State & Local Tax Policy Bulletins
June 29, 1999
Please be advised that the first State and Local Tax Subcommittee conference call of 1999 is scheduled for June 30, 1999 at 1:00 p.m. EST. We will be discussing state and local tax developments affecting REITs. All interested parties are invited to attend. If you would like to participate, please call Charles Dorch in NAREIT's Government Relations Department with your telephone number at 1-800-3NAREIT.
State and Local Tax Subcommittee Meeting at L&A Conference
The State and Local Tax ("SALT") Subcommittee, co-chaired by Rick O'Connor of The Mills Corporation and Steve Ryan of Deloitte & Touche LLP, held a meeting on May 6 at the Law & Accounting Conference in Palm Springs, California. Steve Ryan discussed recent legislative developments in Alabama and Tennessee as well as local developments in Ohio, where several Ohio municipalities have chosen to deny a dividends paid deduction to REITs operating in those states. Joyce Calvin, of PricewaterhouseCoopers LLP, discussed sales and use tax issues faced by REITs, and Ray Koski of National Realty Counselors, Inc. discussed property tax issues affecting REITs. A questionnaire was also distributed requesting participation in an Ohio lobbying effort, on the SALT Subcommittee, and on task forces monitoring single member entity and property tax issues. If you would like to participate in any of the above but have not yet volunteered to do so, please e-mail Charles Dorch at NAREIT at cdorch@nareit.com with your contact information. Any substantive questions should be directed to Dara Freedman, NAREIT's REIT Counsel, at (202) 739- 9446 or dfreedman@nareit.com.
New State Tax Developments
Tennessee: Tennessee recently enacted legislation that subjects limited partnerships ("LPs") and limited liability companies ("LLCs") to the Tennessee Excise (income) and Franchise (net worth) taxes. General partnerships are not subject to these taxes. The legislation, generally effective for tax years beginning on or after July 1, 1999, is intended to prevent a non-Tennessee corporate limited partner or LLC member of a partnership or LLC conducting business in Tennessee from "avoiding" Tennessee tax under current law. However, whether intended or not, this statute will impact REITs and other entities that were not subject to Tennessee tax under prior law. As described below, Texas has also considered amending its tax laws to address this type of organizational structure.
By way of background, the Excise tax is imposed at the rate of 6% of a taxpayer's net earnings (federal taxable income with certain modifications) attributed to Tennessee through formulary apportionment. The Franchise tax is imposed at the rate of 25 cents per $100 on the greater of the amount of the taxpayer's net worth attributed to Tennessee through formulary apportionment or the value of the taxpayer's Tennessee property.
Generally, the new law raises several issues for REITs that directly or indirectly own property in Tennessee. First, and most obviously, the law's failure to allow the equivalent of a dividends paid deduction ("DPD") to LPs and LLCs owned in part by REITs causes such REITs to bear a greater tax liability than REITs that own Tennessee property directly and are entitled to a DPD. Thus, a joint venture between a REIT and a pension fund to hold property that is structured as an LP or LLC will be subject to the Tennessee Excise and Franchise tax even though income derived from property held by directly by such entities (or through a general partnership formed by such entities) would not be subject to the same level of tax. (Note that the tax liabilities may be reduced if the joint venture is structured as a privately-held REIT unless the Administration's closely-held REIT proposal is enacted as proposed).
Second, as with many states' statutes, the treatment of a qualified REIT subsidiary ("QRS") is uncertain. Third, the statute applies retroactively for the tax year ending on or after June 30, 1999, to tax the net earnings from, and net worth of, existing LPs and LLCs that are 80% or more owned by REITs subject to Tennessee tax under prior law years (for example, through direct property ownership, property ownership through a QRS or general partnership interest or otherwise doing business in Tennessee), but it does not apply retroactively to allow such REITs to deduct the net earnings from, and net worth of, these LPs and LLCs for this particular tax year (it does permit a deduction in subsequent years). Thus, the net earnings and net worth of these LPs and LLCs will be taxed both at the partnership level and at the REIT (or REIT's shareholder) level. A conversation with a Tennessee Department of Revenue official confirmed that this absurd result is indeed due to the wording of the effective date provision of the statute.
Finally, the statute does not permit a REIT that owns non-Tennessee LP or LLC interests to deduct the net earnings or net worth of such entities for Excise and Franchise tax purposes or to include the apportionment factors of the non-Tennessee entities in the REITs' apportionment calculation. As a result, 100% of the REITs' apportionment factors will be attributable to Tennessee, and 100% of the REIT's net earnings and the net worth of indirectly owned entities will be attributable to Tennessee. While the DPD may eliminate the Excise tax for REITs that own Tennessee property directly or through a QRS, it will not be available to REITs that own property through an LP or LLC. In this case, double taxation of net earnings may result. Further, by causing the net worth of non-Tennessee entities to be included in the Tennessee Franchise tax base, double taxation of this net worth also may result.
There remains speculation that Governor Sundquist will call the legislature into another special session in November to deal once again with tax reform. Accordingly, NAREIT is considering the formation of a task force to lobby for clarification of, or change to, this law. Readers may recall that NAREIT previously was successful with such an effort when Ohio passed similar legislation. If you are interested in participating in this effort, please contact Charles Dorch at NAREIT at cdorch@nareit.com with your contact information.
Arizona: The Arizona Department of Revenue recently issued Corporate Tax Ruling ("CTR") 99-2 in which it held that a REIT is subject to Arizona corporate income tax (to the same extent as under federal law) and that a REIT's shareholder can qualify for the dividends received deduction under Arizona law if it meets the 50% ownership requirement.
CTR 99-2 is particularly interesting for two reasons. First, because Arizona's corporate income tax provisions, like those in many other states, do not specifically address the taxability of REITs, this ruling clarifies that a REIT must file as an ordinary corporation in Arizona on Arizona Form 120. Furthermore, this ruling clarifies that "REIT Taxable Income," as calculated for federal income tax purposes (including the dividends paid deduction), is the starting point for determining Arizona taxable income.
Second, this ruling also provides that a REIT's corporate shareholder is entitled to the dividends received deduction ("DRD") as long as the shareholder meets the "control" requirements for the DRD under A.R.S. § 43-1122(5). Under A.R.S. § 43-1122(5), a corporate shareholder that owns "50 percent or more of the voting stock of the payor corporation" meets the "control" test for the dividends received deduction. Interestingly, the ruling cited I.R.C. §§ 856(h)(2); 856(a)(6) and 542(a)(2) in holding that the control requirement under Arizona law could only be met during the REIT's first year of existence. As you know, under current law, the "closely held" rules of I.R.C. §§ 856(h)(2), 856(a)(6) and 542(a)(2), which apply for all years after the first year of the REIT's existence, prevent five or fewer individuals from owning more than 50 percent in value of the REIT's stock. Thus, a widely-held corporation or a group of individuals that owned 50% or more of the voting stock of the REIT (but less than 50% of its value) would satisfy the "closely held" rules and presumably still would satisfy the "control" requirement necessary for the dividends received deduction under Arizona law during any year of the REIT's existence. However, the Arizona ruling might turn out to be correct if the Administration's "closely held REIT" proposal is enacted.
Alabama: The U.S. Supreme Court recently held in South Central Bell Telephone Co. v. Alabama, No. 97-2045 (March 23, 1999), that the differing Alabama tax schemes imposed on foreign (non- Alabama) and domestic (Alabama) corporations were unconstitutional. The Alabama legislature is considering its options to fix the unconstitutional provisions and find replacement revenues. An initial proposal to replace both of the taxes imposed on foreign and domestic corporations with a new net worth-based tax that also subjects partnership and limited liability company (LLC) entities to taxation was met with resistance from the business community. A special legislative session is expected to be held in mid-August to address the matter again. REITs conducting business in Alabama should be aware of potential tax increases, both directly and indirectly through taxation of partnerships and LLCs.
Texas: No news is good news! The Texas legislature (which meets every two years) recently adjourned without making any changes to the exclusion from Texas franchise taxation of corporate limited partners of partnerships doing business in Texas, where the corporate limited partner is not separately conducting business in Texas. In previous legislative sessions, this exclusion has been a controversial subject.
By way of background, the Texas franchise tax includes two components: (1) an "earned surplus" or net income-based tax; and (2) a "taxable capital" or net worth-based tax, with the tax liability being equal to the greater of the two. With the judicial allowance of the dividends paid deduction two years ago, the earned surplus component should not be a material item for most REITs. However, corporate REITs that operate in Texas directly may face a significant tax liability based on their net worth. Thus, the continued exclusion of qualifying corporate limited partners from taxation allows for taxable capital tax savings through the use of the limited partnership structure. In such a case, only the general partner would be subject to Texas tax.
This is the first issue of the SALT Bulletin for 1999. If you are interested in continuing to receive subsequent issues or in being a member of the SALT Subcommittee, please e-mail Charles Dorch at NAREIT at cdorch@nareit.com with your contact information.
All NAREIT members are encouraged to contact NAREIT's REIT Counsel, Dara L. Freedman, at (202) 739-9446 or e-mail: dfreedman@nareit.com with any state tax changes or developments that affect the REIT industry.