Last week, Congressman Kevin Brady, the Chairman of the House Ways and Means Committee, published a proposed tax extenders bill. Although the general purpose of extender bills is to renew expiring provisions of the tax law, this particular bill unexpectedly includes an amendment that would put an end to tax-free spinoffs of real estate investment trusts (REITs) from operating corporations. Tax-free REIT spinoffs are rare and do not appear to meaningfully affect tax revenue, so the government does not have a serious tax-revenue stake in this law change. Instead, managers of operating corporations that own real estate and activist investors who seek to compel managers to spin off real estate into REITs have the most at stake in this change. Activist investors support tax-free REIT spinoffs. Managers support taxing REIT spinoffs. Congress is taking the side of managers.
Consider why activist investors support tax-free REIT spinoffs. Activist investors are most likely to gain control, or significant influence, of companies that are struggling financially. Most such companies are saddled with debt and suffering from declining stock value. Activist investors recognize that REIT spinoffs of such companies accomplish two purposes. First, the price of a company's stock often surges on the announcement of a REIT spinoff. This may be caused by a number of factors. For one, investors prefer stock in REITs over stock in other types of corporations because tax law requires REITs to distribute at least 90% of their taxable income, and investors pay more for stock that has regular dividends. Whatever the cause of the surge, shareholders stand to gain from the announcement of a REIT spinoff.
Second, a REIT spinoff can help improve a company's debt rating. An operating company spins off real estate assets with debt that encumbers the property, so REIT spinoffs remove debt from the operating company's balance sheet. The improved balance sheet results in better debt ratings and makes capital more affordable for the company. This result is a bit of smoke and mirrors because the operating company must use the spun-off real estate assets for its operations, and it enters into long-term leases with the REIT to use the real estate. Those leases obligate the company to pay an amount of rent that can be equivalent to the amount paid to service the former debt. Thus, the long-term lease is substantively very similar to debt, but the rating agencies treat them differently. Operating companies stand to benefit from that disparate treatment by spinning off their real estate holdings and debt.
Not surprisingly, ailing companies stand to gain more from REIT spinoffs than healthy companies do. A spinoff announcement would affect the stock price of ailing companies disproportionately more than it would the stock price of healthy companies, and, with poor debt ratings, unhealthy companies have more to gain from removing debt from their balance sheets. For such companies, obtaining tax-free status at the corporate level is irrelevant. In fact, some companies spinoff their real estate holdings using taxable sale-leaseback structures. Tax-free status therefore only becomes relevant to the shareholders who receive distributions of the new REIT stock tax free. Activist investors on boards of ailing corporations recognize the non-tax benefits of REIT spinoffs and can pursue such deals for ailing companies with less attention to the tax aspects of the transactions. Even if ailing companies would continue to do REIT spinoffs after a law change, those types of spinoffs are proverbial low-hanging fruit. To scale REIT spinoffs activist investors need the law to remain the same.
Now consider why managers support taxing REIT spinoffs. Convincing, or compelling, a healthy, thriving company to do a REIT spinoff would require significant effort, and the tax treatment of such a transaction will influence whether the spinoff happens. If a healthy company and its shareholders must recognize and pay tax on a REIT spinoff, tax will most likely tip the scales in favor of not spinning off the assets. Consequently, managers, who wish to retain control of real estate assets, favor taxing REIT spinoffs and support the proposed change because it would help them fend off activist investors. Activist investors would face impossible headwinds campaigning for spinoffs with the specter of additional tax working against them. Taxing REIT spinoffs therefore empowers managers in their struggle to retain control of corporate assets.
The irony of the proposed tax on REIT spinoffs is that it is contrary to one of the original purposes of the corporate tax. At the turn of the twentieth century, when the original corporate tax was enacted, Congress intended to use the corporate tax to curtail the buildup of significant wealth and resources within corporations. At that time, the corporate tax was seen as an antitrust enforcement mechanism designed to restrict the buildup of corporate resources through taxation. The effect of taxing REIT spinoffs is contrary to the original antitrust purpose of the corporate tax--instead of encouraging the dispersion of assets, the tax on REIT spinoffs would dissuade such actions.
A corollary purpose of corporate tax is to prevent managers from amassing retained earnings taxed at a lower rate. At this point, it should be unsurprising that taxing REIT spinoffs is also contrary to this purpose of corporate tax. REIT spinoffs deplete retained earnings in two ways. First, the operating corporation must distribute earnings and profits as part of the spinoff, and, second, the payment of rent to the spun-off REIT restricts the future buildup of retained earnings, and REITs must distribute rental income to maintain their tax status. By taxing REIT spinoffs Congress is abandoning another purpose of corporate tax and paving the way for managers to amass significant retained earnings that are taxed at rates that are lower than the rates applicable to individual income.
The unintended consequences of taxing REIT spinoffs therefor appear to be two. First, taxing REIT spinoffs will have a chilling effect on transactions that might otherwise happen for non-tax reasons. Second, and related to the first, taxing REIT spinoffs weighs in favor of managers and is contrary to fundamental purposes of corporate taxation.
Congress should be slow to enact a law that is contrary to the original purpose of corporate tax. Congress should also be slow to enact a tax provision that could have a profound effect on the economic behavior of corporations. Finally, Congress should not be in the business of enacting laws that favor one constituency (corporate managers) over another (activist investors), without explicitly identifying its rationale for taking a side in business deals. Unfortunately, with the proposed legislation to tax REIT spinoffs, Congress has staked a claim in the ongoing struggle between managers and shareholders, and its claim is decidedly on the side of management.