tax notes Volume 146, Number 9

By Richard M. Nugent Reprinted from Tax Notes, March 23, 2015, p. 1513

®

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

REIT Spinoffs: Passive REITs, Active Businesses

March 23, 2015

tax notes™

REIT Spinoffs: Passive REITs, Active Businesses By Richard M. Nugent Richard M. Nugent is a partner in the tax practice group of Cadwalader, Wickersham & Taft LLP in New York. In this report, Nugent argues that traditional real estate investment trust spinoffs are well supported by current law and that the common criticisms of these transactions generally miss the mark. He concludes that (1) Treasury and the IRS over time have adopted a comprehensive definition of real property for REIT purposes, and the current ruling practice reflects an application of this preexisting standard to contemporary circumstances; (2) although Congress has repeatedly expanded the scope of a REIT group’s permitted activities, REITs remain restricted from running non-real-estate businesses; (3) based on available information, REIT spinoffs are not a great drain on government revenues, may provide important benefits, and are likely worth their relatively small cost to the fisc; and (4) if properly structured, REIT spinoffs generally should satisfy section 355 and do not contravene the underlying policies of that section. A discussion of the section 355 technical and policy issues presented by REIT spinoffs, as well as the conclusion, will appear in Part 2 of this report, which will be published in the March 30 issue of Tax Notes. Nugent presented an earlier version of this report to the Tax Forum in New York on February 2, and he appreciates the members’ feedback. Nugent is extremely grateful to his colleague, L. Matthew Watrous, for his assistance with all aspects of this project, and he appreciates the comments received from, Brad Borden, Will Dixon, Dave Levy, David S. Miller, Linda Swartz and Ed Wei. Copyright 2015 Richard M. Nugent. All rights reserved.

TAX NOTES, March 23, 2015

Table of Contents I.

II.

Introduction . . . . . . . . . . . . . . . . . . . . . . A. Recent Transactions . . . . . . . . . . . . . . B. Reactions to REIT Spinoffs . . . . . . . . . . REIT Technical and Policy Issues . . . . . . A. Technical Requirements . . . . . . . . . . . . B. Meaning of Real Property for REIT Purposes . . . . . . . . . . . . . . . . . . . . . . C. Scope of REIT Activities . . . . . . . . . . . D. REIT Conversion Policy Issues . . . . . . .

1513 1514 1516 1516 1517 1519 1523 1529

I. Introduction A real estate investment trust is essentially a corporation that pools the capital of many investors to own and operate income-producing real estate assets. REITs enjoy a unique hybrid status for federal income tax purposes. From a shareholder’s perspective, a REIT is a separate taxable entity. A REIT shareholder generally is taxed only on dividends paid by the REIT and on gains upon the disposition of REIT shares, and, unlike in a tax partnership, is not deemed to be conducting the entity’s operations. A REIT is a corporation for U.S. tax purposes, but because it receives a dividends paid deduction, the REIT generally is not subject to corporate tax if it distributes to its shareholders substantially all of its taxable income for each year.1 As discussed below, REITs must satisfy numerous requirements to enjoy their special status. This report focuses on REIT technical and policy issues, general tax policy concerns, and section 355 questions presented by REIT spinoffs.2 For purposes of this report, unless otherwise indicated, a REIT spinoff broadly means a transaction in which

1

See section 857(b)(2)(B). For discussions of REIT spinoffs, see Joshua M. Holmes, ‘‘REITs and Spins: Strange Bedfellows’’ (Dec. 1, 2014) (paper presented at the New York Tax Club; copy of manuscript on file with author); Debra J. Bennett, ‘‘The Evolution of REIT SpinOffs,’’ 92 Taxes 9 (Dec. 2014); Robert Rizzi, ‘‘Real Estate and Spinoffs: Revisiting Plum Creek,’’ 40 Corp. Tax’n 50 (2013); David M. Einhorn, Adam O. Emmerich, and Robin Panovka, REITs: Mergers and Acquisitions, section 10.04 (2013); Andrea M. Despotes, ‘‘Assessing REIT Spin-Off Transactions,’’ 1 J. Tax’n Corp. Trans. 17 (2002); Robert Willens and Harley G.A. Wright, ‘‘Tax-Free Real Estate Spinoffs: Will They Catch On?’’ Tax Notes, Feb. 4, 2002, p. 619. 2

1513

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

SPECIAL REPORT

COMMENTARY / SPECIAL REPORT

and the IRS over time have adopted a fairly comprehensive definition of real property for REIT purposes, and the current ruling practice reflects an application of this preexisting standard to contemporary circumstances; (2) although Congress has repeatedly expanded the scope of a REIT group’s permitted activities, REITs remain largely restricted from running non-real-estate businesses; (3) based on available information, REIT spinoffs are not a tremendous drain on government revenues, may provide important benefits, and are likely worth their relatively small cost to the fisc; and (4) if properly structured, REIT spinoffs generally should satisfy section 355 and do not contravene the underlying policies of that section. A. Recent Transactions In November 2013, after receipt of a private letter ruling from the IRS, Penn National Gaming Inc. spun off its subsidiary, Gaming and Leisure Properties Inc. (GLPI), in a tax-free transaction under section 355. GLPI held Penn National’s casino and gaming real estate, elected to be treated as a REIT, and entered into an OpCo-PropCo lease.7 Since some had argued that it would be difficult to observe both the tax-free spinoff rules, which require the conduct of an active business, and the REIT rules, which historically limited REITs to passive operations,8 the Penn National transaction attracted significant attention.9

3 As discussed below, Parent instead may effect the distribution as a split-off in which participating Parent shareholders tender all or a portion of their Parent shares in exchange for SpinCo stock. 4 OpCo-PropCo leases generally are triple net leases. A net lease is one that requires the tenant to pay costs associated with the leased property, such as utilities, maintenance, taxes, and insurance, in addition to rental payments. See Peter M. Fass, Michael E. Shaff, and Donald B. Zief, Real Estate Investment Trusts Handbook, section 1.4, at 45-46 (2014-2015 ed.) (hereinafter REIT Handbook). Double net and triple net leases require the tenant to pay a correspondingly greater range of costs, with triple net leases requiring the tenant to cover the broadest range of costs. See id. 5 See, e.g., Lee A. Sheppard, ‘‘Can Any Company Be a REIT?’’ Tax Notes, Aug. 19, 2013, p. 755 (‘‘Taxpayers used to get the investment tax credit for billboards because they weren’t real estate. Now they can put them in REITs because they are real estate. It makes perfect sense.’’). 6 For instance, two thorough articles have suggested that the overall revenue loss from a REIT spinoff may be limited. See

Bradley T. Borden, ‘‘Rethinking the Tax-Revenue Effect of REIT Taxation,’’ 16 Fla. Tax Rev. ___ (coming 2015) (concluding that net revenue loss from REIT spinoffs is modest, in part because of increased taxation of shareholders on REIT dividends); Austan Goolsbee and Edward Maydew, ‘‘Taxes and Organizational Form: The Case of REIT Spin-Offs,’’ 55 Nat’l Tax J. 441 (2002) (projecting, based on analysis of qualifying assets and other 2002 business data, that loss of tax revenue from the creation of new REITs would be ‘‘modest,’’ in part because of the increase in taxation of shareholders on REIT dividends). See also infra Section II.D.1. 7 See Gaming and Leisure Properties Inc., Annual Report (Form 10-K), at 1 (Mar. 25, 2014). 8 See, e.g., David L. Brandon, ‘‘The Real Spin on the New Spinoff Ruling — Should Corporate-Owned Real Estate Be Put Into REITs?’’ 95 J. Tax’n 92, 95 (2001) (‘‘Even assuming that a business need exists to spin off a company’s real estate, the remaining tax barriers to the transaction, such as the accumulated earnings distribution requirement, may make it impossible to accomplish’’). 9 For examples of noteworthy restructurings of real estate companies before Penn National, see Getty Realty Corp., Annual Report (Form 10-K), at 2-3 (Mar. 29, 2002) (Getty Petroleum spun off its petroleum marketing business in 1997 and left its real estate in the distributing corporation, which elected REIT status four years later); Georgia-Pacific Corp., Annual Report (Form 10-K), at 1 (Mar. 22, 2002); Plum Creek Timber Co. Inc., Annual Report (Form 10-K), at 3 (Mar. 5, 2001) (in 2001 Georgia Pacific spun off some real estate subsidiaries, which merged into an existing REIT, Plum Creek Timber Co.); Howard Hughes

(Footnote continued in next column.)

(Footnote continued on next page.)

1514

TAX NOTES, March 23, 2015

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

(1) a newly taxable C corporation parent (Parent or Distributing) contributes a portion of its assets to its newly formed wholly owned C corporation subsidiary (SpinCo or Controlled) in exchange for 100 percent of SpinCo’s stock, and Parent distributes all the SpinCo stock to Parent shareholders in a transaction intended to qualify as a tax-free reorganization under sections 368(a)(1)(D) and 355;3 (2) SpinCo elects REIT status; and (3) Parent may lease back a substantial portion of its properties from SpinCo (an OpCo-PropCo lease).4 Depending on the nature of the assets involved, REIT spinoffs may raise the question whether the IRS has inappropriately broadened its interpretation of qualifying real property for purposes of the REIT rules.5 Some also have raised a more general concern about the activity level of REITs and their subsidiaries as compared with the expected scope of a REIT’s operations when Congress enacted the original REIT legislation in 1960. These two issues are discussed in sections II.B. and II.C, respectively. REIT spinoffs also lead some to argue that these transactions inappropriately reduce federal tax revenue. That policy issue is discussed in Section II.D. Finally, REIT spinoffs raise the policy question whether SpinCo’s distribution followed by its REIT conversion and entry into an OpCo-PropCo lease produces the type of bona fide separation that section 355 contemplates, as well as the technical question whether REIT spinoffs satisfy the requisite business purpose, active trade or business (ATOB), and device tests. These section 355 issues are discussed in Part 2, Section III. This report argues that traditional REIT spinoffs are fairly well supported by current law and that the common criticisms of these transactions generally miss the mark.6 It concludes that (1) Treasury

COMMENTARY / SPECIAL REPORT

Corp., Annual Report (Form 10-K), at 1-2, F-7, F-9, F-25 (Apr. 8, 2011) (in 2010 General Growth Properties, a REIT, distributed the stock of the Howard Hughes Corp., a C corporation that held a variety of residential, office, and retail real estate, in a tax-free distribution as part of a bankruptcy); Sabra Health Care REIT Inc., Registration Statement (Form S-4 Amendment 4), at 1, 68, 77 (Sept. 28, 2010) (in 2010 Sun Healthcare Group Inc. distributed the stock of Sabra Healthcare REIT Inc., which held Sun Healthcare’s skilled nursing and assisted and independent living facilities and elected REIT status, in a taxable distribution). These transactions involved either a taxable distribution, a merger by Distributing or Controlled (in either case, a C corporation) and a REIT, or a later unrelated REIT election. Also, in 2014 Oil States International Inc. distributed the stock of the worker housing company, Civeo Corp., in a tax-free spinoff. See Oil States International Inc., Quarterly Report (Form 10-Q), at 8 (Oct. 31, 2014). Although there were expectations that Civeo would elect REIT status, it instead decided to pursue a reincorporation in Canada. See Civeo Corp., Current Report (Form 8-K) (Sept. 29, 2014), Exhibit 99.1. 10 See CareTrust REIT Inc., Quarterly Report (Form 10-Q), at 6-7, 10 (Oct. 30, 2014). 11 See CBS Outdoor Americas Inc., Quarterly Report (Form 10-Q), at 8, 25 (Nov. 7, 2014). For a summary of material tax information concerning these REIT spinoffs, see Part 2, Appendix A. 12 See Communications Sales & Leasing Inc., General Form for Registration of Securities (Form 10 Amendment 1), at 1-3, 8 (Dec. 22, 2014). Recently, Windstream announced that Parent will retain a 19.9 percent interest in SpinCo and sell those shares strategically to maximize the amount raised. See Windstream Holdings Inc., Current Report (Form 8-K) (Dec. 18, 2014), Exhibit 99.1; Windstream Holdings Inc., Preliminary Proxy Statement (Schedule 14A), at 17 (Dec. 19, 2014). 13 See Windstream Holdings Inc., Quarterly Report (Form 10-Q), at 45 (Dec. 6, 2014). Windstream’s board approved the

Resorts International — have all indicated they either are planning to separate their (or a subsidiary’s) real estate into a REIT or are at least considering doing so.14 Interested parties have urged other companies with significant real estate assets to consider REIT spinoffs.15

transaction after receiving a letter ruling from the IRS. See Windstream Holdings Inc., Current Report (Form 8-K) (July 29, 2014), Exhibit 99.1. 14 See Pinnacle Entertainment Inc., Current Report (Form 8-K) (Nov. 7, 2014), Exhibit 99.1 (release describing board approval of plan to separate real estate into new REIT, which would lease the real estate back to Pinnacle). Boyd Gaming has stated that it is consulting with advisers to determine if a REIT spinoff is appropriate. Howard Stutz, ‘‘Boyd Gaming Evaluating REIT Spin-Off,’’ Las Vegas Review-Journal (Oct. 30, 2014). After the CEO of MGM Resorts expressed possible interest in REIT status, an activist investor released a proposal on March 17, 2015, urging MGM Resorts to consider separating into a REIT and an operating company. See Land and Buildings, ‘‘Creating a Best in Class REIT and Lodging C-Corp: ~70% Upside to Net Asset Value’’ (2015), available at http://landandbuildings.com/down loads/LandB%20MGM%20REIT%20Presentation%203-17-2015. pdf. Caesars Entertainment’s filings suggest that as part of a bankruptcy plan for Caesars Entertainment Operating Co., the operating company may enter into a REIT spinoff in which creditors would receive REIT stock under a section 368(a)(1)(G) reorganization. See Caesars Entertainment Corp., Current Report (Form 8-K) (Jan. 14, 2015), Exhibit 10.1. In addition to tax-free REIT spinoffs, Sears has announced a plan to transfer some of its retail real estate to a REIT in a sale-leaseback transaction. See Sears Holdings Corp., Current Report (Form 8-K Amended) (Nov. 7, 2014) (‘‘The Company is actively exploring the monetization of a portion of its owned real estate portfolio (potentially in the range of 200-300 stores), through a saleleaseback transaction, with the selected stores to be sold to a newly-formed [REIT]. The Company would continue to operate in the store locations sold to the REIT under one or more master leases.’’). 15 Some contend that McDonald’s Corp. is a prime candidate for a REIT spinoff. Recent rumors that Pershing Square Capital Management was pushing McDonald’s to change its structure apparently led to a run-up in its stock. See ‘‘McDonald’s Rises on Rumor,’’ Los Angeles Times, Dec. 18, 2014, at B4. Pershing Square also pushed McDonald’s to separate its real estate from its operating business in 2005. See Pershing Square Capital Management, ‘‘A Value Menu for McDonald’s’’ (2005). Also, an investor recently pushed for Brookdale Senior Living to separate some of its real estate assets into a REIT. See Sandell Castlerigg Investments, ‘‘Unlocking Shareholder Value: Brookdale Senior Living Inc.’’ (Feb. 2015). Competitors in industries in which a REIT spinoff has occurred have experienced some pressure to follow suit. For instance, Verizon, when asked about the issue after Windstream announced its plans, responded noncommittally. See Reinhardt Krause, ‘‘Verizon Looks at REIT Conversion, Options Open,’’ Investor’s Business Daily, Aug. 13, 2014 (‘‘We will continue to look at (our) portfolio to rationalize it, look at nonstrategic assets that we can spin. We continue to look at access lines, so I guess the way to put this is: Everything is on the table right now.’’). Smaller companies in the telecom industry may be more likely to adopt a REIT structure than Verizon or AT&T. See Krause, ‘‘AT&T, Verizon Unlikely to Go REIT, Frontier May,’’ Investor’s Business Daily, Dec. 26, 2014.

(Footnote continued in next column.)

TAX NOTES, March 23, 2015

1515

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

After Penn National’s REIT spinoff, the Ensign Group Inc. followed suit in June 2014, spinning off CareTrust REIT Inc., which holds Ensign’s skilled nursing, assisted living, and independent living properties. CareTrust entered into an OpCo-PropCo lease with Ensign and elected REIT status for 2014.10 Later, in July 2014, CBS Corp. split off its subsidiary, CBS Outdoor Americas Inc. (CBS Outdoors), which operated an outdoor advertising business and held many advertising structures, such as billboards attached to buildings or mounted in the ground, as well as advertising displays on bus shelters and in other transit areas. CBS Outdoors elected REIT status for 2014 and later changed its name to Outfront Media Inc.11 Several other transactions have been announced as well. Windstream Holdings Inc. plans to spin off its copper and fiberoptic cable assets and related facilities in a new company called Communications Sales & Leasing Inc. (CS&L), which will elect REIT status and enter into an OpCo-PropCo lease with Windstream.12 Windstream expects the transaction to close in the second quarter of 2015.13 Four casino companies — Caesars Entertainment Corp., Pinnacle Entertainment Inc., Boyd Gaming, and MGM

COMMENTARY / SPECIAL REPORT

16 A REIT conversion means a conversion of an existing non-REIT entity into a REIT. See, e.g., LTR 200748005 (ruling on tax consequences of REIT conversion). 17 See, e.g., Martin A. Sullivan, ‘‘Never Mind Inversions, What About REITs?’’ Forbes, Sept. 9, 2014. 18 See, e.g., Gretchen Morgenson, ‘‘A Tax Break That’s Closer to Home,’’ The New York Times, Aug. 10, 2014, at BU1 (‘‘Traditionally, REIT tax treatment could be applied only to assets with physical characteristics: ‘inherently permanent structures,’ according to tax rules. But last May, the Treasury and the I.R.S. proposed new regulations clarifying what constitutes an eligible asset for REIT purposes. . . . The new rules say real estate assets may include microwave transmission, cell and broadcast towers as well as parking facilities, bridges and tunnels, railroad tracks, transmission lines, pipelines and storage facilities.’’). 19 See, e.g., David M. Einhorn, ‘‘Unintended Advantage: Equity REITs vs. Taxable Real Estate Companies,’’ 51 Tax Law. 203 (1998) (‘‘Contrary to the purposes of the original Real Estate Investment Trust Act of 1960 . . . REITs are now active business entities that compete with taxable corporations and expose their shareholders to business risks’’). 20 See, e.g., Howard Gleckman, ‘‘How REIT Spinoffs Will Further Erode the Corporate Tax Base,’’ Forbes, July 31, 2014 (‘‘If these deals become widespread, they’d be another nail in the coffin of the corporate income tax’’). 21 See Tax Reform Act of 2014 (H.R. 1), section 3631(a). As drafted, this proposal would apply to a spinoff of a single larger REIT into multiple smaller REITs or even the spinoff of a taxable C corporation from an existing REIT, even though in those situations the amount of assets in ‘‘REIT solution’’ either stays the same or decreases. 22 See id. at section 3631(b).

gains on their assets as part of that election.23 Fourth, REITs would be required to distribute earnings and profits from non-REIT years solely in cash even though entities electing REIT status typically use a combination of stock and cash.24 Finally, the Camp proposals would exclude assets with a class life of less than 27.5 years from the definition of real property.25 The Camp proposals, in general, were poorly received,26 and the House did not act on them in the last Congress. It is unclear whether similar proposals will be introduced or adopted in the new Congress.27 II. REIT Technical and Policy Issues In Morrissey v. Commissioner,28 the Supreme Court articulated a series of factors for classifying an entity as a taxable association and, weighing those factors, concluded that a trust for the management of land was taxable.29 Because this holding was not restricted to real estate trusts, trusts for investment

23

Id. at section 3647. Id. at section 3639. 25 Id. at section 3633. This would affect many assets currently held in REITs. For instance, most telecommunications cabling, billboards, and microwave transmission towers generally have a class life below 27.5 years. See IRS Publication 946, How to Depreciate Property (Jan. 28, 2014). 26 See, e.g., John D. McKinnon, ‘‘Camp Tax Plan Has Something for Everyone (To Hate),’’ The Wall Street Journal, Feb. 26, 2014 (quoting Republican economist Douglas Holtz-Eakin as stating regarding Camp that ‘‘everyone’s mad at him’’); and Marie Sapirie, ‘‘The Convergence Theory of Tax Reform,’’ Tax Notes, Mar. 31, 2014, p. 1391 (referring to the ‘‘chilly reception’’ that the Camp proposals received from other members of Congress). 27 The recent report on tax reform issued by the Republican staff of the Senate Finance Committee does not mention these proposed restrictions on REITs. See Republican Staff, Committee on Finance, ‘‘Comprehensive Tax Reform for 2015 and Beyond’’ (Dec. 2014) (hereinafter Hatch report). Senator Bernard Sanders, I-VT, recently sent a letter to the White House recommending that the income of casino, outdoor advertising, and prison REITs should not qualify as rent for REIT purposes. See letter from Senator Bernard Sanders to President Barack Obama (Feb. 27, 2015), available at http://www.budget.senate.gov/democratic/ public/_cache/files/7a8dbc99-3850-4760-be3a-2361c1ec4208/sa nders-letter-to-white-house-on-tax-loopholes.pdf. 28 296 U.S. 344 (1935). In Crocker v. Malley, 249 U.S. 223 (1919), the Supreme Court determined that a Massachusetts trust was not taxable as an association because, among other reasons, the beneficiaries lacked any collective control over the trust. Id. at 233-234. 29 See Morrissey, 296 U.S. at 357 (‘‘In what are called ‘business trusts’ the object is not to hold and conserve particular property, with incidental powers, as in the traditional type of trusts, but to provide a medium for the conduct of a business and sharing its gains’’). Hecht v. Malley, 265 U.S. 144 (1924), had already classified some business trusts that resembled business enterprises as associations for income tax purposes even though they were trusts in form and their beneficiaries did not exercise control over the trustees. Hecht relied in part on legislative changes in the Revenue Act of 1918, which separately referred to 24

(Footnote continued on next page.)

1516

TAX NOTES, March 23, 2015

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

B. Reactions to REIT Spinoffs Some have criticized REIT conversions16 in general and REIT spinoffs in particular as unjustified methods of tax avoidance, likening them to inversions and other transactions currently in the news.17 There are at least three common policy criticisms of REIT spinoffs: (1) The definition of real property has been inappropriately expanded to accommodate industries and assets that should not be eligible for REIT status;18 (2) REITs were intended to be passive entities and are now too active;19 and (3) REIT expansion threatens to diminish the corporate tax base or tax revenues generally and is not justified by the benefits produced.20 These criticisms are addressed below, the first in Section II.B, the second in Section II.C, and the third in Section II.D. Former House Ways and Means Committee Chair Dave Camp introduced a detailed series of tax reform proposals in 2013 and 2014 that contained several restrictive provisions affecting REITs. First, section 355 would not apply for a spinoff if either the distributing or the controlled corporation were a REIT.21 Second, neither the distributing nor the controlled corporation in a tax-free spinoff could elect REIT status for at least 10 years after the tax year in which the spinoff occurred.22 Third, entities electing REIT or regulated investment company status would have to recognize all built-in

COMMENTARY / SPECIAL REPORT

A. Technical Requirements An entity must satisfy numerous tests to qualify as a REIT. For purposes of this report, the most significant are that the REIT (1) holds at least 75 percent of its total assets (by value) in real estate assets, cash and cash items (including receivables), and government securities;33 (2) derives at least 75 percent of its income from rents from real property, interest on obligations secured by real property, and certain other sources concerning real property (the

75 percent income test), and at least 95 percent of its income from dividends, interest, and certain other categories concerning real property (the 95 percent income test);34 (3) holds no more than 25 percent of its value in securities, including ownership of taxable REIT subsidiaries (TRSs);35 and (4) during a given tax year, distributes to its shareholders an amount that generally equals or exceeds 90 percent of REIT taxable income.36 Real estate assets generally mean real property (including interests in real property and interests in mortgages on real property) and shares in other REITs.37 Under the regulations, real property includes land or improvements thereon, such as buildings or other inherently permanent structures thereon (including items that are structural components of those buildings or structures).38 Real property generally includes the wiring in a building, plumbing systems, and other items that are structural components of a building or other permanent

34

‘‘associations’’ and ‘‘joint-stock companies,’’ and in part on a narrowed interpretation of Crocker. Id. at 155, 161. 30 See Revenue Act of 1936, P.L. 74-740, sections 13(a)(3), 27, and 48(e) (providing a credit for dividends paid by a ‘‘mutual investment company’’ that distributes substantially all of its net income each year). 31 See, e.g., Hearings Before the Committee on Ways and Means, House of Representatives: First Session on Forty Topics Pertaining to the General Revision of the Internal Revenue Code, 83d Cong. 1497 (1953) (statement of Allan H.W. Higgins) (urging Congress to ‘‘relieve an inequity and unjustifiable hardship’’ for real estate trusts by according them equal treatment with RICs). 32 See An Act to Amend Section 5701 of the Internal Revenue Code of 1954 With Respect to the Excise Tax Upon Cigars, and for Other Purposes, P.L. 86-779, section 10(a) (1960) (hereinafter the 1960 act). For early commentary on REITs, see John K. MacDonald, ‘‘Real Estate Investment Trusts Under the Internal Revenue Code of 1954: Proposals for Revision,’’ 32 Geo. Wash. L. Rev. 808 (1964); Theodore Lynn, ‘‘Real Estate Investment Trusts: Problems and Prospects,’’ 31 Fordham L. Rev. 73 (1962); and H. Cecil Kilpatrick, ‘‘Taxation of Real Estate Investment Trusts and Their Shareholders,’’ 39 Taxes 1042 (1961). REITs grew slowly after passage of the law. In part, this was likely because the form was new, and most early REITs held small, diversified portfolios and attracted little attention, especially compared with the tax shelters that proliferated at the time. See REIT Handbook, supra note 4, at sections 1.8 and 1.1. This was also likely attributable in part to the severe restrictions imposed on REITs — the 1960 statute forced them to cede a variety of profitable activities to independent contractors. The industry experienced its first serious expansion starting in 1969, when a housing boom and the growth of mortgage REITs led to increased investor interest. See id. at section 1.8. This pattern has continued with new types of REITs emerging as new industries come to understand the advantages of REIT status. See Part 2, note 330. 33 See section 856(c)(4)(A).

TAX NOTES, March 23, 2015

See section 856(c)(2), (3). See section 856(c)(4)(B)(i) and (ii). Several other restrictions also apply to REITs regarding ownership of securities. Except for securities of TRSs and securities that qualify as real estate assets (such as shares of qualifying REITs), a REIT may not (1) hold more than 5 percent of the total value of its assets in securities of any one issuer, (2) hold securities representing more than 10 percent of the total voting power of the outstanding securities of any one issuer, or (3) hold securities having a value of more than 10 percent of the total value of the outstanding securities of any one issuer. See section 856(c)(4)(b)(iii). 36 Two overlapping requirements apply to a REIT in this regard. A REIT will generally lose most of its special treatment under sections 856 and 857 unless it distributes the sum of 90 percent of its taxable income (determined without regard to the dividends paid deduction) and 90 percent of its post-tax net foreclosure income. See section 857(a)(1). A REIT is also subject to a 4 percent excise tax on an amount equal to the difference, if any, between the sum of 85 percent of the REIT’s ordinary income and 95 percent of its net capital gain and the amount actually distributed that year. See section 4981(a). Other requirements include the need for centralized management (section 856(a)(1)), transferable shares (section 856(a)(2)), taxable status as a domestic corporation (section 856(a)(3)), at least 100 shareholders (section 856(a)(5)), a calendar-year tax year (section 859(a)), and avoidance of closely held status (as defined in the REIT rules) (section 856(a)(5), (a)(2), (a)(6), and (h)). Those requirements generally are beyond the scope of this report. 37 See section 856(c)(5)(B). Interests in real property include fee ownership and co-ownership of land or improvements thereon, leaseholds of land or improvements thereon, options to acquire land or improvements thereon, and options to acquire leaseholds of land or improvements thereon, but they do not include mineral, oil, or gas royalty interests. See section 856(c)(5)(C). 38 See reg. section 1.856-3(d). Local law definitions are not controlling in interpreting the meaning of real property under the REIT rules. See id. 35

1517

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

in securities (predecessors of modern RICs) sought and obtained relief in the Revenue Act of 1936.30 By the 1950s pressure mounted to give equal treatment to real estate trusts.31 In 1960, shortly before leaving office, President Eisenhower signed into law a bill providing for the creation of REITs.32 Section II.A provides a brief overview of the REIT technical requirements relevant to REIT spinoffs. Sections II.B, II.C, and II.D then address three much-debated issues relating to REITs: the definition of real property for REIT purposes, the activities REITs can engage in, and the overall policy costs and benefits of the newer REITs.

COMMENTARY / SPECIAL REPORT

lease terms and the parties’ other filings in REIT spinoffs generally indicate that the terms of OpCoPropCo leases are intended to approximate those of an arm’s-length transaction.44 Penn National and its advisers, for example, conducted a valuation of the relevant real property, reviewed the terms of comparable leases, and considered factors unique to the GLPI properties in fixing the applicable rental payments.45 Also, the Penn National lease may not be renewed for barge-based casinos if doing so would cause the lease to extend past 80 percent of the barges’ useful life or leave the barges with less than 20 percent of their original fair market value at the end of the lease.46 This limitation generally is a distinguishing feature of a bona fide lease for tax purposes.47 Finally, an entity may not elect REIT status unless it has no accumulated E&P for prior non-REIT years.48 Because section 312 generally allocates a portion of Parent’s non-REIT E&P to SpinCo, SpinCo usually must make a purging distribution to its shareholders to eliminate its non-REIT E&P.49

Id. 40 Id. The IRS has interpreted this exclusion very narrowly. See infra text accompanying note 63. 41 See section 856(d)(2). In REIT spinoffs, to police this requirement, SpinCo will normally include a prohibition on the acquisition of more than a specified percentage of its outstanding shares. For instance, GLPI included a 7 percent limit in its charter, adjustable by the board of directors at a later date. See Gaming and Leisure Properties Inc., Current Report (Form 8-K) (Oct. 15, 2013), Exhibit 3.1, sections 9.1 and 9.2. The IRS generally has respected transfer prohibitions in charters intended to prevent changes in ownership for REIT purposes. See, e.g., LTR 9719018 (charter transfer restrictions valid under state law would be effective in preventing a REIT from becoming closely held under section 856(a)(6)); and LTR 9552046 (same). 42 See sections 856(d)(7), 512(b)(3); and reg. section 1.512(b)1(c)(5). Amounts received for managing or operating property are also considered impermissible tenant service income. See section 856(d)(7)(A)(ii). A person is an independent contractor for a REIT if (1) that person does not directly or indirectly own more than 35 percent of the interests in the REIT; and (2) no more than 35 percent of that person’s shares (if a corporation) or assets and net profits (if not a corporation) are owned by one or more other persons that themselves own 35 percent or more of the interests in the REIT. See section 856(d)(3). 43 See generally Frank Lyon Co. v. United States, 435 U.S. 561 (1978) (citing several factors that indicate whether a lease agreement should be treated in accordance with its form or recast as a financing arrangement, including whether the lessor may receive the real risks of ownership, whether the lease has arm’s-length terms, and whether there is a nontax reason for the lease). See also Rev. Rul. 55-540, 1955-2 C.B. 39 (explaining factors to consider in determining whether an agreement for the use of equipment constitutes a lease or a conditional sales contract for tax purposes). It would almost certainly preclude REIT qualification if the IRS were to recast an OpCo-PropCo lease as a services contract or a joint venture between Parent and SpinCo. The well-advised companies that have engaged in REIT spinoffs

are obviously aware of these risks. See, e.g., Gaming and Leisure Properties Inc., Annual Report (Form 10-K), at 23 (Mar. 25, 2014) (‘‘Rents received or accrued by GLPI from Penn or its subsidiaries will not be treated as qualifying rent for purposes of these requirements if the Master Lease is not respected as a true lease for U.S. federal income tax purposes and is instead treated as a service contract, joint venture or some other type of arrangement. If the Master Lease is not respected as a true lease for U.S. federal income tax purposes, GLPI may fail to qualify to be taxed as a REIT.’’). 44 See Gaming and Leisure Properties Inc., Form for Registration of Securities of Certain Real Estate Companies (Form S-11 Amendment 4), at 46 (Oct. 4, 2013) (‘‘Penn endeavored to have the Master Lease reflect customary arm’s-length commercial terms and conditions’’). 45 See id. 46 See Gaming and Leisure Properties Inc., Current Report (Form 8-K) (Nov. 7, 2013), Exhibit 10.1, section 1.4. The structure of the rent payments in the REIT spinoffs generally is consistent with the treatment of the underlying agreements as leases for tax purposes. The rent in Penn National’s lease contains several elements, only one of which, composing approximately a quarter of the initial rent, is based on the lessee’s revenues. See Gaming and Leisure Properties Inc., Current Report (Form 8-K) (Nov. 7, 2013), Exhibit 10.1, section 3.1. The rent in the Ensign transaction is not based on the lessee’s revenues. See The Ensign Group Inc., Current Report (Form 8-K) (June 5, 2014), Exhibit 10.1, section 2.1. The rent in the Windstream transaction apparently will be based on a fixed amount and not on the lessee’s revenues. See Application to Commonwealth of Kentucky Public Service Commission at Exhibit 4, 2, Matter of the Application of Windstream Kentucky East LLC and Windstream Kentucky West LLC for a Declaratory Ruling That Approval Is Not Required for the Transfer of a Portion of Their Assets (No. 2014-00283). 47 See Rev. Proc. 2001-28, 2001-1 C.B. 1156, section 4.01. 48 See section 857(a)(2)(B). 49 See section 312(h)(1); and reg. section 1.312-10. In transactions to which section 368(a)(1)(D) applies, the regulations

(Footnote continued in next column.)

(Footnote continued on next page.)

39

1518

TAX NOTES, March 23, 2015

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

structure.39 However, the term does not include assets accessory to the operation of a business, such as machinery.40 Rents from real property generally (1) include rents from interests in real property, charges for services customarily furnished in connection with the rental of real property, and certain rent attributable to personal property leased in connection with a real property lease; and (2) exclude rents determined based on the net profits of any tenant and rents received from some related parties (generally, any entity in which the REIT owns 10 percent or more of the stock (by vote or value), assets, or net profits).41 Impermissible tenant service income, which consists of amounts received for furnishing services that are not customary or are for the convenience of the tenant or occupant, also does not qualify as rents from real property, unless the amounts are de minimis or are provided by an independent contractor or TRS.42 Given all these requirements, it is obviously critical that any OpCo-PropCo lease be respected as a lease for tax purposes.43 To this end, the available

COMMENTARY / SPECIAL REPORT

B. Meaning of Real Property for REIT Purposes The REIT qualification of the copper and fiberoptic cable assets of CS&L (the SpinCo in the Windstream transaction) and, to some extent, the outdoor advertising structures in the CBS transaction have raised questions about the meaning of real property for REIT purposes.54 Neither the origi-

nal nor the current version of section 856 defines the term ‘‘real property.’’ The 1962 regulations, which, in relevant part, remain substantially unchanged today, defined real property as ‘‘land or improvements thereon, such as buildings or other inherently permanent structures thereon (including items which are structural components of such buildings or structures).’’55 Thus, the regulations introduced two concepts into the meaning of real property: (1) the inclusion of inherently permanent structures in addition to buildings as real property, and (2) the treatment of structural components of a building or of another inherently permanent structure as part of the real property.56 Treasury and the IRS imported these provisions from the definition of tangible personal property used in determining a taxpayer’s eligibility for additional first-year depreciation deductions under former section 179 — that is, items excluded as tangible personal property for section 179 purposes qualified as real property for REIT purposes.57 Former section 179 is not the only area of the tax law with a definition of real property similar to that in the REIT rules. Various code sections and regulations have used similar language to distinguish between real property and personal property58 or

generally provide for allocation in proportion to the FMV of the two companies or according to net basis ‘‘in a proper case’’ or by other methods ‘‘as may be appropriate under the facts and circumstances of the case.’’ See reg. section 1.312-10(a). In transactions that do not meet the requirements of section 368(a)(1)(D), Distributing’s E&P will generally decrease by an amount equal to the lesser of the net worth of Controlled or the amount that would be determined if the transaction qualified as a reorganization under section 368(a)(1)(D), while Controlled’s E&P cannot be less than the greater of Distributing’s decrease in E&P or Controlled’s E&P before the transaction. See reg. section 1.312-10(b). 50 See section 312(d)(1)(B). 51 See section 305(b)(1). See also Gaming and Leisure Properties Inc., Form for Registration of Securities of Certain Real Estate Companies (Form S-11 Amendment 4), at 35 (Oct. 4, 2013) (‘‘Each GLPI shareholder will be permitted to elect to receive the shareholder’s entire entitlement under the Purging Distribution in either cash or GLPI common stock’’). 52 See id. (‘‘If GLPI shareholders elect to receive an amount of cash in excess of the Cash Limitation, each such electing shareholder will receive a pro rata amount of cash corresponding to the shareholder’s respective entitlement under the Purging Distribution declaration’’). 53 During the financial crisis, the IRS issued several revenue procedures explicitly allowing these distributions to be 90 percent stock and 10 percent cash. See Rev. Proc. 2008-68, 2008-2 C.B. 1373; and Rev. Proc. 2010-12, 2010-3 IRB 302. When the last of these expired, an IRS official publicly stated that the new requirement for obtaining a private letter ruling would be a distribution that was at least 20 percent cash. See Amy S. Elliott, ‘‘IRS May Need to Cut Back on Private Letter Rulings, Official Says,’’ Tax Notes, Oct. 31, 2011, p. 514 (quoting then-IRS Associate Chief Counsel William Alexander as stating that ‘‘The private letter ruling policy is going to be 20’’). 54 This concern is especially present in the REIT conversion context. See, e.g., Morgenson, supra note 18; Steven F. Mount,

‘‘New Wine in Old Bottles: Has the Definition of ‘Real Estate Assets’ Been Expanded for Real Estate Investment Trusts?’’ 54 Tax Mgmt. Memo. 383 (Oct. 7, 2013); Sheppard, supra note 5 (describing data center REIT conversions); and Michael E. Shaff, ‘‘The Service’s Trend of Friendly REIT Rulings Continues,’’ 4 Colum. J. Tax L. Tax Matters 17 (2013). 55 Former reg. section 1.856-3(d) (1962). The definition is located in the same section under the current regulations. 56 See generally Mount, supra note 54. 57 See former reg. section 1.179-3(b) (1960) (‘‘Local law definitions will not be controlling for purposes of determining the meaning of the term ‘tangible personal property’ as it is used in section 179 and the regulations thereunder. For purposes of section 179, the term ‘tangible personal property’ includes any tangible property except land, and improvements thereto, such as buildings or other inherently permanent structures thereon (including items which are structural components of such buildings or structures). Assets accessory to the operation of a business, such as machinery, printing presses, transportation or office equipment, refrigerators, individual air conditioning units, grocery counters, etc., generally constitute tangible personal property for purposes of section 179, even though such assets may be termed fixtures under local law. The term does not include, for example, the wiring in a building, plumbing systems, nor central heating or central air conditioning machinery, pipes, or ducts or other items, which are structural components of a building or other permanent structure, nor does the term include trademarks, goodwill, or other intangibles.’’). 58 See reg. section 1.856-3(d) (‘‘The term ‘real property’ means land or improvements thereon, such as buildings or other inherently permanent structures thereon (including items which are structural components of such buildings or structures). In addition, the term ‘real property’ includes interests in real

(Footnote continued in next column.)

(Footnote continued on next page.)

TAX NOTES, March 23, 2015

1519

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

While a cash distribution will satisfy the tax rules, the amount required to be distributed may be substantial and may exceed the amount of cash to which SpinCo has access or the amount that SpinCo is willing to spend. As a result, SpinCos typically distribute a mix of stock and cash in purging distributions and limit the amount of cash that can be distributed. To achieve the purging effect, the distribution must be taxable under section 305,50 such as a distribution ‘‘in lieu of’’ money.51 Shareholders may choose between cash and stock, with those choosing cash receiving a proportionate share of the amount of cash distributed.52 The IRS generally will not rule on the effectiveness of a purging distribution unless at least 20 percent of the distribution is cash.53

COMMENTARY / SPECIAL REPORT

property. Local law definitions will not be controlling for purposes of determining the meaning of the term ‘real property’ as used in section 856 and the regulations thereunder. The term includes, for example, the wiring in a building, plumbing systems, central heating or central air-conditioning machinery, pipes or ducts, elevators or escalators installed in the building, or other items which are structural components of a building or other permanent structure.’’); reg. section 1.897-1(b)(1) (‘‘The term ‘real property’ includes the following three categories of property: Land and unsevered natural products of the land, improvements, and personal property associated with the use of real property’’); reg. section 1.263A-8(c)(1) (‘‘Real property includes land, unsevered natural products of land, buildings, and inherently permanent structures. Any interest in real property of a type described in this paragraph (c), including fee ownership, co-ownership, a leasehold, an option, or a similar interest is real property under this section. Real property includes the structural components of both buildings and inherently permanent structures, such as walls, partitions, doors, wiring, plumbing, central air conditioning and heating systems, pipes and ducts, elevators and escalators, and other similar property.’’); reg. section 1.48-1(c) (‘‘For purposes of this section, the term ‘tangible personal property’ means any tangible property except land and improvements thereto, such as buildings or other inherently permanent structures (including items which are structural components of such buildings or structures)’’). However, these definitions have some differences. For instance, the regulations under section 263A lack a statement that local law will not be controlling in determining the definition of real property. Accordingly, the IRS apparently believes that local law definitions of real property may be relevant to determining what is real property under section 263A, in contrast to the bar on consideration of local law for purposes of the REIT rules. See ILM 200648026. 59 See section 7704(d)(3) (publicly traded partnerships); and reg. section 1.860G-2(a)(4) (real estate mortgage investment conduits). 60 Whiteco Industries Inc. v. Commissioner, 65 T.C. 664 (1975), acq., 1980-2 C.B. 2, which concerned the former investment tax credit, applied the following six factors to determine whether a structure on real property is inherently permanent: (1) whether the property is capable of being moved and has in fact been moved; (2) whether the property is designed or constructed to remain permanently in place; (3) whether the circumstances show that the property is intended to remain affixed; (4) whether the removal of the property would be a ‘‘substantial’’ job and ‘‘time-consuming’’; (5) whether and to what extent the property would be damaged by removal; and (6) how strongly the property is affixed to land. See id. at 672-673. Whiteco has been applied in various contexts. See, e.g., LTR 8931039 (applying Whiteco to determine if manufactured homes are inherently permanent structures for REIT purposes); ECC 201211011 (applying Whiteco to determine if offshore ‘‘jacket-type’’ platforms are real property for section 263A purposes); and Rev. Rul. 2003-54, 2003-1 C.B. 982 (applying Whiteco to determine if gasoline pump canopies are inherently permanent structures for purposes of determining asset class for depreciation). Nevertheless, there may be some inconsistencies. Large metal towers, for example, are generally real property under the REIT rules (see Rev. Rul. 75-424, 1975-2 C.B. 269), as well as for section 263A purposes (see ECC 201211011). Under the now-repealed ITC,

taxpayers have also pushed the definitions in different directions in different sections of the code, and the IRS recently noted that this process has produced some inconsistency.61 1. Core revenue rulings. From 1969 to 1975, the IRS issued several key revenue rulings on the scope of real property for REIT purposes. They remain the core authorities for determining qualification as real property. Rev. Rul. 69-94, 1969-1 C.B. 189, ruled that a railroad’s trackage, roadbed, buildings, bridges, and tunnels were real property. Later private letter rulings suggest that the crux of this ruling is that an asset that is a passive conduit — that is, one that allows something created by an outside party to flow to another outside party — may qualify as real property.62 While a general counsel memorandum reveals that some IRS personnel believed that the railroad tracks were assets accessory to the operation of a business and thus did not qualify as real

however, some cases and other authorities held that similar towers were in the nature of machinery and therefore qualified as tangible personal property. See, e.g., Weirick v. Commissioner, 62 T.C. 446 (1974) (metal towers affixed to land to support ski lift cables are tangible personal property). But see FSA 003861 (Jan. 31, 2006) (‘‘In light of the decisions since Weirick which have held that component allocations are permissible . . . it is appropriate to question, as one court has, the continuing validity of the court’s holding in Weirick regarding the chairlift towers with their mechanical components’’). 61 REG-150760-13, 79 F.R. 27508, 27510 (May 14, 2014) (to be codified at reg. section 1.856-10) (hereinafter proposed REIT regs) (‘‘In the case of the terms real property and personal property, however, both the regulatory process and decades of litigation have led to different definitions of these terms, in part because taxpayers have advocated for broader or narrower definitions in different contexts.’’). But see Elliott, ‘‘Practitioners Defend REIT Real Property Regs,’’ Tax Notes, Sept. 29, 2014, p. 1532 (quoting David A. Miller of EY as stating that ‘‘railroads and pipelines, water distribution [systems], sewer systems, cable systems, [and] electrical transmission systems’’ have been treated as real property across various code sections). Treasury and the IRS requested comments on whether and how definitions of real property in other areas should apply in the REIT context. 79 F.R. 27510. To the extent real property is or ought to be defined consistently, it is worth remembering that a narrower definition of real property for REIT purposes could affect results in other areas, such as the 1980 Foreign Investment in Real Property Tax Act, under which taxpayers generally prefer a narrow definition of real property. 62 Several private rulings cite Rev. Rul. 69-94 in classifying a variety of modern pipelines and external wiring and cabling as real property for REIT purposes. See, e.g., LTR 201450017 (analyzing telecommunications cabling as ‘‘a passive conduit that allows a Tenant’s signal to flow through the System’’); LTR 200937006 (analyzing pipeline system as ‘‘a passive conduit that does not include any machinery or equipment capable of producing Product or any commodity’’); and LTR 200725015 (analyzing electrical transmission system as a ‘‘passive conduit’’).

(Footnote continued in next column.)

1520

TAX NOTES, March 23, 2015

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

have cross-referenced the REIT definition of real property,59 and courts and the IRS have sometimes used similar analyses in determining if an asset belongs in one category or the other.60 However,

COMMENTARY / SPECIAL REPORT

63

See GCM 33996 (Dec. 12, 1968). Later private rulings addressing the same types of property support the above conclusion. See, e.g., LTR 8931039 (noting that moving a manufactured home is ‘‘a difficult, expensive and time-consuming task,’’ before concluding that such a home is real property for REIT purposes). Rev. Rul. 71-220 has provided the basis for various permanently affixed assets to qualify as real property under section 856. See, e.g., LTR 201250003 (offshore oil platform); and LTR 201143011 (metal billboards). 65 27 T.C. 866 (1957). 66 See id. at 872 (‘‘The right to use the air space superjacent to the ground is one of the rights in land. These air rights are frequently the most valuable rights connected with the ownership of land since the value of commercial property consists almost exclusively of the right of the owner to erect business and industrial structures thereon.’’). Rev. Rul. 71-286 provides the basis for a variety of rights appurtenant to real property to qualify as real property under section 856. See, e.g., LTR 201310020 (boat slips); and LTR 201149003 (easements). 67 An interest in a mortgage qualifies as a real estate asset only if the mortgage is ‘‘on’’ real property. See section 856(c)(5)(B). Rev. Rul. 73-425 concluded that a mortgage secured by the system (and also by the building) was a real estate asset under section 856 and thus must mean that the total energy system itself is real property, at least as long as the system is considered while alongside a building. This ruling may be the basis for the IRS’s recent decision, in the proposed regulations, to classify photovoltaic solar cells as real property only when they are part of a system that primarily services a nearby building. See prop. reg. section 1.856-10(g), examples 8-9. See also LTR 201323016 (citing Rev. Rul. 73-425 in determining that interests in renewable energy facilities located near the buildings they powered were real estate assets under section 856). 64

TAX NOTES, March 23, 2015

consider a group of assets together as a system presaged later private rulings. Finally, Rev. Rul. 75-424, 1975-2 C.B. 269, considered a microwave transmission station and related assets. The ruling concluded that the building, its tower, and some other attached assets were real property, while the antennae, transmitting and receiving equipment, and modular racks to hold the equipment were assets accessory to the operation of a business that did not qualify as real property.68 2. Private rulings interpreting the meaning of real property. Building on these seminal revenue rulings, the IRS has issued several private rulings69 generally applying a ‘‘movability’’ criterion in assessing whether an asset is real property for REIT purposes. Implementing this criterion, while the regulations exclude assets that are ‘‘accessory to the operation of a business,’’ the IRS has ruled favorably when these types of assets comprise part of a system that is inherently permanent or structurally integrated with a building or other permanent structure.70 LTR 199904019 demonstrates how businessrelated assets can qualify under current IRS policy. The ruling concluded that cold storage warehouses, including the components of their installed refrigeration systems, qualified as real property for REIT purposes. It based that determination on Rev. Rul. 73-425 and Whiteco Industries Inc. v. Commissioner,71 among other authorities. Notably, the ruling admitted that the individual components of the refrigeration system were quite movable but nevertheless

68 Like Rev. Rul. 71-220, this ruling has established that structures affixed to real property, in particular transmission towers, generally are also real property under the REIT rules. According to Rev. Rul. 75-424, the modular racks, which did not qualify as real property, were bolted into the floor and ceiling of the building. 69 In June 2013 the IRS halted issuance of REIT-related private rulings on the qualification of assets as real estate assets for REIT purposes and formed a working group in this area. See Elliott, ‘‘IRS May Have Suspended REIT Conversion Rulings,’’ Tax Notes, June 17, 2013, p. 1364. The IRS resumed the issuance of private rulings in this area several months later. See Elliott, ‘‘IRS Resumes REIT Conversion Rulings,’’ Tax Notes, Nov. 25, 2013, p. 822. 70 For a broader list of relevant private letter rulings, see Part 2, Appendix B. The new proposed regulations on the definition of real property for REIT purposes, if finalized in their current form, may affect this analysis in some cases. The proposed regulations contain several requirements that, while based on prior law and private letter rulings, are at least structured differently than the current analysis. See infra Section II.B.3. 71 65 T.C. 664 (1975), acq., 1980-2 C.B. 2 (holding that some frequently moved wooden advertising structures were not inherently permanent structures and therefore not real property for purposes of the now-repealed ITC rules).

1521

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

property, the memorandum concluded that the suggested interpretation was inconsistent with the history of the regulations, which indicated that this exclusionary phrase applied only to business assets that were also fixtures under local law.63 Two years later, the IRS issued Rev. Rul. 71-220, 1971-1 C.B. 210, which concluded that mobile homes affixed to the ground by multiple steel straps were real property (apparently as inherently permanent structures) for REIT purposes. The fact of affixation and the difficulty in moving the property appear to be the key points.64 Air rights over real property qualified as interests in real property in Rev. Rul. 71-286, 1971-2 C.B. 263. The ruling directly relied on Mattie Fair v. Commissioner,65 which treated air rights as cognizable interests.66 In 1973, Rev. Rul. 73-425, 1973-2 C.B. 222, determined that a ‘‘total energy system,’’ essentially a power generator that served a nearby building or set of buildings, was real property for REIT purposes as long as the system was considered along with the nearby buildings it served.67 Classifying a power generator as real property emphasizes how the exclusionary phrase ‘‘assets accessory to the operation of a business’’ in the regulations is narrowly construed. Further, the ruling’s willingness to

COMMENTARY / SPECIAL REPORT

72

LTR 201503010 observed that racking structures are specifically designed for a particular building, impossible to reuse in another building, large, bolted to the floor, and difficult to move. 73 The IRS initially told Iron Mountain that it was ‘‘tentatively adverse’’ to issuing the requested ruling. See Iron Mountain Inc., Current Report (Form 8-K), at 2 (June 6, 2013). 74 LTR 201250003 was addressed to a publicly traded partnership, which is subject to the same definition of real property as REITs. See supra note 59.

and broadcast tower sites were real property for REIT purposes. The sites consisted of a metal tower affixed to nearby real property, attached backup generators, fencing, and sometimes rights to use rooftop spaces. Citing Rev. Rul. 75-424, the ruling blessed the tower, fencing, and backup generator as real property. It likened the rights to use the rooftop spaces to the air rights in Rev. Rul. 71-286 and concluded that the rights are interests in real property. LTR 201450017, believed to be issued to Crown Castle International, determined that parts of indoor and outdoor cellular transmission systems were real estate assets for REIT purposes. The ruling noted that fiberoptic and coaxial cabling was difficult to move, whether located in the ground or in the walls of buildings, and likened it to railroad tracks held to be real property in Rev. Rul. 69-94: ‘‘Similar to the tracks . . . the System Components form a passive conduit that allows a Tenant’s signal to flow through the System.’’75 As these private rulings demonstrate, the current IRS policy on real property for REIT purposes is an extension of the principles articulated in early revenue rulings on new technology and assets. To the extent that more types of assets are today qualifying as real property, that situation is better described as reflecting a decision by entities already qualified as REITs under well-established legal principles to adopt REIT status rather than as an expansion by the IRS of the definition of real property. 3. Proposed regulations. In May 2014 Treasury and the IRS issued proposed regulations (the proposed REIT regs) that would revise the definition of real property for REIT purposes. First, the proposed regulations clarify the definitional scheme for REIT real property: Tangible real property is divided into land and improvements to land.76 Improvements to land, in turn, are divided into inherently permanent

75 LTR 201450017 provides support for the qualification of the assets in the Windstream transaction as real property for REIT purposes, because Windstream will be contributing similar types of cables to CS&L. See Communications Sales & Leasing Inc., General Form for Registration of Securities (Form 10 Amendment 1), at 8 (Dec. 22, 2014). 76 See prop. reg. section 1.856-10(b)-(d). Intangibles may also be real property under some circumstances. See prop. reg. section 1.856-10(f). As with tangible property, some critics have argued that too great a range of intangibles qualify as real property under existing law. See Willard B. Taylor, ‘‘More Comments on Camp’s REIT Proposals,’’ Tax Notes, Apr. 14, 2014, p. 243 (arguing that all the goodwill from an active business should not qualify as real property after a REIT conversion). But see LTR 201129007 (believed to be issued to American Tower; ruling that since the taxpayer held only real property, all its intangibles were qualifying real estate assets for REIT purposes). See also American Tower REIT Inc., Registration Statement (Form S-4 Amendment 3), at 127 (Aug. 25, 2011) (stating

(Footnote continued on next page.)

1522

TAX NOTES, March 23, 2015

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

considered the system as a whole and found that it was sufficiently immovable that it should qualify as real property. Many rulings demonstrate a reliance on movability and affixation. LTR 201143011, for example, held that steel billboard structures, whether mounted to walls or roofs or affixed to the ground through concrete foundations, were real property. Citing Rev. Rul. 71-220 and Rev. Rul. 75-424, among other authorities, the ruling stated that because the billboards were large, well-affixed to adjacent real property, and designed to remain in place, they qualified as inherently permanent structures and therefore as real estate assets. LTR 201503010, believed to be issued to Iron Mountain Inc., likewise ruled that large steel racking structures qualified as real property, emphasizing their immovability and the fact that they could not be easily moved without suffering damage.72 Although the modular racks in Rev. Rul. 75-424 did not qualify as real property, the private ruling stated that the racks at issue therein were comparable to the assets described in Rev. Rul. 71-220 and Rev. Rul. 75-424, which did qualify as real property.73 LTR 201250003 similarly treated rents from the lease of an offshore oil platform as rents from real property because the platform itself was an inherently permanent structure. The platform was permanently affixed to the sea floor by a mooring system, and the taxpayer represented that no similar facility had ever been moved.74 Also, several rulings demonstrate how new companies, particularly data centers and cell tower operators, have increasingly come to understand the advantages of REIT status. LTR 201037005 treated buildings specially designed to serve as data centers as real property for REIT purposes. These buildings included special heating, air conditioning, redundant electrical systems, and raised flooring under which pipes and wires were run. The ruling concluded that all the heating, air conditioning, and electrical systems were structural components of the building and therefore qualified as real property. Two large cell tower operators, Crown Castle International Corp. and American Tower Corp., converted to REITs. LTR 201129007, believed to be issued to American Tower, concluded that wireless

COMMENTARY / SPECIAL REPORT

that the company would treat all its goodwill and other intangibles as interests in real property after REIT conversion). 77 See prop. reg. section 1.856-10(d)(2). 78 See prop. reg. section 1.856-10(d)(3). 79 For instance, prop. reg. section 1.856-10(d)(3)(ii) explicitly categorizes wiring and plumbing systems as structural components. This inclusion matches the current regulations, which state that the term ‘‘real property’’ ‘‘includes, for example, the wiring in a building . . . [and] plumbing systems.’’ Reg. section 1.856-3(d). 80 See prop. reg. section 1.856-10(d)(2)(iii). Based on the IRS’s comments at a hearing on the proposed REIT regs, the IRS apparently believes that this requirement is implied by the exclusion of assets ‘‘accessory to the operation of a business’’ in the current regulations, though that phrase has been interpreted narrowly. See transcript of IRS hearing on proposed REIT regs (Sept. 18, 2014) (statement of David Silber, IRS deputy associate chief counsel). But see GCM 36052 (Oct. 9, 1974) (‘‘Although the Service has heretofore used a functional approach in classifying real and personal property, consideration is presently being given to abandoning that approach in favor of an approach that would place greater emphasis on ‘moveability’’’). 81 The proposed regulations reflect five of the six factors from Whiteco. See prop. reg. section 1.856-10(d)(2)(iv). The proposed regulations omit the first factor, i.e., whether the property is capable of being moved or has been moved, possibly because this factor may be within the taxpayer’s control to some extent. 82 See prop. reg. section 1.856-10(d)(3)(iii). There is no separate passivity requirement for structural components in the proposed regulations. 83 See prop. reg. section 1.856-10(e). 84 See generally Taylor, ‘‘Closing the Gap Between Private Letter Rulings and Regulations,’’ Tax Notes, Aug. 4, 2014, p. 597. The preamble to the proposed REIT regs cites ‘‘the need to provide additional published guidance’’ and states that the division of real property into specified categories in the proposed regulations is ‘‘consistent with section 856, the existing

C. Scope of REIT Activities REIT spinoffs implicate, to some extent, the issue of the permitted scope of REIT group activities. In REIT spinoffs, Parent and SpinCo typically85 enter into an OpCo-PropCo lease, and SpinCo’s TRS generally conducts an active business after the spinoff and performs other standard TRS activities (for example, property management). This is in addition to the activities that TRSs generally perform, such as the provision of non-customary tenant services. Outside the REIT spinoff context, several companies have converted to REITs, and some earn revenue from performing a significant range of services for tenants. While the focus of this report is on REIT spinoffs, the services performed by REITs have become the focus of considerable controversy, and a discussion of this topic would be incomplete unless it addressed more broadly the services provided by REITs and their TRSs. Some may argue that REITs have expanded beyond their original design.86 It is certainly true that the legislative history accompanying the original enactment of the REIT rules drew ‘‘a sharp line between passive investments and the active operation of [a] business.’’87 It is equally clear, however, that beginning shortly after the enactment of the original legislation, the line began to move. The trend has been to expand the scope of a REIT’s permitted activities if the REIT’s predominant character remains that of a corporation in the business of acquiring and leasing real property. The following discussion traces that evolution.88 1. Development of REIT income rules. Under the 1960 legislation, in order for income received regarding a property to qualify as ‘‘good’’ rental income, a REIT had to receive from an unrelated party rent that was not determined by reference to any person’s profits from the property, and the REIT had to hire an independent contractor to perform any services offered to tenants, with the contractor receiving separate payment.89 Therefore,

regulations, and published guidance interpreting those regulations.’’ 79 F.R. 27508. The proposed regulations include extensive examples that are based mostly on current law, including private rulings on which taxpayers cannot formally rely. See prop. reg. section 1.856-10(g). 85 In the CBS transaction, Outfront Media was split off from its parent and does not appear to have entered into any significant long-term leases. Outfront Media does appear to provide some services to tenants. See LTR 201431020 (describing ‘‘utilities, security, and routine maintenance’’ provided under leasing agreements). 86 See, e.g., Einhorn, supra note 19 (predating TRS legislation). 87 H.R. Rep. No. 86-2020, pt. II, at 821 (1960). 88 For a timeline illustrating the evolution of relevant REIT rules, see Part 2, Appendix C. 89 See the 1960 act, supra note 32, at section 10(a).

(Footnote continued in next column.)

TAX NOTES, March 23, 2015

1523

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

structures77 and their structural components.78 Some assets are explicitly included in (or excluded from) these last two categories to match current law.79 Also, the proposed REIT regs provide a series of factors for making a facts and circumstances determination of whether unlisted assets belong in one of these categories. To determine whether an asset that is not explicitly categorized is inherently permanent, the proposed REIT regs first require that the asset be passive.80 They then list five factors adopted from Whiteco for making the final assessment.81 A similar but more extensive set of nine factors applies in determining if an asset is a structural component.82 Finally, the proposed REIT regs include factors for assessing whether an asset is distinct, which requires that it be analyzed separately to determine if it is real property.83 The proposed regulations, on the whole, attempt to codify the IRS’s position in the core revenue rulings discussed above, and to eliminate the gap between the current formal definition for real property, enacted in 1962, and the developments since that time in private rulings.84

COMMENTARY / SPECIAL REPORT

Those regulations allowed REITs to include the full amount received from tenants as ‘‘rents from real property,’’ even if partly attributable to services provided by an independent contractor, as long as the services were customary and there was no separate charge.98 Also, rental amounts determined by reference to the gross receipts or sales of another person from the leased property but adjusted for the cost of sales taxes qualified as good rent.99 The regulations also clarified that REITs could avoid disqualification of rental income if they appor-

90

Although the 95 percent income test was present in its essentials in the 1960 legislation (at a 90 percent standard), the 75 percent income test is usually the more relevant restriction for equity REITs, such as those in REIT spinoffs. See 1960 act, supra note 32 (enacting former section 856(c)(2)). This is because the 75 percent income test is more difficult to meet given the narrower range of types of income that qualify under this test. 91 Id. (enacting former section 856(d)(2)). 92 Id. (enacting former section 856(d)(3)). 93 Id. (enacting former section 856(d)(1)). 94 Id. (enacting former section 856(d)(3)). See also Theodore Lynn, ‘‘Real Estate Investment Trusts: Problems and Prospects,’’ 31 Fordham L. Rev. 73, 92 (1962) (‘‘Whether the trust can act as agent for the contractor in receiving money from the tenants and passing it on to the contractor is unresolved’’). 95 The 1960 legislation defined rents from real property as ‘‘rents from interests in real property,’’ subject to several exclusions. See 1960 act, supra note 32 (enacting former section 856(d)). The legislation made no provision for handling any portion of rent attributable to personal property. 96 This prohibition remains in the statute today in similar form. See section 856(d)(2)(B). 97 See T.D. 6598 (1962). 98 See former reg. section 1.856-4(b)(3)(i)(b) (‘‘An amount will not be disqualified as ‘rent’ if services, such as are usually or customarily furnished or rendered in connection with the mere rental of real property, are furnished or rendered to tenants of the property through an independent contractor. . . . Where no separate charge is made for such services, no apportionment is required to be made between rents from real property and compensation for these services.’’). 99 See former reg. section 1.856-4(b)(1).

tioned amounts received on account of realty and personalty and included only the former amounts as good rental income.100 While these changes were clearly designed to loosen some of the strict passivity requirements imposed by the 1960 statute, REITs were still highly restricted. For example, if REITs included a separate charge for services or wanted to provide new, non-customary types of services, any income from those services had to be received by an independent contractor.101 REITs were effectively prevented from innovating, while their competitors, such as real estate partnerships, faced no such restriction.102 Congress eventually allowed REITs more latitude. A 1976 law allowed REIT income from all customary services to qualify under the 75 percent income test regardless of whether there was a separate charge103 and also allowed rental amounts to qualify in full as long as no more than 15 percent of the amount received was attributable to personal property.104 The Tax Reform Act of 1986 brought further flexibility, particularly by allowing REITs to perform customary services directly.105 Private rulings in the 1990s permitted REITs to take payment for non-customary services performed by independent contractors and generally did not consider the REITs to perform the services themselves.106

100 See former reg. section 1.856-4(a) (‘‘Only that part of the rent which is attributable to ‘real property’ shall be included for purposes of the gross income requirements in section 856 (c)(2) and (3) and paragraph (c) of section 1.856-2’’). See also Marvin S. Kahn, ‘‘Taxation of Real Estate Investment Trusts,’’ 48 Va. L. Rev. 1011, 1028 (1962) (‘‘Where, for example, an amount of rent is received with respect to the rental of both real and personal property, the regulations require an apportionment so that ‘only that part of the rent which is attributable to ‘real property’ shall be included’ as rents from real property’’). 101 See former reg. section 1.856-4(c) (‘‘To the extent that services (other than those customarily furnished or rendered in connection with the rental of real property) are rendered to the tenants of the property by the independent contractor, the cost of the services must be borne by the independent contractor, a separate charge must be made for the services, the amount [of the separate charge] must be received and retained by the independent contractor . . . [and] the independent contractor must be adequately compensated for the services’’). 102 See ‘‘Hearings Before the Subcommittee on Select Revenue Measures of the Committee on Ways and Means, House of Representatives: Issues Relating to Passthrough Entities,’’ 99th Cong. 192 (1986) (statement of Charles R. Gardner, National Association of Real Estate Investment Trusts (NAREIT)) (arguing for changes in the law because ‘‘the restrictions placed on REIT’s are not reasonable in light of the lack of restrictions on partnerships’’). 103 See Tax Reform Act of 1976, P.L. 94-455, section 1604(b) (enacting section 856(d)(1)(B)). 104 See id. (enacting section 856(d)(1)(C)). 105 See TRA 1986, P.L. 99-514, section 663(a). 106 See, e.g., LTR 9428033 (‘‘Since Company collects the charges for these services merely as an agent for the qualifying

(Footnote continued on next page.)

1524

TAX NOTES, March 23, 2015

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

the 1960 legislation classified all income received for a property as ‘‘bad’’ income under the 75 percent income test90 if the tenant was related to the REIT,91 the REIT provided services to the tenant directly,92 or the rent paid was determined by reference to another person’s profits from the leased property.93 Also, it was unclear at the time if amounts received were good rent if the REIT hired an independent contractor to provide services and took payment on the contractor’s behalf,94 or if the amounts were partly attributable to personal property on the leased property.95 Aside from the prohibition on related-party rents,96 these strict rules proved unwieldy, and Treasury soon walked back from the language of the statute in the 1962 regulations.97

COMMENTARY / SPECIAL REPORT

independent contractors, these arrangements are consistent with the requirement under section 1.856-4(b)(5) of the regulations’’); and LTR 9340056 (‘‘It has been represented that in respect of the corporate apartments, in the event that the tenant, acting on its own behalf, hires an independent contractor to provide maid service, the Operating Partnership will separately bill and collect the charge for services due the independent contractor. In turn, the Operating Partnership will then remit the entire fee due to the independent contractor.’’). The regulations require a separate charge for non-customary services performed by an independent contractor for tenants of a REIT. See reg. section 1.856-4(b)(5)(i). 107 See Julie D. Walpole, ‘‘Exploring the Paired Share REIT and Quantifying Its Tax Advantage,’’ at 20 (master’s thesis, MIT) (1998). As an initial matter, there is some evidence that Congress was primarily concerned with banning domestic-foreign stapling arrangements. See, e.g., 94 Cong. Rec. H4881 (June 30, 1983) (statement of former Ways and Means Committee Chair Dan Rostenkowski) (introducing legislation restricting stapled share arrangements by stating that ‘‘in several instances, U.S. corporations have attempted to avoid the subpart F rules and the antiboycott rules by splitting off their foreign operations and conducting them through separate corporations. In these cases, the stock of the two (or more) entities is ‘stapled’ or ‘paired’ so that a shareholder cannot trade the stock separately. The management of the two companies may be the same.’’). 108 As discussed above, until 1986, REITs generally were not allowed to provide any services directly. See supra text accompanying note 105. 109 See Walpole, supra note 107, at 22, 26 (describing use of the arrangement by six REITs during the 1977-1984 period). The attraction arose from the desire to capture more of the value from the properties that the REIT owned. If a REIT must hire a third-party management company to operate properties, significant value may be lost through leakage to the third party, and the properties may generate a relatively lower return for shareholders. However, if the management company and the REIT have the same shareholders, as was the case with stapled share REITs, this is no longer as much of a problem. 110 See Deficit Reduction Act of 1984, P.L. 99-369, section 136(a). Section 269B considers foreign-domestic stapled pairs as two domestic companies, and C corporation-REIT pairs are considered one entity, likely resulting in the REIT failing the income and asset tests. The 1984 legislation grandfathered some entities with already issued stapled shares. See id. at section 136(c). In 1998 Congress imposed further restrictions on these grandfathered stapled share arrangements, effectively capping their growth if the arrangements intended to retain their grandfathered status. See Internal Revenue Service Restructuring and Reform Act of 1998, P.L. 105-206, section 7002. The legislation created a new category of real property called ‘‘nonqualified real property interests,’’ which included, with some exceptions, any real property acquired by either the stapled REIT or its

Section 269B does not apply to modern OpCoPropCo leases in which there is no requirement for any stapled trading of Parent and SpinCo stock.111 Nevertheless, it might be argued that there are some similarities between stapled share arrangements and modern OpCo-PropCo leases. In the former case, the two companies shared management and shareholders, which is also true of OpCo-PropCo leases to a limited degree.112 This overlap of shareholders and management, in turn, created a potential tax problem: If the companies had the same shareholders and managers, there could be an incentive not to use market terms and prices in intercompany transactions and thus strip earnings from the operating company. A limited overlap of shareholders and directors alone should not provide a legal basis to disregard

stapled partner after March 26, 1998. See id. at section 7002(b). Any income or activities of either the REIT or its partner attributable to nonqualified real property interests was not grandfathered and therefore was considered attributable to the REIT for purposes of the REIT qualification tests. See id. at section 7002(a). 111 See section 269B(a)(3) (providing that in determining whether a stapled entity is a RIC or REIT, all entities that are stapled entities regarding one another will be treated as single entities); section 269B(c)(2) (defining stapled entities as any group of two or more entities more than 50 percent of the beneficial interests in each of which are stapled interests); and section 269B(c)(3) (defining stapled interests as two or more interests regarding which, upon the transfer of one interest, the other interest is also, or must be, transferred). 112 A pro rata distribution necessarily produces much overlap; however, the similarity of the shareholder groups is likely reduced by (1) initial exchanges of stock, if necessary to avoid the REIT related-party rent issue; (2) the purging distribution, which presumably alters the ownership interests of SpinCo shareholders; and (3) subsequent public trading. For instance, Penn National exchanged a variety of its stock and options held by its CEO and a related family trust for shares of SpinCo in connection with the spinoff to ensure that no shareholder held a greater-than-10-percent interest in both companies after the distribution (see Penn National Gaming Inc., Annual Report (Form 10-K), at 1 (Feb. 27, 2014)), and the purging distribution ended up providing shareholders who received only stock (roughly half the total number of shareholders) with approximately 50 percent more shares than shareholders who elected to receive cash (see Gaming and Leisure Properties Inc., Annual Report (Form 10-K), at 2 (Mar. 25, 2014)). Also, Penn National and GLPI, like all the entities in completed REIT spinoffs, are publicly traded and have highly different asset and income profiles. Given this, it seems unlikely they will continue to have substantially similar investor bases for long. See, e.g., Einhorn, supra note 19, at 214 (‘‘Property management and property ownership are separate and distinct activities. Each activity has different risk profiles, capital needs, and growth potentials.’’). Parent and SpinCo are also likely to have very different dividend policies after a REIT spinoff. For instance, Windstream announced that after its spinoff, it would pay a dividend of $0.10 per share while CS&L would pay a dividend of $0.60 per share. See Windstream Holdings Inc., Current Report (Form 8-K) (July 29, 2014), Exhibit 99.1.

(Footnote continued in next column.)

TAX NOTES, March 23, 2015

1525

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

2. Paired shares. In the late 1970s and early 1980s, several domestic C corporations arranged for their shares to be stapled (that is, they could not legally trade separately) to entities subject to different tax regimes, such as REITs.107 Because the REIT rules in effect at the time still severely restricted REIT conduct,108 some REITs found stapled arrangements attractive.109 Congress, however, perceived them as abusive attempts to avoid otherwise applicable law, and in 1984 it enacted section 269B, which severely restricted these arrangements.110

COMMENTARY / SPECIAL REPORT

113 See, e.g., Rev. Rul. 70-542, 1970-2 C.B. 148 (lease between C corporation and REIT that shared approximately two-thirds of their directors produced qualifying rents from real property); Walpole, supra note 107, at 28 (describing ‘‘paper clip’’ arrangement of Crescent Real Estate Equities, which operated with greatly overlapping management and shareholders but no formal stapling in the aftermath of section 269B). The length of the lease between Parent and SpinCo is alone likely insufficient grounds for recharacterizing the transaction. The IRS has previously ruled that spinoffs were valid even given representations that the parties would engage in lengthy post-separation agreements. LTR 9351022, believed to be issued to Marriott for its spinoff of its hotel management company, included representations regarding the two companies’ various postseparation agreements. In that case, Distributing and Controlled entered into a management agreement with a 20-year term, with extensions of up to 30 years allowed. See Host Mariott Corp., Registration Statement (Form S-1), at 34 (Dec. 23, 1993). LTR 9745028, believed to be issued to the entity then named Choice Hotels International Inc. regarding its spinoff of a franchising subsidiary, included representations that Distributing’s continuing transactions with Controlled would have arm’s-length terms. In that case, Distributing and Controlled executed an agreement providing Distributing with franchise rights for 20 years, with possible renewals. See Choice Hotels Franchising Inc., General Form for Registration of Securities (Form 10) (Sept. 10, 1997), Exhibit 10.01, section 2.1. Finally, LTR 9649042, believed to be issued to Getty Petroleum regarding its spinoff of its marketing business, included representations regarding postseparation transactions. In the Getty transaction, Distributing and Controlled entered into a lease with a 15-year initial term, with up to four 10-year renewals. Getty Realty Corp., Annual Report (Form 10-K), at 3 (Apr. 28, 2000). See also LTR 8013040 (in connection with a spinoff that qualified under section 355 and was followed by an acquisition of Distributing, Controlled leased a parcel of land to Acquirer for 20 years). 114 In the Penn National transaction, for instance, two directors served on the boards of both Parent and SpinCo. See Gaming and Leisure Properties Inc., Annual Report (Form 10-K), at 20 (Mar. 25, 2014). GLPI had five directors at the time of its 2013 Form 10-K filing (see id. at 94), and Penn National had six (see Penn National Gaming Inc., Annual Report (Form 10-K), at 128 (Feb. 27, 2014). GLPI acknowledged in its filings that this overlap could create actual or apparent conflicts of interest in future negotiations or if the two companies competed in the future. See Gaming and Leisure Properties Inc., Annual Report (Form 10-K), at 20 (Mar. 25, 2014). Accordingly, GLPI adopted governance guidelines requiring the overlapping directors to

(Footnote continued in next column.)

1526

3. TRS legislation. To avoid the restrictive independent contractor requirements and remain competitive in the marketplace, REITs began to use certain partially owned subsidiaries to perform some noncustomary services and manage properties.115 The IRS effectively blessed several of these arrangements.116 In 1999, to allow REITs to compete more effectively,117 Congress authorized REITs to create TRSs.118 A TRS is a subsidiary of a REIT that elects, jointly with the REIT, to be treated as a TRS.119 As a statutory matter, the sole prohibition on TRS activities is a bar on managing or operating healthcare and lodging facilities or licensing brand names for those operations.120 Accordingly, these subsidiaries may perform activities that REITs themselves generally cannot, such as property management and the provision of non-customary services, and their activities are not attributed to the REIT, even if the REIT collects an amount for rent that is partly traceable to the TRS’s activities.121 Thus, through a TRS, the REIT group can now do many things it could not do before.

report any matter that might create, or appear to create, a conflict of interest to the lead independent director for resolution. See Gaming and Leisure Properties Inc., Proxy Statement (Schedule 14A) (Apr. 29, 2014), Exhibit 99.1. 115 See ‘‘Hearing Before the Committee on Finance, United States Senate: Revenue-Raising Proposals in the Administration’s Fiscal Year 2000 Budget,’’ 106th Cong. 216 (1999) (statement of NAREIT that difficulty of providing non-customary services ‘‘assures that REITs are never leaders in their markets, but only followers, to the detriment of their shareholders’’). REITs would hold substantially all the nonvoting preferred stock of a corporation but maintain less than 10 percent of the voting common stock of that corporation in order to comply with the then-applicable law, which prohibited REITs from owning more than 10 percent of a corporation’s voting power. These ‘‘preferred stock subsidiaries’’ or ‘‘third-party subsidiaries’’ could perform some activities that a REIT could not, such as property management, and the REIT would capture substantially all the resulting value as a result of its ownership of the preferred stock. See generally David L. Brandon and Mario J. Deluca, ‘‘Opportunity Knocks for Taxable REIT Subsidiaries,’’ 92 J. Tax’n. 141 (2000). 116 See, e.g., LTR 8825112 (ruling that ownership of all the nonvoting stock of a subsidiary, and none of the voting stock, did not violate the REIT requirements). 117 See, e.g., 145 Cong. Rec. E795 (Apr. 28, 1999) (statement of Rep. William Thomas) (stating that ‘‘current law restrictions require REITs to adhere to unworkable distinctions that defy logic and impede competitiveness’’ and ‘‘expressing worry that REITs will be unable to compete with ‘‘private held partnerships and other more exclusive forms of ownership’’). 118 See Ticket to Work and Work Incentives Improvement Act of 1999, P.L. 106-170, section 543 (hereinafter the 1999 act) (enacting section 856(l)). 119 See section 856(l)(1). 120 See section 856(l)(3). 121 See section 856(d)(7)(C)(i). See also Moline Properties Inc. v. Commissioner, 319 U.S. 436 (1943) (respecting corporation’s status as a separate entity). The relevant regulations on how to (Footnote continued on next page.)

TAX NOTES, March 23, 2015

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

the separateness of the two companies.113 Moreover, the risks described above are not present to the same degree in the completed REIT spinoffs. While Parent and SpinCo will have overlapping shareholders, this overlap — present in every pro rata spinoff — should presumably fade with time because there is absolutely no restriction on trading stock of one company separately from the other. In addition, overlapping directors are kept to a minimum in these transactions, and there are procedures in place to prevent those directors from deciding issues that could affect the other company.114 Accordingly, REIT spinoffs are very different transactions from those Congress restricted in section 269B.

COMMENTARY / SPECIAL REPORT

To ensure that REITs do not primarily engage in active businesses, the 1999 act added a requirement that TRSs not represent more than 20 percent of a REIT’s assets.125 Also, the REIT income tests continue to limit the amounts a REIT may receive from interest and dividends, including from TRSs.126 If a REIT owns a 10 percent or greater interest in the TRS (by vote or value), rent paid by a TRS to its REIT may also be considered bad income.127 Transactions between a REIT and its TRS on non-arm’s-

handle payments to a REIT that are in part attributable to non-customary services provided by others have not been updated since 1981 and state that a separate charge is required. See reg. section 1.856-4(b)(5)(i). However, in Rev. Rul. 2002-38, 2002-2 C.B. 4, the IRS interpreted the passage of the 1999 act as allowing all the payments to a REIT to be classified as good income, even if partly attributable to non-customary or other services provided by a TRS. Separately, sections 857(b)(7) and 482 attempt to discourage a REIT from underpaying its TRS for services. Because there is still a separate charge requirement for payments attributable to non-customary services provided by an independent contractor, REITs generally have an incentive to use their TRSs to perform as many services as possible in order to avoid the extra administrative requirements associated with independent contractors. See reg. section 1.856-4(b)(5)(i). 122 See, e.g., 145 Cong. Rec. S5377 (May 14, 1999) (statement of Sen. Connie Mack) (introducing the 1999 REIT Modernization Act and proposing ‘‘additional refinements’’ on conflicting proposal from the Clinton administration); 145 Cong. Rec. E795 (Apr. 28, 1999) (statement of Rep. Thomas) (same). For a discussion of the various REIT subsidiary proposals at this time, see New York State Bar Association Tax Section, ‘‘Report on Legislative Proposals Relating to REITs’’ (July 8, 1999). 123 See Treasury, ‘‘General Explanations of the Administration’s Revenue Proposals,’’ at 140-141 (Feb. 1, 1999) (proposing the creation of separate types of subsidiaries to perform management and services, the disallowance of deductions for interest paid by a TRS to its REIT, and ‘‘certain additional limitations’’). 124 See id. 125 See 1999 act, supra note 118, at section 541(a) (amending section 856(c)(4)(B)). 126 Either interest or dividends from a TRS are bad income for purposes of the 75 percent income test and therefore cannot represent more than 25 percent of the REIT’s income in a given year. See section 856(c)(3). 127 See section 856(d)(2)(B)(i). There are limited exceptions to this disqualification when a REIT either (1) leases a limited amount of space to a TRS in a property 90 percent or more of

length terms generally are subject to an excise tax, a redetermination by the IRS, or a limitation on deductions.128 Since 1999 there have been further changes to the REIT rules. Legislation enacted in 2008 now allows TRSs to lease healthcare facilities from a REIT (and engage independent contractors to operate the facilities) and allows TRSs to represent up to 25 percent of a REIT’s value.129 These changes cap over four decades of gradual expansion by Congress of the activities in which REITs may engage. Some argue that these congressional changes have gone too far and that REITs are now able to engage in active businesses while avoiding corporate taxation. Initially, it is important to recognize the danger of misunderstanding a REIT’s activities130 or conflating a REIT’s activities with those of its lessee.131 It was understood when REITs were first authorized that they would lease property to very active businesses and that this proximity to an active business would not itself cause a REIT to be engaged in an active business.132 Considering just the activities of REITs themselves, REITs are still unable to provide noncustomary services directly, operate or manage properties, or run a business unrelated to leasing. Only a TRS or independent contractor can perform those activities, and TRSs are subject to tax as C corporations. While it may be that TRSs are not

which is leased to non-TRS, non-related persons or (2) leases a qualified lodging or healthcare facility to a TRS. See section 856(d)(8). 128 In lieu of the application of section 482, section 857(b)(7) imposes a 100 percent tax on redetermined rents, redetermined deductions, and excess interest. Redetermined rents and redetermined deductions are rents paid by a TRS to a REIT, or deductions taken by a TRS, to the extent that those amounts would be subject to redetermination under section 482. See section 857(b)(7)(B) and (C). Excess interest is any interest deduction by a TRS to the extent the payments exceed a commercially reasonable rate. See section 857(b)(7)(D). There are exceptions to these rules, which may cause section 857(b)(7) not to apply to a payment; in that case, section 482 would apply. See section 857(b)(7)(E). Also, the earnings stripping rules of section 163(j) could apply to interest payments made by a TRS to its parent REIT. See section 163(j)(3)(C). 129 See Housing and Economic Recovery Act of 2008, P.L. 110-289, sections 3061 and 3041. 130 See ‘‘Overheard,’’ The Wall Street Journal, June 10, 2013, at C6 (‘‘Iron Mountain also said the IRS had earlier said it was ‘tentatively adverse’ to allowing its racks of computer servers to be defined as real estate’’). Iron Mountain, of course, was referring to racking structures for holding various records, not computer servers. 131 See Sheppard, supra note 5 (featuring a picture of a room full of servers, with the tagline ‘‘Is this real property?’’). 132 See GCM 32907 (Sept. 3, 1964) (‘‘Congress was concerned with the lessor trust conducting a business and not with the fact that the leased assets might be used by the lessee in the active conduct of a business’’).

(Footnote continued in next column.)

TAX NOTES, March 23, 2015

1527

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

Significant discussion preceded the enactment of the TRS legislation.122 The Clinton administration, for instance, initially proposed a scaled-back version, with several additional restrictions,123 that would have allowed two different types of new subsidiaries, one specifically to engage in business activities and another to perform non-customary services.124 Notably, however, even the Clinton administration’s more restrictive proposal would have allowed REITs, through their subsidiaries, both to engage in active businesses and perform noncustomary services.

COMMENTARY / SPECIAL REPORT

REITs themselves can provide some customary services. Some commentators have suggested that entities that primarily perform services should not be REITs,136 or questioned whether REITs should be able to treat payments for these customary services as rent.137 As a legal matter, amounts attributable to certain services have been included in the definition of rents from real property since 1962.138 As to the policy question of whether a REIT should be allowed to receive revenue from services, the only services that a REIT can treat as rent are those ‘‘customarily furnished or rendered in connection with the rental of real property.’’139 In other words, only incidental services provided in connection with the leasing relationship are considered. For example, Equinix Inc., a data center REIT, has reported in filings that it earns a portion of its

133 The only detailed sources on this point are two Treasury studies considering 2001 and the period 2001 to 2004. These sources do indicate that at that time, most TRSs were not profitable. See Thornton Matheson, ‘‘Taxable REIT Subsidiaries: Analysis of the First Year’s Returns, Tax Year 2001,’’ 24 SOI Bull. 114 (2005); and Matheson, ‘‘The Development of Taxable REIT Subsidiaries, 2001-2004,’’ 27 SOI Bull. 196 (2008). 134 See supra note 128. 135 Section 856(c)(4)(B)(ii). 136 See Sheppard, supra note 5 (noting that Equinix makes most of its money from co-location and interconnection ‘‘fees’’). 137 See Taylor, supra note 76, at 243 (‘‘If the consideration paid for the customary services is, say, three or four times the rent that would otherwise be paid for the space, should the payment be treated in its entirety as rent for real property?’’). 138 See former reg. section 1.856-4(b)(3)(i)(b). Congress approved the current definition of rents from real property, including charges for certain customary services, in 1976. See TRA 1976, P.L. 94-455, section 1604(b) (enacting section 856(d)(1)(B)). The Joint Committee on Taxation report accompanying the enactment of the 1976 legislation indicates that Congress recognized that providing services as part of the leasing of real property was ‘‘normal commercial practice.’’ See JCT, ‘‘General Explanation of the Tax Reform Act of 1976,’’ JCS-33-76, at 454 (Dec. 29, 1976). 139 Section 856(d)(1)(B).

1528

revenues from ‘‘interconnection.’’140 Interconnection simply means allowing a tenant to connect its own equipment in the space it leases to another part of the facility or another facility where there may be other servers or a connection to the outside.141 Even if this constitutes a service,142 it is the kind that has value only in relation to the underlying real property. The customer base for these services is also limited to existing lessees. In many cases, including that of Equinix, a non-tenant would have no reason to purchase the service on offer, because it has value only to tenants. Moreover, even if the service did provide value independently of the REIT’s real property,143 the REIT could not directly offer the service to non-tenants to any large degree.144 In short, REITs can directly perform only a narrow range of real-estate-related services and cannot provide those services, to any significant extent, to most consumers. It is unclear why the line between almost all business services and the incidental realestate-related services of a REIT — a line that is

140

See Equinix Inc., Annual Report (Form 10-K), at F-77 (Feb. 28, 2014) (reporting that approximately $320 million out of approximately $2.15 billion in revenues for Equinix’s 2013 tax year came from interconnection). See also LTR 201423011 (ruling that charges for a variety of services provided by a data center REIT qualified as rents from real property, including interconnection services); and LTR 201334033 (same). Most of Equinix’s revenue comes from co-location. See Equinix Inc., Annual Report (Form 10-K), at F-77 (Feb. 28, 2014). Co-location is simply a term for renting data center space to smaller customers and is used in contrast to ‘‘wholesale’’ data center operations, which provide larger spaces and give the tenant more control. See Equinix Inc., Annual Report (Form 10-K), at 11 (Feb. 28, 2014). 141 See Equinix Inc., Annual Report (Form 10-K), at 11, 23 (Feb. 28, 2014). 142 See LTR 201423011 (providing that amounts received under ‘‘Master Service Agreements’’ could nonetheless qualify as rents from real property for REIT purposes, despite the form of the agreements). 143 The services most likely to have that independent value are those most likely to be ‘‘for the convenience of the tenant,’’ like maid service or room service. REITs already generally are unable to count income received from directly performing these services as good income under the 75 percent income test. See sections 856(d)(7) and 512(b)(3); and reg. section 1.512(b)-1(c)(5). 144 The legislative history of the 1986 act, which allowed REITs to perform some customary services, provides an example that strongly suggests that income derived from services provided to the general public was not intended to qualify as rents from real property. See H.R. Rep. No. 99-841, pt. II, at 220 (1986) (‘‘The conferees intend . . . that a REIT may provide customary services in connection with the operation of parking facilities . . . On the other hand, the conferees intend that . . . income derived from the rental of parking spaces to the general public . . . would not be considered to be rents from real property unless all services are performed by an independent contractor.’’). The only way for a REIT to offer those services directly would be if the charges for the services do not exceed the de minimis threshold in section 856(d)(7)(B).

TAX NOTES, March 23, 2015

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

large sources of tax revenue,133 it bears repeating that REITs cannot simply strip earnings from their TRSs and thereby shift active income to themselves. Rather, section 857 imposes a 100 percent tax on excessive interest or rents paid by a TRS to its REIT.134 The requirement that a TRS cannot represent more than 25 percent of the value of a REIT’s assets provides a backstop to section 857.135 It seems unlikely that a REIT could avoid all taxation of income from a large, active business in spite of all these requirements. Further, one could reasonably expect a REIT’s auditors to evaluate thoroughly the adequacy of the transfer pricing with the TRS in assessing the need for any reserves.

COMMENTARY / SPECIAL REPORT

D. REIT Conversion Policy Issues Leaving aside the question whether it is equitable to provide REIT status as an option and then change the law after parties adopt it, the main corporate tax policy concern raised by REIT conversions, including REIT spinoffs, appears to be whether the cost of providing an effective exemption from the corporate tax for these new, nontraditional REITs is too high. That REIT conversions may cause some overall decline in tax revenue cannot be the end of the policy discussion; the entire point of the original REIT bill was to exempt entities from the income tax, and one could not have reasonably expected that legislation to be revenue neutral. The question, therefore, is whether nontraditional REITs provide benefits that justify their costs, measured accurately. As discussed below, REITs, including nontraditional REITs, appear to produce significant benefits,

145

While there are several statements regarding the presumed passivity of REITs in the legislative history of the 1960 bill, legislators were not unaware that a real estate trust would have more activity than a RIC. See ‘‘Panel Discussions Before the Committee on Ways and Means, House of Representatives: First Session on Ideas and Suggestions Submitted to the Committee on Ways and Means on the Broad Subject of Revision of the Federal Income Tax Structure,’’ 86th Cong. 912 (1959) (hereinafter 1959 panel discussions) (question from then-Ways and Means Committee Chair Wilbur Mills) (‘‘Is not a real estate trust inevitably more engaged in an active business, real property management, and so forth, than a mutual fund?’’).

TAX NOTES, March 23, 2015

and their costs appear relatively minor. This analysis points toward permitting REITs to retain their current tax status.146 1. Revenue effects. Various sources have expressed concern that nontraditional REITs will reduce tax revenues147 or erode the corporate tax base.148 While there likely is a revenue impact to granting REITs a dividends paid deduction, the concern over the impact to the public treasury is probably exaggerated. Several effects offset or limit the amount of revenue lost as a result of recent REIT conversions,149 and the few serious examinations of the revenue effect of these conversions generally find that the overall effect is modest. Moreover, it is not clear that the corporate income tax, from which REITs are largely exempted, is worth the defense it is receiving. a. Offsetting or limiting effects. At least four aspects of the REIT rules limit or offset lost revenue from a REIT conversion150: (1) the effect of increased dividend taxation, (2) the effect of the requirement for an initial taxable purging distribution, (3) the effect of reclassifying assets as real property for tax purposes, and (4) the effect of the restrictive rules in section 856 for REIT qualification. First and most importantly, REITs are subject to a quid pro quo: They generally are exempt from entity-level income taxation but must distribute substantially all their taxable income annually.151 Many REITs, in fact, make distributions exceeding the statutory minimum, which is not surprising,

146 Even if the law were to be changed, there are various alternatives to eliminating or imposing additional restrictions on some or all REITs. For example, some have noted that the tax rules governing tax-exempt investors could be reassessed, or a broader reconsideration of the tax system might be undertaken, including whether to equalize the treatment of passthrough and corporate entities. See generally Bradley T. Borden, ‘‘Reforming REIT Taxation (or Not)’’ (in progress) (copy of manuscript on file with author). 147 See, e.g., Gleckman, supra note 20. 148 See, e.g., Majority Tax Staff of the Ways and Means Committee, ‘‘Tax Reform Act of 2014: Discussion Draft, Sectionby-Section Summary,’’ at 123 (Feb. 26, 2014) (‘‘The REIT rules were not intended to facilitate erosion of the corporate tax base by allowing operating companies to convert from taxable C corporations into REITs’’). 149 As one commentator has noted, it is counterintuitive that the REIT regime, the main feature of which is a lack of entity-level tax, also involves a related tax increase on shareholders. See Borden, ‘‘The Counterintuitive Tax Revenue Effect of REIT Spinoffs,’’ Tax Notes, Jan. 19, 2015, p. 381. 150 In fact, it is possible to construct scenarios in which REIT conversions produce a net increase in tax revenues as a result of all these offsetting effects. See Borden, supra note 6, at 47-48. However, using more realistic assumptions, a small decline in overall tax revenues appears to be the most likely outcome. 151 See supra note 36.

1529

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

restrictive and difficult to administer — needs to be modified or complicated yet further. REITs already are not active businesses. There is no real dispute that the activities of SpinCos after REIT spinoffs (and those of REITs generally), while compliant with current law, exceed the original expectation of the scope of REIT activities.145 At the same time, however, REITs generally still remain true to their original purpose: They are companies that acquire and lease real property. Admittedly, TRSs, which are REIT affiliates, provide non-customary services and conduct other activities that REITs themselves cannot perform, but they are taxed like a C corporation on the income earned for doing so. Moreover, on balance the safeguards built into the TRS rules — including a 25 percent value limitation, the treatment of TRS dividends as non-real-estate income in the REIT’s hands, arm’s-length pricing requirements for transactions with the parent REIT, restrictions on TRS leasing from the REIT, and earnings stripping limitations on interest deductions taken on debt owed to the REIT parent — should ensure that the REIT retains its predominant character as a real estate company and discourage transfer pricing abuses between the REIT and its affiliates.

COMMENTARY / SPECIAL REPORT

Second, in addition to the ongoing increase in the taxation of REIT shareholders, an upfront purging distribution is usually required for a REIT conversion, thus producing further tax revenue. While these distributions can qualify for the lower, qualified dividend rate,156 recent distributions by nontraditional REITs are significant in size: In 2014 alone, Iron Mountain issued a purging distribution of $700 million;157 Outfront Media issued a purging distribution of $547.7 million;158 Equinix issued a purging distribution of $416 million;159 and Lamar Advertising Co. issued a series of distributions totaling at least $158 million.160 The size of these distributions reduces the loss in tax revenue attributable to REIT conversions and may discourage existing C corporations from converting.161

Third, nontraditional REITs may have to reclassify as real property some assets previously treated as shorter-lived for depreciation purposes. For instance, in LTR 201410029, a C corporation reclassified assets originally classified as five- to 12-year property as 15- to 39-year property in connection with a REIT election. The taxpayer may have been required to recognize income as a result of a section 481 adjustment.162 That change also should reduce the size of the annual depreciation deductions the REIT can take for the property and thus increase the REIT’s taxable income and the amount it must distribute in taxable dividends.163 Finally, to obtain an accurate idea of the overall revenue effect of REIT conversions, it is necessary to determine the number of companies that will convert. It is worth noting that there are many reasons otherwise eligible companies might choose to remain wholly taxable as C corporations, including (1) the relatively small value of real estate in some industries compared with the costs of conversion; (2) the need for an expensive and taxable purging dividend; (3) the possibility of built-in gains tax, prohibited transactions tax, or excise tax; (4) the need to distribute almost all income as dividends rather than reinvesting earnings; (5) the various strict tests the REIT must meet and must constantly consider in deciding what business decisions to make; (6) initial and ongoing compliance costs; (7) the possibility of significant legal changes in this area; and (8) in REIT spinoffs, the possibility of conflict in the relationship between the operating entity (or entities) and the lessor REIT, the customization of real property for the current owner, or the current owner’s need for a high level of control over its real property, which would be inconsistent with a lessee position.164 While it is clear that REIT

152 See, e.g., Walter I. Boudry, ‘‘An Examination of REIT Dividend Payout Policy,’’ 39 Real Estate Econ. 601 (2011) (in sample of 113 equity REITs from 1997 to 2007, finding that most REITs pay dividends in excess of statutory minimum requirement). 153 See Borden, supra note 146 (citing evidence that suggests C corporations generally distribute approximately 25 percent of their taxable income). 154 See, e.g., ‘‘Berkshire Opposes Dividend Proposal; Buffett, Gates Get Pay Rises,’’ Reuters (Mar. 16, 2014) (noting that Berkshire Hathaway has not paid a cash dividend since 1967). 155 See sections 1(h)(11)(D)(iii) and 857(c)(2)(B) (providing that a REIT generally may only pay qualified dividends out of the amount of qualified dividends it has received plus the amount of its income that was subject to tax). However, REITs may be able to pass on capital gains to shareholders in the form of specially designated capital gains dividends. See section 857(b)(3). 156 See section 857(c)(2)(B)(iii). 157 See Iron Mountain Inc., Quarterly Report (Form 10-Q), at 55 (Oct. 31, 2014). 158 See CBS Outdoor Americas Inc., Quarterly Report (Form 10-Q), at 8 (Nov. 7, 2014). 159 See Equinix Inc., Quarterly Report (Form 10-Q), at 30 (Nov. 7, 2014). 160 See Lamar Advertising Co., Quarterly Report (Form 10-Q), at 26 (Nov. 6, 2014). 161 See, e.g., Civeo Corp., Current Report (Form 8-K) (Sept. 29, 2014), Exhibit 99.1 (citing as a rationale for not converting to REIT status ‘‘the significant cash expenditures that would be incurred in connection with a REIT conversion. The company would incur cash expenditures of approximately $720 million in order to fund tax payments of over $300 million, the cash

portion of a required earning and profits distribution and transaction costs, which collectively would meaningfully increase leverage metrics.’’). 162 See LTR 201410029 (stating that depreciation change would require a section 481 adjustment). A net positive section 481(a) adjustment would generally be taken into account over a period of four tax years. See Rev. Proc. 2015-13, 2015-5 IRB 419, section 7.03(1). 163 Admittedly, a well-advised taxpayer might decide to reclassify its property, or even to make a REIT election, only after the property had been fully depreciated. 164 Goolsbee and Maydew suggested many of these considerations in their 2002 paper, which concluded that many industries had little to gain from adopting the REIT form. Goolsbee and Maydew, supra note 6, at 455 (‘‘Our results document that the potential gains from such REIT spin-offs are highly concentrated in a small number of industries’’). While that paper is somewhat dated, the authors did identify nursing homes as the industry with the greatest potential benefit from REIT spinoffs, and, in fact, there have since been several separations of nursing

(Footnote continued in next column.)

(Footnote continued on next page.)

1530

TAX NOTES, March 23, 2015

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

given how critical yield is to REIT investors.152 By contrast, most C corporations annually distribute only a small portion of their earnings,153 and some make no distributions whatsoever.154 REIT dividends are also nonqualified dividends, usually taxed at ordinary income rates.155 These requirements help to counterbalance the loss of tax revenue from REITs themselves and must be considered in determining the overall effect of REITs on tax revenues.

COMMENTARY / SPECIAL REPORT

b. Estimates. Ultimately, it is a difficult empirical question whether or to what extent recent REIT conversions affect tax revenues. There are at least four relevant sources that have considered this question. A 2002 paper by Austan Goolsbee and Edward Maydew estimated an annual revenue loss of $2.568 billion from separation of real estate into REITs on the assumption that some industries would convert wholesale.165 A 2014 report from the Joint Committee on Taxation estimated that the Camp proposals’ restrictions on future tax-free REIT spinoffs and their requirement for immediate recognition of built-in gain in REIT conversions would together produce only $5.9 billion from 2014 to 2023.166 A 2014 article by Martin A. Sullivan estimated that 20 recent REIT conversions currently produce an annual revenue loss of $900 million to $2.2 billion, considering only the loss of tax revenue at the entity level.167 A coming article by Bradley T. Borden, which considers various offsetting effects, estimates that the group of C corporations that have converted to REITs since 2001 currently produces $258 million in annual net tax revenue loss.168

home properties into REITs, including the spinoff of CareTrust from the Ensign Group. Id. at 452. 165 See id. at 451. This estimate assumes that all the real estate from the 10 industries with the largest potential tax savings is separated into REITs. Id. The paper considers several offsetting effects in determining the overall revenue effect from separation of real estate into a REIT: a decline in corporate tax revenues at the entity level, an increase in individual income tax revenues, reduced interest deductions at the C corporation level because of the transfer of C corporation debt to REITs, and a possible reduction in distributions by C corporations that separate their real estate assets to REITs. Id. at 453. 166 JCT, ‘‘Estimated Revenue Effects of the ‘Tax Reform Act of 2014,’’’ JCX-20-14, at 10 (Feb. 26, 2014) (hereinafter JCT Camp revenue estimate). Presumably, restrictions solely on REIT spinoffs would produce even less than $5.9 billion over the same period. Also, some of this revenue presumably would be derived from spinoffs by REITs of a REIT subsidiary or C corporation subsidiary, even though these transactions have either a neutral or perhaps positive effect on the corporate tax base. The JCT generally seems to consider the effect of changes in tax law on taxpayer behavior, so this figure may consist of revenue from taxpayers that engage in taxable spinoffs, as well as revenue from other taxpayers that remain C corporations in response to the restrictions. See Emil M. Sunley and Randall D. Weiss, ‘‘The Revenue Estimating Process,’’ 10 Am. J. Tax Pol’y 261, 265-266 (1992) (discussing JCT revenue estimating techniques). 167 See Sullivan, ‘‘The Revenue Costs of Nontraditional REITs,’’ Tax Notes, Sept. 8, 2014, p. 1103. 168 See Borden, supra note 6, at 68-69. This article considers both the decline in corporate tax revenue resulting from a REIT spinoff and the increase in individual income tax revenues. To

Notably, only Goolsbee and Maydew, and Borden state that they consider the offsetting effect of REIT dividends on the overall tax revenue loss.169 It is difficult to compare these numbers because each of them estimates the revenue effect of REIT conversions among a different population. The Sullivan estimate does not take into account offsetting revenue effects and therefore is likely too high. On the other hand, the Borden estimate is restricted to 10 REITs170 and may therefore underestimate the total revenue loss because the overall number of these REITs is higher. The total net revenue loss from nontraditional REIT conversions likely falls in between these two estimates. A broad spread of REIT conversions in industries with significant amounts of real estate, which has not happened thus far171 and may never,172 could conceivably increase this number. To be sure, all these estimates involve significant amounts of money. However, these amounts are very small compared with the revenue from other areas of the tax law. For instance, the JCT’s report on the Camp proposals estimated that repealing the last-in, first-out inventory method would produce $79.1 billion from 2014 to 2023 and repealing amortization for pollution control facilities would produce $7.9 billion over the same period.173 In fact, there are approximately 50 different line items in the JCT’s revenue estimate on the Camp proposals that would raise more revenue than the provisions on REIT spinoffs and taxation of built-in gains.174 A different report estimated that changes to the inversion rules would raise $19.46 billion — over three times the revenue expected to be generated from the Camp proposals on REIT spinoffs and the taxation of built-in gains.175 Further, overall internal revenue receipts in 2013 were approximately $2.855

reach an estimate, the author makes a series of assumptions about the ownership of REIT stock, including that 25 percent of REIT shareholders are tax-exempt entities. See id. at 64. The overall revenue effect of REIT spinoffs can vary significantly depending on the amount of tax-exempt ownership of REIT stock, among other factors. Id. at 45-48, 92-93. 169 The exact method used by the JCT to reach its revenue estimate is not clear. See supra note 166. 170 Id. at 66. 171 Goolsbee and Maydew note that there are a variety of reasons REIT conversions may not occur so frequently. See supra text accompanying note 164. 172 A higher figure would represent the conversion of every industry for which REIT conversion was economically efficient, as analyzed in the Goolsbee and Maydew article, supra note 6. 173 See JCT Camp revenue estimate, supra note 166, at 5 and 7. 174 See id. 175 Letter from Thomas Barthold, JCT chief of staff, to Karen McAfee, Ways and Means Committee minority chief tax counsel (May 23, 2014) (estimating $19.46 billion increase in revenue over period 2015 to 2024).

(Footnote continued in next column.)

TAX NOTES, March 23, 2015

1531

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

conversions have become more popular, the number of companies that are willing to accept the difficulties of acquiring and maintaining REIT status should not be overstated.

COMMENTARY / SPECIAL REPORT

In arriving at revenue loss estimates, one must acknowledge that the REIT tax regime depends on the taxability of shareholders. If tax-exempt investors hold REIT shares,177 the amount of tax revenue lost admittedly will increase.178 However, while this may affect the aggregate tax revenue attributable to REITs, it is not an issue unique to REITs but instead is an issue that arises across the tax system whenever tax-exempt entities are involved.179 Moreover, Congress has presumably determined that the benefits of these exemptions justify some amount of lost tax revenue. This decision is apparent in the REIT context as well: In 1993, for example, Congress enacted legislation relaxing restrictions on taxexempt investment in REITs specifically to encourage investments by pension funds in REITs.180

Accordingly, assuming moderate levels of taxexempt investment, it is not clear that the incremental revenue loss would lead Congress to rethink this policy.181 A well-functioning tax system is important to a modern society. Discussion about the decline in corporate tax revenues is appropriate.182 Nevertheless, it seems likely that nontraditional REITs are, and will remain, only a small part of this story.183 c. Is the corporate income tax worth it? The corporate income tax, which REIT conversions purport to threaten, is a secondary source of revenue for the fisc184 and a favorite target of economists and academics.185 Some commentators have argued that the corporate income tax has distorting effects on economic behavior, including favoring financing through corporate debt and retained earnings rather than corporate equity, discouraging distributions of retained earnings, and favoring unincorporated entities over corporations.186 There have been several proposals to eliminate the corporate income

176

See Hatch report, supra note 27, at 29. Some code provisions discourage that ownership. Section 856(h) adopts the test for closely held status, which can cause disqualification for REITs, from section 542(a)(2). The latter section considers some tax-exempt entities to be individuals and therefore allows their ownership stakes to trigger closely held status. REITs can be owned by tax-exempt entities not described in section 542(a)(2), however, without any risk of being considered closely held. See LTR 200507004 (REIT stock owned by charitable trust not treated as owned by any individual and therefore not counted for purposes of closely held determination). 178 Foreign investment can raise similar issues. A foreign investor that is not treated as engaged in a U.S. trade or business generally would be subject to a 30 percent withholding tax on U.S.-source dividend income. See sections 871(a)(1)(A) and 881(a)(1). Income tax treaties generally reduce the withholding rates on dividend income under some circumstances. See Publication 901, U.S. Tax Treaties 35 (2013). 179 See, e.g., David S. Miller, ‘‘Reforming the Taxation of Exempt Organizations and Their Patrons,’’ 67 Tax Law. 451 (2014) (describing the various costs generated by the tax exemption). 180 See S. Rep. No. 103-37, at 84 (1993). This legislation created section 856(h)(3), which provides look-through treatment for ownership of a REIT by some trusts, thereby allowing the REIT to avoid closely held status. These complicated provisions apply to investments by qualified tax-exempt trusts described in section 401(a), including pension plans, in some REITs. See section 856(h)(3). The legislation also added provisions creating unrelated business taxable income for tax-exempt REIT shareholders when a covered REIT is owned predominantly by qualified trusts. REITs are covered only if (1) they would be considered closely held under the general REIT rules but for the application of an exception concerning ownership by qualified trusts, and (2) they are predominantly owned by qualified trusts. See section 856(h)(3)(D). Predominantly means either that one qualified trust owns at least 25 percent of the interests in the 177

REIT (by value) or that multiple qualified trusts, each holding at least 10 percent of the interests in the REIT (by value), together hold more than 50 percent of those interests (by value). See section 856(h)(3)(D)(ii). The overall effect of these rules generally is to require qualified trusts to recognize UBTI when they receive dividends from covered REITs to the extent the trusts would recognize UBTI for an equivalent investment in a partnership. See section 856(h)(3)(C). 181 The Borden paper, for instance, considers the evidence regarding tax-exempt ownership of REIT stock and assumes that 25 percent of REIT stock is held by tax-exempts. See Borden, supra note 6, at 40. The estimate of revenue loss remains relatively modest under this assumption. See id. at 64 and 69 (incorporating 25 percent estimate into analysis, producing $258 million net annual revenue loss). 182 See, e.g., David Gelles, ‘‘Businesses Are Winning Cat-andMouse Tax Game,’’ The New York Times, Aug. 29, 2014, at B1. 183 See, e.g., Elliott, ‘‘REIT and PTP Converters — The Other Corporate Deserters?’’ Tax Notes, Jan. 5, 2015, p. 20 (‘‘There are indications that either the overall loss of tax revenue to the fisc from [REIT and publicly traded partnership] conversions hasn’t been significant or that it’s something that Congress has decided is worth the trade-off’’). 184 See Hatch report, supra note 27, at 29 (finding that corporate income taxes and unrelated business tax on exempt organizations together produced 10.9 percent of internal revenue collections in 2013). 185 See, e.g., Jennifer Arlen and Deborah M. Weiss, ‘‘A Political Theory of Corporate Taxation,’’ 105 Yale L. J. 325, 326 (1995) (‘‘The American tax system imposes a double tax on the profits of corporations. This two-tier taxation is unusual, unfair, and inefficient.’’). 186 See, e.g., Charles E. McLure Jr., ‘‘Integration of the Personal and Corporate Income Taxes: The Missing Element in Recent Tax Reform Proposals,’’ 88 Harv. L. Rev. 532, 538-541 (1975) (describing these and other adverse effects of the corporate income tax).

(Footnote continued in next column.)

1532

TAX NOTES, March 23, 2015

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

trillion, and corporate income tax receipts were approximately $312 billion.176 Thus, even the largest estimates for revenue losses from possible nontraditional REIT conversions likely do not amount to much more than 1 percent of overall corporate income tax revenues and 0.1 percent of overall tax revenues.

COMMENTARY / SPECIAL REPORT

2. Policy justifications. On the other side of the equation, REITs produce many important benefits. REITs were created principally to provide a taxfavored vehicle through which the average investor could participate in a managed real estate portfolio190 and to increase investment in real estate.191 REITs, including nontraditional REITs, continue to serve these purposes. Also, REITs may provide other benefits to the real estate market and its investors. Finally, companies engaging in REIT spinoffs report realizing several nontax benefits that are worth considering.192 a. Public benefits. First, as intended by Congress, REITs generally allow the public to receive significant positive returns by investing in real estate. The National Association of Real Estate Investment Trusts (NAREIT) reports that a diverse range of investors own REIT stock, including mutual and pension funds and institutional and indi-

187 See, e.g., American Law Institute, ‘‘Federal Income Tax Project: Reporter’s Study Draft,’’ at 88-89 (1989) (proposing a dividends paid deduction on newly issued stock, with some limitations); ALI, ‘‘Federal Income Tax Project: Subchapter C, Proposals on Corporate Acquisitions and Dispositions and Reporter’s Study on Corporate Distributions,’’ at 367-370 (1982) (same). Cf. ALI, ‘‘Federal Income Tax Project: Integration of the Individual and Corporate Income Taxes,’’ at 3-5 (1993) (proposing a shareholder credit system rather than a dividends paid deduction for the corporate payer). 188 See Hatch report, supra note 27, at 198-199. 189 A discussion of fundamental corporate tax reform is beyond the scope of this report. 190 See, e.g., 105 Cong. Rec. 1023 (Jan. 21, 1959) (statement of Rep. Curtis) (describing REITs as ‘‘pooling arrangements whereby small investors can secure advantages normally available only to those with larger resources’’). 191 See, e.g., H.R. Rep. No. 86-2020, pt. II, at 821 (1960) (one reason for the exemption of REITs from taxation in the 1960 bill was to alleviate a shortage of private investment in real estate and mortgages). 192 This report does not address every potential policy effect of the REIT regime. For a more critical look at the policy effects of REITs, see Sullivan, ‘‘The Economic Inefficiency of REIT Conversions,’’ Tax Notes, Sept. 15, 2014, p. 1229.

vidual investors.193 Over the past 20 years, U.S. REITs listed in the principal REIT stock index194 have outperformed the S&P 500 index by approximately 12 percent.195 Newer types of REITs appear to provide similarly positive returns.196 A key driver of this performance is the requirement that REITs pay out most of their earnings as dividends. In 2014 the NAREIT All-Equity REIT Index posted an approximately 28 percent total return197 — that is, dividends plus ‘‘price return,’’ with an average dividend yield of approximately 3.55 percent.198 With the one-year Treasury yield curve rate at 0.27 percent (as of March 17, 2015),199 this strong performance makes REITs an attractive option.200

193 See letter from Steven A. Wechsler, NAREIT president and CEO, to then-House Ways and Means Committee Chair Dave Camp and committee ranking minority member Sander M. Levin, D-Mich. (Apr. 15, 2013). 194 This is the FTSE NAREIT US Real Estate Index Series. See generally FTSE NAREIT US Real Estate Indices, available at http://www.ftse.com/products/indices/NAREIT. 195 See NAREIT, ‘‘2013 Total Return Proxy Data’’ (table on file with authors) (showing total return of 583.52 percent for S&P 500, and 653.97 percent for All-REITs Index). This figure, in fact, is closer to 22 percent if mortgage REITs are excluded. See id. (showing return from Dec. 1993 to Dec. 2013 of 583.52 percent for the S&P 500 and 712.85 percent for All-Equity REITs Index). For purposes of inclusion in the FTSE NAREIT indexes, an equity REIT is any tax-qualified REIT that holds more than 50 percent of its total assets in qualifying real estate assets other than mortgages secured by real property (see ‘‘All Equity REITs,’’ REIT.com), while a mortgage REIT is any tax-qualified REIT that holds more than 50 percent of its total assets invested in mortgages and interests in mortgage pools (see ‘‘Mortgage REITs,’’ REIT.com). 196 Many nontraditional REITs have been added to the FTSE NAREIT index only recently. For example, using 2011 as a base and cumulating the annual returns reported for various REIT sectors, the infrastructure category, which includes nontraditional REITs American Tower and Crown Castle International, has realized a total return of approximately 64 percent, Timber approximately 60 percent, and Diversified, which includes a variety of traditional and nontraditional REITs, 49 percent. See ‘‘Annual Price and Total Returns by Property Sector, 1994-2014,’’ REIT.com. For comparison, over the same period, the retail category realized a return of approximately 65 percent, industrial/office approximately 57 percent, and residential approximately 42 percent. See id. The constituent companies of the FTSE NAREIT All-Equity Index are available at https:// www.reit.com/sites/default/files/returns/FNUSIC2014.pdf. 197 See ‘‘Monthly Index Values and Returns,’’ REIT.com (comparing index value of 11,128.83 for Dec. 2013 with value of 14,247.97 for Dec. 2014). 198 See id. (taking average of dividend yields from each month of 2014). 199 See Treasury, ‘‘Daily Treasury Yield Curve Rates,’’ available at http://www.treasury.gov/resource-center/data-chart-center /interest-rates/Pages/TextView.aspx?data=yield. 200 See, e.g., Matt Jarzemsky, ‘‘Dividend-Paying Stocks Fit the Bill — Utilities and REITs Are Among Those Beating Major Indexes,’’ The Wall Street Journal, July 8, 2014, at C1. The Federal Reserve has indicated that it intends to normalize rates in the future, though only slowly and contingent on further economic

(Footnote continued on next page.)

TAX NOTES, March 23, 2015

1533

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

tax, including some that suggest allowing corporations some variant of a dividends paid deduction.187 Most recently, a report prepared by the Republican staff of the Senate Finance Committee urged the adoption of a corporate integration system and described the possibility of achieving that integration in part through a dividends paid deduction mechanism.188 Thus, the system under criticism in one context (that is, the REIT system with a corporate dividends paid deduction) is proposed as a potential candidate for broader adoption in another.189

COMMENTARY / SPECIAL REPORT

improvement. See, e.g., Jeff Kearns and Christopher Condon, ‘‘Yellen Doesn’t See Fed Raising Interest Rates Before April,’’ Bloomberg (Dec. 17, 2014). 201 See REIT Handbook, supra note 4, at section 1.1, 10 (‘‘REITs have helped turn real estate liquid’’). 202 See also ‘‘Hearings Before the Committee on Ways and Means, House of Representatives: U.S. Economy, and Proposals to Provide Middle-Income Tax Relief, Tax Equity and Fairness, Economic Stimulus and Growth,’’ 102d Cong. 1081 (1992) (statement of Rep. James P. Moran) (urging adoption of bill allowing greater investment in REITs because ‘‘There is no question — we have the empirical evidence that since World War II it is real estate that has been the prime factor in the recovery from seven recessions. Today, that is not going to happen because of the factors that I mentioned, and that is why I think we have a different situation facing us than at any time in this Nation’s postwar history, and this committee is going to have to make the changes that will be necessary to bring back real estate and to restore this economy and ultimately to restore the American people’s sense of security about their life and the future of their children.’’). 203 See ‘‘REITs and Conversions,’’ REIT.com. 204 See generally SEC, ‘‘Report on Review of Disclosure Requirements in Regulation S-K’’ (2013) (describing disclosure requirements for public companies). 205 See Frank Packer, Timothy Riddiough, and Jimmy Shek, ‘‘Can Securitization Work? Lessons From the U.S. REIT Market’’ (2013). 206 To the extent a particular type of real property is held primarily by corporations engaged in non-real-estate businesses, it may be more difficult for the market to access information regarding those assets. Thus, when nontraditional REITs begin to hold assets not previously held by REITs, they may address a particular dearth of information in the market about those types of assets.

setting, including the misalignment of incentives between corporate management and shareholders.207 b. Benefits to REIT spinoff companies. REIT conversion, of course, is beneficial to the converting entity from a tax perspective. However, REIT spinoff participants in particular may realize several material nontax benefits from this type of separation,208 which are worth considering in cataloging the overall benefits provided by REIT conversions. They include increased efficiency and market recognition from separating into pure-play companies, unlocking the value of the combined company’s real estate assets, and other market benefits.209 Creating pure-play companies may offer several advantages.210 Ideally, a separation can sharpen the focus of each company’s management on the business with which each is most familiar,211 and the

207

See, e.g., Arlen and Weiss, supra note 185, at 348 (arguing that the two-tier tax system, by increasing cost of distributions to shareholders, provides justification for some corporate managers who ‘‘want to pursue suboptimal investment policies’’). 208 Indeed, some companies engage in taxable REIT spinoffs. See supra note 9. 209 The nontax benefits of REIT spinoffs are also relevant in substantiating the section 355 business purpose for a distribution of SpinCo’s stock. See infra Section III.B.1. 210 Several of the companies that have engaged in REIT spinoffs have made this point explicitly in filings. See, e.g., CareTrust REIT Inc., General Form for Registration of Securities (Form 10 Amendment 5), at 3 (May 13, 2014) (‘‘Ensign expects to realize benefits from being a ‘pure play’ healthcare operator’’); Communications Sales & Leasing Inc., General Form for Registration of Securities (Form 10), at 35 (Oct. 24, 2014) (‘‘Sellers will be able to receive acquisition consideration in the form of equity in a pure play entity like CS&L with a geographically diverse asset portfolio, and this consideration is likely to be a preferred form of equity to sellers of real estate, as compared with an investment in a specialized telecommunications carrier like Windstream.’’). 211 Several available private rulings for REIT spinoffs have cited increased focus on core business as a corporate business purpose for the distribution. See LTR 201433007 (believed to be issued to Ensign); LTR 201411002 (believed to be issued to CBS). While REIT spinoffs that include an OpCo-PropCo lease may limit the REIT’s options to a degree, even in those cases the REIT can obtain new properties and lease them to third parties. Moreover, the public filings for these transactions reflect that intention. For instance, GLPI indicated that its business plan was to acquire new gaming properties and lease them to third parties. See Gaming and Leisure Properties Inc., Annual Report (Form 10-K), at 56 (Mar. 25, 2014) (‘‘In addition, we expect a majority of our future growth to come from acquisitions of gaming and other properties at reasonable valuations to lease to third parties.’’). GLPI, in fact, acquired at least one such property and then leased it. See id. at 43, 87. On March 9, 2015, GLPI also made an offer to acquire all the casino properties of Pinnacle Entertainment. See Pinnacle Entertainment, Inc., Current Report (Form 8-K), Exhibit 99.1 (Mar. 10, 2015). Similarly, CareTrust REIT recently announced that it had acquired a new (Footnote continued on next page.)

1534

TAX NOTES, March 23, 2015

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

Also, REITs appear to provide a variety of market benefits. REITs likely have played a significant role in increasing investment in real estate and in the liquidity of the real estate market,201 which is an important part of the overall economy.202 NAREIT estimates that REITs help support more than 1 million jobs in the United States.203 Public REITs, which are subject to disclosure requirements, generally allow investors to invest in real estate confident in the accuracy of publicly available information regarding the REIT.204 The existence of an organized REIT industry may allow information about specific real estate markets to circulate more efficiently, preventing gluts and busts. In fact, some have suggested that REITs played this role during the financial crisis and prevented the commercial property market from performing as poorly as the residential housing market.205 Moreover, one might expect this benefit to be more pronounced for properties REITs have not previously held.206 Finally, the requirement that a REIT distribute most of its earnings in dividends may mitigate problems that have been identified in the C corporation

COMMENTARY / SPECIAL REPORT

value may be lost in a combined company that operates a non-real-estate core business: Real estate assets may be discounted relative to book or replacement value,216 and real estate assets managed by a REIT may be valued at a premium by the market.217 A REIT spinoff may capture both of those value elements. Also, a REIT spinoff may increase access to investment for Parent and SpinCo.218 In several REIT spinoffs, the announcement of the separation yielded a quick boost in Parent’s stock price.219 New

skilled nursing facility in Colorado. See release, ‘‘CareTrust REIT Acquires Colorado Skilled Nursing Facility,’’ CareTrust REIT (Feb. 3, 2015). 212 See Ensign Group Inc., Current Report (Form 8-K) (Nov. 7, 2013), Exhibit 99.1 (referring to an intent to ‘‘differentiate as two sector-specific ‘pure play’ companies’’ as one of several changes that investors and analysts might notice positively). The market may value diversified companies less than those that engage solely in a single line of business. This discount on diversified companies has been referred to as the ‘‘diversification discount’’ or ‘‘conglomerate discount.’’ See, e.g., Henri Servaes, ‘‘The Value of Diversification During the Conglomerate Merger Wave,’’ 51 J. Fin. 1201 (1996); Philip G. Berger and Eli Ofek, ‘‘Diversification’s Effect on Firm Value,’’ 37 J. Fin. Econ. 39 (1995). But see Belén Villalonga, ‘‘Diversification Discount or Premium? New Evidence From the Business Information Tracking Series,’’ 59 J. Fin. 479 (2004) (presenting several arguments against the existence of a diversification discount). 213 For instance, since casino operators such as Penn National are heavily regulated, the spinoff of GLPI may free the REIT from some of these restrictions, although GLPI still operates two casinos through a TRS. See Gaming and Leisure Properties Inc., Form for Registration of Securities of Certain Real Estate Companies (Form S-11 Amendment 4), at 7 (Oct. 4, 2013) (citing, as a purpose of the spinoff, to allow GLPI to ‘‘pursue certain transactions that Penn otherwise would be disadvantaged by or precluded from pursuing due to regulatory constraints’’). 214 For instance, Penn National’s CEO stated that the ‘‘proposed transaction . . . presents a direct path toward unlocking the tremendous value of our real estate asset portfolio.’’ Penn National Gaming Inc., ‘‘Penn National Gaming Announces Intent to Pursue the Separation of Its Real Estate Assets From Its Operating Assets’’ (Nov. 16, 2012). Similarly, the Ensign Group’s CEO stated that the Ensign transaction was structured to share ‘‘the tremendous value we have created in our real estate with our partners and shareholders.’’ The Ensign Group Inc., ‘‘The Ensign Group, Inc. Announces REIT Spin-Off; Adopts Stockholder Rights Plan’’ (Nov. 7, 2013). 215 Several studies have suggested that divestitures or other separations of real estate lead to an increased valuation for companies. See Ronald C. Rutherford, ‘‘Empirical Evidence on Shareholder Value and the Sale-Leaseback of Corporate Real Estate,’’ 18 AREUEA J. 522 (1990) (finding significant positive returns for selling companies in the period after the announcement of sale/leaseback of real estate assets); Rutherford and Hugh O. Nourse, ‘‘The Impact of Corporate Real Estate Unit Formation on the Parent Firm’s Value,’’ 3 J. Real Estate Res. 73 (1988) (same, after announcement of the formation of various entities to either hold or invest in real estate); Gailen L. Hite, James E. Owers, and Ronald C. Rogers, ‘‘The Separation of Real Estate Operations by Spin-Off,’’ 12 AREUEA J. 318 (1984) (same, after the announcement of spinoffs of real estate assets). But see John L. Glascock, Wallace N. Davidson, and C.F. Sirmans, ‘‘An

Analysis of the Acquisition and Disposition of Real Estate Assets,’’ 4 J. Real Estate Res. 131 (1989) (finding only weak abnormally positive returns for sellers of real estate). 216 See, e.g., Pershing Square Capital Management, ‘‘A TIP for Target Shareholders,’’ at 12 (2008) (arguing for separation of Target’s real estate assets into a REIT because a comparison of the book and replacement values for the company’s real estate with the company’s market capitalization indicated that the market ‘‘assigns little value to Target’s real estate’’). For a discussion of a possible reason for this discount, sometimes referred to as ‘‘latent value’’ or ‘‘hidden value,’’ see Michael J. Brennan, ‘‘Latent Assets,’’ 45 J. Fin. 709 (1990). 217 See, e.g., John B. Corgel, ‘‘Property-by-Property Valuation of Publicly Traded Real Estate Firms,’’ 14 J. Real Estate Res. 77 (1997) (finding evidence that share prices for two hotel REITs traded at significant premiums to underlying real estate value; summarizing literature that finds many of those premiums and speculating that these premiums are attributable to factors such as influence of management and liquidity premium). 218 See Ensign Group Inc., Current Report (Form 8-K) (Nov. 7, 2013), Exhibit 99.1 (referring, under the heading of ‘‘Investor Transparency and Access to Capital,’’ to ‘‘greater visibility into relative financial and operating performance’’ as one of the benefits of the spinoff). Some research has suggested that spun-off firms may be more attractive to investors because they are more transparent than conglomerate companies. See Michael A. Habib, D. Bruce Johnson, and Narayan Y. Naik, ‘‘Spin-offs and Information,’’ 6 J. Fin. Intermediation 153 (1997); Sudha Krishnaswami and Venkat Subramaniam, ‘‘Information Asymmetry, Valuation, and the Corporate Spin-Off Decision,’’ 53 J. Fin. Econ. 73 (1999). But see Andrei Shleifer and Robert W. Vishny, ‘‘Liquidation Values and Debt Capacity: A Market Equilibrium Approach,’’ 47 J. Fin. 1343 (1992) (arguing that conglomerates are more reliable borrowers because they have the flexibility to sell assets in industries when prices are high and have greater flexibility to sell assets in general). 219 Penn National’s stock price increased approximately 28 percent after the company announced plans for a REIT spinoff. See Penn National Gaming Inc. Price Snapshot, Bloomberg (listing closing stock price as $8.50 on Nov. 15, 2012, and $10.90 on Nov. 16, 2012). Windstream’s stock price increased approximately 12 percent. See Windstream Holdings Inc. Price Snapshot, Bloomberg (listing closing stock price as $10.53 on July 28, 2014, and $11.83 on July 29, 2014). CBS’s stock price increased approximately 8 percent. See CBS Corporation Price Snapshot, Bloomberg (listing closing stock price as $37.94 on Jan. 16, 2013, and $40.95 on Jan. 17, 2013). Ensign’s stock price increased approximately 5 percent. See The Ensign Group Inc. Price Snapshot, Bloomberg(listing closing stock price as $22.71 on Nov. 7, 2013, and $23.80 on Nov. 8, 2013). Bloomberg adjusts its historical pricing information to take account of transactions such as spinoffs, so these share prices may not match those listed in other databases, although the percentage changes

(Footnote continued in next column.)

(Footnote continued on next page.)

TAX NOTES, March 23, 2015

1535

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

market will recognize this benefit.212 If the two businesses have conflicting interests or one is subject to significantly greater regulatory requirements, separation may alleviate those problems.213 While a combined company may appear to lack direction or to be deploying its assets inefficiently, separation may provide the market with more clarity on each company’s strategy. A separation may also unlock the value of the combined company’s real estate assets,214 which the market may implicitly discount.215 Two elements of

COMMENTARY / SPECIAL REPORT

should. See Bloomberg, ‘‘Open Market Data Initiative, BLPAPI: Developer’s Guide,’’ at 116 (2012). 220 See Ensign Group Inc., Current Report (Form 8-K) (Nov. 7, 2013), Exhibit 99.1 (citing an intent to ‘‘appeal to a more focused shareholder base’’ as a purpose for the spinoff); Windstream Holdings Inc., Proxy Statement (Schedule 14A) (Dec. 19, 2014) (explaining decision to engage in reverse stock split as part of REIT spinoff transaction by stating that ‘‘following the Spin-Off, a sustained higher per share price of our Common Stock, which should result from the reclassification, might heighten the interest of the financial community in Windstream Holdings and potentially broaden the pool of investors that may consider investing in Windstream Holdings, possibly increasing the trading volume and liquidity of our Common Stock’’). 221 See Ensign Group Inc., Current Report (Form 8-K) (Nov. 7, 2013), Exhibit 99.1 (citing as one purpose of spinoff an intent to ‘‘attract coverage by additional industry-specific analysts’’). See also Stuart C. Gilson et al., ‘‘Analyst Specialization and Conglomerate Stock Breakups,’’ 39 J. Acct. Res. 565 (2001) (finding increased analyst coverage for companies that engage in spinoffs, equity carveouts, and specific stock offerings).

IN THE WORKS A look ahead at planned commentary and analysis. From behind the tree: Reconciling the Marketplace Fairness Act and origin sourcing (State Tax Notes) John A. Swain discusses the origin-based sourcing plan, proposed as an alternative to the Marketplace Fairness Act, and the problems associated with origin-based sourcing and offers a solution for those who still want to proceed with the plan anyway. Michigan has a Public Law 86-272 problem (State Tax Notes) Amy Hamilton discusses potential Public Law 86-272 challenges to Michigan’s business tax that have arisen as a result of language in the state supreme court’s IBM opinion. Participation is significant — Navigating the net investment income and self-employment taxes (Tax Notes) Mark Berkowitz and Jessica Duran describe NII tax developments that are relevant to the analysis of a partner’s income and to the possibility that a partner or LLC member may be exempt from both the selfemployment tax and the NII tax. Outbound liquidations (Tax Notes) Jasper L. Cummings, Jr., explains the selection of a less-than-30-percent threshold for complete liquidation in a recent letter ruling, and he examines why the taxpayer wanted the outbound liquidation to be viewed as a liquidation rather than a section 355 split-up. Tax disputes and controversies in Hong Kong: Practices and procedures (Tax Notes International) Patrice Marceau provides an in-depth view of tax disputes and controversies in Hong Kong, including how to manage a tax audit, key processes to resolve a tax dispute, and potential penalties incurred. Italy introduces a voluntary disclosure procedure (Tax Notes International) Salvatore Mattia reviews Italy’s new voluntary disclosure procedure, which encourages taxpayers to regularize their position with the Italian tax authorities.

1536

TAX NOTES, March 23, 2015

(C) Tax Analysts 2015. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.

types of investors may be attracted to the stock of either Parent or SpinCo as a result of the spinoff.220 Further, companies that separate business units may receive more coverage from financial analysts, which may generate greater investor interest overall.221