United States: The Case For and Against REITs -- Tax-Advantaged Entities, Tax Shelters, or Inept Legislative Drafting?

The use of real estate investment trusts, or "REITs," has increasingly become a point of controversy between state taxpayers and state tax administrators. Taxpayers generally take the position that, as a result of federal and state statutes specifically encouraging the use of REITs and providing related tax benefits, REITs and their shareholders are entitled to deductions not afforded to other types of taxpayers. Some state tax administrators take the position that REITs and their shareholders are taking advantage of inconsistent provisions in federal and state tax law to qualify for special tax treatment not intended by lawmakers. This tension has led to litigation over the use of REITs from coast to coast (and beyond), to legislation intended to curb the perceived abusive use of REITs, and even to some states taking the position that in some instances, the use of REITs is a "tax shelter." This article examines the current status of this important controversy.

REITs are federally created investment vehicles established by Congress in 1960. A REIT is a corporation or other entity that elects to be treated as a REIT and that meets certain requirements as to its ownership, organization, and the nature of its income and assets. A REIT’s activities are generally limited to investing in real estate or loans secured by real estate and related activities. In order to qualify for taxation as a REIT, the entity must pay out substantially all of its ordinary income as dividends. Under the Internal Revenue Code, a corporate REIT generally computes its taxable income and tax in the same manner as non-REIT corporations, except that a REIT is not entitled to the dividends received deduction (DRD) but is specifically entitled to deduct dividends paid to its shareholders (DPD). While a corporate shareholder of a REIT would otherwise be entitled to a DRD for dividends received from the REIT, the IRC specifically denies that deduction for federal income tax purposes. Thus, for federal income tax purposes, a REIT is generally treated as a non-taxable flow through entity, with tax being paid at the REIT shareholder level.

Most if not all states that impose a corporate income tax require corporations to calculate taxable income by reference to the taxpayer’s gross income for federal income tax purposes. Many states allow corporations to deduct from their gross income the deductions afforded under the IRC. However, many states expressly deny the benefit of the federal DRD, and instead, provide for a DRD by state statute. Unlike Congress, some states have not denied the state DRD for dividends received by a corporate shareholder of a REIT. In those states, income earned by a REIT and distributed as a dividend to a corporate shareholder qualifies for the DPD at the REIT level because state law incorporates the federal DPD afforded by the IRC. However, the dividend received by the corporate REIT shareholder may not be included in the state’s tax base, either because the shareholder is not otherwise "doing business" in the state and is thus not subject to the state’s taxing jurisdiction, or because the corporate shareholder claims the DRD afforded by the plain terms of state statute.

The Kentucky Board of Tax Appeals recently rejected a challenge by the Kentucky Department of Revenue to the use of REITs in Autozone Development Corp. v. Department of Revenue.¹ In 1995, Autozone, Inc. restructured its operations. What had been a single, unitary enterprise was broken up into four discrete entities: Autozone Stores, Inc. ("Stores"), which retailed automobile parts at stores located across the country; Autozone Development Corporation ("Development"), a corporate REIT that owned the real property on which Stores operated; Autozone Properties, Inc. ("Properties"), which owned most of Development’s shares; and Autozone, Inc., a holding company that provided management services to the subsidiaries. All four companies were incorporated in Nevada. Development owned or leased land and buildings located in Kentucky.

For Kentucky corporate income tax purposes, the federal DRD is disallowed but by state statute dividend income is excluded from the gross income of a corporation. Under the Kentucky statutes, corporations are generally entitled to the deductions afforded under Chapter 1 of the IRC, which would encompass the DPD allowed to REITs. On its Kentucky corporate income tax returns, Development claimed the DPD for dividends paid to Properties. Although not discussed in the decision, the dividends received by Properties were presumably not subject to the Kentucky corporate income tax, either because Kentucky lacked jurisdiction to tax Properties, or because the dividends qualified for the DRD under the Kentucky statutes. After reviewing the returns filed by Development, the Kentucky Department of Revenue sought to disallow the DPD presumably on the theory that the DPD was not intended to apply in this situation.

Development appealed to the Kentucky Board of Tax Appeals and the Board granted Development’s motion for summary judgment. The Board reviewed the interplay between the applicable provisions in the IRC and the Kentucky statutes and (without saying so expressly) readily concluded that Development’s position was consistent with (if not dictated by) the statutes. Development was entitled to the DPD because the Kentucky statutes incorporate the DPD afforded in the IRC, and the fact that the dividends may have escaped taxation by Kentucky altogether did not change the natural outcome under the statutes. In short, the Board applied the law as written.

The Louisiana Supreme Court sustained a different theory for challenging the Autozone REIT structure in Department of Revenue v. Autozone Properties, Inc. ² Stores paid 8% of its gross sales to Development as rent and deducted that expense from its income for Louisiana corporate income tax purposes. Development paid the 8% to Properties as a dividend, thus qualifying for the DPD in Louisiana. Since Properties itself had no presence in Louisiana, and Nevada, Properties’ legal domicile, imposes no corporate income tax, the 8% passed into Properties’ hands without the imposition of Louisiana corporate income tax.

The Louisiana Department of Revenue sought to tax the 8% not by attempting to disallow the DPD as Kentucky had tried, but instead by asserting jurisdiction to tax Properties. Although the Louisiana courts initially rejected the Department’s attempt to reach out and tax Properties, the Louisiana Supreme Court ultimately ruled in favor of the Department. Relying on International Harvester, ³ the Louisiana Supreme Court held that the Due Process Clause of the United States Constitution does not prevent a state from taxing a nonresident shareholder’s investment income based on its investment in a separate corporation engaging in business activities in the taxing state. In reaching that rather expansive conclusion, the Supreme Court was no doubt swayed by the Department’s allegations that the use of pass through entities, and REITs in particular, is some sort of evil "tax shelter." Having found that Louisiana had jurisdiction to tax the REIT shareholder, the Louisiana Supreme Court remanded the case back to the lower courts to determine Properties’ tax liability.

The New Jersey courts have also considered the tax issues surrounding REITs in UNB Investment Co. v. Director, Division of Taxation. ⁴ United National Bancorp implemented a REIT structure somewhat similar to the REIT structure of Autozone. UNB Investment Company, a New Jersey corporation, owned all of the outstanding stock of Bridgewater Mortgage Company, Inc., a corporate REIT doing business in New Jersey. The REIT distributed its income to UNB as a dividend and claimed the DPD for both federal income tax and New Jersey corporate business tax purposes. UNB reported the dividend payment on its New Jersey corporate business tax return, but claimed a DRD pursuant to the New Jersey statutes. During the years in issue, the New Jersey statutes allowed a corporate taxpayer to exclude from its entire net income 100% of the dividends paid by subsidies in which it owns at least an 80% interest, without any express exception for dividends received from a REIT. The New Jersey Division of Taxation sought to disallow the DRD on the theory that the disallowance was consistent with the federal treatment of dividends received from REITs.

The matter reached the New Jersey Tax Court which held that although UNB was not entitled to a DRD, the Division of Taxation was prohibited from disallowing the deduction in these circumstances since the Division had failed to duly issue a regulation providing notice that a DRD would be disallowed in these situations. The Tax Court recognized that in cases in which the statutory language is unambiguous on its face, a court should not go beyond that language to determine the legislature’s intent. The New Jersey statute on its face provided for a DRD. The Tax Court nevertheless held that since another New Jersey provision linked the meaning of "REIT" to the federal definition, and since under the federal scheme the shareholders of a REIT generally pay income tax on the dividends they receive from a REIT, the New Jersey statute providing for a DRD was ambiguous. In searching for the legislative intent underlying the statute, the Tax Court concluded that it is highly unlikely that the legislature ever recognized or considered the tax consequences of permitting a REIT to take a DPD while generally affording a DRD to corporate shareholders. The Tax Court ultimately concluded that in providing for a DPD, the legislature intended to provide relief from double taxation, but did not intend to exclude income earned by a REIT from taxation altogether.

Having found that UNB was not entitled to a DRD, the Tax Court considered whether disallowing the deduction was warranted in this situation. The Tax Court held that if the Division’s position in the case amounts to a "rule" under the Administrative Procedure Act, the Division was required to formally promulgate that "rule." The Tax Court held that the Division’s position was a "rule" because, in part, it was intended to apply to all corporate shareholders of REITs. Since the Division had failed to formally promulgate its position as a rule, the court held that "it is unfair to penalize taxpayers through ad hoc adjudication under the facts presented here where they have not been put on notice of the Director’s position." The court accordingly held that the tax assessment was invalid.

The issue of whether distributions from a REIT qualify for the DRD is currently in litigation in Massachusetts in BankBoston Corp. v. Comm’r of Revenue. ⁵ The BankBoston companies used a REIT structure similar to the structures discussed above. The REIT distributed its income to its corporate shareholder, Multibank Leasing Company. The REIT qualified for the DPD for federal income tax purposes. Since Massachusetts specifically allows deductions afforded under the IRC, the REIT qualified for the DPD for Massachusetts corporate income tax purposes as well. The shareholder, MLC, did not qualify for the DRD for federal income tax purposes since dividends from a REIT are specifically excluded from the federal DRD. However, since during the period in issue Massachusetts, like Kentucky, did not incorporate the federal DRD, and instead by Massachusetts statute broadly allowed corporations to deduct 95% of dividends received, with no exception for dividends from a REIT, MLC claimed the DRD on its Massachusetts corporate income tax returns.

On audit, the Massachusetts Department of Revenue denied the DRD. The Department reasoned that since the Massachusetts statutes generally provide that only deductions allowable under the IRC may be deducted from Massachusetts gross income, and no DRD was allowable under the IRC in this situation, MLC was not entitled to the deduction. The Department maintained that position even though the taxpayer had claimed the deduction under the plain terms of the Massachusetts DRD statute, and not because the deduction was allowable under the IRC. The Department further claimed that Massachusetts had adopted the federal scheme for taxing REITs and their shareholders at the shareholder level, and allowing the Massachusetts specific DRD would allow all but five percent of the REIT income to totally escape taxation by Massachusetts. The taxpayer argued that it was entitled to the deduction under the plain terms of the Massachusetts DRD statute since the statute broadly allows a deduction and does not contain an express exception for dividends from REITs.

The Massachusetts Appellate Tax Board ruled against the taxpayer and held that the DRD was not allowed. While noting that the taxpayer’s position has a certain logic, the Board concluded that the distribution from the REIT was not a "dividend" within the meaning of the Massachusetts DRD statute. The Board reasoned that because a dividend from a REIT is not treated as a dividend under the federal DRD provision, it is similarly not a "dividend" under the Massachusetts DRD statute, even though the Massachusetts statute did not expressly adopt the federal definition of a "dividend." The Board reached that conclusion despite the fact that the Massachusetts Supreme Judicial Court had previously held the term "dividend" in the Massachusetts DRD statute was broader than the term "dividend" in the federal DRD statute. See Dow Chemical Co. v. Comm’r of Revenue, 378 Mass. 254 (1979). The Board buttressed its holding by suggesting that applying the Massachusetts DRD statute according to its plain terms and allowing the deduction would allow both the REIT and the REIT shareholder to totally escape taxation on all but five percent of the distribution, an "illogical and unwarranted result" in the view of the Board.

The Board noted that during 2003, the Massachusetts legislature amended the corporate income tax provisions to disallow the DRD for distributions from a REIT. As the Board noted, the legislature generally made that amendment retroactive back to tax years beginning on or after December 31, 1999, not far enough back to impact the years in issue in the BankBoston case. When the "REIT issue" was discussed at a recent state tax forum, a prominent state tax administrator with the Massachusetts Department of Revenue proudly proclaimed that Massachusetts had dealt with the REIT issue through legislation, retroactive legislation to boot, triggering a chorus of jaundiced laughter from the taxpayers and tax practitioners in attendance.

REITs As Tax Shelters? -- California Legislation & Litigation

Not one to be bashful in terms of corporate income tax policy, the California Franchise Tax Board has suggested that claiming a DRD attributable to a consent dividend ⁶ from a REIT is a "tax shelter." Effective January 1, 2004, California enacted fairly broad "tax shelter" legislation. Under those provisions, any "person" liable for any tax imposed by the California personal income tax law, the corporation tax law, or related administrative provisions, that has participated in a "reportable transaction" must file the appropriate Franchise Tax Board returns and disclose information as required by IRC § 6011 and the related regulations, as modified for California purposes. A "reportable transaction" includes any transaction that the federal Treasury under IRC § 6011 or the Franchise Tax Board determines as having a potential for tax avoidance or evasion. This includes listed transactions, defined as any transaction that is the same as, or substantially similar to, a transaction specifically identified for federal income tax purposes under IRC § 6011 or for California income or franchise tax purposes as a tax avoidance transaction. The Franchise Tax Board Chief Counsel has specifically identified as a reportable transaction, transactions in which a REIT takes a dividend deduction for a consent dividend but the REIT owners do not report the consent dividend as income. ⁷

The California Franchise Tax Board’s efforts to label REITs as tax shelters in some situations has spilled over into the courts. On June 10, 2005, City National Corporation filed suit against the California Franchise Tax Board in Los Angeles Superior Court. One of the issues in the suit is whether the taxpayer engaged in "tax shelter" transactions involving REITs and regulated investment companies during the subject years. The amount in controversy exceeds $84M. Commenting on the issue during a recent state tax forum, a prominent state tax administrator with the California Franchise Tax Board remarked that if the taxpayers prevail in these types of cases, the Franchise Tax Board may well advocate the wholesale repeal of the DRD.

The REIT tax issue is too big to be confined to the Continental United States. The REIT issue is being litigated in Hawaii. Banks in Hawaii claimed a DRD for the distributions they received from their REIT subsidiaries. The Hawaii Department of Taxation disallowed the deductions and the banks appealed to the Hawaii Tax Appeal Court. In 2004, the Tax Appeal Court granted summary judgment in favor of the Department of Taxation in one of the cases. The taxpayer appealed to the Hawaii Supreme Court, but the case was settled before a decision was issued. The appeal in the other case, In Re Tax Appeal of CPB Inc. and Central Pacific Bank, Nos. 02-0075 & 03-0155, is set for trial in December 2006.

The REIT tax dispute raises a number of interesting issues. The overriding issue -- whether a taxpayer is entitled to a deduction plainly afforded by statute if, in the view of some, the deduction is not what was intended by lawmakers -- extends well beyond the dispute over REITs. The concept that taxpayers and their advisors should be allowed to rely on the law as written without having to psychoanalyze what the lawmakers subjectively intended does have some merit. If the written law is not what the lawmakers intended, perhaps the lawmakers should change the law without relying on tax administrators or the courts to do it for them.

It is often said that bad facts make bad law, and the Louisiana Supreme Court’s opinion in Autozone is a case in point. The Court was obviously influenced by the Department of Revenue’s "tar and feather" approach of disparaging the REIT structure as a "tax shelter," and the Court apparently thought that upholding jurisdiction to tax the nonresident shareholder was the appropriate remedy. However, the law cannot be that merely owning equity in a separate entity doing business in a given state subjects the nonresident shareholder to income taxation in that state. If that were indeed the law, then I guess that means that all members of the Louisiana Department of Revenue are duly filing personal income tax returns and paying tax in all applicable states in which corporations in whose stock the members have invested are "doing business." Surely the members would not engage in "sheltering" their income from state taxation.

For a variety of reasons, tensions between state taxpayers and their advisors and state tax administrators are very high. As is often reported in the press these days, it’s easy to point the finger of blame at certain taxpayers and their advisors. However, actions such as those in Massachusetts in which the substantive state tax law was seemingly changed, retroactively, certainly do not help. There’s plenty of blame for the tension to go around.

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