September 23, 2015

IRS Announcements Create Market Uncertainty for REIT Spin-Offs

The IRS created significant market confusion in issuing a notice and revenue procedure last week regarding “PropCo/OpCo” spin-offs. The notice announced that, absent “unique and compelling circumstances” the IRS ordinarily will not provide guidance with respect to PropCo/OpCo proposed tax-deferred spin-offs. This new position suggests the IRS will closely scrutinize these transactions, creating a “new normal” for companies considering PropCo/OpCo spin-offs. 

In issuing IRS Notice 2015-59 and Rev. Proc. 2015-43 last week, the IRS intentionally created significant market uncertainty about the viability of  “PropCo/OpCo” spin-offs as part of the PropCo’s REIT conversion (e.g., where PropCo leases the real estate formerly owned by OpCo back to OpCo and elects REIT status). The IRS releases did not actually propose any changes to existing law, but rather announced that absent “unique and compelling circumstances” the IRS ordinarily will not issue comfort in the form of a private letter ruling with respect to a proposed tax-deferred spin-off under Section 355 of the Internal Revenue Code (the “Code”) if real property owned by either the distributing corporation or the distributed corporation serves as the basis for a REIT election by either of the two corporations.

The IRS also extended its no-ruling policy to include, among other transactions, spin-offs in which either corporation relies on assets with a value of less than 5% of the corporation’s total assets to satisfy the 5-year “active trade or business” requirement of Section 355.  Because PropCo’s business of leasing real estate back to OpCo generally will not satisfy this requirement, a PropCo may need to retain some amount of active business assets (often in a taxable REIT subsidiary, or TRS).

In its announcements, the IRS stated that such PropCo/OpCo spin-offs and REIT conversions raise “significant concerns” with respect to certain fundamental requirements for tax-free spin-off treatment under Code Section 355 and also raise similar concerns regarding preservation of the corporate tax base generally. The “concerning” requirements under Section 355 are as follows:  each of PropCo and OpCo must be engaged in an active trade or business; a substantial non-tax business purpose must exist for the spin-off; and the proposed transaction must not serve principally as a “device” for distributing earnings and profits of either PropCo or OpCo. 

While not a statement of substantive law, the new no-ruling policy suggests the IRS will closely scrutinize these transactions, which will create a “new normal” for companies considering PropCo/OpCo spin-offs. Given that the tax costs of failing to qualify under Code Section 355 are often catastrophic, the market’s concern over the impact of these releases is certainly warranted.

The IRS did note that it is not particularly concerned about proposed spin-offs in which both distributing and distributed companies will be (and will continue to be) qualifying REITs, or where the distributing company has been a REIT for a “substantial” period of time preceding a spin-off, regardless of whether the distributed company elects REIT status going forward.

Action by the IRS that has the effect of chilling activity in the marketplace is not new to the REIT industry and certainly not new to REIT conversions, whether promoted by REIT activists arguably attempting to maximize short-term gains through financial alchemy or by boards of directors and management teams intending to create long-term value for stockholders. For example, in June of 2013 several companies pursuing REIT conversions and seeking rulings as to whether certain assets would qualify as real property for REIT qualification purposes were forced to publicly announce that the IRS had placed their ruling requests on hold while the IRS “examined” the definition of real property under the REIT qualification provisions of the Code. While the IRS never formally announced any such suspension, in a statement to Tax Analysts magazine on November 15, 2013, the IRS publicly acknowledged that they had stopped issuing these rulings due to the analysis of a “working group” studying the matter. Once the working group had finished its task, the IRS resumed issuing private letter rulings in this area under existing law.

The IRS’ conduct in the summer and fall of 2013 caused a fair amount of uproar and resulted in numerous inquiries on Wall Street by proponents of C-corporation REIT conversions following disclosure by public companies who were seeking to convert to REIT status at that time.

Last week’s announcements with respect to REIT conversions as part of spin-offs may well become a permanent addition to the IRS’s no-rule list with no further meaningful clarification on the subject of PropCo/OpCo spin-offs . These announcements are much more permanent in scope than the temporary suspension of private letter rulings relating to C-corporation conversions that took place in 2013. As such, the IRS’s action is a direct threat to the viability of a number of PropCo/OpCo spin-offs being discussed both in the marketplace and in board rooms, unless of course tax counsel can find a way to opine over or otherwise address the “significant concerns.” In short, we are not optimistic that the IRS will reverse course on its new position any time soon.

Having said this, how does a board of directors of a company intending to engage in a PropCo/OpCo conversion transaction proceed in light of last week’s announcements? No doubt the IRS intended to place a damper on PropCo/OpCo conversion transactions generally. Absent a change in law, however, we think it goes too far to suggest that no PropCo/OpCo spin-off and REIT conversion can qualify under Code Section 355.  The question remains, therefore, whether the facts and circumstances surrounding a proposed PropCo/OpCo spin-off will be sufficiently compelling to enable tax counsel to provide clear guidance in the form of an opinion to a board of directors on whether the spin-off (and related REIT election) will withstand scrutiny if challenged by the IRS, and whether a board of directors will be able to proceed in reliance on such opinion. 

We are certain that, in the meantime, the IRS’ actions of last week will cause tax counsel to existing companies considering PropCo/OpCo conversion transactions to revisit the hurdles necessary to unlock value in connection with a PropCo/OpCo REIT spin-offs, and to determine whether counsel can provide guidance in the form of a tax opinion acceptable to the board of directors in the absence of a private letter ruling. Under the right facts and circumstances, we think this is a real possibility.