Barriers To Foreign Investment In US REITs Removed
Tony Edwards, National Association of Real Estate Investment Trusts
On October 22, 2004, President Bush signed into law the American Jobs Creation Act of 2004 (the Jobs Act) that, among other significant items, enacts several important changes affecting US real estate investment trusts (REITs). Perhaps most relevant to AFIRE members is that foreign portfolio investors in listed US REITs will now receive the same beneficial US tax treatment that applies to investment in other US corporations.
BACKGROUND
US REITs
The United States Congress created REITs in 1960 to make investments in large-scale, significant income-producing real estate accessible to investors from all walks of life. Congress decided that the only way for the average investor to access investments in large-scale commercial properties was through pooling their capital into a single economic pursuit geared to the production of income through commercial real estate ownership. REITs offer distinct advantages for smaller investors: greater diversification through investing in a portfolio of properties rather than a single building and expert management by experienced real estate professionals.
US REITs must comply with a number of requirements related to their operations and distributions, and must meet detailed requirements. The most fundamental of these requirements are as follows: 1) REITs must pay annually at least 90 percent of their taxable ordinary income to shareholders; 2) most of a REIT's assets must be real estate related (including investments in mortgage loans); 3) REITs must derive most of their income from real estate held for the long term; and, 4) REITs must be widely held.
In exchange for satisfying these requirements, REITs benefit from a dividends paid deduction so that most, if not all, of a REIT's income is taxed only at the shareholder level. This single level of tax allows investors (including those outside the United States) to receive a healthy dividend yield.
On the other hand, REITs are limited in the earnings they may retain. As a result, capital for growth and property maintenance and betterment must come largely from funds raised in the investment marketplace, proceeds from dispositions, and through joint ventures.
When a REIT sells real estate in a taxable transaction, it has the choice of distributing the proceeds as a capital gain dividend (which also qualifies for a dividends paid deduction against a corporate-level tax) or retaining the proceeds and paying a corporate tax on the gain. Listed US REITs rarely choose the second option.
Tax Treaties
Under the Internal Revenue Code, a US corporation or its withholding agent must withhold and remit as a tax to the Internal Revenue Service 30 percent of its ordinary dividends paid to non-US shareholders. Since World War II, the United States has entered into many bilateral treaties that reciprocally lower withholding taxes to encourage cross-border investments (See NAREIT tax treaty chart). In most cases, portfolio investors in the securities of companies located in a treaty partner country only pay a 15 percent tax rate on dividends they receive. Some treaties respect the tax-exempt status of charities and pension plans by not taxing dividend income they receive in either country.
Since 1997, US tax treaties have provided that US REIT ordinary dividends paid to institutional investors are subject to the 15 percent rate so long as the institution owns less than: 1) 5 percent of a publicly traded REIT; or, 2) 10 percent of any REIT, the properties of which are sufficiently diversified. This treaty policy recognizes that an investor that owns a non-controlling interest in a listed or diversified REIT should be treated as a portfolio investor in securities rather than as a direct investor in real estate. The attached chart shows the withholding rates on REIT ordinary dividends under all US bilateral tax treaties.
The United States has ratified tax treaties with Canada, Japan, Mexico, the Netherlands, Switzerland, the United Kingdom and Venezuela that exempt pension plans operating in those countries from US tax on dividends paid to them by US corporations. The treaties with Japan, Mexico and the United Kingdom condition this zero withholding with respect to US REIT dividends on the pension fund satisfying ownership criteria patterned on the post-1997 tax treaty position discussed above.
REIT Capital Gains
Under prior law, a non-US investor who received a REIT capital gain distribution was treated as engaged in a US business under the Foreign Investment in Real Property Tax Act (FIRPTA) provisions of the Internal Revenue Code. Accordingly, the distributing REIT was required to withhold a 35 percent tax on the distribution, while the investor, if treated as a corporation for US tax purposes, arguably was required to file a US tax return and required to pay an additional “branch profits” tax solely because of such distribution.
This 35 percent tax and consequent return-filing requirement was especially inappropriate for non-US portfolio investors in listed REITs. Although FIRPTA generally applies when a foreigner sells US real estate, since its inception FIRPTA has exempted a foreigner’s sale of stock in a publicly traded US real estate company if the non-US person owns 5 percent or less of that company’s stock. One would have thought that a similar FIRPTA exception should apply to that same REIT’s capital gain distribution, but that was not the case.
JOBS ACT
As signed by President Bush, the Jobs Act contains all of the provisions that had been separately introduced as the REIT Improvement Act of 2003. The Jobs Act includes a provision that will treat the capital gains distributions of a US-listed REIT to a non-US investor as ordinary dividends so long as the investor owns 5 percent or less of the distributing REIT.
Consequently, a portfolio investor receiving a capital gain distribution from a US-listed REIT will not be required to file a US tax return, the branch profits tax will not apply, and the distributing REIT will withhold at a 30 percent rate or a lower rate prescribed by bilateral treaties (including the zero percent rate applicable in some treaties to pension plans). This provision conforms tax policy to the general FIRPTA rule for sales of REIT stock and to the tax treaty policy concerning REIT ordinary dividends Congress and the Treasury Department adopted in 1997. In essence, non-US portfolio investors in listed US REITs now will be treated the same as if they invested in any other US publicly traded corporation.
The REIT capital gains provisions are effective for taxable years beginning after October 22, 2004, the date of enactment of the Jobs Act.
The Jobs Act also contains several technical amendments that modernize the REIT tax requirements and better assure investors that a company will not lose its REIT status because of a minor oversight. For further information on these rules, please go to http://www.nareit.com/governmentrelations/REITimprovementact.cfm.
1 Both before and after 1997, tax treaties generally provide a 15% withholding rate for U.S. REIT ordinary dividends paid to foreign individuals so long as the investor owns 10% or less of the REIT.
2 Note that under a pending but not ratified Protocol, the 15% rate would apply to most Dutch institutional investors other than pension plans, which would remain exempt from U.S. tax on ordinary REIT dividends.
3 In addition, section 892 of the Internal Revenue Code separately exempts from U.S. tax most dividends from U.S. corporations received by non-U.S. governmental entities, including foreign government pension plans.
4 Similarly, capital gains distributions by a U.S.-listed REIT to a foreign governmental entity that owns 5% or less of the REIT generally should qualify for exemption under section 892 of the Internal Revenue Code.
Tony Edwards is the Senior Vice President and General Counsel of the National Association of Real Estate Investment Trusts. NAREIT is the national trade association for real estate investment trusts ("REITs") and publicly traded real estate companies. Our members are REITs and other businesses that own, operate and finance incoming producing real estate, as well as those firms and individuals who advise, study and service those businesses.
Mr. Edwards is staff liaison for NAREIT's Government Relations Committee, which is responsible for a wide range of issues as part of NAREIT's legislative and regulatory agenda.
