Client Alert

New Tax Legislation Includes Important Amendments Affecting Regulated Investment Companies (Mutual Funds), Including Their Investments in Real Estate Investment Trusts (REITs)

5/17/2006

On May 17, 2006, President Bush signed into law H.R. 4297, the "Tax Increase Prevention and Reconciliation Act," (the "Act"), a $70 billion tax package that will extend the reduced individual 15 percent tax rate on certain dividends and long-term capital gains from the end of 2008 through December 31, 2010.  The Act increases the alternative minimum tax exemption levels for 2006 and extends provisions permitting small businesses to expense up to $100,000 in investments in depreciable assets for two years.  The Act also modifies the scope of the application of the Foreign Investment in Real Property Tax Act of 1980, or FIRPTA, by targeting qualified investment entities with significant interests in U.S. real property and by providing an exception to gain recognition to certain foreign shareholders that receive distributions from a qualified investment entity, including regulated investment companies, or RICs. 

The Foreign Investment in Real Property Tax Act of 1980.  FIRPTA generally treats a foreign person’s gain or loss from the disposition of a U.S. real property interest, or USRPI, as income that is effectively connected with a U.S. trade or business, and thus taxable at the income tax rates applicable to U.S. persons, including the rates for net capital gain.  A foreign investor subject to tax on FIRPTA income is required to file a U.S. income tax return under the normal rules relating to receipt of income effectively connected with a U.S. trade or business.  Further, an entity that distributes FIRPTA income to a foreign person is generally required to withhold U.S. tax from the payment 10 percent of the sales price in the case of a direct sale by the foreign person of a USRPI, and 35 percent of the amount of a distribution to a foreign person of proceeds attributable to such sales from an entity such as a partnership. 

Present Law Concerning Application of FIRPTA Provisions to RICs.  The American Jobs Creation Act of 2004 (the "AJCA") provided that, through December 31, 2007, any distributions by a RIC to its foreign shareholders that are attributable to the RIC’s sale or exchange of USRPIs is subject to U.S. federal income tax as gain effectively connected with the conduct of a U.S. trade or business under FIRPTA.  A URRPI does not include any interest in a domestically controlled qualified investment entity, which generally is a RIC (or real estate investment trusts, or REITs) in which less than 50% in value of the RIC (or REIT) has been owned directly or indirectly by foreign shareholders during the 5-year period ending on the date of disposition.

New Rules Narrowing FIRPTA’s Application to RIC Distributions.  The Act provides that any distribution by a RIC to a foreign shareholder that is attributable to gain from the RIC’s sale or exchange of a USRPI will not be subject to tax under FIRPTA unless more than half of its assets are invested directly or indirectly in U.S. real property holding companies or REITs.  This provision is effective as if it were included in the AJCA. The Act also provides that a distribution by a RIC to a foreign shareholder that is attributable to sales of USRPIs is not treated as gain from the sale of a USRPI by that shareholder if the distribution is made with respect to any class of stock that is regularly traded on an established securities market located in the United States and if such shareholder did not own more than 5 percent of such class of stock at any time during the one year period ending on the date of the distribution; such distributions are instead treated as dividend distributions.  Because this rule requires RIC shares to be listed on an exchange, it does not appear to apply to open-end RICs.  This provision is effective for taxable years of RICs beginning after December 31, 2005.  After December 31, 2007, the pre-AJCA Act rules that do not require the look-through of USRPI gains for RICs generally will be applicable.

New Look-Though Provision for RIC Distributions.  Under the Act, any distribution that is made by a RIC that would otherwise be subject to FIRPTA withholding because the distribution is attributable to the disposition of a USRPI will retain its character as FIRPTA income when distributed to any other RIC or a REIT and will be treated as if it were a disposition of a USRPI by that other RIC or REIT.  In addition, a RIC will be subject to the FIRPTA rules, even after December 31, 2007 (when the law reverts back to pre-AJCA rules) in any case in which a REIT makes a distribution to the RIC that is attributable to gain from the sale or exchange of a USRPI in the hands of the RIC (provided that the RIC itself is a USRPI or would be a USRPI, as described above).  These provisions are effective for taxable years of RICs beginning after December 31, 2005. 
Withholding on FIRPTA Distributions.  The Act amends the foreign withholding provisions of the Internal Revenue Code to statutorily require a RIC to withhold tax on FIRPTA gain at a rate of 35 percent, or a lesser rate to the extent provided in regulations.  This change also applies to taxable years beginning after December 31, 2005, except no amount will be required to be withheld with respect to any distributions before the enactment date that were not subject to withholding under prior law.

No Avoidance of FIRPTA through Wash Sales.  Finally, the Act broadens the scope of the "wash sale" rules for foreign investors.  Under the Act, a foreign investor that disposes its RIC or REIT stock during the 30-day period preceding a distribution on that stock that would have been treated as a distribution from the disposition of a USRPI, that acquires a substantially identical interest, or enters into a contract or option to acquire such an interest, during the 61-day period beginning the first day of such 30-day period preceding that distribution, and that does not in fact receive the distribution in a manner that subjects the person to tax under FIRPTA, is required to pay FIRPTA tax on an amount equal to the amount of the distribution that was not taxed under FIRPTA as a result of the disposition.  This provision also applies to "substitute dividend payments" under stock loan transactions.  The wash sale treatment does not apply if the investor actually received the distribution or if the investor disposed of RIC shares that are regularly traded on an established securities market in the U.S., provided that the investor did not own more than 5 percent of such stock at any time during the one-year period ending on the date of the distribution.  Further, the Act does not require withholding with respect to an applicable wash sale transaction.  The Act’s wash sale amendments are effective for taxable years of RICs beginning after December 31, 2005, except the rules do not apply to any distribution or substitute dividend payment occurring within 30 days after the date of enactment.

Reporting of Tax-Exempt Interest.  Prior to the Act, a RIC was not required to report on a Form 1099 tax-exempt interest passed through to shareholders.  The Act requires RIC to report such tax-exempt interest.  This provision applies to interest paid after December 31, 2005.

No Delay of Sunset Provision Applicable to Section 529 Plans.  Under Section 529 of the Internal Revenue Code, taxpayers can establish "qualified tuition programs," commonly referred to as "Section 529 Plans."  Subject to caps, income earned within a Section 529 Plan is exempt from federal income taxation if proceeds in the plan are used to pay qualified tuition expenses of the beneficiary.  Section 529 Plans are sponsored by states in conjunction with mutual fund companies that offer shares in their RICs to participants in the Section 529 Plans.   The Economic Growth and Tax Relief Reconciliation Act of 2001 greatly expanded the scope of Section 529 Plans.  However, absent further legislation, this expansion will terminate – or "sunset" – after December 31, 2010.  Although mutual fund companies offering shares to Section 529 Plans have pushed to eliminate the sunset date, the Act does not do so.

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