excluded. The Temporary Regulations rightly exclude the spinoff transactions in which an existing REIT spins off another REIT or an “old and cold” taxable REIT subsidiary. 
  • Pending Spinoffs Grandfathered. The Temporary Regulations do not apply to spinoffs that are described in a ruling request that was submitted to the IRS on or before December 7, 2015, which request was not withdrawn and with respect to which a ruling has not been issued or denied as of December 7, 2015.
  • New Proposed Regulations Concerning Definition of Converted Property. Simultaneously with the Temporary Regulations, new proposed regulations provide for an expanded definition of “converted property.” Under this proposed definition, converted property would not only include property owned by a C corporation that becomes the property of a REIT but also “any other property the basis of which is determined, directly or indirectly, in whole or in part, by reference to the basis of the property owned by a C corporation that becomes the property of a REIT.” This definition would apply to conversion transactions that close on or after the date the proposed regulations are published. It is not clear which scenarios the IRS is targeting with this change and no technical explanation of its purpose was provided.

We will continue to monitor the developments surrounding REIT spinoffs and these Temporary Regulations.
 

1 Unless otherwise stated, all section references herein are to the Internal Revenue Code of 1986.

If you have any questions regarding this Sidley Update, please contact the Sidley lawyer with whom you usually work, or

Christian Brause
Partner
+1 212 839 5720
 
David C. Miller
Partner
+1 212 839 7362
 

Sidley Tax Practice

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