2015 Tax Extenders and More: Part II – A Financial Services-Securities and Business Perspective
We recently issued an Alert providing tax highlights of the Omnibus Appropriations Act, 2016 (the “Act”), which includes the “Protecting Americans from Tax Hikes Act of 2015” (“PATH”). This legislation was enacted on December 18, 2015 (“date of enactment”). In this second overview Alert, we bring to your attention a number of provisions that may be of interest to the financial services/securities and business communities not covered in our initial alert.
- Extension of treatment of certain dividends of regulated investment companies (“RICs”). Under a temporary provision of prior law that had expired for tax years of a RIC beginning after December 31, 2014, a RIC that earned certain interest income that generally would not be subject to U.S. tax if earned by a foreign person directly could, to the extent of such net interest income, designate dividends it paid as derived from such interest income for purposes of the treatment of a foreign RIC shareholder. As a result, such dividends were not subject to gross-basis U.S. tax. In addition, subject to certain requirements, the RIC was exempt from withholding the gross-basis tax on such dividends. Similar rules applied with respect to the designation of certain short-term capital gain dividends. PATH reinstates and makes permanent these rules, effective for dividends paid with respect to any tax year of a RIC beginning after December 31, 2014.
- Extension of basis adjustment to stock of S corporations making charitable contributions of property. This is a second provision of particular significance to the S corporation community. See our discussion of the “Extension of reduction in S corporation recognition period for built-in gains” in our initial Alert. If an S corporation contributes money or other property to a charity, each shareholder takes into account the shareholder’s pro rata share of the contribution in determining its own income tax liability. A shareholder of an S corporation reduces the basis in the stock of the S corporation by the amount of the charitable contribution flowing through to the shareholder. In the case of charitable contributions made in tax years beginning before January 1, 2015, the amount of a shareholder’s basis reduction in the stock of an S corporation by reason of a charitable contribution made by the corporation was equal to the shareholder’s pro rata share of the S corporation’s adjusted basis in the contributed property. For contributions made in tax years beginning after December 31, 2014, the amount of the reduction was the shareholder’s pro rata share of the fair market value of the contributed property. PATH makes permanent the pre-2015 rule requiring reduction by the S corporation’s adjusted basis and not fair market value, effective for charitable contributions made in taxable years beginning after December 31, 2014.
- Extension of RIC qualified investment entity treatment under FIRPTA. PATH permanently extends the treatment of RICs as qualified investment entities and, accordingly, not subject to withholding tax under the Foreign Investment in Real Property Tax Act (“FIRPTA”).
- Extension of 15-year straight line cost recovery for qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail improvements. PATH permanently extends the 15-year recovery period for qualified leasehold improvements, qualified restaurant property, and qualified retail improvement property.
- Tax-free spinoffs involving REITs. As noted in our initial Alert, PATH specifically addresses a variety of technical and policy considerations of real estate investment trusts (“REITs”). Of particular note is a provision that deals with tax-free spinoffs involving REITs. This provision provides that a spinoff involving a REIT will qualify as tax-free only if immediately after the distribution both the distributing and the controlled corporation are REITs. Neither a distributing nor a controlled corporation is permitted to elect to be treated as a REIT for 10 years following a tax-free spinoff. This provision applies to distributions on or after December 7, 2015, but will not apply to any distribution pursuant to a transaction described in a ruling request initially submitted to the IRS on or before that date, which request has not been withdrawn and with respect to which a ruling has not been issued or denied in its entirety as of such date. (Thus, a number of transactions that have been announced but not completed will be grandfathered.)
- Reduction in percentage limitation on assets of a REIT which may be taxable REIT subsidiaries. PATH modifies the rules with respect to a REIT’s ownership of a taxable REIT subsidiary (“TRS”), which is taxed as a corporation. Effective for tax years beginning after December 31, 2017, the securities of one or more TRSs held by a REIT may not represent more than 20% (rather than 25% under pre-PATH law) of the value of the REIT’s assets.
- Prohibited transaction safe harbors. REITs are subject to a prohibited transaction tax of 100% of the net income derived from “prohibited transactions.” Subject to specified safe harbors, a prohibited transaction is a sale or other disposition of property by the REIT that is “stock in trade of a taxpayer or other property which would be properly included in the inventory of the taxpayer if on hand at the close of the tax year, or property held for sale to customers by the taxpayer in the ordinary course of his trade or business” and is not foreclosure property. PATH provides for an alternative 3-year averaging safe harbor for determining the percentage of assets that a REIT may sell annually and not be subject to the prohibited transaction tax. The provision also clarifies that the determination of whether the property is inventory is made without regard to whether or not it qualifies for the safe harbor from the prohibited transaction tax. The provision is generally effective for tax years beginning after the date of enactment. However, the clarification of the safe harbor takes effect as if included in the Housing Assistance Tax Act of 2008.
- Repeal of preferential dividend rule for publicly offered REITs. A REIT is allowed a deduction for dividends paid to its shareholders that are not “preferential dividends.” A dividend is preferential unless it is distributed pro rata to shareholders, with no preference to any share of stock as compared with other shares of the same class, and with no preference to one class as compared with another except to the extent the class is entitled to a preference. PATH repeals the preferential dividend rule in the case of publicly offered REITs, effective for distributions in tax years beginning after December 31, 2014. A REIT is publicly offered if it is required to file annual and periodic reports with the SEC under the Securities Exchange Act of 1934.
- Authority for alternative remedies to address certain REIT distribution failures. PATH provides the IRS with authority to provide an “appropriate remedy” for a preferential dividend distribution by non-publicly offered REITs in lieu of treating the dividend as not qualifying for the REIT dividend deduction and not counting toward satisfying the requirement that REITs distribute 90% of their income each year. That authority applies if the preferential dividend is inadvertent or due to reasonable cause and not due to willful neglect. This provision applies to distributions made in tax years beginning after December 31, 2015.
- Limitations on designation of dividends by REITs. Under PATH, the aggregate amount of dividends that can be designated by a REIT as qualified dividends or capital gain dividends cannot exceed the dividends actually paid by the REIT (including dividends paid after the end of the REIT tax year but treated under the Internal Revenue Code as paid by the REIT with respect to the tax year). This provision applies to distributions in tax years beginning after December 31, 2015.
- Debt instruments of publicly offered REITs and mortgages treated as real estate assets. The REIT qualification rules require, in part, that at least 75% of the value of a REIT’s assets must be real estate assets, cash and cash items and government securities (the “75% asset test”). At least 75% of a REIT’s gross income must be from certain real estate related and other items (the “75% income test”), and at least 95% of a REIT’s gross income must be from specified sources that include the 75% income items and also interest, dividends, and gain from the sale or other disposition of securities (whether or not real estate related) (the “95% income test”). PATH provides that debt instruments issued by publicly offered REITs, as well as interests in mortgages on interests in real property, are treated as real estate assets for purposes of the 75% asset test. Income from debt instruments issued by publicly offered REITs are treated as qualified income for purposes of the 95% income test, but not the 75% income test (unless they already are treated as qualified under pre-PATH law). Also, not more than 25% of the value of a REIT’s total assets is permitted to consist of such debt instruments. This provision is effective for tax years beginning after December 31, 2015.
- Asset and income test clarification regarding ancillary personal property. PATH provides that certain ancillary personal property that is leased with real property is treated as real property for purposes of the 75% asset test. Also, an obligation secured by a mortgage on such property is treated as real property for purposes of the 75% income and asset tests, provided that the fair market value of the personal property does not exceed 15% of the total fair market value of the combined real and personal property. This provision is effective for tax years beginning after December 31, 2015.
- Hedging provisions. Under pre-PATH law, except as provided by Treasury regulations, income from certain clearly identified REIT hedging transactions, including gain from the sale or disposition of such a transaction, is not included as gross income under either the 95% income or 75% income tests noted above. Transactions eligible for this exclusion include (i) transactions that hedge indebtedness incurred or to be incurred by the REIT to acquire or carry real estate assets and (ii) transactions entered into primarily to manage risk of currency fluctuation relating to any item that qualifies for the 95% income or 75% income test (both (i) and (ii) a “qualifying hedge”). PATH expands the treatment of REIT hedges to include income from hedges of previously acquired qualifying hedges that a REIT entered to manage risk associated with liabilities or property that have been extinguished or disposed (in whole or in part). This provision is effective for tax years beginning after December 31, 2015.
- Modification of REIT earnings and profits calculation to avoid duplicate taxation. PATH provides that current (but not accumulated) REIT earnings and profits for any tax year are not reduced by any amount that is not allowable as a deduction in computing taxable income for the tax year and was not allowable in computing its taxable income for any prior tax year. The provision applies only for purposes of determining whether REIT shareholders are taxed as receiving a REIT dividend or as receiving a return of capital (or capital gain if a distribution exceeds a shareholder’s stock basis). The provision is effective for tax years beginning after December 31, 2015.
- Treatment of certain services provided by taxable REIT subsidiaries. As a result of PATH, a TRS is permitted to provide certain services to the REIT, such as marketing, that is typically done by a third party. A TRS is permitted to develop and market REIT real property without subjecting the REIT to the 100% prohibited transactions tax. The provision also expands the 100% excise tax on non-arm’s length transactions to include services provided by the TRS to its parent REIT. This provision is effective for tax years beginning after December 31, 2015.
- Exception from FIRPTA for certain stock of REITs. PATH increases from 5% to 10% the maximum stock ownership a shareholder may have held in a publicly traded corporation to avoid having that stock treated as a U.S. real property interest on disposition. In addition, the provision allows certain publicly traded entities to own and dispose of any amount of stock treated as a “United States real property interest” (“USRPI”), including stock in a REIT, without triggering FIRPTA withholding. However, an investor in such an entity that holds more than 10% of such stock is still subject to withholding. This provision applies to dispositions and distributions on or after the date of enactment.
- Interests in RICs and REITs not excluded from definition of United States real property interests. Under pre-PATH law, an interest in a corporation is not a USRPI if (1) as of the date of disposition of such interest, such corporation did not hold any USRPIs, and (2) all the USRPIs held by such corporation during the shorter of (i) the period of time after June 18, 1980, during which the taxpayer held such interest, or (ii) the 5-year period ending on the date of disposition of such interest, were either disposed of in transactions in which the full amount of the gain (if any) was recognized, or ceased to be USRPIs by reason of the application of this rule to one or more other corporations (the so-called “cleansing rule”). PATH provides that the cleansing rule applies to stock of a corporation only if neither such corporation nor any predecessor of such corporation was a RIC or REIT at any time during the shorter of the periods described in “(i)” and “(ii)” above. This provision applies to dispositions on or after the date of enactment.
- Dividends derived from RICS and REITs ineligible for deduction for United States source portion of dividends from certain foreign corporations. Under pre-PATH law, dividends received by a corporation from a foreign corporation are generally not eligible for the corporate dividends received deduction. However, if a U.S. corporation is a 10% or greater shareholder of a foreign corporation, the U.S. corporation is generally entitled to a dividends received deduction for the portion of dividends received that are attributable to the post-1986 undistributed U.S. earnings of the foreign corporation. PATH provides that for purposes of determining whether dividends from a foreign corporation (attributable to dividends from an 80% owned domestic corporation) are eligible for a dividends received deduction, dividends received by the foreign corporation from RICs and REITs are not treated as dividends from domestic corporations. This provision applies to dividends received from RICs and REITs on or after the date of enactment. Further, PATH specifically states that no inference is intended with respect to the proper treatment of dividends received from RICs or REITs before the date of enactment under the rules governing the dividends received deduction in connection with dividends received from certain foreign corporations.