The following article is adapted and reprinted from the M&A Tax Report, Vol. 9, No. 12, July 2001, Panel Publishers, New York, NY.

REIT SPINOFFS

By Robert W. Wood

Its no secret to M&A Tax Report readers that Section 355 has long been a special and closely watched area of the tax law. Indeed, as long ago as the repeal of the General Utilities doctrine way back in 1986, Section 355 was viewed by practitioners as one of the last bastions (or vestiges) of General Utilities — or from the Service's perspective, as one of the last loopholes in General Utilities repeal. Although there has been a tightening and transmutation of Section 355 authority over the years (including the enactment of Section 355(e) a few years back), Section 355 remains a terribly important planning tool in acquisition transactions.

Any liberalization may come as a bit of a surprise. Witness the more tolerable Section 355(e) regulations which were issued earlier this year. For recent coverage of Section 355(e), see Wood, "Now Section 355(e) Rules Save Us!" Vol. 9, No. 7, The M&A Tax Report, February 2001, p. 1; and Wood, "More on Anti-Morris Trust Regs," Vol. 9, No. 8, The M&A Tax Report, March 2001, p. 1.

Real Estate, Too!

Now, the IRS has ruled that companies can spinoff real estate assets under Section 355 in the form of real estate investment trusts. Revenue Ruling 2001-29, 2001-26 I.R.B. 1, is an important ruling that in many ways abrogates the IRS' traditional skepticism about real estate and the active business requirement of Section 355.

The single issue raised in the ruling is whether a real estate investment trust ("REIT") can be engaged in the active conduct of a trade or business within the meaning of Section 355(b) solely by virtue of the functions with respect to rental activity that produce income qualifying as rents from real property within the meaning of Section 856(d). The ruling goes through the expected analysis of Section 355(a)(1) — that both the distributing and controlled corporations must be engaged (immediately after a distribution) in the active conduct of a trade or business.

Of course, those active trades or businesses must be actively conducted throughout the five year period ending on the date of the distribution. See Reg. §1.355-3(b)(2)(iii). Revenue Ruling 2001-29 goes through the historic rulings (among them Revenue Ruling 73-236, 1973-1 C.B. 183), which dealt with REIT status and real estate. Notably, the ruling recites the amendments to the REIT rules, specifically Section 856(d)(2)(C) which came about in 1986. This section was amended to modify the definition of rents from real property.

Ultimately, the 2001 ruling concludes that Revenue Ruling 73-236 is obsolete. Revenue Ruling 73-236 had denied Section 355 treatment to a distribution of stock by a C corporation that converted to a REIT because the REIT was not engaged in the active conduct of a trade or business. Interestingly, in "obsoleting" Revenue Ruling 73-236, the IRS notes that in doing so, it does not imply a view as to whether a distribution of stock involving a REIT election by the distributing or the controlled corporation would otherwise satisfy the requirements of Section 355. This would include, says the Service, the business purpose requirement of Reg. §1.355-2(b).

All the Fuss?

Maybe this doesn't seem too significant, but there has already been some fuss over this new ability of firms to spinoff land. Revenue Ruling 2001-29 could clearly allow companies to reduce their tax burden by moving real estate assets off of their books and paying rent to a REIT which holds the property. The Wall Street Journal quickly noted that the ruling (as with all published rulings) was not specific as to a particular company. However, it is considered to have cleared up a "knotty" tax issue involving a merger in the forest products industry. Plum Creek Timber Co., a REIT based in Seattle owning substantial timberlands, last year agreed to buy Timber Co., a non-REIT, plus the timber harvesting unit of Georgia-Pacific Corp. The all-stock deal agreed to last year was supposed to be worth $3 billion. See Starkman, "IRS Rules Firms Can Spin Off Land to Cut Their Taxes," Wall Street Journal, June 6, 2001, p. A4.

Georgia-Pacific has said the company expected the IRS ruling, but will nevertheless pursue a private letter ruling as to its particular deal (with $3 billion involved, wouldn't you?!). The Wall Street Journal notes the helpful clearing of ambiguity, something that the Service sometimes doesn't address for many years. Here, the IRS had in the 1973 revenue ruling defined REITs as passive-investment vehicles and has never explicitly changed that definition — despite the 1986 amendments to the Code that allowed REITs to actively manage their portfolios. Revenue Ruling 2001-29 is the first recognition that explicitly defines a REIT's current business and operations as "active" for purposes of Section 355.

M&A Maven

Robert Willens, Managing Director at Lehman Brothers Holdings, Inc. — and a M&A Tax Report Advisory Board Member — was quoted as succinctly characterizing the impact of the ruling as "huge." Id. Indeed, he pointed out that companies such as McDonald's Corp. and Wal-Mart Stores, Inc. could spinoff their real estate assets to shareholders in tax efficient REITs.

Not far behind our own Robert Willens' trumpeting of the anticipated and potential uses of Revenue Ruling 2001-29 was The Wall Street Journal's coverage of peripatetic corporate tax revolutionary (sorry, Lee, but the description fits), Lee Shepherd. As many M&A Tax Report readers know, Lee Shepherd is a contributing editor for Tax Notes, the hugely followed weekly tax newsletter published by tax publishers (and Freedom of Information Act specialists), Tax Analysts of Arlington, VA. Lee Shepherd is famous (or is that infamous?) for criticizing tax breaks for big business. (I remember seeing Lee speak to a group of conservative corporate tax advisors, with a lot of mouths agape!)

Still, Lee gave an uncharacteristic blessing to this Revenue Ruling 2001-29, saying it was "nice" from a tax perspective, but she questioned whether real estate was that burdensome a thing to own, whether companies would really need tax deductions [for the rent paid to a REIT], etc. See Starkman, "IRS Rules Firms Can Spin Off Land to Cut Their Taxes," Wall Street Journal, June 6, 2001, p. A4.

The Financial Times covered the ruling, too, also quoting Willens, and also mentioning potential for companies like McDonald's. See Cohen and Edgecliffe-Johnson, "IRS to Allow Real Estate Spin-Offs," Financial Times, June 7, 2001, p. 20. But shortly thereafter, the same paper cautioned that investors should not get too excited. Indeed, it quoted Wal-Mart as saying there was no plan to do a REIT spin, and it pointed out lack of diversification and even post-spin conflict of interest issues. Id.

A Few Comments, Please?

Despite what I view as the universally positive nature of Revenue Ruling 2001-29, it is interesting to note comments submitted in mid-May to Commissioner Rossotti about the then-proposed (and now issued) ruling. The Committee on Real Estate of the American Bar Association Section of Taxation (along with a few other reviewers) made comments to the Commissioner about the proposed ruling which would modify or get rid of the now antiquated Revenue Ruling 73-236, 1973-1 C.B. 183. Although revenue rulings perhaps cannot (or should not, anyway) go into extreme detail about the background of a change and all of the authorities, these comments (dated May 17, 2001) are extraordinarily useful in reviewing what came out (and what went behind) the IRS' ruling.

The proposed ruling described in the May 17, 2001 ABA comments to Commissioner Rossotti described two different situations (not one situation, as the ruling was issued). The second situation which was described in the ABA's comments was a spinoff based on facts similar to those described in Revenue Ruling 92-17, 1992-1 C.B. 142, which concerned a general partner of an operating partnership, the general partner performing sufficient operational and management functions for the operating partnership with respect to the leasing of real estate. Predictably, the ABA committee members commenting to the Commissioner recommended that the general partner in that circumstance should also be treated as engaged in the active conduct of a trade or business for purposes of Section 355(b).

Actually, Revenue Ruling 92-17 had not involved a REIT. Rather, 92-17 concluded that a corporation acting as a general partner of a limited partnership was engaged in a trade or business when its officers performed active and substantial management functions with respect to the limited partnership's commercial real estate business. In effect, the ABA committee members sought to extend (quite reasonably in my view) the logic of Revenue Ruling 92-17 to REITs.

Conclusion

Notwithstanding the brevity of Revenue Ruling 2001-29, it is an enormously important and effective revenue ruling — not overstated by M&A Tax Report advisor Bob Willens. Will real estate spins truly start big time now? We'll be watching...

REIT Spinoffs, Vol. 9, No. 12, The M&A Tax Report (July 2001), p. 1.