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Tax Guidance Essentials
White Paper: REIT Foreign Currency Gains
Clinton's Student Loan Plan Is Silent on Tax Implications
IRS EO Lookout List A Thing of the Past, Koskinen Says
Tax Reform Policies of the Presidential Candidates
Dodd-Frank and Oil & Gas Audit Fees
California franchise tax
Criminal Investigation Division
Foreign Account Tax Compliance Act
foreign financial institutions
Foreign Sales Corporations
Hiring Incentives to Restore Employment
I.R.C. § 1362(a)
I.R.C. § 351
IRC Section 1502
IRC Section 338
net investment income
Rev. Rul. 73-234
Rev. Rul. 86-126
tax planning for retirees
Trust Administration and Taxation
Unemployment Insurance Reauthorization
voluntary disclosure of offshore accounts
voluntary disclosure policy
06-03-2008 | 05:14 PM
Gerald W. Paulukonis, J.D.
White Paper: REIT Foreign Currency Gains
REITs are subject to a number of rules to ensure that their primary focus is commercial real estate activity. REITs must meet two gross income tests. First, at least 95 percent of a REIT’s annual gross income must be from specified sources, such as dividends, interest, rents, and other enumerated qualifying passive income sources [IRC § 856(c)(2)]. In addition, at least 75 percent of a REIT’s annual gross income must consist of real property rents, mortgage interest, gain from the sale of real estate assets, and certain other real estate-related sources, with a number of qualifying income items enumerated [IRC § 856(c)(3)].
REITs must also meet several asset diversification tests. At the end of each quarter of the taxable year, a REIT must have at least 75 percent of the value of its total assets represented by real estate assets, cash and cash items, and government securities [IRC § 856(c)(4)(A)]. Other asset diversification requirements restrict the securities that may be included in a REIT’s asset composition [IRC § 856(c)(4)(B)].
Failure to meet the above tests can result in loss of REIT status. For some failures, however, if a REIT can show reasonable cause, it may be able to simply pay a monetary penalty and bring itself into compliance [IRC § 856(c)(6), (7)].
Given the importance of complying with these REIT tests, it would seem obvious that the IRS would set forth clear guidelines as to whether commonly incurred items of income are qualified income under the REIT income tests. Until recently, this has not been the case with foreign currency gains.
Similarly, the effect of foreign currency exchange rate fluctuations on the valuation of assets can affect the percentage makeup of a REIT’s asset portfolio, and thereby affect its ability to meet the asset diversification tests. Yet, the statutory language does not expressly clarify how foreign currency exchange fluctuations affect valuation for purposes of the REIT asset diversification tests, nor has there been any IRS guidance on the matter.
Taxation of Foreign Currency Gains, “Functional Currency,” and “Qualified Business Units”
To understand the effect of foreign currency gains on REITs, the statutory framework for taxing those gains should be understood. The taxation of foreign currency gains and losses is determined by provisions apart from the REIT statutory scheme [see IRC §§ 958-989]. Any foreign currency gain (or loss) attributable to a Section 988 transaction must generally be computed separately and treated as ordinary income (or loss) [IRC § 988(a)]. A “
foreign currency gain” is any gain from a Section 988 transaction to the extent that it does not exceed gain realized by reason of changes in exchange rates on or after the booking date [IRC § 988(b)(1)]. A “Section 988 transaction” is any transaction described in IRC Section 988(c)(1)(B) if the amount which the taxpayer is entitled to receive (or is required to pay) by reason of that transaction is denominated in terms of a nonfunctional currency or is determined by reference to the value of one or more nonfunctional currencies [IRC § 988(c)(1)(A)]. The transactions described in IRC Section 988(c)(1)(B) include (1) the acquisition of a debt instrument, (2) becoming the obligor under a debt instrument, and (3) accruing (or otherwise taking into account) any item of gross income or receipts which is received after the date on which so accrued or taken into account. The disposition of a nonfunctional currency is also treated as Section 988 transaction, and any gain or loss from the disposition is treated as foreign currency gain or loss [IRC § 988(c)(1)(C)].
In general, except as provided in regulations, all determinations related to foreign currency transactions must be made in the taxpayer’s functional currency [IRC § 985(a)]. Thus, to know whether a taxpayer has a foreign currency gain or loss, the taxpayer’s functional currency must be known. The determination of a taxpayer’s functional currency is often tied to the concept of a “qualified business unit” (QBU). In general, a taxpayer’s functional currency is the US dollar, but in the case of a QBU, the functional currency is the currency of the economic environment in which a significant part of the QBU’s activities are conducted, and which is used by the QBU in keeping its books and records [IRC § 985(b)(1)(B)]. A QBU is any separate and clearly identified entity that engages in a business activity if that activity is reflected in a separate set of books [see IRC § 989(a)]. Any entity other than an individual can be a QBU. Thus, a REIT or a REIT subsidiary can be a QBU. A REIT or REIT subsidiary may also maintain a QBU [Treas Reg § 1.989(a)-1(b)].
A domestic REIT’s functional currency is generally the US dollar because it is a US corporation. Therefore, a domestic REIT generally recognizes foreign currency gain or loss on every IRC Section 988 transaction because those transactions are denominated in a nonfunctional currency to the REIT [see IRC § 988; Treas Reg § 1.988-1(a)].
A REIT may, however, seek a private letter ruling to use a foreign currency as its functional currency. If this is done, the REIT determines its functional currency by applying the principles used to determine the functional currency of a QBU that is not required to use the US dollar. Under those principles, the REIT’s functional currency is the currency of the economic environment in which a significant part of the QBU’s activities are conducted, if the QBU keeps, or is presumed to keep, its books and records in that currency [Treas Reg § 1.985-1(c)(1)]. The economic environment in which a significant part of the QBU’s activities are conducted is determined by taking into account all facts and circumstances [see Treas Reg § 1.985-1(c)(2) (providing a list of facts and circumstances taken into account)]. As a practical matter, REIT subsidiaries wishing to do so are able to use the currency where their properties are located as a functional currency [see, for example, Ltr Ruls 200548004, 200532015, 200519007].
The same rules for determining a REIT’s functional currency come into play for any QBU maintained by that REIT. Thus, a REIT may have a QBU with a functional currency other than the US dollar [see
Treas Reg § 1.985-1(c)]. Indeed, a functional currency must be determined for each QBU. Therefore, a REIT with multiple QBUs may have a different functional currency for each QBU. Any REIT with a QBU that has a functional currency other than the US dollar
may recognize foreign currency gains under IRC Section 987 if the QBU transfers cash or other property to it [see IRC § 987(3)].
How Foreign Currency Gains Fit Into the REIT Picture
For many years, the IRS has recognized that foreign real estate investments are permissible and can result in qualifying income and assets under the REIT income and asset tests. Thus, qualifying real estate assets under IRC Section 856(c)(4) include
land and improvements located outside the US, and qualifying mortgages on real property [see IRC § 856(c)(5)(B)] include security interests which, under the laws of the jurisdiction in which the property is located, are the legal equivalent of a mortgage or deed of trust in the US. Similarly, rents on foreign real property qualify under the REIT gross income tests to the same extent that they would qualify if the property were located in the US, and interest on foreign mortgage loans qualifies under those tests to the same extent that it would qualify if the loans were governed by US law and the property were located in the US
Rev Rul 74-191, 1974-1 CB 170
The treatment of foreign currency gain that may result from investing in real property or other assets that produce income denominated in a currency other than the taxpayer’s functional currency, however, has not been clear.
In addition, a REIT with a QBU that has a functional currency other than the US dollar may recognize foreign currency gains under IRC Section 987 if the QBU transfers cash or other property to it [see IRC § 987(3)]. The treatment of these gains under the REIT provisions has is also unclear.
Changes in foreign currency exchange rates affect REITs in a number of ways. If a foreign currency depreciates against the US dollar (
. the US dollar strengthens in relation to that currency), the value of a REIT’s investment in securities and other assets denominated in that currency will decline. With the plummeting of the value of the US dollar against the euro, the Canadian dollar, and other currencies in the past several years, the converse has occurred. The weakening of the US dollar, particularly against the euro, has caused the value of many REIT investments in assets denominated in other currencies to increase significantly. This can result in significant foreign currency gains that can skewer a REIT’s income.
For example, assume a REIT bought a shopping center in Milan, Italy in 2001 for 2 million euros, has operated it since then, and plans to sell it in December 2007 for 2 million euros. Assuming that capital expenditures equal the tax depreciation accruing during that period, there would be no capital gain on the sale. Yet, because of the significant decline of the US dollar vis-à-vis the euro between 2001 and 2007, the appreciation of the euros received from the sale when they are converted back into US dollars will result a separate and significant gain.
The IRS Clarifies the Issue for Foreign Currency Gains under IRC Section 988
Until recently, it wasn’t clear how the currency conversion gain in the above example should be treated under the REIT income and asset tests. REITs have typically established a REIT subsidiary in each currency zone in which they operate and then secured a private letter ruling from the IRS regarding the proper treatment of currency gains in those zones. This is expensive and time-consuming.
In May 2007, the IRS released Revenue Ruling 2007-33 [2007-21 IRB 1281] and
Notice 2007-42 2007-21 IRB 1288]. These releases clarify that in the vast majority of cases, a REIT’s foreign currency gains earned in the operations of a foreign real estate business will be qualifying income under the REIT rules.
In Revenue Ruling 2007-33, the IRS ruled that foreign currency gain that is recognized by a REIT will be qualifying income under the REIT gross income tests to the extent that the underlying income so qualifies. The ruling provided the following example:
is a REIT and has the US dollar as its functional currency.
invests both in real property from which it derives rental income and in debt instruments that are partially or fully secured by mortgages on real property. Some of the leases of the real estate that
owns provide for rents to be paid in euros. For some of these leases,
recognizes rental income for federal income tax purposes before receiving the corresponding rent payments.
’s rental income from these euro-denominated leases otherwise qualifies under the REIT income tests. Some of the mortgage loans that
acquires are denominated in euros, and both principal and interest under these loans are payable in euros.
’s interest income from these euro-denominated loans otherwise qualifies under the REIT income tests.
’s activities of investing in rent-producing real estate and in mortgage loans are not subject to the branch transactions provision of IRC Section 987. Therefore, if the euro changes in value against the dollar, payments of rent under the leases of the real estate and periodic payments made under the mortgage loans may generate foreign currency gain or loss [see IRC § 988; Treas Reg § 1.988-2(b)]. During its taxable year,
recognizes rental income on the euro-denominated leases, interest income on the euro-denominated mortgage loans, and IRC Section 988 gain on payments received under the leases and the mortgage loans.
The IRS ruled that because of the close nexus between the foreign currency gain on the payments received by
and the income from which those payments are derived, the foreign currency gain qualifies under the REIT gross income tests because both the rental income and mortgage interest income do. Applying the same “close nexus” rationale of Revenue Ruling 2007-33 to the example of the sale of the shopping center in Milan, the foreign currency gain from the euros received on the sale would also be qualifying income under the REIT gross income tests.
IRS Provides Guidance for Determining Proper Treatment of F
oreign Currency Gains under IRC Section 987 under REIT Gross Income Tests
In September 2006, the IRS issued proposed regulations under IRC Section 987 (the branch transactions provision), under which the owner of a QBU must generally determine the character of a IRC Section 987 gain or loss in the year of remittance using a modified asset method. The modified gross income method [see Temp Treas Reg § 1.861-9T(j)] cannot be used [Prop Treas Reg § 1.987-6(b); see 2006-42 IRB 698; 71 Fed Register 52,876; the asset method is set forth in Temp Treas Reg § 1.861-9T(g)]. The proposed regulations as they now exist do not apply to REITs [Prop Treas Reg § 1.987-1(b)(1)(iii)].
Notice 2007-42 [2007-21 IRB 1288]—issued at the same time as Revenue Ruling 2007-33—provides guidance regarding the proper treatment of IRC Section 987 gains. The Notice states that the IRS intends to amend the proposed regulations under IRC Section 987 to include guidance concerning the proper characterization under the REIT income tests of the foreign currency gains recognized by a REIT on a remittance from a QBU of the REIT.
Until further guidance is issued, the Notice instructs REITs to use rules set forth in proposed regulations under IRC Section 987 to determine if those gains qualify under the REIT gross income tests—in other words, REITs should use a modified asset method to make that determination, and cannot use a modified gross income method. Under the asset method, a REIT would apportion foreign currency gain to the qualifying REIT income categories [see IRC § 856(c)(2), (3)] based on the average total assets allocable to those income categories for the taxable year, as determined under asset valuation rules set forth in the regulations. Thus, the value of the assets, and not the gross income from them, would be the determining allocation factor [see Prop Treas Reg § 1.987-6(b); see Temp Treas Reg § 1.861-9T(g)].
Impacts of Revenue Ruling 2007-33 and Notice 2007-42
The most immediate impact of the IRS guidance is that REITs will no longer have to obtain a private letter ruling to determine how most of their foreign currency gains will be treated under the REIT income tests. An even more favorable longer-term impact is that absence of uncertainty regarding the treatment of foreign currency gains is likely to accelerate further international investment and overseas expansion by REITs.
Legislation on the Horizon
At least two bills have been introduced in Congress [see S. 2002, H.R. 1147] to codify the position of the IRS in Revenue Ruling 2007-33. Each bill would specify by statute that qualified REIT income under the REIT gross income tests includes any foreign currency gains derived by a REIT with respect to its business of investing in foreign real estate assets [new IRC § 856(c)(2)(I), (c)(3)(J) (proposed)].
The bills also address related REIT foreign currency problems that were not resolved by Revenue Ruling 2007-33 or Notice 2007-42. Although Revenue Ruling 2007-33 in particular was welcome, it took the IRS nearly four years to issue it because of questions about the extent of the government’s regulatory authority in the area. Some members of Congress fear similar delays with related REIT issues if legislation is not enacted.
The bills expressly provide the IRS with authority to determine what items of income can either be included or disregarded for purposes of the REIT income tests [new IRC § 856(c)(2)(J), (c)(3)(K) (proposed)]. Under current law, taxpayers must seek private letter rulings from the IRS as to whether particular types of income are qualifying income under the REIT tests or can be ignored for purposes of those tests. The bills would give the IRS authority to convert its private letter rulings to individual taxpayers into general public guidance, which would be a more efficient use of its resources. The co-sponsors of the bills expect that with this authority, the IRS would also treat the following items either as included as qualified income under the REIT income tests or ignored for purposes of those tests:
Dividend-like items such as Subpart F deemed dividends;
Passive foreign investment company (PFIC) income; and
Other income directly attributable to a REIT’s business of owning and operating commercial real estate, such as amounts attributable to recoveries in settlement of litigation, or “break up fees” attributable to a failure to consummate a merger.
These issues are all currently unresolved, and their clarification could accelerate the expansion of US REITs in foreign real estate markets.
Each bill would also provide that foreign currency would qualify as “cash or cash items” for purposes of meeting the REIT asset test, provided that the REIT or its QBU used the foreign currency as its functional currency [see IRC § 856(c)(4)]. Foreign currency currently does not qualify as cash or cash items.
Each bill would also clarify that changes in the value of a REIT’s assets resulting solely from foreign currency exchange rates used to value a foreign asset would not affect an entity’s REIT status. Although implied by current statutory language [see IRC § 856(c)(4) (flush language)], this result is not completely clear, and this clarification is welcomed by the REIT industry.
The bills would also make the following additional changes:
Increase the limit on taxable REIT subsidiaries from 20 to 25 percent of a REIT’s total assets [see IRC §
Change two of the REIT prohibited transaction safe harbors for so-called “dealer sales” [see IRC § 857(b)(6)(C), (D)]. First, the required holding period for real estate would be reduced from 4 years to 2 years. This change recognizes the liquidity of real estate in the current marketplace and would allow REITs to maintain an international competitive advantage. Second, the amount of real estate assets a REIT may sell in any taxable year would be changed. Currently, a REIT can sell 10 percent of its portfolio in any taxable year. The 10 percent level is measured by reference to the REIT’s tax basis in its assets [see IRC §§ 857(b)(6)
]. The bills would measure the 10 percent level by reference to the fair market value of the REIT’s assets. S. 2002 would also allow a REIT to choose either method for any given year [see IRC §§ 857(b)(6)(C)(iii), (D)(iv)]. This change would prevent REITs that have owned their properties for longer periods from being penalized and thereby prevented from prudently managing their properties.
Parallel the treatment under the REIT rules of health care facilities to lodging facilities [see IRC §§ 856(d)(8)(B), 856(d)(9)(A), (B), 856(l)(3)];
Allow stock of qualified non-US REITs to be treated as a qualified asset under the REIT asset tests, and treat income from those non-US REITs as qualified income under the REIT gross income tests [see IRC §
856(c)(3)(D), 856(5)(B); IRC § 856(c)(8) (proposed)
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