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This is the fifth in a series of commentaries intended to highlight some of the questions that arise in modern practice under FIRPTA where the answers are unclear, and where the Treasury Department and the IRS could usefully provide guidance addressing a host of questions that has existed for many years. This commentary will focus on the question of how, if at all, §897(h)(1) applies when one REIT liquidates into another in a taxable liquidation described in §§331 and 336 of the Code.

Assume that a privately-held upper-tier REIT (“UTR”) is owned in part by one or more foreign shareholders. Assume that UTR owns an interest in a lower-tier REIT (“LTR”) but does not own 80% or more of LTR within the meaning of §§332 and 337, and that LTR's assets consist wholly of one or more U.S. real property interests (each, a “USRPI”) within the meaning of FIRPTA, making the stock of LTR a USRPI in the hands of UTR.¹ Assume further that the value of LTR's USRPIs exceeds the basis thereof, but that the value of LTR's stock held by UTR is equal to or less than its basis in such stock, e.g., because the stock was recently purchased. A liquidation of LTR would be described in §§331 and 336 of the Code. In such liquidation, LTR would recognize taxable gain, although a portion of that gain would be nontaxable due to the dividends-paid deduction allowed under §562(b) for liquidating distributions. UTR would recognize no gain and would have no E&P attributable to the liquidation, but would take a stepped-up basis in the distributed assets.

In Notice 2007-55,² the IRS announced that it would issue regulations to the effect that a liquidating distribution by a REIT was a “distribution” within the meaning of §897(h)(1), with the result that a foreign shareholder of the REIT (other than a foreign shareholder that owns 5% or less of a publicly-traded REIT) would be required to report gain to the extent the distribution was attributable to the REIT's sale of a USRPI. In the Notice, the IRS also stated that it would challenge an assertion by any foreign taxpayer that §897(h)(1) does not apply to distributions in complete liquidation under §331 for periods prior to the effective date of the regulations. The IRS also clarified that the term “distribution” as used in §§897(h)(1) and 1445(e)(6) includes any distribution included under §331, “where the distribution is attributable, in whole or in part, to gain from the sale or exchange of a USRPI by a qualified investment entity or other pass-through entity.”

The fact pattern here raises a number of interpretive issues, the first of which is related to the issue presented where a foreign shareholder owns recently-purchased REIT stock with a high outside basis and the REIT has a low inside basis in its historic assets. If Notice 2007-55 is correct that §897(h)(1) applies to liquidating distributions, then such a foreign shareholder may have gain attributed to it even though it has no net gain with respect to its stock. This problem is traceable to the fact that, while §897(h)(1) adopts a partnership approach to taxing inside gain, there is no mechanism in the REIT rules to give a purchaser of REIT stock a basis step-up similar to that provided purchasers of partnership interests under §754.

The further technical question presented by the tiered REIT liquidation in the fact pattern described above is whether the relevant “disposition of a USRPI” is the §336 liquidating disposition by LTR of its interest in its USRPIs or the §331 disposition by UTR of its interest in the stock of LTR. In either case, as explained below, the follow-on question is whether a later distribution by UTR would be described in §897(h)(1).

Section 897(h)(1) provides in part:

Any distribution by a qualified investment entity to a nonresident alien individual, a foreign corporation, or other qualified investment entity shall, to the extent attributable to gain from sales or exchanges by the qualified investment entity of United States real property interests, be treated as gain recognized by such nonresident alien individual, foreign corporation, or other qualified investment entity from the sale or exchange of a United States real property interest. … [Emphasis added.]

The italicized language above, referring to another “qualified investment entity,” was added to §897(h)(1) by TIPRA in 2006.³ The purpose of the addition was to prevent the avoidance of §897(h)(1) by tiered REITs in the following scenario: LTR sells a USRPI to a third party for cash and distributes the proceeds of that sale to UTR, which then distributes the proceeds to its shareholders (including any foreign shareholders). That case is fairly simple to understand. In that simple case, the upper-tier REIT would receive cash, and the cash would be treated as gain from the sale of a USRPI to the extent attributable to the gain recognized by the lower-tier REIT on its earlier sale. Because the upper-tier REIT would itself be deemed to have recognized gain from the sale of a USRPI, the ensuing distribution it makes to its own foreign shareholders would also be described in §897(h)(1). In other words, the fact that the upper-tier REIT is a domestic person does not prevent §897(h)(1) from applying to distributions attributable to dispositions of USRPIs by a lower-tier REIT when the upper-tier REIT distributes the funds to its own foreign shareholders.

The liquidation case, however, cannot be so simply fit into the statutory language. There are two ways to interpret this language as applied to the liquidation of LTR into UTR. First, one could focus on the §336 distribution by LTR to UTR, which is the transaction covered by the italicized language above. Clearly, the gain asset being measured here is the USRPI owned by LTR. In this case, the gain is recognized, not on a sale to a third party, but in the distribution itself. The attributable amount of the gain would be, by definition, 100% thereof. But UTR has recognized no gain on the receipt, because it had no gain, or a built-in loss, with respect to its LTR shares. Moreover, in the ordinary case, UTR would not make a back-to-back distribution to its shareholders. It would not be compelled to do so, because, having recognized no gain, it does not need to make a minimum distribution.

The second way to interpret §897(h)(1) in this context is to focus on UTR's §331 disposition of its interest in LTR. The obvious problem with this mode of analysis is that UTR is not distributing anything to its shareholders in connection with the transaction. Accordingly, there is nothing for §897(h)(1) to apply to.⁴

It follows that, under either reading of the statute, the only way for §897(h)(1) to have any application is to treat a subsequent, unrelated distribution made by UTR to its foreign shareholders (which could be an ordinary dividend, a capital gain dividend, a redemption, a liquidating distribution, etc.) as “attributable to” the disposition of a USRPI. But if the USRPI to which any such distribution is “attributable” is UTR's stock in LTR, there is no gain for §897(h)(1) to apply to. Only if a later distribution by UTR to its shareholders were treated as “attributable” to LTR's §336 gain on the distribution of its USRPIs would §897(h)(1) potentially apply.

Stated another way, the risk is that the IRS would apply §897(h)(1) as a “step-into-the-shoes” rule, seeking to preserve the gross amount of gain that LTR recognized with respect to the liquidating distribution of its USRPIs in a later distribution by UTR to its shareholders, without any offset for the latter's stock basis in LTR. The IRS might want to attempt this, since UTR's stepped-up basis in the distributed USRPIs would ordinarily ensure that any gain recognized by LTR would disappear from the system. However, this is a difficult argument for the IRS to make, both on a technical ground and on a policy ground.

As a technical matter, despite the fact that §897(h)(1) is a partnership-style or “look-through” rule, it cannot oust §§331 and 336 from concurrent jurisdiction, providing UTR with a stepped-up basis in the distributed USRPIs. As a policy matter, neither UTR nor its foreign shareholders have realized any gain at all, since under these facts UTR had a basis in the stock of LTR equal to or greater than the value thereof. Even if the IRS were to advance a step-into-the-shoes rule, it would seem to need to account for UTR's offsetting loss.⁵

The fact that there is no clear answer to the question posed herein is likely attributable to the fact that §897(h)(1) was never intended by Congress to capture liquidating distributions, much less in-kind distributions by lower-tier to upper-tier REITs. It appears that Congress had in mind only those relatively simple cases in which a distribution by a REIT was attributable to its own disposition of a USRPI at a gain to a third party, or to a disposition by a lower-tier REIT of a USRPI to a third party. Even if Congress had an internal REIT liquidation in mind when it added the tiering rule to §897(h)(1), which is highly unlikely, the rule would have had no application in the normal case, because in the normal case a liquidation of a lower-tier REIT into an upper-tier REIT would be described in §§332 and 337, and no gain would be recognized by any party.⁶ While §332(c) would appear to create dividend income to the upper-tier REIT, that rule does not implicate §897(h)(1) in a situation in which no amount is being distributed to the upper-tier REIT's shareholders.

This commentary also will appear in the September 2008 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Rubin and Hudson, 912 T.M., Federal Taxation of Foreign Investment in U.S. Real Estate, and in Tax Practice Series, see ¶7120, Foreign Persons' U.S. Activities.