Minnesota Supreme Court Gets it REIT: Rejects 'Economic Substance'


In a landmark decision issued yesterday, the Minnesota Supreme Court struck a blow for taxpayers by reversing a Minnesota Tax Court decision that had allowed the Minnesota Department of Revenue to disregard a taxpayer's captive - REIT structure on the basis that the transactions creating the structure lacked economic substance. Describing as "radical" the Department's attempt to disregard the structure as a sham, the Minnesota Supreme Court held for the taxpayer, explaining: "If Minnesota statutes allow a favorable tax treatment, neither our court nor the Commissioner has the power to disregard those statutes and impose a different tax treatment. And, if we conclude a taxpayer has complied with the relevant statutes, that ends our analysis." HMN Financial, Inc. and Affiliates v. Commissioner of Revenue, Supreme Court of Minnesota, Docket No. A09-1164 (decided May 20, 2010).


The dispute involved a classic mortgage REIT with an 80/20 twist to make it effective within Minnesota's unitary combined filing regime. Captive REIT structures are intended to produce a double deduction: a dividends-paid-deduction ("DPD") for the Real Estate Investment Trust that pays a dividend, and a dividends-received-deduction ("DRD") for the receiving shareholder. At the core, the structure works when a state (1) conforms generally to the Internal Revenue Code, and thus conforms to the IRC § 857(b)(2)(B) DPD for REITs, but (2) decouples from federal DRD rules and thus fails to follow the federal rule that denies a DRD to the shareholder who receives a dividend for which a DPD was taken.

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