Foreign inclusions qualify for REIT income test and currency gains are excluded

Plain-English summary

A timberland REIT operated abroad through foreign subsidiaries, including controlled foreign corporations and passive foreign investment companies. It expected subpart F, qualified electing fund, and non-QEF inclusions attributable to interest, dividends, qualifying gains, and items analogous to real-property rents. The IRS ruled that those inclusions were qualifying income for the REIT's 95-percent gross-income test because their treatment was consistent with Congress's passive-income purpose. It also ruled that foreign-currency gains recognized when previously taxed earnings were distributed were passive foreign exchange gains and therefore excluded from gross income for that test.

Ruling snapshot

• Question: Do the REIT's subpart F and PFIC inclusions qualify under section 856(c)(2), and are section 986(c) currency gains excluded from the REIT gross-income test?
• Outcome: Approved; the inclusions qualify and the related currency gains are excluded from gross income for section 856(c)(2).
• Key authorities: IRC §§ 856(c)(2), 856(c)(5)(J), 856(n), 951, 986(c), 1291, and 1293

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201605005                                              [Third Party Communication:
Release Date: 1/29/2016                                        Date of Communication: Month DD, YYYY]
Index Number: 856.01-00
                                                               Person To Contact:
--------------------------------------------------             ---------------------------, ID No. ---------------
---------------------------------------                        -----------------
---------------------------------------------------            Telephone Number:
-----------------------------------                            ----------------------
 ------------------------------                                Refer Reply To:
                                                               CC:FIP:B1
                                                               PLR-114627-15
                                                               Date: October 26, 2015




Legend:

Taxpayer          =         -----------------------------------------
------------------------------------------------------

State             =        --------------

Dear ----------------------:

       This is in reply to a letter dated April 21, 2015, in which Taxpayer requests
rulings in connection with its real estate investment trust (“REIT”) foreign income under
section 856 of the Internal Revenue Code of 1986, as amended (the “Code”).

Facts:

       Taxpayer is a corporation organized under the laws of State that has elected to
be taxed as a REIT. Taxpayer was organized for the purpose of making direct and
indirect investments in commercial timberland businesses. Taxpayer realizes profits
from the harvest and sale of timber and the long-term appreciation of the underlying
timber properties.

      Taxpayer operates in foreign countries through one or more foreign subsidiaries
and associated intermediate holding companies (each, a “Foreign Sub”). Some Foreign
Subs are qualified REIT subsidiaries (“QRSs”) under section 856(i), partnerships, or
disregarded entities. Taxpayer has jointly elected section 856(l) taxable REIT
subsidiary (“TRS”) status with other Foreign Subs that are corporations for federal
income tax purposes (each, a “Foreign TRS”).
PLR-114627-15                                  2

       Taxpayer expects that its Foreign TRSs will be either (i) controlled foreign
corporations (“CFCs”) within the meaning of section 957(a), with respect to which
Taxpayer will be a United States shareholder within the meaning of section 951(b) (a
“United States Shareholder”), (ii) passive foreign investment companies (“PFICs”) within
the meaning of section 1297(a), for which Taxpayer has made or intends to make
elections under section 1295(a) to treat as qualified electing funds (“QEFs”) for all
taxable years during which the corporation was a PFIC that are included in the
Taxpayer’s holding period of the PFIC stock (“pedigreed QEFs”), or (iii) PFICs for which
Taxpayer has not made a mark-to-market election and which are not pedigreed QEFs
with respect to Taxpayer.

         As a United States Shareholder with respect to the CFCs, Taxpayer is required
under section 951(a)(1)(A)(i) to include in gross income its pro rata share of the CFCs’
subpart F income, as defined in section 952(a). Taxpayer expects that the subpart F
income of the CFCs will consist of items that are foreign personal holding company
income (“FPHCI”) within the meaning of section 954(c). Taxpayer’s inclusions under
section 951(a)(1)(A) that are attributable to the CFCs’ deriving (i) interest; (ii) dividends;
(iii) gains from the sale or other disposition of stock, securities, or real property that is
not property described in section 1221(a)(1); and (iv) items that also would constitute
“rents from real property” under section 856(d) if received by a REIT are referred to
hereinafter as the “Subpart F Inclusions.”

        As a shareholder in PFICs for which Taxpayer has made QEF elections,
Taxpayer is required under section 1293(a) to include in gross income its pro rata share
of the earnings and profits of each QEF. Taxpayer expects to include amounts in
income under section 1293(a) with respect to numerous PFICs for which it has made (or
will make) QEF elections. Taxpayer’s inclusions under section 1293(a) that are
attributable to the QEFs’ deriving (i) interest; (ii) dividends; (iii) gains from the sale or
other disposition of stock, securities, or real property that is not property described in
section 1221(a)(1); and (iv) items that also would constitute “rents from real property”
under section 856(d) if received by a REIT are referred to hereinafter as the “QEF
Inclusions.”

        As a shareholder in PFICs for which Taxpayer has not made mark-to-market
elections and which are not pedigreed QEFs with respect to Taxpayer, Taxpayer is
required under section 1291(a)(1)(B) to include certain amounts in gross income.
Taxpayer expects to include amounts in income under section 1291(a)(1)(B) with
respect to PFICs for which it has not made (and will not make) a QEF or mark-to-market
elections (the “Non-QEF Inclusions” and, together with QEF Inclusions, the “PFIC
Inclusions”). Taxpayer represents that the majority of the gross income that each of
these PFICs will derive while owned by Taxpayer will be comprised of one or more of
the following items: (i) interest; (ii) dividends; (iii) gains from the sale or other
disposition of stock, securities, or real property that is not property described in section
PLR-114627-15                                3

1221(a)(1); and (iv) items that also would constitute “rents from real property” under
section 856(d) if received by a REIT.

        Taxpayer expects to recognize foreign currency gains with respect to
distributions of previously taxed earnings and profits (“PTI”) as described in section
986(c)(1) attributable to the Subpart F Inclusions and QEF Inclusions (the “Section
986(c) Gains”).

       Taxpayer requests the following rulings:

   1) The Subpart F Inclusions and the PFIC Inclusions will be treated as qualifying
      income under section 856(c)(2).

   2) The Section 986(c) Gains will not be taken into account for purposes of section
      856(c)(2).

Law and Analysis:

Ruling #1: Whether the Subpart F Inclusions and PFIC Inclusions will be treated
as qualifying income under section 856(c)(2).

       Section 856(c)(2) provides that, in order for a corporation to qualify as a REIT, at
least 95 percent of the corporation’s gross income must be derived from certain
enumerated sources, which include dividends, interest, rents from real property, gain
from the sale or other disposition of stock, securities, and real property (other than
property in which the corporation is a dealer), abatements and refunds of taxes on real
property, income and gain derived from foreclosure property, and certain commitment
fees.

       Section 856(c)(5)(J) provides that to the extent necessary to carry out the
purposes of part II of subchapter M of the Code, the Secretary is authorized to
determine, solely for purposes of such part, (i) whether any item of income or gain that
does not otherwise qualify under sections 856(c)(2) or (3) may be considered as not
constituting gross income for purposes of sections 856(c)(2) or (3), or (ii) whether any
item of income or gain that otherwise constitutes gross income not qualifying under
sections 856(c)(2) or (3) may be considered as gross income which qualifies under
sections 856(c)(2) or (3).

       The legislative history underlying the tax treatment of REITs indicates that a
central concern behind the gross income restrictions is that a REIT’s gross income
should largely be composed of passive income. For example, H.R. Rep. No. 2020, 86th
Cong., 2d Sess. 4 (1960) at 6, 1960-2 C.B. 819, at 822-23 states, “[o]ne of the principal
purposes of your committee in imposing restrictions on types of income of a qualifying
PLR-114627-15                                   4

real estate investment trust is to be sure the bulk of its income is from passive income
sources and not from the active conduct of a trade or business.”

Subpart F Inclusions

        Section 957 defines a CFC as a foreign corporation in which more than 50
percent of the total combined voting power of all classes of stock entitled to vote, or the
total value of the stock is owned by United States Shareholders on any day during the
corporation’s taxable year. A United States Shareholder is defined in section 951(b) as
a United States person who owns 10 percent or more of the total voting power of the
foreign corporation.

       Section 951(a)(1)(A)(i) generally provides that if a foreign corporation is a CFC
for an uninterrupted period of 30 days or more during a taxable year, every person who
is a United States Shareholder of the corporation and who owns stock in the corporation
on the last day of the taxable year in which the corporation is a CFC shall include in
income the shareholder’s pro rata share of the CFC’s subpart F income for the taxable
year.

       Under section 952, subpart F income includes foreign base company income.
Under section 954(a)(1), foreign base company income includes FPHCI, which is
defined under section 954(c)(1) to mean certain enumerated types of income. Subject
to certain exceptions, FPHCI includes (i) dividends, interest, royalties, rents, and
annuities under section 954(c)(1)(A); and (ii) the excess of gains over losses from the
sale or exchange of certain property under section 954(c)(1)(B).

        Taxpayer’s Subpart F Inclusions will be attributable to subpart F income of CFCs
that consists of: (i) interest; (ii) dividends; (iii) gains from the sale or other disposition of
stock, securities, or real property that is not property described in section 1221(a)(1);
and (iv) items that also would constitute “rents from real property” under section 856(d)
if received by a REIT. Therefore, treatment of the Subpart F Inclusions attributable to
such income as qualifying income for purposes of section 856(c)(2) does not interfere
with or impede the policy objectives of Congress in enacting the income test under
section 856(c)(2).

PFIC Inclusions

       Section 1297(a) provides that a foreign corporation is a PFIC if either (1) 75
percent or more of the gross income of such corporation for the taxable year is passive
income, or (2) the average percentage of assets (as determined in accordance with
section 1297(e)) held by such corporation during the taxable year which produce
passive income or which are held for the production of passive income is at least 50
percent. Section 1297(b) defines the term “passive income” as income of a kind that
would be FPHCI under section 954(c), subject to certain exceptions.
PLR-114627-15                                 5


       Section 1295(a) provides that a PFIC will be treated as a QEF with respect to a
shareholder if (1) an election by the shareholder under section 1295(b) applies to such
PFIC for the taxable year; and (2) the PFIC complies with such requirements as the
Secretary may prescribe for purposes of determining the ordinary earnings and net
capital gains of such company and otherwise carrying out the purposes of the PFIC
provisions. Section 1293(a) provides that every United States person who owns (or is
treated under section 1298(a) as owning) stock of a QEF at any time during the taxable
year of such fund shall include in gross income (A) as ordinary income, such
shareholder’s pro rata share of the ordinary earnings of such fund for such year, and
(B) as long-term capital gain, such shareholder’s pro rata share of the net capital gain of
such fund for such year.

        Section 1291(a)(1) provides that if a United States person receives an excess
distribution (as defined in section 1291(b)) in respect of stock in a PFIC that is a section
1291 fund (as defined in §1.1291-1T(b)(2)(v)), then (A) the amount of the excess
distribution shall be allocated ratably to each day in the shareholder’s holding period for
the stock, (B) with respect to such excess distribution, the shareholder’s gross income
for the current year shall include (as ordinary income) only the amounts allocated under
section 1291(a)(1)(A) to (i) the current year, or (ii) any period in the shareholder’s
holding period before the 1st day of the 1st taxable year of the company which begins
after December 31, 1986, and for which it was a PFIC, and (C) the tax imposed by
chapter 1 of the Code for the current year shall be increased by the deferred tax amount
(determined under section 1291(c)). Under section 1291(a)(2), the rules of section
1291(a)(1) apply to any gain recognized on the disposition of stock of a section 1291
fund as if the gain were an excess distribution.

         Taxpayer’s QEF Inclusions will be attributable to income of PFICs (with respect
to which a QEF election has been or will be made) that consists of: (i) interest;
(ii) dividends; (iii) gains from the sale or other disposition of stock, securities, or real
property that is not property described in section 1221(a)(1); and (iv) items that also
would constitute “rents from real property” under section 856(d) if received by a REIT.
Taxpayer’s Non-QEF Inclusions are derived with respect to PFICs that will generate the
same types of passive income. Therefore, treatment of the PFIC Inclusions as
qualifying income for purposes of section 856(c)(2) does not interfere with or impede the
policy objectives of Congress in enacting the income test under section 856(c)(2).

Ruling #2: Whether the Section 986(c) Gains will be taken into account for
purposes of section 856(c)(2).

      In general, sections 959(d) and 1293(c) provide that when a taxpayer includes in
income a Subpart F Inclusion or QEF Inclusion, the subsequent distribution to the
shareholder of the PTI attributable to the inclusion is not treated as a dividend for
purposes of chapter 1 of the Code.
PLR-114627-15                                 6


        Section 986(c)(1) provides that foreign currency gain or loss with respect to
distributions of PTI (as described in section 959 or section 1293(c)) attributable to
movements in exchange rates between the times of the deemed and actual distribution
shall be recognized and treated as ordinary income or loss from the same source as the
associated income inclusion.

       Section 856(n)(1)(A) provides that “passive foreign exchange gain” for any
taxable year will not constitute gross income for purposes of section 856(c)(2).

        Section 856(n)(3) defines passive foreign exchange gain as: (A) real estate
foreign exchange gain (as defined in section 856(n)(2)); (B) foreign currency gains (as
defined in section 988(b)(1)) which is not described in subparagraph A and is
attributable to (i) any item of income or gain described in section 856(c)(2), (ii) the
acquisition or ownership of obligations (other than foreign currency gains attributable to
any item described in clause (i)), or (iii) becoming or being the obligor under obligations
(other than foreign currency gain attributable to any item of income or gain described in
clause (i)); and (C) any other foreign currency gains determined by the Secretary.

      While the Section 986(c) Gains are not foreign currency gains defined in section
988(b)(1), such Section 986(c) Gains are attributable to the Subpart F Inclusions and
QEF Inclusions, items of income that are qualifying income for purposes of section
856(c)(2). This Section 986(c) Gain is substantially similar to passive foreign exchange
gain described in section 856(n)(3)(B)(i). Therefore, pursuant to section 856(n)(3)(C),
the Section 986(c) Gains are excluded from gross income for purposes of section
856(c)(2) because these foreign currency gains are considered passive foreign
exchange gain that is excluded from gross income for purposes of section 856(c)(2).

Conclusion:

        Based on the facts and representations set forth above, we rule that (i) under
section 856(c)(5)(J)(ii), the Subpart F Inclusions are considered gross income that
qualifies for purposes of section 856(c)(2), (ii) under section 856(c)(5)(J)(ii), the PFIC
Inclusions are considered gross income that qualifies for purposes of section 856(c)(2),
and (iii) under section 856(n)(3)(C), the Section 986(c) Gains are excluded from gross
income for purposes of section 856(c)(2).
PLR-114627-15                                  7

       Except as expressly provided herein, no opinion is expressed or implied
concerning the tax consequences of any aspect of any transaction or item discussed or
referenced in this letter. In particular, no opinion is expressed concerning whether
Taxpayer otherwise qualifies as a REIT under subchapter M of the Code.

      This ruling is directly only to the taxpayer requesting it. Section 6110(k)(3) of the
Code provides that it may not be used or cited as precedent.

         In accordance with the Power of Attorney on file with this office, a copy of this
letter is being sent to your authorized representatives.

                                           Sincerely,


                                           __________________________________
                                           Steven Harrison
                                           Branch Chief, Branch 1
                                           Office of Associate Chief Counsel
                                           (Financial Institutions and Products)