As the world emerges from its pandemic haze, various sectors of the economy are recovering differently and at different paces. For managers of Real Estate Investment Trusts, or REITs, who likely encountered earnings volatility and concomitant unpredictability regarding valuations and cash flow—this recovery period presents some challenges and opportunities. Among those is the issue of REIT transfer pricing. One of many planning opportunities for management in the post-Covid era—when uncertainties remain—is to evaluate whether intercompany arrangements between the REIT and its taxable REIT subsidiaries, or TRS, meet the arm’s length standard outlined in Internal Revenue Code section 482.
Arm’s Length at a Glance
The arm’s length principle—the standard adopted by section 482—is the foundation of transfer pricing. It states that the price changed in a controlled transaction between two related parties—in this case, the REIT and its TRS—is equal to that in a transaction between two unrelated parties on the open market. Therefore, a controlled transaction meets the arm’s length standard when the results are consistent with those realized between uncontrolled taxpayers in the same transaction. It comes down to comparable transactions under comparable circumstances. The arm’s length standard in intercompany arrangements applies particularly to the lodging and health-care verticals.
The REIT Investment Diversification and Empowerment Act of 2007, commonly referred to as RIDEA, provided guidance allowing a REIT to lease property to its TRS entities and treat the rent as qualifying 75% gross income under two conditions:
- The property in question is a qualified health-care (section 856(e)(6)(D)) or lodging facility (section 856(d)(9)(D)) and
- The property is managed by an eligible independent contractor (section 856(d)(9)(A))
This structure is commonly referred to as a standard PROPCO/OPCO structure in which the REIT, the PROPCO—as the real estate owner—enters into an arm’s length transaction to lease the property to the TRS, the OPCO; the OPCO must indirectly operate the health-care or lodging facility through an eligible independent contractor. The TRS is a corporation subject to corporate-level tax on the net income generated.
Under the arm’s length rule for REITs defined under section 856(d)(8)(A)(ii) (6), the rent that the TRS pays to the REIT must meet the “substantial comparability requirement,” meaning the rent paid by the TRS to the REIT is substantially comparable to such rents paid by the other tenants of the REIT’s property for comparable space. If the rent does not meet this criterion, it is subject to a 100% excise tax imposed under section 857, assessed by the IRS on any amount of “redetermined rent” that was not set at arm’s length.
Updated Study Can Mitigate Risk
Risk management is a primary focus for management in any business. With tenants struggling to meet their lease obligations resulting from business disruptions and a workforce in flux, commercial real estate owners are facing greater challenges managing risk. Given the potential for a tax audit in an intercompany arrangement, careful consideration should be given as to whether lease modifications satisfy the arm’s length standard under section 482. Therefore, REITs are well advised to engage in an updated transfer pricing study to reduce audit risk in an intercompany arrangement.
The IRS regulations in section 482 allow for various testing methodologies to evaluate intercompany rents and determine if they fall within arm’s length; the most common benchmark used in these assessments are third-party comparables.
With the recent market volatility and business disruptions due to COVID-19, and the challenges experienced in the real estate sector, the Organisation for Economic Co-operation and Development, or OECD, endorsed the use of “transfer pricing adjustments” to help taxpayers through the challenges of COVID-19 in a Dec. 18, 2020 publication.
Aside from the tax audit risk associated with redetermined rent, REITs have other reasons to consider updating their transfer pricing. These include liquidity management, improved earnings, and Sarbanes-Oxley controls for public companies, including:
- Managing liquidity. If the TRS is paying below-market rent in a healthy market, this will create excess cash, earnings, and therefore, taxable income for the TRS.
- Improved Financial Earnings. It is possible for REITs to improve short-term earnings based on their ability to release valuation allowances that have accumulated over time for tax provision purposes. These valuation allowances result from TRS net operating losses generated by above-market leases paid to the REIT. By releasing these valuations allowances, a net tax benefit could be created while enabling the TRS to continue relying on net operating losses to offset taxable income.
- Sarbanes-Oxley—SOX—Controls. SOX controls that govern public companies should include language for REITs regarding arm’s length; specifically, that REITs annually review their intercompany arrangements to determine that they are and will continue to comply with arm’s length guidance. This is especially pertinent to those lodging and healthcare REITs whose cash flows are beginning to increase as they gradually recover from the pandemic lockdowns and now operate in a more opened-up (albeit a somewhat cautious) market. Leases that were signed pre- pandemic, or that were renegotiated based on the uncertainty brought on by COVID-19, may no longer fall within arm’s length criteria.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Stephen Bertonaschi is a senior managing director in the Tax Advisory group within the Real Estate practice at FTI Consulting, Inc.
Kenneth R. Bernice is a managing director in the Tax Advisory group within the Real Estate practice at FTI Consulting, Inc.
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