REIT MERGERS & ACQUISITIONS

TAX CONSEQUENCES

By: Barnet Phillips, IV December 5, 2005

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REIT Mergers & Acquisitions

Tax Consequences

1. Taxable Transactions - Basics

1. Purchase of corporate assets by REIT

1. Seller recognizes gain or loss - possibility of installment treatment.

2. REIT achieves basis step-up (or down) for assets and new holding period begins for assets.

3. If seller is a "C" corporation which then distributes proceeds to sharehold-ers, there is a double tax.

4. An asset purchase can be accomplished by a forward merger of target corporation into acquirer (i.e., target does not survive). Rev. Rul. 69-6, 1969-1 C.B. 104.

5. A "deemed" asset purchase can also be accomplished by purchasing stock of a corporation that is an "S" corporation or a member of an affiliated group and making a § 338(h)(10) election. Treas. Reg. § 1.338(h)(10)-1.

2. Purchase of all or substantially all of stock of corporation by REIT

1. To achieve basis step-up for assets, a § 338 election (deemed asset sale and liquidation) must be made.

1. In case of target "C" corporation, unlikely transaction since the tax cost to the "C" corporation of the deemed asset sale and liquidation generally outweighs the benefit of step-up to the REIT (unless "C" corporation has available net operating loss carryovers).

2. If REIT purchases 100% stock of "C" corporation and there is no § 338 election, "C" corporation should become a qualified REIT subsidiary ("QRS"). A QRS is a corporation 100% owned by a REIT which is not a taxable REIT subsidiary (TRS). For TRS see VI.B. below.

1. Based upon Private Letter Rulings ("PLRs"), transaction treated as stock purchase by REIT followed by a deemed § 332 liquidation with assets having carryover basis contributed to QRS. See III.C.3. below.

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2. REIT inherits in § 332 liquidation the earnings and profits ("E&P") of the "C" corporation, which it must distribute by year-end. Treas. Reg. § 1.857-11. Under § 332(c) REIT also has income to the extent the liquidated target is a REIT and the liquidating distribution gave rise to a dividends paid deduction to the target REIT.

3. In an ordinary § 332 liquidation, the transferee corporation takes a transferred (or carry over) basis in the assets of the liquidating corporation [§ 334(b)(1)].

4. On February 4, 1988 the IRS issued Notice 88-19 (1988-1 C.B. 486) announcing an intention to promulgate regulations under § 337(d) with respect to property of a C corporation that becomes property of a REIT in a carry over basis transaction. The Notice stated that, where the regulations applied, the C corporation would be subject to corporate level gain (but not loss) as if it had sold all of its assets at fair market value and immediately liquidated. The Notice indicated, however, that the regulations should not affect the tax treatment of other parties to the transaction. The Notice further provided that immediate gain recognition could be avoided if the taxpayer made an election consistent with § 1374 ("§ 1374 Election") to treat the built-in gain on the C corporation property as subject to corporate level tax if it were disposed of during a 10-year recognition period.

5. As a consequence of this Notice, many taxpayers made 'protective' § 1374 Elections to avoid corporate level gain on the deemed disposition. On February 7, 2000, the Treasury published Temp. Reg. § 1.337(d)-5T [TD 8872] (the "-5T Regulations") reflecting the principles set forth in Notice 88-19. As foreshadowed in Notice 88-19, the -5T Regulations took effect (retroactively) from June 10, 1987. Taxpayers subject to the -5T Regulations were, however, permitted to file § 1374 Elections with the first Federal income tax return filed by the REIT after March 8, 2000.

6. A number of comments were received on the -5T Regula-tions [see a summary of the comments of the National Association of Real Estate Investment Trusts (NAREIT) at 2000 TNT 92-1]. Of particular concern was whether taxpayers who had made "protective" § 1374 Elections pursuant to the terms of the Notice were required to make new elections under the Regulations. After considering submissions, Treasury issued two new sets of temporary regulations [TD 8975] Temp. Reg. § 1.337(d)-6T and Temp. Reg. § 1.337(d)-7T (the -6T and -7T Regulations respectively).

7. Finally, on March 18, 2003, Treasury issued final regula-tions [TD 9047]: Treas. Reg. § 1.337(d)-5, Treas. Reg. § 1.337(d)-6, and Treas. Reg. § 1.337(d)-7 (-5, -6, and -7 Regulations respectively). The -5 Regulations remain unchanged from the -5T Regulations. The -6 Regulations and -7 Regulations do not substantially change the -6T Regulations and -7T Regulations.

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8. Taxpayers now have the option to apply the -5 or the -6 Regulations to transactions occurring between June 10, 1987 and January 1, 2002 but taxpayers must apply the -7 Regulations to transactions occurring on or after January 2, 2002.

9. The -6 regulations provide that, if a C corporation converts to REIT status or the property of the C corporation otherwise becomes property of a REIT in a carry over basis transaction then, if the C corporation has a net built in gain in its assets, the C corporation is subject to deemed sale treatment immediately prior to the transaction and the basis of the property in the hands of the REIT is adjusted accordingly unless the REIT elects to be subject to § 1374 treatment. If there would be a net loss on the deemed sale, such a loss may not be realized and the REIT will take a carry over basis in the C corporation's property.

10. The -5 Regulations provide that the C corporation is treated as if it had sold all of its assets at their respective fair market values, however the -6 regulations state that the C corporation is treated as having sold only that property actually transferred to the REIT. The -6 regulations also do not apply a deemed liquidation analysis of the C corporation. Commentators had argued that the deemed liquidation could be read as resulting in the imposi-tion of a shareholder level tax and would inappropriately eliminate the C corporation's tax attributes, such as net operating loss carryforwards and earnings and profits, to which the REIT might otherwise succeed. The -5 Regulations require REITs to affirmatively make a § 1374 Election in order to avoid adverse gain recognition consequences. They also provide that if the taxpayer elects to be subject to § 1374, the built-in gain is subject to the rules applying to foreclosure property (potentially resulting in the conversion of built-in (capital) gain to ordinary income). The -6 Regulations clarify that a taxpayer that made a "protective" § 1374 Election pursuant to Notice 88-19 does not need to make an additional election.

11. The -6 Regulations provide that a § 1374 election may be made with any federal income tax return filed on or before September 15, 2003. The -6T Regulations had provided that such an election could be made on or before March 15, 2003, but Treasury extended the date in response to commentator concerns that, in the case of a conversion transaction occurring on January 1, 2002 (the last date of applicability of the -6T Regulations), the time limit for making a § 1374 election could preclude a REIT from extending the due date of its Federal income tax return beyond March 15, 2003.

12. The -7 Regulations make the § 1374 Election automatic, although a taxpayer can elect "deemed sale" treatment. The regulations also contain an anti-stuffing rule to prevent taxpayers transferring to a corporation property with a built-in loss to reduce net built-in gain on a deemed sale.

13. The final regulations also clarify that once certain tax attributes are used to offset built-in gain, they can still be used to offset REIT taxable income generated from the built-in gain.

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3. In the case where target is a REIT, there remains the possibility of maintaining target's independent REIT status provided there are at least 99 other shareholders, but still no basis step-up for assets.

2. Stock acquisition can be accomplished by reverse-subsidiary merger of transitory, shell subsidiary of acquiring corporation with and into target corporation with target corporation surviving. Rev. Rul. 73-427, 1973-2 C.B. 301; Rev. Rul. 67-448, 1967-2 C.B. 144; See PLR 9717036. The shell could be any form of disregarded entity ("DRE") including a QRS or an LLC which makes an election under Temp. Reg. § 301.7701-3. See the 2003 regulations on mergers involving DREs below at II.B. 2. Tax-free Reorganizations (§ 368 of the Internal Revenue Code)

1. General Requirements

1. § 368 of the Code lists specific corporate transactions that are afforded tax-free treatment to corporate parties and shareholders.

2. In addition to express Code requirements, there are important, general judicial requirements.

1. Continuity of Interest

1. Substantial portion of consideration must be stock of acquirer (or in certain cases, parent of acquirer) and target shareholders must continue to hold that stock interest. Treas. Reg. § 1.368-1(b). Cases hold that approximately 40% stock consider-ation is sufficient. Paulsen v. Commissioner, 469 U.S. 131, 136 (1985) (citing Nelson v. Helvering, 296 U.S. 374 (1935)). IRS's favorable ruling standard is 50%. Rev. Proc. 77-37, 1977-2 C.B. 568. Recently promulgated Final Regulations (the "New COI Regulations ") which supplement the existing Final Treas. Reg. § 1.368-1(e) addressing continuity of interest (the "COI Regulations "), provide that the minimum amount of acquiring corporation stock needed to satisfy COI is 40%. [See T.D. 9225, (September 16, 2005)]. The New COI regulations generally adopt the principle that if there is a binding contract that provides for "fixed consideration" the value of the consideration for COI purposes would be measured on the last business day before the first date there is a binding contract between the parties to the transaction (the signing date) and not the closing date of the transaction. The COI regulations provide that a disposition by target shareholders of acquiring corporation immediately before or following the acquisition of target corporation does not affect the tax-free treatment of the reorganization, even in the case where the post-acquisition disposition is pursuant to a pre-existing binding contract. Treas. Reg. § 1.368-1(e)(1).

2. Stock consideration can be either common or preferred, but in certain reorganizations (§§ 368(a)(1)(B), 368(a)(1)(C) and 368(a)(2)(E)) must be substantially or entirely voting stock (i.e., right to vote for directors). Under § 351(g) non-qualified preferred

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stock is treated as boot even though such stock is treated as stock for the purpose of determining whether a reorganization is tax-free.

3. The IRS has ruled that a partnership's distribution to partners of an acquiring corporation's stock received pursuant to a statutory merger does not affect whether continuity of interest is satisfied. See Rev. Rul. 95-69, 1995-2 C.B. 38. After the promulgation of the COI Regulations, Rev. Rul. 95-69 appears irrelevant because a distribution to partners of an acquiring corporation's stock will not violate continuity of interest.

4. The Final Regulations do not separately articulate rules addressing the concept of remote continuity of interest, which arose out of Groman v. Commis-sioner, 302 U.S. 82 (1937), and Helvering v. Bashford, 302 U.S. 454 (1938). The continuity of business requirements articulated in the Final Regulations address the issues raised in Groman and Bashford by treating the issuing corporation as continuing a target business or owning target business assets if these activities are conducted by a member of a qualified group or, in certain cases, by a partnership that has a member of the qualified group as a partner. See Continuity of Business Enterprise, II.A.2.b. below.

2. Continuity of Business Enterprise

1. Acquirer must continue a significant line of the historic business of target or continue to use a significant portion of the historic assets of target in a business. Example in Treasury Regulations indicates one-third of historic assets is a significant portion. Treas. Reg. § 1.368-1(d)(5) (Example 1).

2. Final Regulations addressing the continuity of business enterprise requirement (the "COBE Regulations") expand the manner in which the COBE requirement can be satisfied by including the Acquirer as conducting target business or using target assets in a business if these activities are conducted by a member of Acquirer's "qualified group." A "qualified group" includes one or more chains of corporations connected through stock ownership using the control test of § 368(c).

3. Transfers of assets into corporate subsidiaries are autho-rized by statute. After December 31, 2000 REITs can now maintain substantial holdings in three types of corporate entities: Taxable REIT subsidiaries (TRSs) discussed below at VI.B.; wholly owned QRSs; and subsidiaries which are themselves REITs (and therefore, not wholly owned). Other forms of corporate subsidiaries may cause the REIT to violate the asset requirements of the REIT regime.

4. The COBE Regulations provide that continuity of business enterprise is not violated on a drop-down of target assets to a partnership so long as (i) members of a qualified group, in the aggregate, own an interest in the partnership representing a significant interest in the partnership business or (ii) one or more members of the qualified group

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have active and substantial management functions as a partner with respect to the partnership business. Treas. Reg. § 1.368-1(d)(4)(iii).

3. Business Purpose

1. There must be a business purpose for the reorganization. Treas. Reg. § 1.368-1(c).

2. Generally, easily shown, particularly when public company shareholders vote on the transaction.

2. Specific Types of Reorganizations

1. § 368(a)(1)(A) - Straight A Merger

1. Simple, straightforward--target corporation merges into acquirer pursuant to state law.

2. Maximum flexibility from a tax perspective (i.e., in terms of consideration and other requirements), but this transaction is sometimes avoided because of need in some cases for approval by acquirer's shareholders.

3. There has been considerable uncertainty and debate in recent years as to whether the merger of a target REIT into a DRE (such as acquiring REIT's newly-formed QRS) should qualify as a reorganization under § 368(a)(1)(A). As recently as 1995, the Service had ruled that such a merger qualified as so called "A Merger". On May 16, 2000, however, the Service reversed its position, issuing proposed regulations (the "2000 Proposed Regulations") that stated that when a target entity merges into a DRE of an acquiring parent corporation there was not a good statutory merger under state law for purposes of § 368(a)(1)(A) (see Fed Reg. Vol. 65, No 95, p 31115).

4. These heavily criticized regulations were withdrawn on November 15, 2001, and the Service issued new proposed regulations (the "2001 Regulations") permitting the merger of a target into a DRE to qualify as an A Merger with the corporate parent of the DRE. [See below and Fed. Reg. Vol. 66. No. 221 p. 57,400].

5. On January 23, 2003, the Service issued final, temporary, and proposed regulations (the "2003 Regulations") which retain the general framework of the 2001 Regulations with some minor modifications. [See Treasury Decision 9038, REG-126485-01, (January 23, 2003)]

6. Evidence of the Service's former ruling position can be found in PLR 8903074 where the Service ruled that the merger of target REIT into acquiring REIT's newly-formed QRS was a merger of target REIT into acquiring REIT which qualified as a

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reorganization under § 368(a)(1)(A). In PLR 9411035, the Service ruled that the merger of one non-QRS REIT subsidiary ("Sub") into another QRS of the same "Parent" was treated as if it were a merger and liquidation of Sub into Parent. In PLR 9512020 a merger of a corporation into a QRS was assumed to be treated as a merger into the Parent of QRS under § 368(a)(1)(A).

7. The 2000 Proposed Regulations on disregarded entities, when analyzing a reorganization under § 368, treated a DRE as disregarded for tax purposes only and not for state law merger purposes. The 2000 Proposed Regulations provided that when the target was merged into a DRE the transaction was not a good reorganization under § 368(a)(1)(A) presumably on the grounds that, while there had been a good merger under state corporate law with the DRE, there had not been a good corporate merger with the corporate parent of the DRE. The 2000 Proposed Regulations also provided that when the reverse occurred (i.e. an owner of a DRE merges that entity into target) the merger was to be treated as a contribution of the assets of the DRE, to the target, in exchange for stock of the target and the Service held that the merger could qualify under § 351 (provided the other requirements of § 351 are met).

8. The effect of the 2000 Proposed Regulations seemed to be that where a wholly-owned subsidiary was used in a forward triangular type reorganization the acquisition of assets must qualify as a Stock-for-Assets Reorganization under § 368(a)(1)(C) in order to be tax free.

1. PLR 9718006: REIT's acquisition of stock of Target companies solely in exchange for REIT voting beneficial interests treated as acquisition of assets, properly analyzed under § 368(a)(1)(C). Acquiring REIT acquired stock of Target companies in exchange for voting beneficial interests. IRS rules Target companies will be QRSs after transaction through deemed liquidations as part of integrated acquisition plan. However, deemed liquidation means REIT acquired assets rather than stock. Thus, proper analysis is under § 368(a)(1)(C). Immediately following the asset acquisition, assets deemed contributed to newly-formed subsidiaries that will be treated as QRSs.

2. Rev. Rul. 67-274, 1967-2 C.B. 141: Acquisition of stock of Target followed by prompt liquidation of Target pursuant to a single plan is treated as a tax-free asset acquisition under § 368(a)(1)(C).

3. Rev. Rul. 72-405, 1972-2-C.B. 217: Parent corporation's formation of subsidiary solely to acquire the Target's assets in exchange for Parent's voting stock, immediately followed by a liquidation of the subsidiary into the Parent pursuant to a single plan is treated as a tax-free asset acquisition under § 368(a)(1)(C).

9. NAREIT made submissions to the Service on the 2000 Proposed Regulations, focusing on the effect of the regulations as outlined in the previous paragraph. See (Aug 15, 2000) 2000 TNT 158-45. NAREIT argued that the 2000 Proposed Regulations had a disproportionate adverse effect on REITs, depriving REITs of access to the tax free reorganiza-tion provisions of the Code. NAREIT argued that A Mergers, which utilize a wholly owned

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subsidiary, provide more flexibility to companies than triangular "B mergers" because they allow for boot, require no shareholder approval and they create no dissenters' rights. Further, because of the nature of their asset holdings, REITs have difficulty accomplishing other types of triangular reorganizations. The significant amount of debt often carried by REITs prevents them from meeting the "substantially all" requirement of § 368(a)(1)(C) (the so-called "C Reorganiza-tion") (See II.B.3 below). The only subsidiaries REITs can form are QRSs or a TRSs (See I.B.1.b.iii above). A TRS is an entity that is taxable on its real estate income, and a QRS is a DRE. Thus a triangular merger under § 368(a)(2)(D) or § 368(a)(2)(E) was either impossible under the 2000 Proposed Regulations, or created double taxation of REIT assets. While it remained possible to do a triangular merger utilizing a subsidiary which is itself a REIT the shareholding and other qualifying requirements for REITs made this mechanism cumbersome and unwieldy.

10. The Service replaced the 2000 Proposed Regulations with new Proposed Regulations issued on November 15, 2001. Both the 2001 Proposed Regulations and the 2003 Regulations permit a merger of a corporation into a DRE to qualify as an A Merger by defining a "statutory merger or consolidation" under § 368(a)(1)(A) as a transaction effected pursuant to the laws (not, as under the 2000 Proposed Regulations, the corporate laws) of the United States or any State, in which all the assets and liabilities of each member of a combining unit (comprised of a "Combining Entity": a business entity that is taxed as a corporation, and all the DREs owned by that Combining Entity) become assets and liabilities of another combining unit and the Combining Entity of the transferor unit ceases its legal existence for all purposes. The requirement of the transferee unit to transfer all the assets and liabilities does not require the merger to meet the technical and stringent "substantially all" requirement of § 368(a)(1)(C).

11. Under Example 2 of the 2001 Proposed Regulations and the 2003 Regulations a merger of a target REIT into an acquiring REIT's QRS may now qualify as an A Merger. The target REIT's assets and liabilities become assets and liabilities of acquiring REIT and the target REIT merges out of existence. Further the merger of a target REIT into a QRS of a REIT will qualify as a good forward triangular merger under § 368(a)(2)(D) if the target shareholders receive stock of a corporation that "controls" the acquiring REIT. While the 2001 Proposed Regulations and 2003 Regulations permit forward mergers into a DRE, Example 6 of the 2003 Regulations holds that the reverse merger of an acquiring parent's DRE into a target corporation cannot qualify as an A merger because, contrary to the requirements of the Regula-tions, all the assets of the transferor unit (the acquiring parent and its DRE), do not become assets of the target, and the acquiring parent continues in existence).

12. NAREIT made further submissions on the 2001 Proposed Regulations on March 5, 2002 [See 2002 TNT 54-45]. While acknowledging the efforts of the Treasury and the Service in resolving many of the issues identified by NAREIT in their submis-sions on the 2000 Proposed Regulations, NAREIT argued that the regulations should be amended to permit reverse subsidiary mergers in the REIT context, where there is no potential for a divisive reorganization. The 2003 Regulations do not reflect NAREIT's concerns.

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2. § 368(a)(1)(B) - Stock-for-Stock Reorganization

1. Exchange of acquirer's (or acquirer's parent's) solely voting stock (common or preferred) for 80% control (both voting and non-voting) of target shares.

2. Solely voting stock requirement is very strict -- no leeway for cash or other consideration (except cash in lieu of fractional shares and if provided by target through dividends or redemption of stock prior to reorganization).

3. § 368(a)(1)(C) - Stock-for-Assets Reorganization

1. Substantially all assets of target acquired for solely voting stock of acquirer or acquirer's parent. IRS ruling standard for "substantially all" is 90% of target's net and 70% of target's gross assets. Rev. Proc. 77-37, 1977-2 C.B. 568.

2. Solely voting stock does not permit other consideration.

1. Exception: up to 20% other kinds of consideration can be used, but then must count target liabilities assumed by the acquirer towards the 20% limitation.

2. In the event of acquiring real estate, counting assumed liabilities towards 20% limitation usually forecloses use of consideration other than voting stock.

3. In context of REITs, IRS has ruled that an Acquiring REIT's acquisition of all of the assets of Target S Corporation in exchange for REIT voting stock (and cash in lieu of fractional shares), followed by liquidation of Target S Corporation qualified as a tax-free reorganization under § 368(a)(1)(C). PLR 9606005.

4. The ability of a corporation to engage in a "forward" subsidiary merger under § 368(a)(1)(C) is affected by the fact that the subsidiary of the REIT will be a QRS (and therefore a DRE). A "forward" subsidiary merger will therefore tend to qualify as an A Merger rather than a C (See II.B.1.d. above and II.B.4 below).

5. It would be possible to do such triangular reorganizations with non-wholly owned (but 80% controlled) subsidiaries that also independently qualify as REITs after the transaction. These should be analyzed as § 368(a)(2)(D) and § 368(a)(2)(E) and possibly § 368(a)(1)(B) reorganizations.

4. § 368(a)(2)(D) - Forward-subsidiary merger

1. Target merges with and into a directly controlled subsidiary of acquirer with target shareholders receiving acquirer stock.

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2. Substantially all assets of target must be transferred. IRS's favorable ruling standard is 90% of target's net and 70% of target's gross assets. Rev. Proc. 77-37, 1977-2 C.B. 568.

3. No subsidiary stock can be used.

4. Usually accomplished with newly-formed subsidiary, but not necessary.

5. Preferred by corporate lawyers since it avoids the possible need for consent by acquirer's shareholders, and it isolates liabilities of target in a subsidiary.

6. Maximum flexibility on use of non-stock and non-voting stock consideration.

7. However, as noted above at II.B.1.c a wholly owned subsidiary of a REIT must either be a QRS or a TRS. If the subsidiary is a TRS, the REIT will be subject to double taxation on the acquired assets. If the subsidiary is a QRS, the reorganization will qualify as an A Merger rather than as a forward-subsidiary merger unless the target shareholders receive stock of a corporation that controls the acquiring REIT. See II.B.1.c. above.

5. § 368(a)(2)(E) - reverse-subsidiary merger

1. Merger of subsidiary of acquirer with and into target with target surviving, and in the merger, control of target is acquired in exchange for voting stock of acquirer. After merger, surviving target must retain substantially all of its assets.

2. Substantially all of the assets is same standard as for reorganiza-tions under § 368(a)(1)(C) and § 368(a)(2)(D) : 90% of target's net assets and 70% of target's gross assets for IRS favorable ruling. Rev. Proc. 77-37, 1977-2 C.B. 568.

3. Statute permits up to 20% non-stock consideration.

4. Corporate lawyers prefer because of avoidance of acquirer shareholder vote, isolation of liabilities and survival of target, which makes it less likely that lease and loan-covenants regarding assignment will be triggered.

5. Note however that reverse-subsidiary mergers are complicated by the 2003 Regulations. A wholly owned subsidiary, which is not a TRS, will be a QRS, and therefore cannot qualify as a merger-sub for purposes of § 368(a)(2)(E). Furthermore, Example 6 of the 2003 Regulations indicates that a reverse-subsidiary merger of a DRE (such as a QRS) into a target corporation will not qualify as an A merger (See II.B.1.c. above). Provided other requirements are satisfied, this form of transaction may qualify as a Stock- for-Asset Reorganiza-tion (See II.B.3 above) or a contribution in a § 351 transaction (See IV.A below). While a

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reverse subsidiary merger under § 368(a)(2)(E) is possible if the wholly owned subsidiary is a TRS or a REIT and the survivor maintains TRS or REIT status, there is the potential for unnecessary double taxation and/or complexity.

3. Other Issues

1. Tax-free reorganizations are often accomplished through one or more steps that are integrated and judged as a single transaction.

1. For example, a typical two-step acquisition is a first-step tender offer followed by second-step merger. The transactions together usually qualify overall under § 368(a)(1)(A) or § 368(a)(2)(D).

2. Standard for integration can be simply steps taken pursuant to a plan, or steps that are interdependent, or steps taken pursuant to a legally binding commitment. If there is a legally binding commitment, integration of steps is clear. Walt Disney Incorporated v Commissioner, 97 TC 221 (1991); JE Seagrams Corp. v Commissioner, 104 TC 75 (1995); Turner Broadcasting Corp. v Commissioner, 111 TC 315 (1998). When there is no legally binding commitment, it is uncertain how and if other integration standards apply, and one must look to facts and circumstances. King Enterprises v United States, 418 F. 2d 511 (1969); MacDonald's Restaurants of Illinois Inc. v Commissioner, 688 F 2d 520 (1986).

3. Note that the existence of contingencies or conditions to the consummation of a binding legal commitment will not prevent the application of the doctrine and the integration of the steps. JE Seagrams Corp. v Commissioner, supra; Field Service Advice 199929013.

2. Often the form of the transaction may permit it to qualify as more than one type of tax-free reorganization with substantially the same results. 3. Special Issues Involving REITs

1. A REIT is an investment company

1. One requirement for tax-free reorganization treatment which is generally of no consequence to corporate parties is that if both parties are investment companies, an undiversified investment company will not receive tax-free treatment. § 368(a)(2)(F). A REIT is an investment company but is generally diversified.

2. Two REITs can engage in a tax-free reorganization since both are diversified.

3. A REIT cannot acquire an undiversified investment company, and vice-versa, in a tax-free reorganization.

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4. An undiversified investment company is a "C" corporation, 50% or more

of the assets of which are stock and securities and 80% or more of the assets of which are held for investment, and either (i) more than 25% of its asset value is in stock and securities of one issuer or (ii) more than 50% of its asset value is in stock and securities of five or fewer issuers. For this purpose, 50% or greater subsidiaries are looked-through as if parent directly held its proportion of assets. § 368(a)(2)(F)(ii), (iii).

2. REIT acquiring a "C" corporation

1. Regulations issued by the Service provide that if a "C" corporation converts to REIT status or is acquired in a tax-free reorganization by a REIT, either:

1. "C" corporation recognizes and pays tax on net built-in gain on assets, or

2. REIT can elect under § 1374 to be taxed on such net built-in gain inherent in the "C" corporation's assets (which have a carryover basis) if such assets are disposed of within 10 years of conversion or acquisition. NAREIT had made comments on these regulations as proposed; no changes were made in the final regulations. See above I.B.1.b.iv.

2. "C" corporation that either converts to REIT status or is acquired by a REIT in a tax-free corporate reorganization must eliminate, through dividend distributions, all its E&P before the end of the taxable year. § 857(a)(3)(B); Treas. Reg. § 1.857-11. Otherwise, REIT will lose REIT status.

3. Where a REIT acquires target with non-REIT E&P, REIT could have target distribute all of its E&P prior to the acquisition. Care must be taken that dividend distribution is not recharacterized as part of the purchase price (thereby, not reducing non-REIT E&P).

1. In Waterman Steamship Corp. v. Commissioner, 430 F.2d 1185 (5th Cir. 1970), Target distributed dividend to Parent in the form of short-term notes. Shortly thereafter, Parent sold Target stock to Buyer, which lent funds to Target to pay the notes. Reasoning that the transaction was a sham designed solely to avoid taxes (dividend eliminated in consolidated return), the court disallowed the purported dividend and recast the distribution as part of the purchase price.

2. In Casner v. Commissioner, 450 F.2d 379 (5th Cir. 1971), Target distributed unwanted assets to Selling Shareholders immediately prior to and as part of negotia-tions for the sale of the Selling Shareholders' Target stock. Court held distributions prior to signing of any binding purchase contracts constituted dividends to Buyer followed by payment of dividend amount to the Selling Shareholders as additional purchase price for the Target stock.

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3. In Rev. Rul. 75-493, 1975-2 C.B 108, the Service announced it would not follow Casner. IRS will treat distributions under similar set of facts as a dividend. Distinguished Waterman Steamship on grounds that there, the funds to pay the dividend were actually furnished by the buyer.

4. In TSN Liquidating Corp. v. United States, 624 F.2d 1328 (5th Cir. 1980), the Court upheld dividend treatment where, as contemplated by the stock purchase agreement, Target distributed unwanted assets, constituting 78% of Target assets, prior to stock sale. Acquirer subsequently reinfused new capital into Target. Court reasoned that mere infusion of capital does not require application of Waterman Steamship.

5. In PLR 9717036, the IRS upheld the characterization of pre-merger dividend distribution. Prior to the acquisition through a merger of QRS with and into Target, Target declared and distributed dividends in the form of notes sufficient to ensure Target would have no E&P. Waterman Steamship distinguished because notes payable only with cash from assets or continuing separate operations of former Target or from loans against former Target's assets. It is unclear from the factual description whether the distribution was contemplated by the merger agreement.

6. When a publicly traded REIT acquired all of the outstanding stock of a privately held corporation, the IRS ruled in PLR 9813004 that the Target's distribution to its investors (prior to its acquisition by a REIT) was a dividend to the extent there was available E&P in the Target. In that case the stock purchase agreement specifically contemplated that a distribution would be made and the distribution was partly funded out of excess cash and partly funded out of borrowing secured over assets of the Target. PLR 9813004 indicates a consider-able relaxation in the Service's approach to the application of Waterman Steamship.

3. Use of Qualified REIT Subsidiaries ("QRSs")

1. QRSs are ignored for all tax purposes so that REIT is deemed to own assets and receive income and deductions of QRS directly.

2. Any corporation wholly-owned by a REIT may be treated as a QRS, regardless of whether the corporation had always been owned by the REIT. The only require-ment is 100% ownership. An acquired "C" corporation may qualify as a QRS. However, if the REIT acquires an existing corporation, the corporation is deemed liquidated and reformed as QRS, thus any pre-REIT built-in gain is subject to the normal rules of § 337. See III.C.3. below.

3. PLRs have ruled that on conversion of a "C" corporation to a REIT, pre-existing subsidiaries of the former "C" corporation (even subsidiaries that were acquired by "C" corporation from others) automatically become QRSs through a deemed tax-free § 332 liquida-tion and recontribution of assets to the new QRS. This transformation occurs without actual liquidation-reformation. PLRs 9421034, 9330022 and 9625024.

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The same analysis (i.e., deemed liquidation of "C" corporation followed by reformation of assets into a QRS) has also been applied in the following circumstances:

1. PLR 9612024: Existing REIT, stock of which is contributed in the formation of a Newco holding company (which will also qualify as a REIT), deemed to be a QRS of the Newco. Newco deemed to have completely liquidated REIT and reincorporated immediately before the effective date of Newco's REIT election.

2. PLR 9609024: Two "C" corporations acquired in cash merger by Acquirer which will elect REIT status deemed to be QRSs. Acquired "C" corporations deemed to have been liquidated in a tax-free § 332 liquidation immediately prior to the effective date of Acquirer's REIT election and their assets contributed to new wholly-owned subsidiaries.

3. PLR 9717036: Target and subsidiaries acquired by REIT through a cash merger treated as QRSs. Acquirer formed transitory subsidiary, which merged into Target. Target and subsidiaries deemed to have been liquidated immediately following the merger in a tax-free § 332 liquidation and their assets contributed to new wholly-owned subsidiaries. Due to deemed liquidation, transaction considered an asset acquisition, although assets have a carryover basis.

4. PLR 9620031: QRSs of Target UPREIT treated as QRSs of Acquiring REIT after merger of Target UPREIT into Acquiring REIT. UPREIT merges directly into REIT in a transaction intended to qualify as a tax-free merger under § 368(a)(1)(A) (IRS did not rule on merger). Assets and liabilities of Target UPREIT QRSs treated as contributed to newly formed wholly-owned subsidiaries. No deemed liquidation necessary to reach conclusion because Target was REIT, and therefore, QRSs of Target are ignored (treated as directly owning assets). PLR 9527020, on similar facts, reaches same conclusion.

4. Since a QRS is a DRE, the effect of the 2003 Regulations (see part II.B.1.c. above) seems to be that where a wholly-owned subsidiary is used in triangular type reorganization the acquisition of assets can qualify as an A Merger.

4. Non-REIT E&P Issues

1. Corporation does not qualify as a REIT for any taxable year unless, as of the close of the taxable year, it has no E&P accumulated in any non-REIT year. § 857(a)(2)(B); Treas. Reg. § 1.857-11(b).

2. In a taxable year in which REIT has non-REIT E&P (year of formation or due to transaction to which § 381 applies to cause REIT to succeed to another corporation's E&P), REIT must distribute non-REIT E&P.

3. Under prior law, subsequent adjustment to E&P could cause REIT to lose REIT status. For example, if REIT had E&P of $60 of which $50 is REIT E&P and $10 of

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inherited accumulated non-REIT E&P, a $60 dividend distribution during the year would eliminate all E&P and therefore all non-REIT E&P. However, if pursuant to later IRS audit adjustment for the year of distribution REIT E&P is increased by $1, REIT will not have distributed all non-REIT E&P because REIT E&P is deemed to be first distributed.

4. In taxable years after December 31, 2000 the ordering rules applicable to distributions from E&P are simplified. Under new law, distributions of E&P generally are treated as made first from E&P that was generated when the entity did not qualify as a REIT, rather than from the earliest E&P of the REIT. § 857(d)(3)(A).

5. The referral by Treas. Reg. § 1.857-11(c) to the distribution procedures of Section 852(e) now make a mistake regarding the "C" corp. earnings and profits no longer a question of REIT qualification since § 852(e)(2) provides a mechanism to make distributions in later years if there is a "determination."

5. REIT might not be a corporation

1. Some REITs are business trusts rather than corporations under state law.

2. Although business trusts are treated as corporations for tax purposes, a REIT formed as a business trust may have to be reformed as a corporation under state law in order to effect a merger with a corporation (particularly if the other entity is from a different jurisdiction).

3. Note that a § 368(a)(1)(A) reorganization requires a merger or consolida-tion pursuant to state law. This may require incorporation of a business trust.

4. Reincorporation of REIT formed as a business trust will qualify as an independent tax-free reorganization. § 368(a)(1)(F). E.g., PLR 8538023.

6. Continuity and UPREITs

1. COBE Regulations provide that a corporate partner ("PTR") will be treated as conducting the partnership's business for purposes of the continuity of business enterprise if either (a) the PTR has active and substantial management functions, or (b) the PTR has a significant interest in the business. Treas. Reg. § 1.368-1(d)(4)(iii). Thus, continuity of business enterprise will not be violated on a drop-down of target assets into a partnership provided at least one of the foregoing conditions is satisfied. See II.A.2.b. above.

2. The COBE Regulations represent a shift in position. In GCM 35117, the IRS had taken the position that a drop-down of target assets into a partnership, unlike a corpora-tion, violates continuity rules. This position was reviewed and reaffirmed in GCM 39150. But see PLR 983202, in which the IRS ruled, that a merger of two REITs, pursuant to a binding agreement entered into prior to the effective date of the COBE regulations, did not fail to qualify

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as a tax-free reorganization under § 368(a)(1)(A) merely because partnerships controlled by the target REIT contribute their assets to a partnership controlled by the acquiring REIT.

3. Thus, transfer of assets to a partnership of an acquiring UPREIT may now be assured of tax-free reorganization treatment.

7. Acquisition of REIT - - Final Distribution Requirement & Deficiency Dividends

1. REIT that is acquired ("Target REIT") must satisfy its distribution requirements under § 857 for its short tax year ending on the date of acquisition.

1. If Target REIT remains in existence for a period of time following the acquisition (e.g., if Target REIT is acquired in a "C" reorganization), it can satisfy its REIT distribution requirements by declaring and distributing a "subsequent year dividend" (a.k.a. a "spillover dividend") to its former shareholders, provided Target REIT makes the proper election on its final tax return. § 858(a). See PLR 8007088.

2. If Target REIT does not remain in existence, acquirer can utilize the "subsequent year dividend" provision to satisfy Target REIT's final distribution requirement by making a distribution to Target REIT's former shareholders provided (i) Target REIT declared the dividend and fixed the record date of the dividend prior to the acquisition date, and (ii) the appropriate election under § 858 is made on Target REIT's final tax return.

3. If, however, Target REIT does not declare the dividend prior to the acquisition date (and therefore does not set a record date prior to the acquisition date), it is unclear whether the "subsequent year" dividend provision could be used by acquirer to satisfy Target REIT's final distribution requirement.

2. In general, if there is an adjustment (i.e., as a result of a final determina-tion or closing agreement) to REIT's income for a prior year, and such adjustment would cause REIT not to have satisfied its minimum distribution requirement, REIT can nevertheless preserve its status as a REIT by electing to distribute an additional dividend (a "deficiency dividend") in the current year and claiming an additional dividends paid deduction for the year affected by the adjustment. § 860(f). The foregoing dividend deficiency election is available to the acquirer of a REIT in a tax-free reorganization described in § 381(a). Thus, if Target REIT is acquired in a § 381(a) transaction, and subsequent to the acquisition there is an adjustment to Target REIT's income, the acquirer can elect to make a "deficiency dividend" to its current shareholders, and Target REIT would be entitled to the deficiency dividend deduction. § 381(c)(23); Treas. Reg. § 1.381(c)(25)-1. 4. Tax-Free Transfers to Controlled Corporations Under § 351.

1. General Requirements of § 351

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1. Exchange of property to a corporation solely in exchange for stock in such corporation if immediately after the exchange the transferor(s) are in control of the corporation. § 351(a).

2. "Control" is defined as ownership of 80% of the voting power of all classes of voting stock and 80% of the total number of shares of all other stock. §§ 351(a) and 368(c).

3. If consideration other than stock in the transferee corporation is received, gain, but not loss is recognized. Gain recognized not in excess of the fair market value of the other consideration received. § 351(b).

4. Tax-free treatment pursuant to § 351 does not apply to the transfer of property to an investment company. § 351(e).

1. A transfer of property to a REIT is considered made to an investment company if the transfer results, directly or indirectly, in diversification of the transferor's interests. Treas. Reg. § 1.351-(c)(1). A transfer ordinarily results in diversification if, in the exchange, two or more persons transfer non-identical assets to a corporation. Treas. Reg. § 1.351-(c)(5).

2. A transfer of stocks and securities will not be treated as resulting in diversification if each transferor transfers a portfolio of stock which satisfies the 25% and 50% tests of § 368(a)(2)(F)(ii), applying all relevant provisions of § 368(a)(2)(F). Treas. Reg. § 1.351-1(c)(6)(i). See III.A.4. above (regarding the 25% and 50% tests).

3. For purposes of § 368(a)(2)(F)(ii), a person holding stock in a REIT is treated as holding a proportionate share of the assets of the REIT. §368(a)(2)(F)(ii).

2. Using § 351 as an Alternative to a Tax-Free Reorganization

1. A § 351 transaction can be used as an alternative to a § 368 reorganization. Rev. Rul. 84-71, 1984-1 C.B. 106.

1. Although there is no statutory definition of "property" for purposes of § 351, the term generally encompasses any tangible or intangible asset that may be transferred, including stock or securities of another corporation. Rev. Rul. 74-502, 1974-2 C.B. 116 (domestic corporation); Rev. Rul. 75-143, 1975-1 C.B. 275 (foreign corporation).

2. Two corporations can effectively combine through a § 351 transaction. For example, the shareholders of both corporations can contribute their stock to a holding company in exchange for 100% of the holding company's outstanding stock. Because the shareholders have contributed property to the holding company in exchange for > 80% of the holding company's stock, the transaction can qualify under § 351. Often stock transfers are

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accomplished by mergers of two newly-formed shell subsidiaries of new holding company with and into the two existing corporations. See I.B.2.above.

1. If the holding company issues solely voting stock, the transaction also may qualify as a § 368(a)(1)(B) reorganization. See II.B.2. above.

2. If either or both corporations are REITs or UPREITs, restrictions on transfers to investment companies can apply. See IV.B.4. below.

2. Typically, § 351 is easier to satisfy. For example, unlike a reorganization under § 368(a)(1)(B), there is no "solely for voting stock" requirement and the receipt of additional consideration does not destroy the tax-free nature of the transaction. However, non-qualified preferred stock is treated as boot even though the nonqualified preferred stock continues to be treated as stock received by the transferor for purposes of qualification of a transaction under § 351. See II.A.2.a.ii. above regarding nonqualified preferred stock with respect to tax-free reorganizations.

3. Although less of a problem after the promulgation of the COBE Regula-tion, there is no continuity problem under § 351. Double and triple drop-downs into subsidiary corporations and partnerships are more acceptable.

1. Rev. Rul. 77-449, 1977-2 C.B. 110: Successive transfers of assets from Parent to its wholly-owned subsidiary and subsequently from the subsidiary to a lower-tier subsidiary each qualified for tax-free treatment under § 351.

2. Rev. Rul. 83-34, 1983-1 C.B. 79: Transaction qualifies under § 351 where Parent transferred assets to an 80% owned subsidiary, and such subsidiary transferred the assets to its 80% owned subsidiary.

3. Rev. Rul. 83-156, 1983-2 C.B. 66: Transfer of assets by Parent to wholly-owned subsidiary was tax-free under § 351 where transfer was followed by a transfer of those assets to a partnership, the partners of which were the subsidiary and a wholly-owned lower-tier subsidiary.

4. PLR 8503012: The IRS did not rule upon, but expressed "serious reservations" whether a transfer of property qualified under § 351 where shareholders transferred assets to a corporation which subsequently transferred those assets to a partnership in which it was a 50% partner.

5. PLR 9106037: Transfer of assets by Parent to wholly-owned subsidiary was tax-free under § 351 where Parent corporation contributed assets to a wholly-owned subsidiary, which contributed those assets to a partnership in which the subsidiary was a 50% partner. Partnership then contributed the assets to a corporation in which the partnership owned a 99.9% interest.

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4. § 351 may offer an opportunity for UPREITs to effect tax-free

transactions where a § 368 reorganization may not be available.

1. ROC/Chateau Transaction. PLR 9744003: This transaction involved the merger of Chateau Properties, Inc. ("Chateau"), a public UPREIT, and ROC Communities, Inc. ("ROC"), a public REIT. Pursuant to the merger agreement, a wholly-owned subsidiary of Chateau merged with and into ROC, and ROC shareholders received Chateau stock. Simultaneously with and as an integral part of the merger, certain partners in the Operat-ing Partnership ("OP") in which Chateau was the general partner contributed partnership units and other property to Chateau in exchange for Chateau stock. In addition, Chateau borrowed money and redeemed some of its shares. ROC shareholders and transferring OP unit holders owned at least 80% of the voting shares of Chateau immediately following the merger. It was intended by the parties that the merger and the transfer of OP units be viewed as a single integrated transaction and together qualify for tax-free treatment pursuant to § 351.

2. Transfer to an Investment Company: How does the ROC/Chateau transaction avoid the investment company exception to § 351 non-recognition (i.e., § 351(e)) because OP Units and the stock of ROC are not on their face identical properties?

3. Although, the Service, in its favorable ruling (which was obtained after the transaction was consummated) does not specifically address this point, it is nonetheless subsumed in the conclusion that the general rule of § 351 applied to the transaction. Presumably the rationale was, by analogy to Treas. Reg. § 1.351-1(c)(6)(i) concerning a transfer of a diversified portfolio of stock and securities (see IV.A.4.b. above), that each party has transferred a diversified portfolio of real estate, and therefore, the transfer did not cause diversification so long as the real estate transferred by ROC shareholders and holders of Chateau OP units (i.e., proportionate interest in a group of manufactured home communities) were identical properties.

4. This position was not without risk, as the Preamble to Treas. Reg. § 1.351-1(c)(6) states that the subject of real property transfers is beyond the scope of the regulations.

5. Note that transfer of diversified stock or securities portfolio permitted by Treas. Reg. § 1.351-1(c)(6)(i) indicates that the characteristics of two groups of assets may be "identical" although the assets themselves may not be:

1. Newco is formed by X transferring GM stock and Y transferring Ford stock. This would not meet the test of Treas. Reg. § 1.351-1(e)(6)(i).

2. Newco is formed by X transferring a widely diversified portfolio of small cap stocks and Y transferring a widely diversified portfolio of high-grade corporate bonds. This could meet the test of Treas. Reg. § 1.351-1(c)(6)(i).

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3. PLR 9722003 indicates that a diversified portfolio of real estate can be considered "identical" to another portfolio of real estate assets although individual assets may not be. In other words if a diversified portfolio of stocks is identical to a diversified portfolio of bonds, a diversified portfolio of rental apartment buildings can be identical to a diversified portfolio of different apartment buildings. But what if one portfolio were luxury and the other middle income apartments, or if the first were apartments but the second commercial office buildings? Thus the boundaries of this analysis are still unclear. 5. REITS and Tax-Free Spin-Offs

1. Basic Requirements of Tax-Free Spin-Off

1. A distribution of stock of "Controlled" by a distributing corporation ("Distributing") will qualify as a tax-free distribution under § 355 if (1) Distributing controls Controlled immediately before the distribution, (ii) the distribution is not a device to bail-out E&P, (iii) both Distributing and Controlled are engaged in the active conduct of trade or business before and immediately after the distribution, (iv) Distributing distributes all or an amount of stock constituting control of Controlled, (v) a valid corporate business purpose exists, (vi) there is continuity of interest and (vii) there is continuity of business enterprise.

2. Owning and operating real or personal property does not constitute the active conduct of a trade or business unless the owner performs significant services with respect to the operation and management thereof. Treas. Reg. § 1.355-3(b)(2)(iv)(B). An example in the regulations provides that a distribution of Controlled whose sole asset is a building satisfies the active trade or business test because Controlled will manage the building, negotiate leases, seek new tenants and repair and maintain the building. Treas. Reg. § 1.355-3(c), Example 12.

3. For a checklist of information to be submitted in connection with a request for a ruling on whether a distribution will qualify as a tax-free distribution under § 355, see Rev. Proc. 96-30, 1996-1 C.B. 696, modified by Rev. Proc. 2003-48, 2003-29 I.R.B. 86. With the issuance of Rev. Proc. 2003-48, the IRS has instituted a pilot program of at least one year where it will no longer entertain requests to issue private letter rulings under § 355 that rule on whether certain factual requirements have been met. Instead, Rev. Proc. 2003-48 requires that any ruling requests postmarked after August 8, 2003 include representations by the taxpayer that the transaction for which the ruling is requested is carried out for a specified business purpose and is not a device for the distribution of earnings and profits as well as certain representations regarding § 355(e).

2. Spin-Offs involving REITs

1. Prior to Revenue Ruling 2001-29 the Service maintained that a REIT that conducted leasing activities which generated qualifying rental income for purposes of the REIT gross income tests was not engaged in an active trade or business for purposes of this tax free spin-off requirement. Rev. Rul. 73-236, 1973-1 C.B. 183 and PLR 8013039; see PLR 9512020

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(no mention of requirement). Even if this was truly ever the law, after the amendments to the REIT rules in 1986, the continued validity of Revenue Ruling 73-236 was doubtful.

2. NAREIT made submissions to the Internal Revenue Service seeking a modification of Revenue Ruling 73-236 (see 2000 Tax Notes Today 62-65). Based on Treas. Reg. § 1.355-3(b)(2)(iv)(B) (cited above), and the expanded ability of REITs to provide non-customary services to its tenants through TRSs (see below), NAREIT argued that the Service should recognize that REITs can be engaged in an active trade or business.

3. Finally, Revenue Ruling 2001-29 held that a REIT can be engaged in the active conduct of a trade or business within the meaning of § 355(b) solely by virtue of the functions it performs with respect to its rental activities and Revenue Ruling 73-236 was held to be obsolete.

4. Nonetheless, even though spin-offs by REITs of a new or existing REIT or a C Corp. is now, at least, from the practical standpoint more feasible (receipt of a favorable Service ruling is more likely) if the transaction entails placing C Corp. assets into a REIT, a substantial obstacle remains since it will be necessary to establish a much stronger business purpose than in the usual case. See Treas. Reg. § 1.355-2(b)(5), Example 7 and Rev. Proc. 96-30 Sec. 4.04(c) 1996-1 C.B. 696. 6. Amendments to the REIT regime effective January 1, 2001.

A. The Real Estate Investment Trust Modernization Act of 1999 (the "RMA") was signed

into law on August 5, 1999.

B. The RMA contains a number of beneficial provisions, effective from January 1, 2001,

which permit a REIT to establish taxable subsidiaries ("TRSs") to perform activities that the REIT is

not permitted to perform directly, including providing non-customary services to the REIT's tenants.

1. Under the RMA, other than interests in a TRS, REITs are not permitted to

own more than 10% of the vote or value of the stock in any entity.

2. TRSs are not subject to the current 5% asset limitation, but stock in a TRS is instead treated as a non-qualifying asset for purposes of the 75% REIT asset test. Thus, the value of all TRSs owned by a REIT is limited to a maximum value equal 25% of the REIT's total assets (provided the REIT owns no other non-qualifying assets).

3. TRSs are subject to corporate level federal income tax on their net income.

C. The RMA also contains a provision (the "earnings stripping provision") that is designed to prevent a REIT from overcapitalizing a TRS with debt and siphoning off the earnings of the TRS on a pre-tax basis through interest payments to the REIT.

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4. Under current law, it is common for REITs to capitalize taxable preferred

stock subsidiaries (i.e., entities in which the REIT owns all of the non-voting stock which represents substantially all of the value of the entity, "TPSs") with significant amounts of debt, including debt owed to the REIT.

5. The use of debt benefits the REIT in two ways: First, it reduces the value of

the TRS for purposes of allowing the REIT to satisfy the 5% asset limitation (i.e., to prevent the TRSs

value from exceeding 5% of the REIT's total assets). Second, a REIT can withdraw earnings from the

TRS on a pre-tax basis through interest payments on debt owed to the REIT.

6. The RMA applies the existing rules under § 163(j) (commonly referred to as the "earnings stripping limitation") to interest paid or accrued (directly or indirectly) by a TRS to a REIT. The earnings stripping limitation applies only to thinly capitalized TRSs, i.e., TRSs with a debt-to-equity ratio (as of the end of the TRS's taxable year) that exceeds 1.5:1. If a TRS's debt-to-equity ratio exceeds the 1.5:1 ratio test as of the end of its taxable year, the earnings stripping limitation generally prohibits a TRS from deducting certain interest paid or accrued during such taxable year on debt owed to a REIT. 7. Amendments to the REIT regime by the American Job Creation Act of 2004

A. The American Job Creation Act of 2004, P.L. 108-357 (the "AJCA") was signed into

law on October 22, 2004.

1. The AJCA modifies a number of rules relating to REITs, many of which

are effective for tax years beginning after December 31, 2000.

2. The AJCA relaxed the REIT disqualification provisions, permitting certain de minimis exceptions to the asset test if the REIT cures the problem within a certain period after it is identified. § 856(c)(7)(A). With respect to more significant asset test failures a penalty tax is imposed as well. § 856(c)(7)(B).

B. Straight Debt modifications: the REIT asset tests require, among other things, that a

REIT may not hold more than 10% of the value of the outstanding securities of a single issuer. For

these purposes, "straight debt" is excluded from the definition of securities.

3. The AJCA expands the meaning of straight debt to include a debt obligation that contains certain contingencies for payment of interest or principal, as long as certain requirements are satisfied. § 856(m)(2).

4. In addition, for purposes of the 10% asset test, the AJCA eliminates the rule requiring a REIT to own a 20% equity interest in a partnership in order for debt of the partnership to qualify as straight debt in the hands of the REIT. § 856(c)(7)(C).

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5. The AJCA further eases the requirement that a REIT may not hold more

than 10% of the securities of any single issuer by excluding from the definition of "securities" loans to individuals or estates, securities issued by a REIT and certain state, local or foreign government-issued securities. § 856(m)(1).

C. Modifications in the FIRPTA rules for REITs: in general, FIRPTA rules provide that

gain or loss derived by a nonresident individual or foreign corporation from the disposition of a U.S.

real property interest is treated as gain or loss that is effectively connected with the conduct of a U.S.

trade or business. § 897(a)(1).

6. For those purposes, the receipt of distributions from a REIT is generally

treated as a disposition of a U.S. real property interest by the recipient to the extent that it is attributable to a sale or exchange of U.S. real property interest by the REIT. The distributions are generally subject to withholding tax at a rate of 35% and the foreign recipients are required to file U.S. income tax returns. In addition, foreign corporations generally are subject to branch profit tax at a 30% rate.

7. The AJCA amended the Code so that a distribution from a REIT attribut-able to FIRPTA gains is no longer treated as effectively connected income for a foreign investor as long as the distribution is received with respect to a class of stock that is regularly traded on an established securities market in the U.S. and the foreign investor does not own more than 5% of that class of stock at any time during the tax year. § 897(h)(1).

8. A foreign investor is no longer required to file a U.S. federal income tax return by reason of receiving such a distribution and the branch profit tax no longer applies. The distribution is treated as a regular REIT dividend to the investor, taxed as ordinary income subject to withholding. § 857(b)(3)(F).