Practical Tax Considerations for REITs and Their Foreign Shareholders

Practical Tax Considerations for REITs and Their Foreign Shareholders

Background

...A REIT is allowed to invest in both U.S. real estate and debt instruments secured by real property. [26 USC § 856(c)(5)(B).] The REIT may earn income classified as dividends, interest, rents, and gain from the disposition of assets. That income, in the hands of the REIT (as, of course, with all of its other shareholders), will be classified as either ordinary income or capital gain income...

A REIT may or may not be treated as a U.S. real property holding corporation ("USRPHC"). That designation turns on the amount of U.S. real estate that the REIT owns. A REIT that does not own the required percentage of U.S. real estate will not be a USRPHC. A debt denominated REIT will very likely not be a USRPHC, for example.

Distributions of Ordinary Income

1. In General. Since a REIT is an entity that would be taxable as a domestic corporation if it were not a REIT [26 USC § 856(a)(3)], then its distributions of operating income are treated as a dividend. A dividend paid by a domestic corporation is U.S. source income and, when paid to a foreign person, is subject to a 30 percent tax withholding rate unless an exemption under U.S. domestic tax law or a U.S. income tax treaty applies. A foreign shareholder who is entitled to a reduced treaty rate should give the REIT a Form W-8 BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding. The REIT may rely on that form (unless, of course, the REIT knows that it is incorrect) and reduce the amount of the withholding as indicated in the form. Most U.S. income tax treaties reduce the amount of withholding on treaties, 15 percent being the most common tax withholding rate. [See 3-50 Rhoades & Langer, U.S. International Taxation and Tax Treaties, §50.03[3], which lists the tax treaty withholding rates for all treaties.]

A REIT need not withhold if the shares of the REIT that are beneficially owned by a foreign shareholder are held in street name by a U.S. financial institution and the dividend is paid to the institution. [Treas. Reg. §1.1441-1(b)(2)(ii).] The withholding obligation then falls on the institution.

2. Consent Dividends. At times, a REIT may not have sufficient cash to meet its annual distribution requirement. To alleviate that problem, REITs are allowed to elect "consent dividend" treatment. [Treas. Reg. §1.561-1(a)(2).] A consent dividend is not an actual distribution, but rather a deemed distribution for tax purposes, followed by a deemed contribution of the same amount back to the REIT by the shareholder. The amount of a consent dividend is considered as distributed in money by the REIT to the foreign shareholder on the last day of the tax year of REIT and as contributed to the capital of the REIT by the foreign shareholder on such day. [
26 USC § 565(c).]...

Distributions of Capital Gain Income

When dealing with capital gain distributions, the Code divides the foreign shareholders of a REIT into two classes and then, once again, divides one of those classes again. First, the Code divides shareholders into those who hold publicly-traded shares and those who hold non-publicly-traded shares. Those that hold shares of a class of stock that is regularly traded are divided into two groups: those shareholders that own more than five percent of the public shares and those that own five percent or less of that class. [26 USC § 897(h).]...

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Branch Profits Tax. In what may seem counterintuitive, a foreign corporation that holds more than five percent of a publicly-traded, domestically-controlled (that is, more than half of the stock is owned by U.S. persons) REIT's stockmay also be subject to the branch profits tax. [Treas. Reg. §1.884-1(d)(2)(xi), Ex. 4.] You may recall that the branch profits tax is a tax imposed on foreign corporations that engage in a U.S. business. The reason that tax applies to the foreign corporate shareholder of the REIT when it receives a capital gain distribution from the REIT is that the income earned from a disposition of a U.S. real property interest is treated as if the foreign corporation were engaged in a U.S. business. [26 USC § 897(a)(1).]

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This publication contains information in summary form, current as of the date of publication, and is intended for general guidance only. It should not be regarded as comprehensive or a substitute for professional advice. Before taking any particular course of action, contact Ernst & Young or another professional advisor to discuss these matters in the context of your particular circumstances. We accept no responsibility for any loss or damage occasioned by your reliance on information contained in this publication.

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LEXIS users can access the complete commentary HERE. Additional fees may apply. (Approx. 6 pages.)

RELATED LINKS: For more information on REITs and the foreign shareholder, see:

For revised requirements under FIRPTA, see:

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