The Impact of the American Jobs Creation Act of 2004 on RICs and REITs

On Friday, October 22, 2004, the President signed the American Jobs Creation Act of 2004 (the "Act") into law. The Act includes a number of provisions concerning regulated investment companies ("RICs"), real estate investment trusts ("REITs") and their respective shareholders. The following is a summary of certain relevant changes.

Tax Changes for RICs and RIC Shareholders

Treatment of Certain RIC Distributions

The Act amends Sections 871 and 881 of the Internal Revenue Code (the "Code") to include new subsections which generally would exempt from federal income tax withholding "interest-related dividends" and "short-term capital gain dividends" paid by a RIC to foreign shareholders.

Interest-Related Dividends. For taxable years beginning on or after January 1, 2005, distributions paid to a foreign shareholder and designated by a RIC as "interest-related dividends" attributable to the RIC’s net interest income earned on typical debt instruments generally will be exempt from federal income taxation. An interest-related dividend is any dividend which is designated by the RIC as an interest-related dividend in a written notice mailed to its shareholders not later than 60 days after the close of its taxable year.

Short-Term Capital Gain Dividends. For taxable years beginning on or after January 1, 2005, the Act also generally exempts from federal income taxation any "short-term capital gain dividends" attributable to the RIC’s net short-term capital gain paid to a foreign shareholder. A short-term capital gain dividend is any dividend which is designated by the RIC as a short-term capital gain dividend in a written notice mailed to its shareholders not later than 60 days after the close of its taxable year.

U.S. Real Property Interests ("USRPIs")

For taxable years beginning on or after January 1, 2005, to the extent a foreign shareholder’s capital gains realized on the disposition of RIC shares, short-term capital gain dividends and capital gain distributions are attributable to gain from the sale or exchange of a USRPI, such gains or distributions will be subject to U.S. federal income tax withholding. Such gains or distributions may also be subject to U.S. federal income tax reporting and taxation as gain effectively connected the conduct of a U.S. trade or business. The term USRPI does not include any interest in a "domestically-controlled" RIC, which is a RIC in which less than 50% in value of the stock is held directly or indirectly by foreign persons.

Estate Tax Treatment

For estates of decedents dying on or after December 31, 2004, if the decedent is a resident of a foreign country but is not a citizen or resident of the United States at the time of the decedent’s death, shares of a RIC held by the decedent will not be deemed property situated in the United States to the extent that, at the end of the quarter of the RIC’s taxable year immediately preceding the decedent’s date of death, the assets of the RIC were "qualifying assets" (i.e., assets exempt from the estate tax if held directly by the decedent).

Sunset of Laws

If Congress does not extend the foregoing changes in law, the changes will not apply to tax years beginning on or after January 1, 2008.

Qualified Publicly Traded Partnerships

Generally beginning in 2005, added to the list of sources from which a RIC must derive at least 90% of its annual gross income will be net income derived from, and gains from the sale or other disposition of, an interest in a "qualified publicly traded partnership." A "qualified publicly traded partnership" is a publicly traded partnership but does not include a partnership if 90% or more of its gross income consists of income meeting the RIC income test under Section 851(b)(2). Additionally, the Act amends the RIC asset test under Section 851(b)(3) so that, generally beginning in 2005, not more than 25% of the value of a RIC’s total assets may consist of the securities of any one issuer (other than cash and cash items (including receivables), government securities and securities of other regulated investment companies), in two or more issuers the RIC controls and which are engaged in the same or similar trades or businesses, or in one or more qualified publicly traded partnerships.

The Act also provides that the special rule for publicly traded partnerships under the passive loss rules of Section 469 of the Code (requiring separate treatment) applies to a RIC holding an interest in a qualified publicly traded partnership, with respect to items attributable to such interest.

Translation of Foreign Taxes

For taxable years beginning on or after January 1, 2005, RICs generally are required to translate foreign taxes into U.S. dollars using the exchange rate as of the date the income accrues.

Modification of Straddle Rules

Generally beginning in 2005, the Act makes several changes to the rules governing straddles. First, taxpayers generally are permitted to identify the offsetting positions that are components of a straddle at the time the taxpayer enters into a transaction that creates a straddle, including an unbalanced straddle. If there is a loss with respect to any identified position that is part of an identified straddle, the basis of each of the identified positions that offset the loss position in the identified straddle is increased by an amount that bears the same ratio to the loss as the unrecognized gain (if any) with respect to such offsetting position bears to the aggregate unrecognized gain with respect to all positions that offset the loss position in the identified straddle.

Second, the Act clarifies that the existing straddle loss deferral rules treat as a two-step transaction the physical settlement of a straddle position that, if terminated, would result in the realization of a loss. The taxpayer is treated as terminating the position for its fair market value immediately before the settlement, and selling at fair market value the property used to physically settle the position.

Third, the Act eliminates the exception from the straddle rules for stock (other than the exception relating to qualified covered call options). Thus, offsetting positions comprised of actively traded stock and a position with respect to substantially similar or related property generally constitute a straddle. The Act also amends Section 246(c) of the Code so that the holding period for the dividends-received deduction, as well as qualified dividend income, does not include any time during which the shareholder is protected from the risk of loss otherwise inherent in the ownership of any equity interest if the shareholder obtains such protection by writing an in-the-money call option on the dividend-paying stock.

Minimum Holding Period for Foreign Tax Credit on Withholding Taxes on Income Other Than Dividends

Generally beginning in 2005, the Act expands the provision regarding disallowance of foreign tax credits to include credits for gross-basis foreign withholding taxes with respect to any item of income or gain from property if the taxpayer who receives the income or gain has not held the property for more than 15 days during the 31 day period that begins 15 days before the date on which the right to receive the payment arises. In addition, no credit will be allowed to the extent that a taxpayer is obligated to make related payments with respect to positions in substantially similar or related property.

Tax Changes for REITs and REIT Shareholders

REIT Qualification

10% Asset Test. Among other REIT qualification requirements, at the close of each quarter of the taxable year, except for securities that are real estate assets, government securities and securities of taxable REIT subsidiaries ("TRSs"), a REIT’s investment in the securities of one issuer cannot exceed 10% of the total value of the outstanding securities of that issuer (the "10% asset test"). Prior law provides a "straight debt" exception in which securities of an issuer are not taken into account in applying the 10% asset test if: (i) the issuer is an individual; (ii) the only securities of such issuer which are held by the REIT or a TRS of the REIT are straight debt (as so defined); or (iii) the issuer is a partnership and the REIT holds at least a 20% profits interest in the partnership.

Under the Act, retroactively for taxable years beginning after December 31, 2000, except as provided in regulations, straight debt and the following other types of securities are not considered "securities" for purposes of the 10% asset test:

  • any loan to an individual or estate,
  • certain rental agreements,
  • any obligation to pay rents from real property,
  • any security issued by a State or any political subdivision thereof, the District of Columbia, a foreign government or any political subdivision thereof, or the Commonwealth of Puerto Rico, but only if the determination of any payment received or accrued under such security does not depend in whole or in part on the profits of any entity not described in this category or payments on any obligation issued by such an entity,
  • any security issued by a REIT, and
  • any other arrangement as identified by the IRS.

In addition, for purposes of the 10% asset test, the definition of "straight debt" is modified to provide more flexibility than existed under the prior rules. As under present law, "straight debt" is still defined by reference to Section 1361(c)(5) of the Code, but the Act provides special rules to permit certain contingencies under the straight debt exception. Any interest or principal will not be treated as failing to satisfy Section 1361(c)(5)(B)(i) of the Code, which disallows certain contingent payments, solely by reason of the fact that the time of payment of such interest or principal is subject to a contingency, but only if: (i) any such contingency does not have the effect of changing the "effective yield to maturity," other than a change in the annual yield to maturity which does not exceed the greater of 1/4 of 1% or 5% of the annual yield to maturity; or (ii) neither the aggregate issue price nor the aggregate face amount of the debt instruments held by the REIT exceeds $1,000,000 and not more than 12 months of unaccrued interest can be required to be prepaid thereunder. Also, the time or amount of any payment is permitted to be subject to a contingency upon a default or the exercise of a prepayment right by the issuer of the debt, provided that such contingency is consistent with customary commercial practice.

For purposes of the 10% asset test, the Act also eliminates the rule requiring a REIT to own a 20% equity interest in a partnership (if it owns any interest in the partnership) in order for the debt to qualify as "straight debt," providing instead new "look-through" rules for determining a REIT partner’s share of partnership securities. A REIT’s interest as a partner in a partnership will not be considered a security and the REIT shall be deemed to own its proportionate share of each asset of the partnership. The REIT’s interest in partnership assets will be the REIT’s proportionate interest in any securities issued by the partnership and the value of any debt instrument shall be the "adjusted issue price" thereof (as defined in Section 1272(a)(4) of the Code). Any debt instrument issued by a partnership also will not be considered a security to the extent of the REIT’s interest as a partner in the partnership or if at least 75% of the partnership’s gross income is derived from sources which satisfy the 75% gross income test of Section 856(c)(3) of the Code.

Finally, securities of certain corporate or partnership issuers that otherwise would be permitted to be held without limitation under the straight debt rules will not be so permitted if the REIT holding such securities, and any of its TRSs, holds any securities of the issuer which are not permitted securities and have an aggregate value greater than 1% of the issuer’s outstanding securities, without regard to the new look-through rules for partnerships.

Failure to Satisfy Asset Tests. Beginning in 2005, if a REIT fails to satisfy any 5% or 10% asset test for a particular quarter, it will not lose its REIT status if the failure is due to the ownership of assets the total value of which does not exceed the lesser of (i) 1% of the total value of its assets at the end of the quarter for which such measurement is done or (ii) $10,000,000; provided in either case that the REIT either disposes of the assets within 6 months after the last day of the quarter in which it identifies the failure (or such other time period prescribed by the Treasury), or otherwise meets the requirements of those rules by the end of such time period.

In addition, if a REIT fails to meet any asset test for a particular quarter and the failure exceeds the de minimis threshold described above, the REIT still will be deemed to have satisfied the requirements if: (i) following its identification of the failure, the REIT files a schedule with a description of each asset that caused the failure; (ii) the failure was due to reasonable cause and not to willful neglect; (iii) the REIT disposes of the assets within 6 months after the last day of the quarter in which the identification occurred (or such other time period prescribed by the Treasury) or the requirements of the rules are otherwise met within such period; and (iv) the REIT pays a tax on the failure which is the greater of $50,000 or an amount determined by multiplying the highest rate of tax for corporations, under Section 11 of the Code, by the net income generated by the assets for the period beginning on the first date of the failure and ending on the date the REIT has disposed of the assets or otherwise satisfy the requirements. Such tax will be treated as an excise tax. Note that to use this exception, the Act appears to require the REIT to have violated the relevant asset test by more than the de minimis threshold, and the that de minimis exception described above only applies to the 5% and 10% asset tests.

Gross Income Tests. Beginning in 2005, the rules governing the tax treatment of hedging instruments generally are conformed to the rules included in Section 1221 of the Code. To the extent a transaction hedges any indebtedness incurred or to be incurred to acquire or carry "real estate assets," any income or gain from the disposition income from a hedging transaction will not constitute qualifying income for purposes of the 95% gross income test. The Treasury may provide exceptions to this rule pursuant to future regulations.

Moreover, even if a REIT fails to satisfy one or both of the 75% or 95% tests for any taxable year, it may still qualify as a REIT for such year if: (1) the REIT’s failure to comply was due to reasonable cause and not to willful neglect; and (2) following the REIT’s identification of the failure, a description of each item of its gross income included in the 75% and 95% tests is set forth in a schedule for such taxable year.

The Act also amends the tax liability owed by the REIT when it fails to meet the 95% gross income test by applying a taxable fraction based on 95%, rather than 90% of the REIT’s gross income.

New Penalty. Beginning in 2005, if a REIT fails to satisfy one or more requirements for REIT qualification, other than the gross income tests and asset tests, it may retain its REIT qualification if the failures are due to reasonable cause and not willful neglect, and if the REIT pays a penalty of $50,000 for each such failure.

USPRIs

Beginning in 2005, any distribution made by a REIT to a foreign shareholder to the extent attributable to gain from sales or exchanges of a USRPI, with respect to any class of stock which is regularly traded on an established securities market located in the United States, shall not be treated as gain recognized from the sale or exchange of a USRPI if the shareholder did not own more than 5% of such class of stock at any time during the taxable year. The distribution will be treated as an ordinary dividend to that investor, taxed as an ordinary dividend that is not a capital gain. A foreign shareholder no longer will be required to file a U.S. federal income tax return by reason of receiving such a distribution, and the branch profits tax no longer applies to such a distribution. However, the distribution will be subject to U.S. federal income tax withholding as an ordinary dividend from a REIT.

New Testing Dates for Rent Comparability

Retroactively for taxable years after December 31, 2000, the Act provides specific testing dates for the safe harbor rules regarding whether 90% of a REIT property is rented to unrelated persons and whether the rents paid by related persons are substantially comparable to unrelated party rents. The testing dates are: (i) at the time the lease is entered into; (ii) at the time of each extension of the lease, including a failure to exercise a right to terminate; and (iii) at the time of any modification of the lease between the REIT and the TRS if the rent under such lease is effectively increased pursuant to such modification. These testing rules are provided solely for purposes of the special provision permitting rents received from a TRS to be treated as qualified rental income for purposes of the income tests.

Customary Services Exception

Beginning in 2005, the Act eliminates the safe harbor under Section 857(b)(7)(B)(ii) allowing rents received by a REIT to be exempt from the 100% excise tax if the rents are for customary services performed by the TRS or are from a TRS and are described in Section 512(b)(3) of the Code. Instead, such payments are free of the excise tax if they satisfy the existing safe harbor that applies if the REIT pays the TRS at least 150% of the cost to the TRS of providing any services.

Expansion of Deficiency Dividend Procedure

Generally beginning in 2005, the Act amends Section 860(e) of the Code to permit both RICs and REITs to pay a deficiency dividend when the RIC or REIT determines that it has underdistributed its income for a prior year. Thus, the deduction for deficiency dividends no longer requires the decision of a court, a closing agreement, or an agreement signed by the IRS.

Provisions Relating to Tax Shelters

Generally beginning in 2005, the Act imposes a penalty of $50,000 for failing to disclose a reportable transaction, other than a listed transaction, and $200,000 for failure to disclose a listed transaction ($10,000 and $100,000, respectively, in the case of a natural person). The IRS has no authority to rescind the penalty for failure to disclose a listed transaction but may rescind penalties for failure to disclose other reportable transactions under certain circumstances.

The Act also creates a new penalty on any "reportable transaction understatement." This penalty applies to any listed transaction and any other reportable transaction if a significant purpose of the transaction is the avoidance or evasion of federal income tax. The penalty is equal to 20% of the understatement if the transaction is disclosed and 30% if not disclosed. There is a strengthened reasonable cause exception to this penalty.

As under prior law, RICs generally are not required to disclose a reportable transaction unless it is a listed transaction.

Partnership Provisions

For any distributions or transfers after the date of enactment of the Act, the Act generally provides that the basis adjustment rules under Section 743 of the Code are mandatory, rather than elective, in the case of the transfer of a partnership interest with respect to which there is a "substantial built-in loss." For this purposes, a substantial built-in loss exists if the partnership’s adjusted basis in its property exceeds by more than $250,000 the fair market value of the partnership property. An alternative basis adjustment rule is provided for "electing investment partnerships." However, it is not expected that "operating partnerships" of REITs and "master portfolios" of RICs ordinarily will qualify for this election.

The Act also provides that a basis adjustment under Section 734 of the Code is required in the case of a distribution with respect to which there is a "substantial basis reduction." A substantial basis reduction means a downward adjustment of more than $250,000 that would be made to the basis of partnership assets if a Section 754 election were in effect.

Other Provisions

In addition to the changes summarized above, below are highlights of other Act provisions which may be applicable:

  • Except as provided by a special transition period rule, for taxable years beginning on or after January 1, 2005, the Act repeals Sections 860H through 860L of the Code, relating to financial asset securitization trusts (FASITs).
  • Generally beginning in 2005, a taxpayer will be allowed to elect to deduct up to $5,000 of start-up and $5,000 of organizational expenditures in the taxable year in which the trade or business begins. However, each $5,000 amount is reduced (but not below zero) by the amount by which the cumulative cost of start-up or organizational expenditures exceeds $50,000, respectively. Start-up and organizational expenditures that are not deductible in the year in which the trade or business begins would be amortized over a 15-year period consistent with the amortization period for Section 197 intangibles.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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