Final Regulations Issued on the Requirements for Domestically Controlled REITs

On April 24, 2024, the Treasury and the IRS released final regulations (TD 9992, the “Final Regulations”) revising the standard under which a qualified investment entity (“QIE”) such as a REIT, will qualify as a “domestically controlled” QIE (“DC QIE”) under the so-called “FIRPTA” rules (the Foreign Investment in Real Property Tax Act).¹ The Final Regulations generally adopt the proposed regulations relating to DC QIEs that were issued on December 29, 2022 (the “Proposed Regulations”) with certain revisions.² Significantly, as further described below, the Final Regulations provide an extended transition period to apply the new rules for those QIEs that meet specified requirements. Satisfying the requirements will be critical for those QIEs, including REITs, that otherwise would have lost their DC QIE status upon the effectiveness of the Final Regulations.

Why “Domestically Controlled” Status Matters

Foreign persons are generally subject to U.S. federal income tax on any gain on the sale or disposition of any U.S. real property interest (“USRPI”) as if such gain were income effectively connected with the conduct of a U.S. trade or business. Foreign persons are also generally required to file a U.S. federal income tax return for any taxable year in which such gain is recognized. USRPIs include interests in real property located in the United States, as well as interests in a U.S. real property holding corporation (“USRPHC”). An equity REIT (that is, a REIT the assets of which predominantly comprise of real property) is often treated as a USRPHC.

However, equity interests in a DC QIE are not treated as USRPIs. A QIE is “domestically controlled” if less than 50% of its stock (by value) has been held, “directly or indirectly” by foreign persons at all times during the testing period (generally, the five-year period ending on the sale or disposition of such stock).

Historically, limited guidance existed as to what constituted “indirect” ownership by foreign persons. Though only applicable for the requesting taxpayer on the provided facts, the IRS had released a private letter ruling in 2009 that essentially concluded that a REIT need not look through domestic corporations to determine whether the REIT was domestically controlled.³

The Proposed Regulations: Introducing The Look-Through Rule

In issuing the Proposed Regulations, the government sought to clarify the meaning of indirect ownership for purposes of the DC QIE test by implementing a “look-through” approach. Under this approach, “non-look-through persons” indirectly holding tested QIE stock through one or more “look-through persons” would be treated as owning a pro rata share of the tested QIE, in proportion to their interest in the applicable look-through person(s).

• “Look-through persons” generally include REITs, RICs, partnerships (other than publicly traded partnerships), S corporations, and “foreign-owned domestic corporations” (i.e., any non-public domestic C corporation if foreign persons directly or indirectly hold 25% or more of its outstanding stock (by value)).
• “Non-look-through persons” generally include individuals, corporations (other than REITs, RICs and “foreign-owned domestic corporations”), and qualified foreign pension funds (“QFPFs”) and their wholly owned subsidiaries (qualified controlled entities, or “QCEs”).
• QFPFs and QCEs are treated as foreign persons for purposes of the DC QIE test. This treatment applies even if the QFPF or QCE in question is not treated as a “nonresident alien individual or foreign corporation” for purposes of Section 897.

The Final Regulations: What’s New, What’s Not

• DC QIE Determination

  The Final Regulations generally adopt the look-through rules of the Proposed Regulations and the rule that QFPFs and QCEs are treated as foreign persons for purposes of the DC QIE test.⁴ Notable revisions include:

  • Increased Foreign Ownership Threshold. The term, “foreign-controlled domestic corporation” [emphasis added] replaces the term “foreign-owned domestic corporation.” A “foreign-controlled domestic corporation” is any non-public domestic C corporation if foreign persons hold, directly or indirectly, more than 50% (rather than 25% or more) of its outstanding stock (by value). The government considered and rejected several alternative proposals made by commenters on the basis that the commenters’ proposed revisions would facilitate perceived abusive structures or introduce more complexity in testing QIEs.
  • Special Rule for Certain Public RICs. The Final Regulations, like the Proposed Regulations, generally treat RICs as “look-through” persons. Under the Final Regulations, however, “public RICs” (i.e., non-QIE publicly traded RICs) generally are treated as “non-look-through” persons.⁵
  • Expanded “Actual Knowledge” Override. Consistent with the Proposed Regulations, the Final Regulations provide that any shareholder owning less than 5% of the stock of a publicly traded U.S. QIE will be treated as a “non-look-through” U.S. person unless the QIE has actual knowledge that such person is a foreign person. The Final Regulations also introduce a new rule that no such shareholder, public RIC, publicly traded partnership or domestic corporation is eligible to be treated as a non-look-through person if the tested QIE has actual knowledge such person or entity is “foreign-controlled” (which is determined assuming any such person or entity is a non-public domestic C corporation).

• The Extended Transition Rule

  The Final Regulations generally took effect on April 25, 2024. Significantly, however, the government included an extended transition rule in response to concerns that the applicability date set forth in the Proposed Regulations would have unfair retroactive effect.

  A QIE that exists on the effective date of the Final Regulations is exempt from the new look-through rules as it pertains to domestic C corporations for up to ten years from the release date of the Final Regulations (i.e., until April 24, 2034), if:

  1. the QIE is and remains a DC QIE (without regard to the new look-through rule),
  2. the QIE does not acquire new USRPI interests during the transition period that exceed 20% of the aggregate fair market value of the total USRPI interests held by the QIE on April 24, 2024, and
  3. the percentage ownership of the QIE (by value) by persons that are non-look-through persons under the Final Regulations has not increased by more than 50% in the aggregate over the percentage of stock of the QIE owned directly or indirectly by non-look-through persons since April 24, 2024.

  To determine the fair market value of USRPI interests as of a given date (i) USRPI assets held at the end of the preceding fiscal quarter will be attributed the value used for purposes of the tested REIT or RIC’s “asset testing” on that date, and (ii) USRPI interests acquired subsequently may be valued using any reasonable method consistently applied for all purposes of the transition rule.

  The transition period applicable to a QIE ceases the day after any requirement of the transition period is no longer met, provided that in connection with a subsequent disposition of QIE stock, the QIE can still benefit from the transition rule for the portion of the look-back period during which all three requirements were satisfied.

• FIRPTA Certificate Reliance

  The Final Regulations confirm that a withholding agent may rely on a “FIRPTA certificate” issued by a QIE certifying as to its DC status. For example, a buyer of QIE stock from a foreign seller can rely on a FIRPTA certificate certifying the QIE is a DC QIE, subject to the same requirements applicable to FIRPTA certificates generally.⁶

Initial Takeaways

• Managers of REITs (or other QIEs) that are intended to be “domestically controlled” should review existing structures and any existing related contractual obligations to investors to assess continued compliance under the Final Regulations.
• Managers of existing REITs should review existing information about the direct and indirect beneficial owners of the REITs’ investors to determine whether additional information is necessary to substantiate DC REIT status under the Final Regulations.
• Managers forming new REITs intending to qualify as DC REITs should (i) carefully consider these new rules and their impact on investment structuring and (ii) obtain sufficient documentation and representations from investors regarding their direct and indirect beneficial owners.
• All REIT managers should monitor on an ongoing basis any REITs intended to be treated as DC REITs to take into account any subsequent direct or indirect ownership changes.