If you have a real estate investment trust (REIT), a taxable REIT subsidiary (TRS) may play a critical function in supporting its commercial success while safeguarding the favorable tax status it enjoys. Here, we answer common questions about REITs and discuss how to leverage transfer pricing and protect your income in a REIT scenario.
How can a REIT help protect income?
Under Internal Revenue Code (IRC) Section 856, REITs retain their tax status only if, among other conditions, they meet various gross income tests relating to real estate and portfolio-related income and other non-real estate-related income. Real estate and portfolio-related income is often referred to as good income, while other non-real estate-related income is considered bad income.
By forming a TRS, bad income may be kept separate from that of the REIT and allow it to pass the gross income tests of IRC Section 856.
Because TRSs are treated as C corporations for US tax purposes, transactions between REITs and their taxable subsidiaries should be at arm’s length, priced as if between third parties. Transfer pricing rules exist to ensure that an appropriate amount of taxable income is reflected at different entities within a controlled group. IRC Section 482 provides the US transfer pricing rules.
By following and demonstrating that it follows the transfer pricing rules with respect to transactions between the REIT and its TRSs, a REIT can mitigate a threat to its tax status.
Is the IRS placing increased focus on REIT-TRS transactions?
Yes. In recent years, the IRS has increasingly scrutinized and challenged REIT-TRS transfer pricing arrangements.
If the REIT-TRS group undertakes intercompany transactions not at arm’s length—for example, excessive rent to the REIT or excessive deductions for the TRS—a 100% excise tax could be applied to the resulting income or deductions.
What are some examples of the IRS’s increased focus?
The IRS asserted that the REIT overcharged rent to the TRS, and imposed a 100% federal excise tax on the amount by which the rent was held to be greater than the arm’s length rate—namely, $3.3 million for 2008 and a TRS adjustment of $1.6 million for agreeing to be party to the REIT’s bank loan agreement.
La Quinta Corporation
La Quinta Corporation was a former REIT of La Quinta Holdings and is now part of Corepoint Lodging. The IRS asserted that the REIT overcharged rent to the TRS, and the IRS imposed a 100% excise tax on the REIT of $158 million for 2010 and 2011.
What types of transactions would be prone to IRS scrutiny?
The most likely candidates to attract IRS attention would involve some or all of the following transaction types:
- Rent. A REIT may lease space to its TRS; the resulting rent would be a deduction for the TRS, so the IRS would be concerned with rent above a market rate.
- Service Fees. A TRS may provide a range of services to its REIT; the service fees would constitute income to the TRS, so the IRS would be concerned if there’s any undercharge for the services.
- Financing. A REIT and its TRS may enter into intercompany lending arrangements between one another or one may guarantee the borrowing of the other; the IRS would want to ensure the interest payments or guarantee fees are arm’s length.
- Sharing of resources. A REIT and its TRS may share resources such as office space or employees; the IRS would expect the method of allocating costs between the two be reasonable.
How can you mitigate the risk of an IRS audit?
At a minimum, IRS audits can be expensive and time-consuming, whether you use your personnel or hire an outside service provider. In the worst case, however, a REIT can jeopardize its tax status if it’s found substantially in breach of REIT rules.
Transfer Pricing Studies
A prudent strategy to mitigate risk and proactively short-circuit an IRS audit before it even begins would be to prepare a transfer pricing study under Section 482 that benchmarks the REIT-TRS transactions and documents they’re indeed arm’s length. There are two common types of transfer pricing studies—a planning study and a documentation study.
A planning study is a forward-looking analysis that suggests appropriate intercompany charges before the transaction occurs. It’s often adopted when a new transaction is being entered into because of an acquisition, a restructuring, or an operational change.
A documentation study, on the other hand, uses the principles of Section 482 to defend existing and historic transfer pricing arrangements. It can be very beneficial when your organization is under IRS audit or trying to support a financial statement position.
What would a transfer pricing study show?
In general, there are two approaches that could be used to defend a REIT’s transfer pricing.
In the first method, the focus is on profitability of the TRS. If, as a result of the transfer pricing, the TRS can be shown to be making an industry normal amount of profit, then a conclusion could be reached that the transfer pricing is reasonable. What’s normal is established by looking at profitability earned by independent public companies undertaking similar activities to the TRS. For example, if the TRS is providing property management services or maid services, then the right benchmarks might be comparable service providers.
Return Earned by REIT
The second tactic is to test the return earned by the REIT. There are certain summary metrics that gauge the financial performance of the property. One of these is the capitalization rate, namely, the ratio of net operating income to property asset value.
Another, more commonly used metric is the internal rate of return (IRR). Technically, this is the discount rate that renders the net present value of all cash flows from a project equal to zero; it’s easier to understand as an indicator of the profitability of a project. Industry data on capitalization rates and IRRs for different types of property allow a comparison between the REIT’s IRR and those of comparable properties.
What are the next steps?
For organizations that have a REIT, here are next steps for leveraging transfer pricing.
- A REIT with taxable subsidiaries should create a mapping of its intercompany transactions. It’s important not to overlook transactions just because they’re not currently charged for, such as implicit loan guarantees.
- For each intercompany transaction, the basis for the pricing should be confirmed. For example, if services are charged at a cost-plus 5% rate, how are costs calculated, and where did the markup percentage originate?
- The next step would be to develop documentation to support the pricing arrangements so that if an audit were to occur, the REIT would be well-positioned to respond.
- To the extent transactional pricing support or documentation are weak, a REIT may want to consider engaging third-party help.
We’re Here to Help
If you have questions or would like assistance with a transfer pricing study, please contact your Moss Adams professional.