Background

Under Section 897, foreign corporations and nonresident aliens are generally subject to US federal income tax on any gain arising from the disposition of a US real property interest (USRPI), which may include interests in certain domestic corporations. However, interests in REITs (and certain regulated investment companies) that are “domestically controlled” are not treated as USRPIs. A REIT generally is considered “domestically controlled” if less than 50% of the value of its stock is held “directly or indirectly” by foreign persons at all times during the five-year period ending on the date of the disposition of an interest in the REIT (or during the REIT’s existence if shorter).

On April 24, 2024, the Treasury and the IRS released final regulations (2024 Final Regulations), generally effective for transactions occurring on or after April 25, 2024, expansively interpreting the phrase “directly or indirectly” for purposes of determining whether a REIT is domestically controlled. The 2024 Final Regulations adopted a partial look-through approach, dividing owners into “non-look-through persons” and “look-through persons,” with only non-look-through persons being taken into account for purposes of determining whether a REIT is domestically controlled. While domestic C corporations were generally classified as non-look-through persons, the 2024 Final Regulations included a special look-through rule that required looking through any non-public “foreign-controlled” domestic C corporation in which foreign persons hold directly or indirectly more than 50% of the fair market value of the corporation’s outstanding stock, as well as a 10-year transition rule with respect to existing entities. For a detailed discussion of the 2024 Final Regulations, see our prior alert, “IRS Issues Final Regulations Addressing Ownership of Domestically Controlled REITs.”

The Proposed Regulations

The preamble to the Proposed Regulations states that the Treasury and the IRS have reconsidered their prior interpretation of “indirectly” reflected in the domestic corporation look-through rule and, upon further review, are now of the view that the text of Section 897(h)(4)(B), “as informed by the traditional tools of statutory construction, including evaluation of the provision’s purpose,” militate for treating an entity that is subject to US taxation as a non-look-through person. Accordingly, while the Proposed Regulations generally retain the 2024 Final Regulations, including the framework of “non-look-through persons” and “look-through persons,” they would remove the domestic corporation look-through rule and corresponding transition rule. Instead, all domestic C corporations would be treated as non-look-through persons in determining whether a REIT is domestically controlled.

The Proposed Regulations, upon finalization, would apply to transactions occurring on or after October 20, 2025. However, taxpayers may choose to apply the final regulations to transactions occurring on or after April 25, 2024. Taxpayers may also rely on the Proposed Regulations for transactions occurring before the date the Proposed Regulations are finalized. As a result, the Proposed Regulations would effectively retroactively revoke the domestic corporation look-through rule.