How Windstream Ruling Will Affect Foreign Taxpayers

by Bilzin Sumberg

In general, a REIT is a special purpose entity for U.S. federal income tax purposes that requires at least 75 percent of the value of the entity’s gross assets to consist of real estate assets, cash, cash items, and governmental securities. Although a REIT is subject to federal income tax at regular corporate rates, it is entitled to a deduction for dividends paid to shareholders and therefore typically pays little or no corporate income tax. 

Recently, much attention has been focused on the private letter rulings issued by the IRS to Windstream Holdings, Inc. (“Windstream”), a voice and data network communications company. These rulings allow Windstream to (i) spin off a bundle of its telecom assets (i.e., fiber optic and copper lines) into a separate publicly-traded company on a tax-free basis; and (ii) then elect REIT status for that new entity.  The REIT will lease those assets back to Windstream in exchange for arm’s length deductible rental payments.  It is expected that the REIT will pay out most of its income as a dividend to its shareholders and therefore will not be subject to corporate income tax. It has been reported that this strategy will reduce Windstream’s U.S. federal income tax liability by more than $250 million a year.

This is not the first time that the IRS has approved REIT status for entities owning assets that generally are not considered real property in the everyday sense of the words.  The IRS has issued rulings approving REIT status for companies owning billboards and advertising signs, casinos, boat slips, data storage centers and private prisons.  In May of 2014, the IRS issued proposed regulations clarifying what constitutes real property for REIT purposes.Those regulations define real property as land, permanent structures, and structural components, and specifically include “transmission lines” in the definition of real property.  The proposed regulations, however, are not effective until they are issued in final form.  As a result, it was interesting that the IRS granted the ruling to Windstream allowing its fiber and copper network assets to qualify as “real property” for purposes of the REIT provisions. 

Impact on Foreign Taxpayers

The preamble to the proposed REIT regulations specifically indicates that the “clarified” definition of real property is limited to the REIT provisions and should not be applied to other areas of the Internal Revenue Code (the “Code”), including the foreign investment in U.S. real property tax act (FIRPTA). (Although the FIRPTA regulations have a similar definition of real property). In general, under FIRPTA, gain recognized by a foreign person on the disposition of a U.S. real property interest is subject to U.S. federal income tax as if such gain were effectively connected to a U.S. trade or business and subject to tax at graduated tax rates applicable to U.S. persons. 

Even though the proposed REIT regulations cannot be relied on for purposes of determining whether an asset constitutes real property under the FIRPTA rules, the proposed regulations (along with the IRS rulings involving what constitutes real property for REIT purposes) nevertheless will have a direct impact on how foreign taxpayers are taxed under the FIRPTA regime. The FIRPTA provisions, along with most comprehensive U.S. income tax treaties, have specific rules dealing with how foreign persons are taxed when they receive distributions from REITs and when they sell their REIT shares that are different from the FIRPTA provisions generally applicable to foreign persons who receive distributions from U.S. real property holding companies and dispose of U.S. real property interests.

Distributions by REITs

Under Section 897(h)(1), any distribution by a REIT to a foreign person that is attributable to gain from the sale or exchange of a U.S. real property interest will be treated as gain recognized by the foreign person from the sale or exchange of a U.S. real property interest and subject to tax at graduated rates under FIRPTA. Therefore, if the foreign shareholder is a corporation, the REIT is required to withhold 35 percent of such distribution, the foreign shareholder is required to file a U.S. corporate income tax return, and the foreign shareholder may be subject to an additional 30 percent branch profits tax. The IRS takes the position that a liquidating distribution by a REIT attributable to gain from the sale of a U.S. real property interest will be covered by this rule as well. 

There is an exception to this rule, however, for any distribution by a REIT with respect to any class of stock which is regularly traded on an established securities market located in the United States if such foreign person did not own more than five percent of such stock at any time during the 1-year period ending on the date of such distribution. If this exception applies, the distribution will be treated like an ordinary dividend (even though it is attributable to gain from the sale of a U.S. real property interest) and either (i) subject to a 30 percent withholding tax (or a reduced treaty rate, if applicable), or (ii) eligible for a complete exemption under Section 892 if the shareholder is a foreign governmental or international organization. (It should be noted that this exception is slightly different than the exemption available to foreign persons who sell interests in publicly traded U.S. real property holding companies that are not REITs.  Under Section 897(c)(3), a foreign person will not be subject to tax under FIRPTA with respect to gain from the sale of any class of stock of a corporation that is regularly traded on an established securities market, so long as that person did not own more than 5 percent of such class of stock during the last five years). 

These tax consequences should be contrasted with the tax consequences that generally apply when a U.S. real property holding company that is not a REIT makes a distribution to a foreign person and that distribution is attributable to gain from sale of a U.S. real property interest.  In that case, the distribution is simply treated like a regular dividend and is either (i) subject to a 30 percent U.S. withholding tax (or reduced treaty rate, if applicable) or (ii) a eligible for a complete exemption under Section 892. The distribution also may be completely exempt from withholding if it is a liquidating distribution and the U.S. real property holding company sells all of its U.S. real property interests in a fully taxable transaction.

Furthermore, ordinary REIT dividends generally are not eligible for the reduced withholding tax rate of five percent (or zero, in some cases) available under many income tax treaties with respect to dividends paid by U.S. real property holding companies. Instead these dividends generally are subject to a 15 percent withholding tax (or zero, if paid to a pension fund) under most U.S. income tax treaties.  

Dispositions of REIT Shares   

Under Section 897(h)(2), gain recognized by a foreign person on the disposition of shares in a “domestically controlled” REIT will be completely exempt from U.S. federal income tax.  For this purpose, a domestically controlled REIT is any REIT in which at all times during the last five years (or shorter period, if the REIT was not in existence for at least five years) less than 50 percent of the value of the REIT shares were owned directly or indirectly by foreign persons. (See PLR 200923001 for an interesting ruling involving a domestically-controlled REIT that appeared to be more than 50 percent owned indirectly by foreign persons). This treatment should be contrasted to the general rule that requires gain to be recognized when a foreign person sells shares in a “domestically controlled” U.S. real property holding company that is not a REIT.


As noted above, the definition of real property under the proposed REIT regulations cannot be relied on for other purposes of the Code, including the FIRPTA provisions. Despite this disparate treatment, foreign taxpayers clearly will be affected by these regulations, as well as any private letter ruling issued by the IRS in which it treats assets that generally are not considered to be real property as real property for purposes of determining whether an entity qualifies as a REIT.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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