IRS Proposes to Reverse C-Corporation Look-Through Rule for Domestically Controlled REITs

Key Takeaways

• In proposed regulations issued Oct. 20 (the Proposed Regulations), the Treasury Department reversed its prior (and heavily criticized) position codified in final regulations that became effective on April 25, 2024 (the 2024 Final Regulations), requiring the “look-through” of certain non-publicly traded domestic C corporations (i.e., those with greater than 50% foreign ownership) (the C-Corporation Look-Through Rule) in testing for domestically controlled REIT (DCREIT) status.
• The Proposed Regulations reverse the rule in the 2024 Final Regulations and instead provide that a domestic C corporation is not “looked through” for purposes of testing DCREIT status. This is a reversion to pre-2024 industry practice, as prior to the 2024 Final Regulations, advisors generally took this position based on Private Letter Ruling 200923001 (the 2009 Private Letter Ruling). The Proposed Regulations’ codification of the reasoning in the 2009 Private Letter Ruling will bring certainty and administrability to both new and existing tax structures involving DCREITs.
• The Proposed Regulations, upon finalization, will be effective for transactions occurring on or after April 25, 2024, meaning that the C-Corporation Look-Through Rule will effectively be null from its inception. Importantly, taxpayers may rely upon the Proposed Regulations for transactions occurring prior to the date on which they are finalized.
• Other important aspects of the 2024 Final Regulations remain unchanged, including look-through rules for non-public REITs, S-corporations and partnerships, and the treatment of qualified foreign pension funds and their controlled entities as foreign persons for purposes of DCREIT determinations.

Domestically Controlled REITs

The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) treats gain recognized by a foreign person on the disposition of a United States real property interest (USRPI) as income effectively connected with a U.S. trade or business and thus subject to the regular U.S. federal income tax (see Section 897(a)(1)). However, Section 897(h)(2) provides that interests in a DCREIT are not USRPIs. Accordingly, gain recognized on the sale of shares in a DCREIT is exempt from FIRPTA. For a REIT to be domestically controlled, less than 50% of the value of its stock must at all times during the specified testing period (generally a five-year lookback) be held directly or indirectly by foreign persons. Stated differently, more than 50% of a REIT’s stock must be held by U.S. persons for it to qualify as a DCREIT.

The 2024 Final Regulations

As noted above, in determining whether a REIT is a DCREIT, the 2024 Final Regulations required the C-Corporation Look Through Rule to be applied in cases in which a C-Corporation was more than 50% foreign-owned. The 2024 Final Regulations also contained a complex and difficult-to-administer transition rule to deal with existing DCREIT structures.

The 2024 Final Regulations (and specifically the December 2022 proposed regulations that preceded them) were heavily criticized by practitioners, including the ABA Tax Section (whose comment letter was drafted by Paul Hastings partner Chris Mangin) and the business community for including the C-Corporation Look-Through Rule. Critics argued that the C-Corporation Look-Through Rule was contrary to congressional intent, inconsistent with prior guidance, extremely difficult to administer in practice, damaging to the efficient allocation of foreign capital into the United States and was of uncertain regulatory validity.

The Proposed Regulations

As stated in the preamble to the Proposed Regulations, the Treasury Department and the IRS have reconsidered the C-Corporation Look-Through Rule and are now of the view that imposing look-through treatment on a domestic C corporation is not the appropriate statutory construction that should be given to the text of Code Section 894(h)(4)(B). Consequently, the Proposed Regulations remove the C-Corporation Look-Through Rule effective April 25, 2024, rendering it stillborn.

Though the Proposed Regulations are only in proposed form at this juncture and are not yet final, taxpayers may rely upon the Proposed Regulations for transactions occurring prior to the date the Proposed Regulations are finalized.

The Proposed Regulations largely leave other portions of the 2024 Final Regulations in place.

Implications

The Proposed Regulations will provide much-needed certainty for structuring foreign investments in U.S. real estate, both with respect to existing and future structures. Specifically, we expect the Proposed Regulations to have the following implications, among others:

• Greater flexibility in the use of domestic C corporations as a structuring tool in DCREIT structures, given the codification of non-look through status in the Proposed Regulations.

• Resurrection of both existing and future “synthetic” DCREIT structures.
• Elimination of the need to determine and track compliance with the byzantine transition rules of the 2024 Final Regulations for DCREIT structures already in existence, particularly for those structures in which the business plan contemplates continual capital raising and asset acquisitions.