Nathan C. Brown, Real Estate Investment Trusts and Subpart F: Characterizing Subpart F Inclusions for Purposes of the Reit Income Tests

• Jurisdiction: United States,Federal
• Citation: Vol. 20 No. 2
• Publication year: 2006
• topic: Corporate / Commercial,Tax Law,Real Estate

REAL ESTATE INVESTMENT TRUSTS AND SUBPART F: CHARACTERIZING SUBPART F INCLUSIONS FOR PURPOSES OF THE REIT INCOME TESTS

INTRODUCTION

Matthew A. Stevens, Special Counsel to the Chief Counsel of the Internal Revenue Service, once observed that "much of [the Internal Revenue Code's] magic arises when rules from two different parts of its provisions intersect."¹

This Comment analyzes the "magic" surrounding the intersection of Internal Revenue Code Sec. 856-859, which create and regulate Real Estate Investment Trusts,²and Internal Revenue Code Sec. 951-964, collectively referred to as "Subpart F." Subpart F governs the taxation of U.S. shareholders on income earned by certain foreign corporations operating abroad. Specifically, this Comment seeks to determine whether Subpart F income inclusions are "dividends" for purposes of the Real Estate Investment Trust income tests.

Part I of this Comment covers basic principles of U.S. international and corporate tax policy and introduces the Real Estate Investment Trust and Subpart F. Neither Subpart F, the legislation creating and defining the Real Estate Investment Trust, nor any regulation or ruling directly addresses the appropriate classification of Subpart F inclusions for purposes of the Real Estate Investment Trust income tests.

Part II analyzes other areas of the Internal Revenue Code,³its corresponding regulations, and Internal Revenue Service rulings which characterize Subpart F income or similar inclusions for purposes of a variety of tests and qualifications. The characterizations found in Internal Revenue Service rulings fall into three general categories: (1) those that characterize the income inclusion as a dividend; (2) those that explicitly rule that the inclusion is not a dividend; and (3) those that contain a "look-through" provision for characterizing inclusions based on the appropriate classification of the corresponding earnings of the Controlled Foreign Corporation.

Part III seeks to determine which characterization of Subpart F inclusions is most appropriate for purposes of the Real Estate Investment Trust income test, looking to case law and revenue rulings for guidance in comparing similar sections of the Internal Revenue Code. This paper argues that the most appropriate characterization of Subpart F income for purposes of the Real Estate Investment Trust income test is as a "dividend." However, the "look- through" provision contained in some sections of the Code represents a more progressive rule that would better protect the purpose of the Real Estate Investment Trust.

I. BASICS OF U.S. TAXATION, REITS, AND SUBPART F

While the United States "has the power to tax U.S. persons on their worldwide income,"⁴international jurisdictional limitations constrain the government's ability to tax a foreign corporation on its foreign source income.⁵

Domestic tax policy, codified in the Internal Revenue Code (the Code) controls the breadth of tax jurisdiction. As a result of its policy decisions, the United States "reaches more taxpayers and conduct than most other nations."⁶Still, sections of the Code allow special tax breaks for entities and individuals intended to further a variety of specific goals related to international competitiveness and economic growth.⁷

A. U.S. International Tax Policy

There are four recognized types of tax jurisdiction: (1) source-based jurisdiction; (2) territorial-based jurisdiction; (3) residence-based jurisdiction; and (4) citizenship-based jurisdiction.⁸Source-based taxation allows a nation to tax all income with a domestic source, even if the taxpayer is not a resident or citizen of that nation.⁹Territorial-based jurisdiction permits a nation to tax income only within its territory.¹⁰Residence-based jurisdiction allows a nation to tax all the income of a resident, even if the income has a foreign source.¹¹

Citizenship-based jurisdiction allows a nation to tax all the income of its citizens, even the foreign-source income of a citizen living abroad.¹²

Choosing a jurisdictional basis "defines the limits of the nation's tax jurisdiction."¹³For example, a nation whose tax jurisdiction is source-based could not tax the income of a resident citizen if the income was earned abroad. And, a nation whose jurisdiction is residence-based could not tax income earned within the territorial limits of that nation if the taxpayer was a resident of a foreign state.

The United States utilizes all four theories in its international tax policy.¹⁴

Most relevant for this Comment, the Code exerts source-based jurisdiction over income earned by foreign corporations where that income is "effectively connected with a trade or business conducted in the United States," while relying on residence or citizenship-based theories to tax domestic corporations on their worldwide income.¹⁵

B. U.S. Corporate Taxation

United States corporate tax law is based on a "classical double tax system."¹⁶The Code treats a corporation and its shareholders as separate persons for tax purposes.¹⁷Thus, earnings are taxed both at the corporate level and when distributed to shareholders in the form of a "dividend."¹⁸

In addition to other "economic distortions,"¹⁹double taxation encourages investment in business forms other than corporations.²⁰Partnerships, for example, enjoy "flow-through" taxation, and are subject only to a single level of taxation.²¹In addition, the Code allows for the creation of special forms, which, like partnerships, are taxed only at the shareholder level-Regulated Investment Companies (RICs) and Real Estate Investment Trusts (REITs) both avoid double taxation under the Code.²²

C. Introduction to the Regulated Investment Company and the Investment

Company Act of 1940

Generally, a RIC is any domestic corporation which is registered under the Investment Company Act of 1940.²³The Investment Company Act of 1940, enacted in response to abuses in the investment industry in the late 1930s, "imposes an extensive federal regulatory structure on investment vehicles known as investment companies."²⁴Investment companies allow investors to invest in "pools of corporate debt and equity securities" and offer diversification of risk and relatively inexpensive professional management.²⁵

And, if a RIC meets certain requirements related to its income, it is given favorable tax treatment as a "pass-through" entity, avoiding double taxation.²⁶

The Investment Company Act of 1940 creates two general classifications of investment companies: "unit investment trusts" and "management companies."²⁷A unit investment trust's portfolio of debt and equity securities is fixed; thus, a unit investment trust has no need for an investment manager or a board of directors.²⁸In contrast, a management company's portfolio is managed by an investment advisor and has a board of directors to oversee its activities.²⁹Both unit investment trusts and management companies are eligible for RIC status under Sec. 851 of the Code.³⁰

In addition to registration under the Investment Company Act of 1940, to qualify as a RIC, the domestic corporation must comply with certain limitations on its income.³¹To meet the RIC income test, at least 90% of a domestic corporation's gross income must be derived from "dividends, interest, payments with respect to securities loans . . . and gains from the sale or other disposition of stock or securities."³²"[N]et income derived from an interest in a qualified publicly traded partnership"³³is also qualified income for purposes of the RIC income test, as is "other income . . . derived with respect to its business of investing in such stock, securities, or currencies."³⁴

D. Introduction to Real Estate Investment Trusts

The REIT, often described as a mutual fund for real estate,³⁵was created to "provide a tax-favored vehicle through which the average person could invest in a professionally managed portfolio of real property" ³⁶and to improve small investors' access to larger commercial real estate programs.³⁷In exchange for meeting a number of requirements intended to further this intent, "the REIT can avoid all federal income taxes."³⁸

Favorable tax treatment for REITs was "largely patterned after the

Investment Company Act of 1940."³⁹Legislative history indicates that

Congress intended to provide "substantially the same tax treatment for [REITs] as present law provides for regulated investment companies."⁴⁰Additionally, the Committee attempted to "draw a sharp line between passive investments and the active operation of business"⁴¹and was careful to "extend the [RIC] type of tax treatment only to income from the passive investments of [REITs]."⁴²

There are eight organizational requirements for an entity to qualify as a REIT.⁴³The entity must (1) be organized as a corporation, trust, or association; (2) be managed by one or more trustees or directors; (3) have transferable shares or certificates; (4) be taxable as a domestic corporation but for the operation of I.R.C. Sec. 856-859; (5) not be a financial institution or insurance company; (6) be owned by 100 or more persons; (7) not be closely held; and (8) elect to be taxed as a REIT or have in effect such an election made for a previous taxable year.⁴⁴

In addition, there are three main qualification tests and operational requirements for a REIT to retain tax-favored status: (1) the REIT asset tests; (2) the distribution requirement; and (3) the REIT income tests.⁴⁵These requirements will be explained in the following sections.

1. The REIT Asset Tests

REITs are subject to an asset test.⁴⁶In fact, a REIT is subject not to one asset test but six "interacting asset tests,"⁴⁷applied on a quarterly basis:⁴⁸

1. At least 75% of the value of its total assets must consist of real estate assets, cash and carry items and government securities;⁴⁹

2. Not more than 25% of the value of its total assets may consist of securities not includable under the 75% test;⁵⁰

3. Not more than 20% of the value of its total assets may consist of...