On December 29, 2022 the IRS and the Treasury Department issued a notice of proposed rulemaking (REG-100442-22) (the “Proposed Regulations”) that, among other things, affects the determination when Real Estate Investment Trusts (“REITs”) are treated as domestically controlled.
As a general matter, absent some applicable exception, foreign investors in REITs are subject to U.S. federal income tax on dividends and on depositions of their interests in REITs. REITs are treated as domestic U.S. corporations. Most REITs1 hold assets that consist primarily of U.S. real property interests (“USRPI”) under the definition of Section 8972 (commonly referred to as “FIRPTA”). Thus, under the FIRPTA rules REITs themselves are generally treated as USRPIs, and dispositions of USRPIs by a foreign person are subject to taxation under FIRPTA and a withholding tax regime.
To encourage foreign investment in REITs, and to lessen the compliance burden on REITs, Congress enacted numerous exceptions from this general rule. One of the exceptions provides that an interest in a REIT is not treated as USRPI (and is not subject to FIRPTA taxation and withholding) if the REIT qualifies as a “domestically controlled investment entity” (“D-REIT”) within the meaning of Section 897(h)(4)(B).
A REIT is a D-REIT if less than 50% of the fair market value of its outstanding stock is directly or indirectly held by “foreign persons” during a statutorily specified testing period (typically five years ending on the date of the disposition). Unfortunately, neither Section 897 nor the Treasury regulations define precisely the term “foreign person” for purposes of the D-REIT test.
Treasury regulations § 1.897-1(c)(2)(i) states that “ . . . the actual owners of stock, as determined under [Treasury regulations] § 1.857-8, must be taken into account.” Treasury regulations § 1.857-8 provide that the actual owner of REIT shares is the “person who is required to include in his return the dividends received on the stock.” Based on the plain reading of these regulations, and based on the IRS interpretation stated in a 2009 private letter ruling,3 many taxpayers and practitioners have concluded that the words “directly or indirectly” do not require looking through domestic taxable corporate entities. Thus, the prevailing view has been that domestic taxable C-corporations are not treated as foreign persons, even if they have a majority of foreign shareholders.
Certain presumption rules were enacted in the Protecting Americans from Tax Hikes Act of 2015 (“PATH Act”). Each shareholder who owns less than 5% of a publicly traded REIT stock is presumed to be domestic. Any stock of a REIT held by a publicly-traded REIT or Regulated Investment Company (“RIC”) is treated as held by foreign person unless the upper tier REIT or RIC itself is domestically controlled. Any stock of a REIT held by a private REIT or RIC is treated as held by a U.S. person to the extent U.S. persons hold stock, or are treated as holding stock, in such upper tier REIT or RIC. In a 2013 legislative discussion draft, Congress considered adding new constructive ownership rules that would address the possibility of looking through C-corporations, but that proposal was not adopted by the PATH Act, while other proposals were. Furthermore, the legislative history accompanying the PATH Act cited favorably the 200923001 private letter ruling as a statement of the existing law.4
Highlights of the Proposed Regulations on Domestically Controlled REITs
The proposed regulations define stock that is held “indirectly” by taking into account stock of the REIT held through certain entities under a limited “look-through” approach. The Proposed Regulations apply a “look-through” approach until you reach a “non-look-through person.” Non-look-through persons are individuals, certain domestic C-corporations (other than certain foreign-owned domestic corporations), foreign corporations, publicly traded REITs, publicly traded partnerships, an estate, and certain other entities.
The Proposed Regulations apply a look-through approach to “foreign-owned domestic corporations” that are defined as any non-public domestic corporation where foreign persons hold directly, or indirectly, at least 25% of the fair market value of the corporation’s shares. This rule would prevent using intermediary “blocker” domestic C-corporations by foreign investors to qualify as non-foreign persons for D-REIT testing purposes. As currently written, this proposed look-through rule would apply even to widely-held non-public domestic corporation or corporations that are owned by widely-held investment funds.
The ultimate negative impact, however, would not be on the foreign persons investing through the “look-through” C-corporations, but rather on the other foreign investors who hold their interests directly in non-publicly traded REITs. There is also a significant risk of broader negative impacts on real estate funds and commercial real estate markets because uncertainty created by the Proposed Regulations may affect availability of foreign equity capital and depress real estate prices at the time when real estate prices are already under pressure because of rising interest rates.
Although the Proposed Regulations have not been finalized, and they would apply only to transactions occurring on or after the regulations are finalized, they could have a retroactive effect and impact existing investment structures. The D-REIT test requires testing of ownership over the testing period, which can be up to five years preceding the transaction, and transactions occurring after the Proposed Regulation are finalized would use the new rules to test the ownership over the testing period. For example, if the Proposed Regulations are finalized on January 1, 2025, and there is a disposition of REIT shares on June 30, 2025, the corporate “look-through” rule may apply to testing REIT ownership at all times after June 30, 2020.
Moreover, the IRS took the unusual step of announcing in the preamble to the Proposed Regulations that it may challenge positions contrary to the proposed look-through rules even before the regulations are finalized.
What Will Happen?
In response to the Proposed Regulations the IRS received numerous comments from the public (including from Bilzin Sumberg).5 In general, the commentators recommended that the IRS withdraw the corporate “look-through” rule or, in the alternative, scale back the corporate “look-through” rule to exempt specific non-abusive structures. Additionally, the commentators focused on the unfairness of the retroactive effect of the corporate “look-through” rule and asked the IRS to “grandfather” existing investment structures.
While we cannot predict whether the Proposed Regulations will be finalized, and what form they will take if they are finalized, the IRS is expected to review and consider the public comments. Prior to adoption, Proposed Regulations may be withdrawn or modified at any time.
What Should You Do?
Foreign investors and real estate fund sponsors should review their investment structures, organizational documents, side letters, and contractual undertakings to determine whether they may be affected by these Proposed Regulations and whether any actions are required.
We will continue to monitor developments in this area and are available to answer your questions.
 A notable exception are debt REITs that hold mostly mortgages.
 Unless stated otherwise, all references to “Section” are referring to sections of the Internal Revenue Code of 1986, as amended, or the Treasury regulations promulgated thereunder.
 In private letter ruling 200923001 the IRS did not look through corporate entities that, under the facts of the ruling, were represented to be fully taxable domestic corporations for U.S. federal income tax purposes. A private letter ruling may be relied upon only by the taxpayer to which it is issued. However, private letter rulings often provide useful indication of the IRS interpretation, positions and administrative practice.
 Joint Committee on Taxation, General Explanation of Tax Legislation Enacted 2015 (JCS-1-16), March 2016, p. 280.