Several recent corporate spin-offs in the United States have involved real estate investment trusts (REITs). Provided several requirements are satisfied, including qualification of the “spun-off” entity as a REIT and the spin transaction as a tax-free spin-off, REIT spin-offs can result in significant value to shareholders. In these transactions, a corporation distributes a subsidiary corporation holding real estate to the distributing corporation’s shareholders in a tax-free spin-off. Not only is the spin-off tax-free, but the distributed company elects REIT status and thus enjoys potentially substantial tax savings going forward. The Internal Revenue Service (IRS) recently has issued a number of favorable private letter rulings (PLRs) for such transactions. REIT spin-offs should be of potential interest to any U.S. corporation owning significant real estate.
As a general rule, a corporation’s distribution of property to its shareholders is taxable to both the distributing corporation and its shareholders. Under the spin-off provisions of section 355 of the Internal Revenue Code, however, a distribution by a corporation of the stock of a controlled subsidiary corporation can be accomplished wholly tax-free if several requirements are satisfied.
One of the requirements for a tax-free spin-off is the so-called business purpose requirement. The distribution must be motivated, in whole or substantial part, by one or more non-federal-tax corporate business purposes. The regulations state that potential avoidance of federal taxes is relevant in determining the extent to which a corporate business purpose motivated the transaction. In satisfying the requirements for a tax-free spin-off involving a REIT, the business purpose requirement is likely to be the main pressure point.
A REIT generally is not subject to U.S. federal income tax on its taxable income to the extent distributed to its shareholders because of the application of a dividends paid deduction. REIT qualification depends on the REIT’s ability to meet various complex requirements, including the requirement that at least 75 percent of the value of the REIT’s assets consist of cash, cash items, government securities and “real estate assets,” and that at least 75 percent of the REIT’s gross income is derived from rents from real property and other real-estate-related income. The IRS historically has issued PLRs on the qualification of assets as real estate assets. However, the U.S. Department of the Treasury and the IRS recently issued proposed regulations establishing proposed guidelines on the types of assets that would qualify. Under the applicable guidance, a company with substantial non-real-estate assets generally is not eligible to elect REIT status. However, the company might be able to overcome this obstacle by transferring real estate assets to a subsidiary and distributing the stock of the subsidiary to its shareholders. Following the distribution, the subsidiary would elect REIT status.
The IRS recently issued three favorable PLRs addressing spin-offs of real estate by operating companies where, immediately after the spin-offs, REIT elections were to be made for the companies’ spun-off real estate subsidiaries.
IRS Ruling Policy
Over the years, the IRS has substantially carved back on the spin-off issues regarding which it will issue a PLR. In 2003, the IRS ceased ruling on highly factual aspects of spin-offs, including the business purpose requirement, but continued to rule on whether a transaction otherwise qualified for non-recognition under section 355. Although rulings contained a caveat that the IRS expressed no opinion on satisfaction of the business purpose requirement, the rulings were based in part on taxpayer representations regarding business purpose. In 2013, the IRS carved back further on its ruling policy and no longer rules on qualification under section 355 as such at all; rather, it only rules on “significant issues.”
Recent PLRs and Transactions
PLR 201337007, apparently issued to Penn National Gaming, Inc., based on publicly available facts, involved a corporation’s distribution to its shareholders of the stock of a subsidiary holding substantially all of its casino-related real estate. The ruling concluded that the spin-off qualified under section 355 despite the stated intention to elect REIT status for the real estate company (based in part on business purpose representations). The PLR also confirmed that certain properties constituted “real estate assets” for REIT purposes.
An important aspect of the ruling is that, following the spin-off, most of the real estate was to be leased back to the distributing corporation. The rent paid presumably would be tax deductible to the distributing corporation, and, as a result of the REIT’s dividend paid deduction, the rental income in turn earned by the REIT generally would not be subject to corporate-level tax.
Regarding business purpose, the ruling relied on representations by the taxpayer that the spin-off was being carried out to facilitate strategic expansion opportunities by permitting the REIT the ability to pursue transactions with competitors, diversify into different businesses, pursue certain transactions that the distributing corporation would be disadvantaged by or precluded from pursuing because of regulatory constraints, and fund acquisitions with its equity on significantly more favorable terms than those that would be available to the distributing corporation.
PLR 201411002, apparently issued to CBS Corp. based on publicly available facts, relates to a corporation’s distribution to certain of its shareholders of the stock of a subsidiary holding certain of the corporation’s billboard displays in redemption of distributing corporation stock in a so-called split-off. The ruling concluded that the transaction qualified under section 355 (based in part on taxpayer representations regarding business purpose).
Regarding business purpose, the ruling relied on representations by the taxpayer that the transaction would enable the business’s management team to focus on its relevant business, requirements and performance without the distraction of one or more businesses operating under a different business model; to provide a more attractive equity currency for acquisitions; to enhance and align the equity-based incentive programs to better reflect business objectives, goals and financial performance of each business; and to better enable each business to independently optimize its capital structure and return of capital policies.
Finally, on July 29, 2014, Windstream, a network communications provider, announced plans to effect a REIT spin-off of certain of its telecommunications network assets. Windstream reported that it had received a favorable PLR, although it is unclear whether the PLR was issued under the IRS’s more limited spin-off ruling policy. As in the Penn National transaction, the spun-off REIT will lease its assets back to the distributing corporation, generating the attendant tax benefits described above.
Significance of These PLRs and Transactions
The PLRs contained the standard caveat that the IRS expresses no opinion on satisfaction of the business purpose requirement, which is likely the main pressure point for satisfaction of the spin-off requirements.
William Alexander, IRS Associate Chief Counsel (Corporate), has suggested that the IRS believes that the potentially substantial tax savings stemming from a REIT election following a spin-off does not preclude satisfaction of the business purpose requirement. Alexander said that although the IRS does not rule on whether the business purpose requirement is satisfied, “if we were sure it couldn’t be done [in a REIT spinoff], then you would know that.” Amy S. Elliot, ABA Meeting: Alexander Sets Reachable Bar for Business Purpose in REIT Spinoffs, 2014 TNT 19-5 (Jan. 29, 2014).
In any case, prudent taxpayers typically seek legal opinions on satisfaction of the spin-off requirements. Notably, a PLR cannot be used or cited as precedent by taxpayers other than the taxpayer to whom it is addressed.
The transactions discussed above suggest a trend in favor of the separation of real estate from related operating businesses resulting in significant associated tax savings and enhanced ongoing tax efficiency of ownership of real estate assets through a REIT.
For a corporation to engage in any spin-off, it must conduct extensive analysis as to the transaction’s feasibility. In the context of most REIT spin-offs, the businesses are vertically integrated, in that the real estate is needed in the operating business. The business need for a continuing economic and legal relationship created by the lease structure should be carefully analyzed before a corporation engages in the transaction. In the public company context, both the distributing corporation and the spun-off corporation will owe ongoing fiduciary duties to their shareholders in making business decisions.
Notably, in February 2014, Chairman Camp of the House Committee on Ways and Means released a discussion draft containing several REIT provisions, including a prohibition on REIT spin-offs. The administration’s 2015 budget proposal released in March 2014 did not contain a similar provision. While it is unclear whether any prohibition ultimately will be enacted, to the extent that a business case exists for the spin-off, the possibility of the prohibition should be taken into account in analyzing the timing of consummating such a transaction.
REIT spin-offs should be of particular interest to any corporate business with significant real estate holdings. A REIT spin-off can generate substantial tax efficiencies creating incremental value in the combined enterprises. Careful legal and financial analysis of these transactions should be undertaken.