Treasury Department Testifies in Favor of REIT Dividend Compromise in Tax Treaty Policy (October 7, 1997)

 

Statement of Department of the Treasury Joseph H. Guttentag
Re:International Tax Counsel Before the Committee on Foreign Relations

United States Senate,
Mr. Chairman and members of the Committee, I am pleased today to recommend on behalf of the Administration, favorable action on eight bilateral tax treaties and protocols that the President has transmitted to the Senate and that are the subject of this hearing. These agreements would provide significant benefits to the United States, as well as to our treaty partners. Treasury appreciates the Committee's interest in these agreements as demonstrated by the scheduling of this hearing. Treasury requests the Committee and the Senate to take prompt and favorable action on all of these agreements.

Distributions from Real Estate Investment Trusts (REITs)

Our tax treaties must provide appropriate tax treatment for categories of income which are specially treated under the Code. One important example of such provisions are the REITs, created by Congress to help investors achieve diversified ownership in primarily passive real estate investments. In the case of foreign investors, the Congress provided for a 30% withholding tax except for certain capital gain distributions. These rules reflected U.S. tax policy which is consistent with those of most other countries: each country reserves the right to impose a full tax on income from real property, leaving the residence country to alleviate any resulting double taxation.

REITs are created as U.S. corporations and their distributions are in the form of corporate dividends. Unlike corporations, however, they generally are not subject to tax at the corporate level and, if their distributions were not subject to full taxation, their income would not be subject to full taxation at the entity level or the shareholder level. Therefore, a decision must be made whether to characterize the distributions as distributions of real property rental income subject to at least one level of full U.S. taxation or as a dividends subject to a lower rate.

It has been U.S. policy since 1988 to treat REIT distributions as conduit distributions of real estate rental income. The policy originated in a 1988 directive, with which the Department of the Treasury agreed, from the Joint Committee on Taxation and the Senate Committee on Foreign Relations. The purpose of excluding certain REIT dividends from preferential dividend withholding tax rates under the treaties is to prevent foreign investors from utilizing a REIT conduit to convert high-taxed U.S. source rental income into lower taxed dividend income by passing the rental income through a REIT. This policy avoids a disparity between the taxation of direct real estate investments and real estate investments made through REIT conduits. Limited relief from this rule generally is provided in the case of REIT dividends beneficially owned by individuals holding less than a 10-percent interest in the REIT. Such REIT dividends qualify for the reduced withholding tax rates generally available in respect of dividends.

Economic changes since these policies were established ten years ago require that we review our position in order to insure that our treaty policies reflect the best interests of the United States. These interests include not discouraging, through our tax rules, desirable foreign investment. To that end we have consulted with representatives of the REIT industry and we are now satisfied that our current treaty policy should be modified. While the treaties before you represent policies with which we all have agreed, we now believe that it is appropriate to revise our treatment of REIT dividends under our treaties.

Our new policy takes into account that portfolio investments in a REIT whether by individuals or institutional investors may be indistinguishable in intent and results from similar investments in other corporate securities and should be afforded similar tax consequences in appropriate circumstances. In carrying out such a policy however, two other considerations are significant. First, we should maintain a reasonable neutrality with respect to the taxation of foreigners and U.S. citizens. A potential U.S. investor in a shopping mall should not be out bid by a foreigner because we have, through our treaty process, provided inappropriate tax benefits to the foreigner. Second, we should not provide such generous REIT benefits that foreigners choose to make economically distorted investments to our disadvantage. For example, we do not want a foreigner that is considering building a major job-producing new factory in the United States to choose instead to buy an existing office building because of inappropriately favorable tax treatment of the latter.

The proposal which we put before you today has been developed by the staff of the Joint Committee on Taxation in consultation with the staff of this Committee and Treasury and with the help of the REIT industry. Our existing treaty policy provides for a 30% withholding tax on REIT dividends with an exception for payments to individuals who hold 10% or less of the REIT. Our new policy retains the current treatment of individuals with 10% or smaller holdings of the REIT and, in addition, provides for a 15% withholding tax on dividends paid by (i) a publicly traded REIT to any shareholder who holds a 5% or smaller interest in the REIT, and (ii) a publicly traded or non-publicly traded REIT, the holdings of which are substantially diversified, to a shareholder who holds a 10% or smaller interest in the REIT.

We are going to reflect this new policy in our model treaty and in future treaty negotiations. Furthermore we support the proposal to insert a reservation to the Senate's advice and consent to our pending treaty with Luxembourg to reflect our new REIT policy in that treaty, as well as assuring "grandfathered" benefits for certain current investments. We are also going to use our best efforts to secure agreement with Austria, Ireland and Switzerland to protocols to our new treaties to reflect our new REIT policy.

 

We believe that the foregoing proposal goes as far as we can in accommodating the changes in the REIT industry consistent with sound tax policy designed to take into account the factors described above. Representatives of the REIT industry have been most helpful in providing us with information with respect to developments in the industry and changes in investment patterns since adoption of our 1988 policy and have indicated their support for the new policy.