Transfer Pricing in a REIT Context – Why It Matters!
Are you an owner/manager of real estate? Have you thought about operating as a REIT? If so, consideration should be given to ensure that the REIT owners only pay income taxes on the earnings of the REIT. REITs generally provide their owners with a single level of taxation on its taxable income, but there are numerous provisions which not only impose income taxes on the REIT, but also impose a 100% penalty tax on a variety of transactions.
This article will focus on the 100% penalty tax as it relates to transactions between a REIT and a related company and a REIT’s best defense against IRS scrutiny – a transfer pricing study.
Prior to 1999, REITs were primarily passive owners of real estate. In 1999, Congress enacted the taxable REIT subsidiary (“TRS”) provisions to allow REITs to compete with their taxable competitors. As such, any service that is considered non-customary or cutting-edge could be provided by the TRS and not by the REIT. Additionally, REITs were permitted to lease a qualified lodging facility to a TRS provided certain condition are met. In 2008, this was extended to healthcare properties.
Since the REIT and TRS are essentially operating in a captive environment, as the REIT typically owns 100% of the TRS, a REIT is subject to a 100% penalty tax on any amount from its TRS that exceeds what an unrelated party would have paid in an arm’s length transaction. This was designed to prevent a REIT from engaging in tax arbitrage (i.e., non-taxable REIT receives payments from a TRS (for services TRS provides or for rent the TRS pays from property leased from the REIT) which reduces taxable income of the TRS and increases the non-taxable income to the REIT).
Currently, REITs are subject to a 100% penalty tax on redetermined rents, redetermined deductions, excess interest and redetermined TRS service income. The 100% penalty tax is in lieu of any additional corporate income tax faced by the TRS as a result of any distribution, apportionment, or allocation, under IRC Sec. 482, which governs allocation of income and deductions among taxpayers owned or controlled by the same party. IRC Sec. 482 utilizes an arm’s length standard which is met “if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstance.” This standard makes it challenging for REITs to find third parties that transact with each other in same manner that the REIT and TRS transact.
The IRS has developed various methods that allow testing for arm’s length pricing and have the benefit of utilizing information on comparable transactions or pricing. Prudent taxpayers can rely on transfer pricing specialists to perform transfer pricing studies that allow them to establish and support the intercompany pricing between the related parties. A contemporaneous transfer pricing study can be used to defend against an IRS inquiry as to whether the intercompany transactions were priced arm's length.
See below a summary of the Relevant Code Sections and Transfer Pricing Considerations in a REIT context:
1. Relevant Code Sections
IRC Sec. 856
- Lease of lodging/healthcare properties to a TRS.
- Rent based on gross revenues.
- Comparable rent test for qualifying income for certain types of leases.
IRC Sec. 857
- Imposes 100% excise tax on re-determined rents, re-determined deductions, excess interest and re-determined TRS service income.
- A REIT and its TRS can base allocations on "any reasonable method."
IRC Sec. 482
- Applicability of IRC Sec. 482 when 100% excise tax is imposed is a matter of debate.
- Is 100% excise tax the sole recourse available to the IRS?
2. What is REIT Transfer Pricing?
- REITs can only earn rental or interest income as revenues.
- Non-customary services and functions are often performed through TRSs. Further, lodging and certain healthcare REITs almost always lease their properties to a TRS.
- An intercompany transaction between a REIT and TRS necessitates a transfer pricing analysis to avoid 100% PTT under IRC Sec. 857.
- The 100% PTT on re-determined rents, interest, service income and deductions is much higher than 35% tax imposed under IRC Sec. 482.