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IRS Provides Guidance on Subpart F and PFIC Inclusions for the 95 % REIT Test
June 2011

On May 13, 2011, the Internal Revenue Service (the Service) released Private Letter Ruling 201119001. In this ruling, the Service stated that income included by a REIT under 951(a)(1)(A) (Subpart F Inclusions), 951(a)(1)(B) ( Section 956 Inclusions), 1293(a)(1) (QEF Inclusions), and 1291(a) (the PFIC Inclusions) will be considered gross income qualifying under 856(c)(2) (the REIT 95% income test). Background To qualify as a REIT, an entity must meet certain annual income tests and quarterly asset tests. The original legislative policy behind the REIT income tests was to ensure that a REIT's gross income consists mainly of passive income and not income from the active conduct of a trade or business.1 REIT 75 Percent Income Test In order to maintain REIT status for any taxable year, 75% of a REIT's gross income must be derived from (1) rents from real property, (2) interest obligations secured by mortgages on real property, (3) gain from the sale of real property, (4) gains from the sale of shares of other REITs, (5) abatements and real property tax refunds, (6) income and gain derived from foreclosure property, (7) amounts received as consideration for entering into agreements to make loans secured by mortgages on real property, (8) gain from the sale of a real estate asset that is not a prohibited transaction, and (9) qualified temporary investment income.2 REIT 95 Percent Income Test Additionally, in order to maintain REIT status for any taxable year, 95% of a REIT's gross income, excluding gross income from prohibited transactions, must be derived from (1) sources which satisfy the 75% income test, (2) dividends, (3) interest, (4) gain from the sale stocks or securities, and (5) mineral royalty income.3 Consequently, a REIT may derive only 5% of its gross income from sources other than those listed above. Section 856(c)(5)(J) Section 856(c)(5)(J) provides that to the extent necessary to carry out the purposes of the REIT rules, the Service is authorized to determine whether any item of income or gain which is not otherwise qualified under the 95% or the 75% income test is qualifying gross income, not qualifying gross income or is ignored. Taxation Under Subpart F Subpart F4 provides a comprehensive set of special rules for taxing certain U.S. shareholders of controlled foreign corporations (CFCs). The fundamental operative feature of the Subpart F rules is the acceleration of U.S. taxation of certain undistributed earnings of the CFC; i.e., Subpart F is an anti-deferral regime. Once a determination is made that a foreign corporation is a CFC, it must be further determined which shareholders of the CFC are subject to taxation under Subpart F. Only those CFC shareholders that fall within the definition of U.S. Shareholders are subject to taxation under Subpart F.5

See H.R. Rep. No. 2020, 86th Cong., 2nd Sess. 4 (1960). 2See Sections 856(c)(4)(A)-856(c)(4)(B)(iii)(III).
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Section 856(c)(2). See Sections 951965. 5 See Sections 951(a) & 951(b).
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This document was not intended or written to be used, and it cannot be used, for the purpose of avoiding U.S. federal, state or local tax penalties.

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PwC IRS Provides Guidance on Subpart F and PFIC Inclusions for the 95% REIT Test

U.S. Shareholders are subject to tax on their pro rata share of only certain types of income, withdrawals, and investments of the CFC. Specifically, these include (1) Subpart F income, (2) previously excluded Subpart F income withdrawn from certain investments, and (3) the amount of the CFC's earnings invested in U.S. property.6 Subpart F income includes: (1) foreign base company income, (2) certain insurance income, (3) a portion of international boycott income, (4) the sum of the amounts of any illegal bribes, kickbacks, or other payments paid on behalf of the CFC, and (5) income derived from any foreign country for which 901(j) denies a foreign tax credit for taxes paid to such country.7 Subpart F foreign base company income includes: (1) foreign personal holding company income, (2) foreign base company sales income, (3) foreign base company services income, and (4) foreign base company oil related income.8 Foreign personal holding company income includes passive types of income such as dividends, interest, rents, and royalties.9 Section 956 contains the Subpart F rules governing a CFC's investment of its earnings in United States property. Under this section, if a CFC invests its current or accumulated earnings in certain types of property located (or deemed to be located) in the United States, then the amount of such earnings is taxed to the U.S. shareholders in the year in which the investment is made.10 Taxation Under the PFIC Provisions The Passive Foreign Investment Company (PFIC) provisions apply to a foreign corporation only if it is classified as a PFIC. There are two alternative tests for PFIC statusan income test and an asset test. A foreign corporation is considered a PFIC if 75% or more of its gross income is classified as Section 951(a)(1). Section 952(a). 8 Section 954(a). 9 Section 954(c). 10 See Sections 956 & 951(a)(1)(B).
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passive or if at least 50% of the foreign corporation's assetsmeasured by asset value or adjusted basis, depending on certain factors produce, or are held for the production of, passive income.11 There are three separate taxation regimes under the PFIC provisions: the excess distribution regime, the QEF regime, and the mark-to-market regime. The excess distribution regime imposes an interest charge on excess distributions from PFICs. An excess distribution is defined by reference to prior-year distributions and may include all or some of any actual distribution.12 2. The QEF rules are generally similar to the CFC inclusion rules. Under the QEF election, the U.S. investor is treated as receiving an annual distribution in the amount of his pro rata share of the PFIC's earnings and profits, classified as either ordinary income or capital gains.13 3. The mark-to-market regime allows the U.S. investor to treat his stock in the PFIC as if it were sold at the end of each year. If the stock has increased in value since the prior year, the U.S. investor includes the appreciation in his income as ordinary income. If the stock has decreased in value since the prior year, the U.S. investor is permitted to deduct the depreciation to the extent of appreciation that he included in income in prior years.14 Treatment of Subpart F and PFIC inclusions for purposes of the 75 and 95 Percent REIT Tests It is common for a REIT to invest both domestically and abroad. As part of an outbound investing strategy a REIT may recognize Subpart F and PFIC income. 1.

See Sections 1297(a) & 1297(e). Section 1291. 13 See Sections 12931295. 14 Section 1296.
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This document was not intended or written to be used, and it cannot be used, for the purpose of avoiding U.S. federal, state or local tax penalties.

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PwC IRS Provides Guidance on Subpart F and PFIC Inclusions for the 95% REIT Test

However, the appropriate classification of Subpart F and PFIC inclusions for purposes of the REIT income tests has been unclear. Neither Subpart F, the legislation creating and defining the REIT, nor any regulation or ruling directly addresses the appropriate classification. While such inclusions are similar to dividends, the Service has been reluctant to treat Subpart F or PFIC inclusions as dividends for purposes of the Code. Concerns Addressed by PLR 201119001 Until the release of PLR 201119001, the Service had not issued guidance addressing the appropriate classification of Subpart F or PFIC inclusions for purposes of the REIT income tests. The taxpayer in the PLR is a public REIT that invests directly and indirectly in foreign subsidiaries. The foreign subsidiaries meet the applicable tests to be treated as CFCs and PFICs. Through these subsidiaries the taxpayer leases industrial facilities. The subsidiaries' leasing activities generate Subpart F and PFIC income, which was recognized by the taxpayer. The taxpayer requested a ruling as to whether the Subpart F and PFIC inclusions would be considered gross income that qualifies for the 95% test. Based on the facts as represented in the PLR and pursuant to 856(c)(5)(J)(ii), the taxpayer's Subpart F Inclusions attributable specifically to foreign base company income, Section 956 Inclusions , and the taxpayer's PFIC Inclusions are qualifying income for purposes of the 95% test. The Service used identical reasoning to reach its conclusion for all three items of income listed aboveforeign base company Subpart F inclusions, Section 956 Inclusions, and PFIC Inclusions. That is, treatment as qualifying for the 95% income test since it is passive in nature and does not interfere with or impede the policy objectives of Congress in enacting the income test under Section 856(c)(2).15
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Open questions: PLR 201119001 does not address the qualification of such inclusions under the 75% income test. Such a ruling would be more difficult from a policy matter as it would require the Service to look through to the underlying activities of a taxable REIT subsidiary. It is unclear from this ruling whether the taxpayer tried to have this issue addressed and the Service was unwilling to rule. A private letter ruling binds only the IRS and the requesting taxpayer. Thus, a private ruling may not be cited or relied upon as precedent. For additional information concerning this issue, please contact: Adam Handler 213-356-6499 adam.handler@us.pwc.com Daniel G. Haggard 646-471-2046 daniel.g.haggard@us.pwc.com

PLR 201119001 (5/13/2011).

This document was not intended or written to be used, and it cannot be used, for the purpose of avoiding U.S. federal, state or local tax penalties.

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PwC IRS Provides Guidance on Subpart F and PFIC Inclusions for the 95% REIT Test

For more information, please contact your local PwC real estate tax service provider or one of the contacts below.

Nationally
Gary Cutson US RE Tax Technical Issues Leader New York 646-4718805gary.cutson@us.pwc.com Paul Ryan US RE Tax Leader New York 646-471-8419 paul.ryan@us.pwc.com

Regionally
Atlanta Dennis Goginsky 678-419-8528 dennis.goginsky@us.pwc.com Boston Timothy Egan 17-530-7120 timothy.s.egan@us.pwc.com Laura Hewitt 617-530-5331 laura.a.hewitt@us.pwc.com Chicago Jill Loftus 312-298-3294 jill.h.loftus@us.pwc.com Alan Naragon 312.298.3228 alan.naragon@us.pwc.com Dallas Colin Stevenson 214-756-1752 philip.c.sutton@us.pwc.com Los Angeles Adam Handler 213-356-6499 adam.handler@us.pwc.com Phil Sutton 213-830-8245 philip.c.sutton@us.pwc.com New York Martin Doran 646.471.8010 martin.doran@us.pwc.com Joni Geuther 646.471.4526 joni.geuther@us.pwc.com James Guiry 646.471.3620 james.m.guiry@us.pwc.com Christine Lattanzio 646.471.8463 christine.a.lattanzio@us.pwc.com James Oswald 646.471.4671 james.a.oswald@us.pwc.com Steve Tyler 646.471.7904 steve.tyler@us.pwc.com David Voss 646.471.7462 david.m.voss@us.pwc.com San Francisco Neil Rosenberg 415-498-6222 neil.rosenberg@us.pwc.com Washington DC Kelly Nobis 703-918-3104 kelly.s.nobis@us.pwc.com Tim Trifilo 703-918-3338 timothy.j.trifilo@us.pwc.com

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