August 3, 2011
Background: First Model Captive REIT Statute-Dividends Paid Deduction Denied
By way of background, NAREIT worked for a number of years with the Multistate Tax Commission (MTC), an organization of state governments that recommends uniform statutes, in connection with the MTC's draft captive REIT statute. In January 2008, the MTC's Executive Committee approved a draft statute that essentially would require a captive REIT to add back its dividends paid deduction (DPD).
In general, a captive REIT is defined as a private REIT more than 50% held by a taxable, non-REIT, non-"foreign REIT-like" corporation (called "qualified foreign entities"). Furthermore, a non-listed U.S. REIT more than 50% owned by a listed Australian property trust (LAPT, or now called an Australian REIT) specifically would not be considered a captive REIT. On July 31, 2008, the full MTC approved this model statute (the First Captive REIT Statute). Prior to the MTC's adoption of the First Captive REIT Statute, a number of states, including Louisiana, Maryland, and Rhode Island, had approved similar statutes. Since the MTC's approval of the First Captive REIT Statute, a number of other states, including Georgia, Virginia and West Virginia, have enacted similar statutes.
Second Model Captive REIT Statute Approved - Add back of Related Party Expenses Paid to Captive REIT
Since the MTC's adoption of the First Captive REIT Statute in 2008, there was some concern raised that the model statute was insufficient to prevent the inappropriate use of REITs when a state did not have nexus over a captive REIT. In such case, it could not deny the DPD, but it did have nexus over a related taxpayer that was claiming deductions for amounts paid to the REIT.
As a result, the MTC began to consider another version of its model captive REIT statute that would add back certain expenses paid by a related party to a captive REIT. Wisconsin enacted a similar add back statute a number of years ago, as did Oklahoma.
The definition of "captive REIT" included in this new version was largely the same as that in the original model statute. (This issue was first noted in the April 19, 2011 SALT Report. On July 27, 2011, the MTC approved this additional model statute (the Second Captive REIT Statute).
First Proposal Would Have Taxed Pass-Through Entities, Including REITs
Notwithstanding its work on these two model captive REIT statutes, some MTC members continue to be concerned about the inappropriate use of pass-through entities and REITs, not only for tax advantages, but also for reasons that are viewed as permitting unfair competition with C corporations. Specifically, the MTC held a public hearing on May 16, 2011 in connection with a proposed pass-through entity statute (First Pass-Through Entity Proposal).
Ostensibly, the First Pass-Through Entity Proposal was meant to address the perceived inequity that may exist when an insurance company, subject to premiums, but not income tax in most states, invests in another state through a pass-through entity and apparently avoids income tax on the flow through income of the pass-through entity. A similarly invested shareholder in a C corporation that operated the same business would face income tax at the C corporation level as well as at the shareholder level.
The First Pass-Through Entity Proposal would have imposed entity-level state income tax on a pass-through entity more than 50% owned by an insurance company. It also would have gone quite a bit further by potentially imposing entity-level state income tax on a partnership owned by an entity not subject to income tax "although not subject to income tax" was undefined. Thus, it appeared that this proposal could have imposed an entity-level tax on any operating partnership or REIT owned more than 50% by another entity not "subject to tax" in that same state. Further, it defined a REIT as a "pass-through entity"
The MTC held a public hearing with respect to this proposal on May 16, 2011. At the public hearing, a representative from the insurance industry spoke and suggested that the draft had not been sufficiently investigated. This witness raised some additional issues as well concerning potential discrimination against insurance company-owned pass-through entities and raised the argument that insurance companies on the whole were subject to a comparatively large tax burden.
Dara Bernstein, NAREIT's Senior Tax Counsel, spoke on behalf of NAREIT and urged that the statute be narrowly tailored to achieve its objective (in other words, to the concern that insurance companies were escaping tax on their investments in pass-through entities) without affecting non-abusive or legitimate real estate investments. Kathleen Courtis of General Growth Properties also spoke at the hearing and provided information concerning the typical investment structures involving REITs and umbrella partnership REITs (UPREITs), particularly with relation to pass-through entities. With the participation of a task force comprised of interested NAREIT members, NAREIT submitted a comment letter, as well as an additional comment letter, in which NAREIT suggested alternative statutory language.
Second Proposal Would Have Eliminated DPD if REIT Majority Owned by Entity "Not Subject to Income Tax"
On June 6, the MTC "Hearing Officer" posted a revised proposal, MTC Proposed Statute Regarding Pass-Through Entity Income That is Ultimately Realized by an Entity That is not Subject to Income Tax (Second Pass-Through Entity Proposal). NAREIT appreciates that this revised proposal accepted NAREIT's comment specifically to exclude a REIT from the definition of "pass-through entity" (although it still would tax a pass-through entity 50% or more owned by an insurance company at the entity level). With that said, the Second Pass-Through Entity Proposal continued to raise a number of concerns. As specifically related to REITs, this proposal continued to suggest adding back a REITs' dividend paid deduction (DPD) to the extent 50% or more owned by an "entity that is not subject to income tax" (other than insurance companies, this term was not defined).
On July 25, NAREIT submitted a letter to the MTC, noting that the MTC's two existing captive REIT statutes already should address the situation in which an insurance company owns more than 50% of a non-listed REIT and, therefore, the Second Pass-Through Entity Proposal should be unnecessary. Furthermore, the NAREIT letter argued that the Second Pass-Through Entity Proposal was ambiguous, difficult to administer (particularly for listed REITs who cannot identify every shareholder) and could lead to double taxation. Finally, the letter indicated that the Second Pass-Through Entity Proposal appeared to overturn the existing unrelated business taxable income (UBTI) rules with respect to tax exempt entities. These rules have been around for decades to address the situation in which a tax exempt entity earns unrelated business income; in such case, the income is subject to an entity-level tax. The percentage of the tax exempt entity's ownership in a pass-through entity is not relevant to this inquiry (other than with respect to the pension-held REIT rules, which treat certain pension investors in REITs as earning what otherwise would be UBTI of the REIT if the REIT is a "pension held REIT").
Dara Bernstein also raised these points at the MTC's July 28 Executive Committee hearing held in Montana. At the hearing, the MTC's Executive Committee agreed with these arguments, and voted to return the Second Pass-Through Entity Proposal to its Uniformity Committee for further analysis.
NAREIT will continue to monitor this proposal as appropriate and welcomes the continued participation of its members in a task force that will assist us in doing so.