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THE JOURNAL OF THE AMERICAN TAXATION ASSOCIATION American Accounting Association Vol. 38, No. 2 DOI: 10.2308/atax-51540 Fall 2016 pp. 21–26

DISCUSSION OF

Taxes, Investors, and Managers: Exploring the Taxation of Foreign Investors in U.S. REITs

Stacie K. Laplante University of Wisconsin–Madison

INTRODUCTION

H oward, Pancak, and Shackelford (2016; hereafter, HPS) examine a 2004 tax law change that lowered the withholding

tax rate on capital gain distributions to investigate the effect of taxes on the responsiveness of foreign investors and

managers of publicly traded U.S. real estate investment trusts (REITs). Prior to the law change, a 35 percent

withholding rate applied to capital gain distributions from U.S. REITs to foreign investors, and subjected the foreign recipient

to mandatory filing of U.S. tax returns. After the change, the withholding rate fell to a rate specified in the tax treaty between

the U.S. and the foreign country, ranging from 10 percent to 30 percent. The U.S. tax return filing requirement was also

abolished for foreign investors that owned less than 5 percent of the REIT during the preceding year. HPS predict and find a

significant negative coefficient on the 2005 tax rate, consistent with an increase in foreign investment into U.S. REITs that

varies by the amount of the rate reduction (i.e., the bigger the tax rate reduction, the bigger the increase in foreign investment in

the REIT in 2005). HPS also predict that REIT managers increase capital gain realizations after the rule change. While they do

not find evidence of an immediate impact of the lower withholding rates on REIT managers’ capital gains realizations, HPS

show an effect when they expand the sample through 2009.

Consistent with the ‘‘all parties’’ idea in the Scholes et al. (2015) framework, HPS identify an interesting setting to study parties directly affected by a tax change, foreign investors, as well as those indirectly affected, REIT managers. Because the

2004 law change differentially affects a specific group of REIT investors, it is a powerful setting for HPS to investigate their

questions empirically. I begin my discussion with an overview of the evolution of REITs to provide additional context for the

setting of the study and to help motivate my primary observations. I end my discussion by arguing that it appears possible to

interpret some of the information provided in HPS to help policymakers understand how investors and managers will respond

to tax law changes, as advocated by Clemons and Shevlin (2016 ).

BACKGROUND

A REIT is a public or private entity that owns, operates, develops, and/or finances income-producing real estate. 1

REITs

were created in 1960 as part of the Cigar Excise Tax Extension Act to facilitate long-term financing of commercial real estate.

Certain rules must be met to qualify for REIT status. To qualify as a REIT an entity must, among other things, (1) otherwise be

taxable as a corporation but for its REIT status; (2) have at least 75 percent of its assets and gross income connected to real

estate; (3) derive at least 75 percent of gross income from real estate activities, such as rent, interest on mortgage financing, and

sales of real estate; (4) pay at least 90 percent of taxable income to shareholders each year as dividends; (5) have a minimum of

I appreciate helpful comments from Margot Howard, Kenneth J. Klassen, and Dan Lynch. I thank Timothy Riddiough and Michael Grupe for helpful discussions and materials. I am especially grateful to Kenneth J. Klassen and the other members of the 2016 JATA Conference Committee for providing me the opportunity to discuss this paper.

The comments contained in this discussion pertain to the conference version of the paper.

Editor’s note: Accepted by Kenneth J. Klassen.

Submitted: July 2016 Accepted: July 2016

Published Online: July 2016

1 See https://www.reit.com/ for more information on REITs.

21

100 shareholders; (6 ) allow no more than 50 percent of the shares to be owned by ‘‘five or fewer’’ individuals during the last half of its taxable year; and (7) be managed by a board of directors or trustees (SEC 2012). If an entity qualifies as a REIT, then

it escapes entity-level tax on earnings that are distributed to shareholders.

Evolving REIT rules and economic fluctuations influence the attractiveness of investing in REITs as well as REIT

managers’ behavior. REIT growth was slow and variable from 1960 to the early 2000s (see Figure 1). By 1973, the market

capitalization of all classes of REITs (equity, mortgage, and hybrid) reached $1.4 billion, driven by mortgage REITs engaged in

land development and construction financing (NAREIT 2015b). It fell back to $712 million in 1974 before resuming its ascent.

In 1980, Congress enacted the Foreign Investment in Real Property Tax Act (FIRPTA) as a means to tax the gains on non-U.S.

investors’ income from the sale of U.S. real property. As HPS explain, FIRPTA levied fairly harsh taxes on capital gains

distributions from REITs to foreign investors. It also imposed U.S. filing requirements on foreign investors receiving capital

gains distributions. Combined, FIRPTA arguably dampened the desirability of REITs as an investment opportunity for foreign

investors and possibly altered managers’ asset investing activity (e.g., Baily and Slaughter 2009).

After FIRPTA rules were implemented, multiple law changes affecting REITs occurred. Some of the more substantial

changes include the following:

1. The Tax Reform Act of 1986 (TRA 86 ) included passive activity loss rules that curtailed the ability of limited

partnerships to pass through losses. TRA 86 helped level the playing field with respect to attracting investors because

REITs have never been allowed to pass losses on to investors. TRA 86 also contained provisions to allow REITs to be

internally advised and managed.

2. The Omnibus Budget Reconciliation Act of 1993 altered the ‘‘Five or Fewer’’ rule to count each pension plan beneficiary as one investor instead of the plan itself as one investor, opening the door for pensions to invest in REITs.

FIGURE 1 U.S. REIT Industry Equity Market Capitalization

(Millions of Dollars at Year End)

Source: NAREIT (2015a).

This figure plots the market capitalization of all tax-qualified real estate investment trusts (REITs) with more than 50 percent of total assets in qualifying real estate assets other than mortgages secured by real property that are listed on the New York Stock Exchange, the American Stock Exchange, or the NASDAQ National Market List.

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3. A 1997 agreement between the U.S. Department of the Treasury and the Joint Committee on Taxation allowed for a

15 percent withholding tax on dividends paid by publicly traded REITs to any shareholder, including foreign

investors, owning 5 percent or less interest in the REIT. This did not cover capital gain distributions to foreign

investors, but anecdotal evidence suggests it opened the door to foreign capital flowing into U.S. REITs (see NAREIT

2015a).

4. In 2003, the U.S. and U.K. signed a new tax treaty allowing U.K. pension funds to invest in U.S. REITs without any

withholding taxes.

5. As part of the American Jobs Creation Act of 2004 (AJCA 2004), foreign investors owning 5 percent or less of a U.S.

REIT were no longer subject to a withholding rate of 35 percent or mandatory filing of U.S. tax returns. This law

change is the focus of HPS’s manuscript.

6. The 2008 REIT Investment and Diversification Act allowed REITs to buy and sell assets more efficiently, increased

the size of allowable REIT subsidiaries, and relaxed rules related to healthcare REIT’s use of taxable subsidiaries.

7. The Protecting America from Tax Hikes Act of 2015 further eased FIRPTA’s grasp by increasing the ownership

percentage of a foreign investor that triggers the U.S. tax return filing requirement from 5 percent to 10 percent.

In addition to evolving REIT rules, other macroeconomic phenomena help explain why foreign investors are attracted to

U.S. REITs; and were even attracted prior to AJCA 2004 when 35 percent withholding tax rates and onerous U.S. tax filing

requirements existed. Evidence of macroeconomic effects is found in survey evidence gathered by the Association of Foreign

Investors in Real Estate (AFIRE). AFIRE is an organization whose members include foreign and domestic entities who invest

in real estate all over the world and their advisors, managers, accountants, and lawyers. 2

The organization claims to ‘‘have a

common interest in preserving and promoting investment in cross-border real estate’’ (available at: http://www.afire.org/Files/

2016_Survey/Public/2016_Survey_Press_Release.pdf ). AFIRE conducts an annual survey of its members to track global real

estate investment trends, asking both similar and new questions each year. The survey provides some insight into why foreign

investors willingly subjected themselves to scrutiny of the Internal Revenue Service prior to 2004, and why they might have

been more interested in investing when tax rate and filing requirements eased. In Table 1, I summarize the answers to two

questions from the 2004 through 2010 surveys. The first question is: ‘‘what country provides the most stable and secure real

estate investments?’’ The U.S. ranks first every year, with anywhere from 43 percent to 64 percent of the votes. The U.K. is

second in 2004–2006 and Germany is second in 2007–2010. Even in the depths of the recession from 2007–2009, the U.S.

procures nearly twice as many or more votes than the runner-up countries. The second pertinent question from the AFIRE

surveys is: ‘‘what country provides the best opportunity for capital appreciation?’’ The U.S. receives the most votes every year

in this category as well, with anywhere from 23 percent to 64 percent of the votes. The runner-up countries in this category vary

each year, receiving 10 percent to 30 percent of total votes. Combined, these votes suggest that the U.S. appears to be a

TABLE 1

Summary of AFIRE Annual Survey Questions

Year

What country provides the most stable and secure real estate investments?

What country provides the best opportunity for capital appreciation?

1st 2nd 1st 2nd

Country Votes Country Votes Country Votes Country Votes

2004 U.S. NA U.K. NA U.S. NA Japan NA

2005 U.S. NA U.K. NA U.S. NA China NA

2006 U.S. 64% U.K. 11% U.S. 23% India 18%

2007 U.S. 57% Germany 11% U.S. 26% China 21%

2008 U.S. 53% Germany 11% U.S. 37% Brazil 16%

2009 U.S. 43% Germany 22% U.S. 50% U.K. 30%

2010 U.S. 44% Germany 22% U.S. 64% China 10%

Data are taken from Association of Foreign Investors in Real Estate (AFIRE) annual surveys. See https://www.afire.org/ for additional information and survey results after 2010.

2 Membership in AFIRE is by invitation only. See http://www.AFIRE.org/ for more details.

Discussion of: Taxes, Investors, and Managers: Exploring the Taxation of Foreign Investors in U.S. REITs 23

The Journal of the American Taxation Association Volume 38, Number 2, 2016

consistently desirable destination for foreign investment dollars, potentially reflecting well-developed property rights protected

by a reliable court system, a stable political system, and a fairly robust and resilient economy.

Figure 1 depicts the culmination of the evolving REIT rules coupled with economic fluctuations both in the U.S. and

abroad on the REIT industry. Continuing its slow ascent from the mid-1970s, the market capitalization of U.S. REITs began to

grow, accelerating around 2002 and reaching $438 billion in 2006. By 2008, however, REIT market capitalization fell by more

than 50 percent to under $191 billion as the financial crisis took its toll. The subsequent recovery sees market capitalization

reaching nearly $939 billion at the end of 2015.

OBSERVATIONS OF HPS

With the exception of 2007 and 2008, it appears from Figure 1 that the market capitalization of publicly traded U.S. REITs

benefited dramatically in the 2000s from a combination of laxer rules and broader economic circumstances. This leads to the first

two observations of HPS. First, in H1 the manuscript states that it seeks to test the responsiveness of foreign investors to the change in the withholding tax rate on capital gain distributions from REITs that occurs in 2004. Responsiveness implies action on part of

the foreign investors. However, in tests of H1, the responsiveness of foreign investors, Foreign Investment, is measured as the market value of the foreign investment in a particular REIT calculated as the number of shares held by foreign investors times the

market price for December of the corresponding year. The underlying assumption is that the increase in market price is unrelated to

the foreign investors’ change in tax rate, which is reasonable given foreign investors hold, on average, only 1.53 percent of the

REIT shares in the sample. However, it does not seem necessary to include market price in the proxy for responsiveness of foreign

investors because the market price is a function of the actions of all investors. A more direct measure of foreign investors’ behavior,

such as the number of common shares held by the foreign owners in each REIT before and after the rule change, could be a better

proxy to capture the underlying construct of the responsiveness of foreign investors to the rule change.

Second, H2 tests the responsiveness of REIT managers to changes in the REIT distribution tax rates. HPS report evidence

in Table 4 that suggests there is no change in REIT managers’ capital gain realizations in 2005 after relaxation of the FIRPTA

rules. HPS argue that the failure to reject the null could arise from the small sample size (n ¼ 61) or because the sale of large commercial property takes too much time to be detected in a single year. An alternative explanation for the lack of results in

2005, however, is that REIT managers faced restrictions on selling property, thereby limiting their ability to respond to

favorable tax rate changes for foreign investors. Prior to 2008, REITs were subject to a prohibited transaction tax of 100 percent

of the net profit on sales of assets that did not meet certain requirements. The tax was applied unless assets were held for a

minimum of four years and (1) the REIT made no more than seven sales within a tax year; or (2) if more than seven sales

occurred, total asset sales amounted to no more than 10 percent of aggregate beginning of year bases of all REIT assets (I.R.C. Section 857(b)(6 )(C) and (D) prior to the enactment of the 2008 REIT Investment and Diversification Act). According to

Cullen (2009, 27), ‘‘given the punitive nature of this ( prohibited transaction) tax, REITs almost always structure their dispositions in a manner that qualifies for the safe harbor from this tax.’’ Therefore, despite the lower withholding rate on capital gains distributions, the severe restrictions on REIT managers’ ability to time capital gains did not ease until 2008.

HPS address the stated reasons for lack of findings related to H2 by extending the sample period through 2009, thereby

increasing their sample size from 61 to 353, and allowing additional time for commercial real estate sales to occur. However, in

2008, the REIT Investment and Diversification Act substantially eased the burden of the prohibited transaction tax by reducing

the minimum holding period of assets within the REIT by half, to two years, and allowing the amount of total asset sales to no

more the 10 percent of the fair market value of all REIT assets (as opposed to 10 percent of the bases) (I.R.C. Section 857(b)(6 )(C) and (D)). These changes to the safe harbor rules provided ‘‘much needed additional flexibility to REITs to dispose of assets during these troubled economic times’’ (Cullen 2009, 30). The changes also provide an alternative explanation for the evidence related to H2, reported by HPS in the last column of Table 4, Panel B. These unrelated changes in 2008 increased

REIT managers’ ability to recognize capital gains. Therefore, it is not surprising that managers appear to respond to lower

withholding tax rates by recognizing more capital gains for the expanded 2005–2009 sample period. One way of alleviating this

issue could be to examine the change in 2005–2007 and 2008–2009 separately to disentangle the two effects.

The next observation of HPS relates to the economic interpretation of their results. Clemons and Shevlin (2016, 33) provide

suggestions to help make academic tax accounting research pertinent to policymakers by, among other things, providing ‘‘detailed interpretations and implications of the research results.’’ Policymakers are interested in the economic consequences of law changes, arguably favoring rules that increase the efficiency of markets without substantially reducing the amount of tax

collections. HPS carefully point out that their findings are consistent with the loosening of the FIRPTA rules in 2004 affecting

foreign investment in U.S. REITs but do not speak to any changes in total inbound investment in U.S. real estate. 3

However, the

3 This makes sense because their data do not capture total inbound investment in the U.S., or any shifting in investments between private REITs or other forms of investing in U.S. real estate (e.g., through partnerships) and public REITs.

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statistics documented by HPS provide an opportunity to estimate forgone tax revenue from the sample REITs subject to the 2004

reduction in withholding taxes, by taking into account the changes in capital gain distributions from 2004 to 2005. This

information is useful for two reasons. First, the FIRPTA rule changes affect an easily identifiable, narrow set of taxpayers,

providing an opportunity to incorporate the economic behavior into the calculation of the revenue effect. As Feldstein (1994, A14)

points out, estimating the tax revenue changes incorporating the effect on behavior ‘‘is important for evaluating the desirability of each specific tax proposal. Good tax policy needs good revenue estimates of each proposed tax change.’’

4 Second, FIRPTA rules

remain important to policymakers as evidenced by further relaxation of these rules in December 2015.

Based on information from Tables 2, 3, and 4 of HPS, I estimate the impact of the 2004 FIRPTA rule change on the

amount of withholding tax forgone by the U.S. Treasury and report the results in Table 2. I estimate the withholding tax

separately for 2004 and 2005, and report the average, minimum, median, and maximum amounts. The estimated annual

withholding tax lost is the difference between these two amounts and averages approximately $28,238; ranging from $0 to

$3,289,027. Note that the upper bound of this range assumes that the highest percentage of foreign ownership belongs to the

REITs with the biggest capital gains. Given the gross tax receipts of the U.S. government in 2005 were approximately $2.15

trillion, 5

this admittedly very rough calculation reveals that the U.S. government forfeited a miniscule amount of tax revenue in

2005 related to the FIRPTA rule change. Given HPS could provide a more accurate calculation using the data underlying the

descriptive statistics, they have a potential opportunity to provide policymakers with useful data related to the relaxation of the

FIRPTA rules.

CONCLUSION

Howard, Pancak, and Shackelford (2016 ) provide evidence that withholding taxes on capital gains distributions are

associated with the behavior of parties directly and indirectly affected by the tax, foreign investors in U.S. REITs, and REIT

managers. REITs are entities that must follow strict, yet evolving, rules to enjoy the benefits of a single level of taxation. Given

the additional tax law changes that occurred in December 2015 to the same rules governing REITs that are the subject of this

study, HPS identify an interesting and timely topic that has broad appeal.

I offer three primary observations of HPS. In tests of foreign investors’ responsiveness to rule changes, H1, the proxy for

investor responsiveness, includes the number of shares outstanding as well as the market price. Given the study occurs when

the market capitalization of all U.S. REITs is growing quickly, a more direct measure of investor responsiveness is the number

TABLE 2

Calculation of Forgone Withholding Tax Revenue

Average Minimum Median Maximum

Capital Gains (2005) $34,700,000 $— $3,400,000 $242,900,000

Foreign Ownership ( percent) 3 1.53% 3 0.01% 3 1.18% 3 4.46%

Capital Gains—Foreign $530,910 $— $40,120 $10,833,340

Withholding Tax Rate 3 20.2% 3 10.0% 3 15.0% 3 30.0%

Withholding Tax (2005) $107,244 $— $6,018 $3,250,002

Capital Gains (2004) $25,300,000 $— $2,500,000 $418,900,000

Foreign Ownership ( percent) 3 1.53% 3 0.01% 3 1.18% 3 4.46%

Capital Gains—Foreign $387,090 $— $29,500 $18,682,940

Withholding Tax Rate 3 35% 3 35% 3 35% 3 35%

Withholding Tax (2004) $135,482 $— $10,325 $6,539,029

Withholding Tax (2004–2005) $28,238 $— $4,307 $3,289,027

Capital Gains (2005) and (2004) is reported in Table 4 of HPS and represents the total capital gain distributions per share (NAREIT 2015a) multiplied by common shares outstanding (CRSP). Foreign Ownership ( percent) is reported in Table 2 of HPS and is calculated as the number of shares held by the foreign owners (FactSet) multiplied by the share price for December (CRSP) divided by common shares outstanding (CRSP). The same percentage is used for 2004 and 2005 because I am not able to calculate the foreign ownership percentage separately for each year based on the available data. Withholding Tax Rate is reported in Table 3 of HPS for 2005 and is the statutory maximum rate of 35 percent for 2004.

4 From the data presented in HPS, it is not possible to incorporate changes in the foreign investment from 2004 to 2005. It is unclear whether the percent of foreign ownership reported in Table 2 of HPS is an average of 2004 and 2005, or if it is from only one of the years.

5 See https://www.whitehouse.gov/omb/budget/Historicals/ for details.

Discussion of: Taxes, Investors, and Managers: Exploring the Taxation of Foreign Investors in U.S. REITs 25

The Journal of the American Taxation Association Volume 38, Number 2, 2016

for foreign shares outstanding excluding the market price. In tests of REIT managers’ responsiveness to the 2004 FIRPTA rule

change (H2), it is important to acknowledge that managers faced a severe constraint on selling assets prior to 2008 in the form

of a prohibited transaction tax. I end my discussion by arguing that it appears possible to interpret some of the information

provided in HPS to help policymakers understand how investors and managers will respond to these law changes, as advocated

by Clemons and Shevlin (2016 ). Overall, I think HPS identify an interesting setting and contribute to the literature that

examines the effect of tax law changes on direct, as well as indirect, beneficiaries of the change.

REFERENCES

Baily, M. N., and M. J. Slaughter. 2009. How FIRPTA Reform Would Benefit the U.S. Economy. Available at: http://www. investinamericacoalition.org/docs/what-others-are-saying/firpta-report-1019.doc?sfvrsn¼2

Clemons, R., and T. Shevlin. 2016. The tax policy debate: Increasing the policy impact of academic tax accounting research. The Journal of the American Taxation Association 38 (1): 29–37.

Cullen, D. F. 2009. The new REIT prohibited transactions safe harbor. Journal of Passthrough Entities (January/February): 27–30. Feldstein, M. 1994. The case for dynamic analysis. Wall Street Journal (December 14): A14. Howard, M., K. A. Pancak, and D. A. Shackelford. 2016. Taxes, investors, and managers: Exploring the taxation of foreign investors in

U.S. REITs. The Journal of the American Taxation Association 38 (2). National Association of Real Estate Investment Trusts (NAREIT). 2015a. Understanding Mortgage REITs. Available at: https://www.reit.

com/

National Association of Real Estate Investment Trusts (NAREIT). 2015b. Industry Timeline. Available at: https://www.reit.com/ investing/reit-basics/reit-industry-timeline

Scholes, M. S., M. A. Wolfson, M. Erickson, M. Hanlon, E. L. Maydew, and T. Shevlin. 2015. Taxes and Business Strategy. Boston, MA: Pearson Print.

Securities and Exchange Commission (SEC). 2012. Real Estate Investment Trusts (REITs). Available at: https://www.sec.gov/answers/ reits.htm

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