The Treasury and the IRS have issued temporary and proposed regulations that amend the built-in gains tax rules under Regulation Section 1.337(d)-7 to require immediate taxation with regard to certain transactions. In addition, the regulations impose a 10-year recognition period, rather than the current 5-year recognition period, for conversion transactions occurring on or after August 8, 2016.

Background

Current Regulation Section 1.337(d)-7 provides that, if property owned by a C corporation becomes the property of a RIC or REIT (the converted property) as a result of a C corporation converting to a RIC or REIT or the transfer of assets from the C corporation to the RIC or REIT in a carryover basis transaction (conversion transaction), then the RIC or REIT will be subject to tax on the net built-in gain in the converted property under the rules of Section 1374 (Section 1374 treatment) as if the RIC or REIT were an S corporation, unless the C corporation elects to recognize gain and loss as if it sold the converted property to an unrelated party at fair market value (deemed sale treatment). In general, Section 1374 subjects an S corporation to corporate-level taxation on built-in gains recognized within five years (the recognition period) on assets formerly held by a C corporation.

The Protecting Americans Against Tax Hikes Act of 2015 (PATH Act) added Section 355(h)(1), which provides, subject to certain limited exceptions, that tax-free spin-off treatment under Sections 355 and 356 does not apply to a distribution if either the distributing corporation or the controlled corporation is a REIT. Section 856(c)(8), also added by the PATH Act, precludes a corporation from electing REIT status during the 10 years following a Section 355 spin-off if the corporation was the distributing corporation or the controlled corporation in that distribution (or is a successor to such a corporation). Sections 355(h)(1) and 856(c)(8) apply to distributions on or after December 7, 2015 but, under a limited grandfathering rule, do not apply to distributions made pursuant to a transaction described in a private letter ruling request submitted to the IRS before December 7, 2015.

Temporary regulations (T.D. 9770)

The preamble to the Temporary Regulations indicates that the Treasury and the IRS believe that certain transactions could be used to circumvent the new restrictions on tax-free spin-offs involving REITs imposed under Sections 355(h) and 856(c)(8), added by the PATH Act and thus, the Temporary Regulations are necessary to prevent abuses of these sections and to further the repeal of the General Utilities doctrine.

Conversion transaction following a spin-off

Temporary Regulation Section 1.337(d)-7T(c)(6) provides that, if a corporation participates in a Section 355 tax-free spin-off as a controlled corporation or the distributing corporation and, during the 10 years following the distribution, engages in a conversion transaction with a REIT, the corporation is treated as having made the deemed sale election in connection with the conversion transaction. For example, if a corporation participates in a tax-free spin-off transaction and, within 10 years thereafter, merges into a REIT in an otherwise nontaxable merger, the corporation will recognize gain (and loss) as if it sold all of its property to an unrelated party at fair market value. This amendment applies to conversion transactions occurring on or after June 7, 2016.

Implications. While the aforementioned PATH Act changes generally preclude a REIT from participating in a tax-free spin-off under Section 355 and preclude a C corporation that participated in a tax-free spin-off from making a REIT election during the 10 years after the spin-off, Temporary Regulation Section 1.337(d)-7T(c)(6) provides a further backstop to these rules, by preventing a C corporation that has participated in a tax-free spin-off from subsequently merging into a REIT without recognizing gain inherent in its assets. This rule applies not only to a C corporation that previously participated in a spin-off as a controlled corporation or the distributing corporation, but also to a corporation that was a member of the separate affiliated group of the distributing corporation or the controlled corporation, and to "predecessors" and "successors" of such a corporation. Accordingly, when evaluating any potential conversion transactions between a C corporation and a REIT, advisors will need to pay particular attention to whether the C corporation (or a member of its affiliated group), or a predecessor or successor thereof, participated in a tax-free spin-off during the prior 10 years.

As noted, Temporary Regulation Section 1.337(d)-7T(c)(6) applies to conversion transactions occurring on or after June 7, 2016. If applied literally, this rule would cause a C corporation to recognize gain under the deemed sale treatment if that corporation participates in a conversion transaction with a REIT on or after June 7, 2016 (e.g., the C corporation makes a REIT election effective on or after June 7, 2016 or is merged tax-free into an existing REIT on or after June 7, 2016) and had previously participated in a tax-free spin-off transaction prior to the effective date of new Sections 355(h) and 856(c)(8) (i.e., December 7, 2015) but still within the 10-year look-back period. Tax Notes Today reported on June 10, 2016, that a Treasury Department official has publicly stated that the Temporary Regulations will likely be clarified to provide that Temporary Regulation Section 1.337(d)-7T(c)(6) will not apply to spin-offs before December 7, 2015. Tax advisors will want to monitor developments to confirm whether this correction is actually made.

Spin-off following a conversion transaction

Temporary Regulation Section 1.337(d)-7T(b)(4) provides that, if a REIT acquires assets from a C corporation in a conversion transaction and, during the following 10 years, participates in a tax-free spin-off as a controlled corporation or distributing corporation, the REIT must recognize any remaining unrecognized built-in gain and losses inherent in the converted property in the year of the spin-off. Exceptions are provided for REIT-to-REIT spin-offs where both REITs qualify as REITs for the two subsequent years, and for any spin-off of a TRS that qualifies under Section 355(h)(2)(B). This amendment applies to conversion transactions occurring on or after June 7, 2016, and to conversion transactions and related Section 355 distributions for which the conversion transaction occurs before, and the related Section 355 distribution occurs on or after, June 7, 2016.

Implications. Because new Section 355(h) generally precludes a REIT from participating in a nontaxable spin-off under Section 355, it appears that Temporary Regulation Section 1.337(d)-7T(b)(4) will have limited applicability, but could apply, for example, when a REIT-to-REIT spin-off qualifies for nontaxable treatment under Section 355, but the REITs do not qualify for REIT status for the subsequent two years.

Five-year recognition period increases to 10 years

Temporary Regulation Section 1.337(d)-7(b)(2)(iii) imposes a new 10-year recognition period for purposes of the built-in gain rules and, thus, the regulations no longer incorporate the five-year recognition period applicable to S corporations under Section 1374(d). This amendment applies to conversion transactions that occur on or after August 8, 2016. The former five-year recognition period continues to apply to conversion transactions that occurred prior to August 8, 2016. For example, assume a C corporation converted to REIT status effective January 1, 2015 and, on December 2, 2016, acquires the assets of another C corporation in a nontaxable merger. In this case, the converted assets attributable to the January 1, 2015 conversion transaction are subject to a five-year recognition period, while the converted property attributable to the December 2, 2016 conversion transaction will be subject to a 10-year recognition period.

Implications. It is disappointing that the Temporary Regulations provide a departure from the recognition period used by S corporations under Section 1374(d) (which has been five years since 2011, made permanent under the PATH Act), and instead impose a new 10-year recognition period for conversion transactions occurring on or after August 8, 2016. Taxpayers that are contemplating conversion transactions during 2016 may want to consider whether the conversion transaction can be accomplished prior to August 8, 2016.

Proposed regulations (REG-126452-15)

The proposed regulations mirror the Temporary Regulations, but also propose a slight modification to the definition of converted property. The modification would also treat as converted property any property whose basis is determined, directly or indirectly, in whole or in part, by reference to the basis of property owned by a C corporation that becomes the property of a RIC or a REIT. The Preamble to the proposed regulations state that the Treasury Department and the IRS believe that such property presents similar concerns with regard to General Utilities repeal as other property of a C corporation that becomes the property of a RIC or REIT.

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